Conventional Financial System and

Islamic alternative
 Contents

 Saving and investment function;

 Financial intermediary and its types;
 Banking and Islam;
 Role of banks in economy;
 Structure of conventional model of banking;
 Comparison of Islamic and conventional banking;
 Possibility of Islamization of banking system;
 Q & A;

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 Saving and investment function

INCOME

CONSUMPTION BUSINESS
Individual

Business

Govt TAX GOVERNMENT

dis-savers
Firms

Institutions
SAVING DIRECT INVESTMENT
Individual

Business
Savers
INDIRECT INVESTMENT Govt

Firms
Indirect invetment is doen through financial
intermediaries like:
Banks, funds, investment trusts, and other Institutions
financial institutions

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 Financial intermediary and its types

 A financial intermediary is an institution, firm or individual who

mediates between two or more parties in a financial context;
 It facilitates in channeling of funds between those who have
(savers) and those who do not have (dis-savers);
► Banks:
 Commercial banks, Development banks and Investment banks;
► Saving associations;
► Loan associations;
► Credit unions;
► Credit societies;
► Post offices;
► Insurance companies;
► Brokerage houses;

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 Banking and Islam

 Although institutional presence of banks was not there in early Islamic

history but the function of saving and investment was there even before
Islam;
 The Mudarabah business between Rasoolullah (ؐ) and Ummul Moomineen
hazrat Khadejatul Kubra (RA) before Islam, was an example of financial
intermediation;
 Some other historical evidences prove this fact;
 Therefore contemporary scholars are of the view that banking itself is a
permissible concept and the issue is in methodology;
 If methodology is correct then the banking becomes acceptable to Islam;
 The Western model of banking is based on Lending and Borrowing on
interest which is not allowed in Islam;

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 Role of banks in economy

Exchange of financial assets on behalf of customers;

Exchange of own financial assets;
Provide safety of cash to depositors:
• Very important facility;
Investment device for market participants:
• Deposits are used in economy;
Platform for small savers:
• Small savers participate in economic functions through their investments;
Channelize idle wealth of society:
• The wealth was kept privately and becomes idle;
• An individual can also participate in economy;

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 Role of banks in economy

Assist in settlement of claims:

• Provide services for members of society;
• Check and payment instruments;
• Ease in payments;

Provide cash management services;

• No need for keeping books in home;

A governmental tool for monetary control;

• Hoarding and inflation control;
• Money supply to a particular sector;

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 Structure of conventional model of banking

 Receive deposit on interest;

 And give money on interest;

LEND
LEND

DEPOSITORS BANK CUSTOMERS

INTEREST INTEREST

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 Evolution of Islamic Banking at Global Level

 Credit Societies and Cooperatives were providing the banking needs

in colonial states
 A pioneering experiment in Mit, Ghamar, Egypt in 1963-1967
 This bank was introduced in the Rural sector of the country
 Nasser Social Bank established in Egypt in 1971.
 Purpose of Nasser Social Bank was social (interest free loans to
needy, support to students, micro credit to small manufacturers etc.)

MNAJEEBKHAN@HOTMAIL.COM /SHARIAH CONSULTANT

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 Evolution of Islamic Banking at Global Level

 A group of businessmen taking lead from this idea, Dubai Islamic Bank
was established in 1975
 The most important development in the history of Islamic banking was
the establishment of Islamic Development Bank (IDB) in 1975
 During 1975-1990, it matured into viable alternative model of financial
intermediation
 Multinational banks entering into Islamic banking operations like
HSBC Amanah, Citibank etc.

MNAJEEBKHAN@HOTMAIL.COM /SHARIAH CONSULTANT

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 Evolution of Islamic Banking in Pakistan
Three Phases

Unique in Islamic countries – Islamic banking attempted twice

 1st Phase (Starting from 1979)

Pre-judgment

 2nd Phase (Starting from 2001)

Post-judgment
 3rd Phase (Starting from 2012)

MNAJEEBKHAN@HOTMAIL.COM /SHARIAH CONSULTANT

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 1st Phase-pre-judgment
(Starting from 1979)
 First, as an interim arrangement, the operations of three
financial institutions, namely Investment Corporation of
Pakistan (ICP), National Investment Trust (NIT) and House
Building Finance Corporation (HBFC) were initially targeted
for elimination of interest in Feb. 1979.
 Second, with effect from July 1, 1981, government
directed all deposit taking institutions, including
scheduled banks, to open Profit and Loss Sharing
(PLS) deposit counters, side by side with standard
interest bearing countersMNAJEEBKHAN@HOTMAIL.COM /SHARIAH CONSULTANT

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 1st Phase-pre-judgment
(Starting from 1979)
 Third, a law was promulgated called the Mudaraba Ordinance 1980,
which provided for the establishment of mudaraba companies and
regulation of their business. These companies, while mobilizing funds
from the market on a participative basis, were to restrict their business
on the basis of only such instruments which were consistent with the
requirements of Shari’ah.
 Fourth, on Jan. 1, 1985 the State Bank of Pakistan finally announced a
phased conversion of the interest-based system to what was termed as
non-interest based system. Under this program, all operations of
scheduled banks were to be brought in conformity with the financing
modes specified under the order over a specified period. Foreign
MNAJEEBKHAN@HOTMAIL.COM /SHARIAH CONSULTANT
currency transactions and investment in government securities were
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excluded from the purview of this order.
 1st Phase-pre-judgment
(Starting from 1979)
 The process of economy wide Islamization of the banking system in Pakistan was
initiated after a declaration by then president in February 1979
 During 1980’s numerous pioneering steps were taken for Islamization of whole
financial system
 Significant amendments in the legal framework - seven laws amended
including Banking Companies Ordinance, State Bank of Pakistan (SBP) Act,
Companies Ordinance, Stamps Act
 Framework for Profit and Loss Sharing (PLS) Deposits
 All local currency financing switched to Islamic modes
 Standardized documents for permissible Islamic modes of finance
 Establishment of Banking tribunals (special courts) with powers of civil and
criminal courts and obligation to decide the recovery suits in 90 days
 Framework for Islamic marketable securities (Participation Term Certificates)
 Framework for Mudaraba Companies

MNAJEEBKHAN@HOTMAIL.COM /SHARIAH CONSULTANT

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 …contd

These effort could not produce desired results mainly due to:
Absence of Shariah compliance framework & oversight mechanism
Non-availability of Shariah compliant government securities.
Judicial system’s inability to decide recovery suits within 90 days
Lack of Capacity building in all stakeholders
Acute capacity constraints – banks having no understanding of the
objectives and operations of Islamic banking
No awareness amongst the masses
Inadequate training to the staff of SBP and banks.
Weak political resolve of successive governments for Islamization of
economy
MNAJEEBKHAN@HOTMAIL.COM /SHARIAH CONSULTANT

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 2nd Phase-Post-Judgment
(Starting from 2001)

 In 1980’s numerous pioneering steps were taken for Islamization of

financial system but the procedure adopted by banks in Pakistan was,
however, declared un-Islamic by the Federal Shariat Court (FSC) in
November 1991

 However, the Government and some banks/DFIs preferred appeals to

the Shariat Appellate Bench (SAB) of the Supreme Court of Pakistan. The
SAB delivered its judgment on December 23, 1999 rejecting the appeals

 Policy Decision : In 2001 It was decided that the shift to interest free
economy would be made in a gradual and phased manner and without
causing any disruptions and hence the three pronged strategy
MNAJEEBKHAN@HOTMAIL.COM /SHARIAH CONSULTANT

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 Prudential & Regulatory Framework for Islamic Banking in Pakistan

 Establishment of IBD – SBP

 In December 2001, SBP issued detailed criteria for establishment of Islamic
commercial banks in the private sector through a three pronged strategy
 Detailed Criteria for setting up of Islamic commercial banks in private
sector,
 Detailed Criteria for setting up of subsidiaries of Existing banks,
 Detailed Criteria for opening of Stand alone branches for Islamic banking in
conventional banks
Minimum Capital Requirement (MCR)
 MCR for full fledged Islamic banks and Islamic Subsidiary is same as for
Conventional banks , however subsidiary has been given the flexibility of
five years to reach to Rs. 10 billion from Rs. 6 billion at time of inception
 Nominal Rs.50 million for Islamic Banking branches of Conventional banks

MNAJEEBKHAN@HOTMAIL.COM /SHARIAH CONSULTANT

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 …Contd


Model Agreements for the various modes of Islamic finance issued by SBP

i.Murabaha Facility Agreement

ii.Musawamah Facility Agreement
iii.Lease Agreement
iv.Salam Agreement
v.Musharaka Investment Agreement
vi.Istisna Agreement
vii.
Agreement for Interest free Loan
viii.
Mudaraba Financing Agreement
ix.Syndication Mudaraba Agreement

MNAJEEBKHAN@HOTMAIL.COM /SHARIAH CONSULTANT

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 Possibility of Islamization of banking system

The Western model was developed on interest based lending and borrowing therefore it
was rejected by Islamic circles;

But as discussed above, the objection was on methodology and not the concept, therefore
an alternative model has been suggested by Muslims scholars;

CII (Council of Islamic Ideology) has prepared a report on 'Elimination of interest from
economy” and suggested some models for financial intermediation;

Islamic financial institution brought big changes on liability and assets side of their
operations;

Islamic Financing is a transformation from Lending and Borrowing to 'Exchange of asset &
services based and equity participation based Financing' using Islamic contracts;

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 Basic concepts and philosophy of Islamic banking

Prohibition of Riba;
• Principles governing loans and debts;
• Prepayment of debts;

Risk sharing /profit sharing (Al Kharaj bid Damam);

Assets backing and value addition;

Time value of money in Islamic perspective;

Prohibition of speculation (gambling);

Sanctity of contracts (violation of law of contracts);

Shari'ah approved activities (permissible Vs impermissible businesses);

Categories of Islamic Modes (four types of permissible transactions);

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 Governing Principles
Characteristics

Equitable Distribution of
Riba-Free Wealth

Financial Intermediation Based on

Shariah Principles- A system grounded
Elimination of on morals and Asset Backed Real
Gharar ethics Transactions

Prohibition of Speculation Risk and Reward Sharing

MNAJEEBKHAN@HOTMAIL.COM /SHARIAH CONSULTANT

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 Prohibition in Islamic financial system

Islamic economic guideline are of two types:

• Prohibitive guidelines:
• The guidelines that provide guidance on prohibited
economic activities, action and contract in Islam;
• Prohibition of interest is an example of it;
• Permissive guidelines:
• The guidelines that explain preferable and permissible
economic activities, actions and contracts in Islam;
• Preference of equitable wealth distribution and
permissibility of trade are example of this type;
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 Prohibition & Permission in Islamic financial system

Haram Preferable
Preferable&&Permissible
PermissibleEconomic
Economic
HaramEconomic
Economicdealings
dealingsand
andactivities
activities
dealings
dealings and
andactivities
activities

Partnership Trade & business

Violation of Islamic Dealing in Haram
law of contract goods and services

Equitable distribution of
Rental business
wealth

Maiser & Qimar (gambling)

Riba (interest)
[a type of Gharar]
Profit Vs Loss Rights Vs Rewards

Gharar (excessive uncertainty Exchange of services

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 Prohibition in Islamic financial system

Haram
Haram Economic
Economic dealings
dealingsand
and activities
activities

Violation of Islamic law of contract Dealing in Haram goods and services

●
Void contracts; ●
Business of liquer and other
●
Suspended (hung) contracts; impermissible or dubious items;
●
Conditional contracts; ●
Contract of impermissible services;
●
Non transparent contracts;

Maiser & Qimar (gambling) [a type of Gharar] Riba (interest)

●
Pure gambling like betting in casinos; ●
Modern day interest;
●
Gambling in sports and games like paid ●
Increase in dues (receivables) in case of
contests; delays;
●
Gambling in business like cash settled ●
Interest on loans and debts;
derivatives (option, future, forward & Gharar (excessive uncertainty) ●
Some types of FX transactions;
swaps);
●
Non transparent deals;
●
Interdependent contracts;
●
Many types of non clarities which
ultimately makes the transaction a matter
of conflict;
●
Incomplete information of subject matter
or price;

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 Possibility of Islamization of banking system

 Islamic banks receive remunerative deposit on partnership basis and non remunerative
deposits on Qard basis;
 They give financing to customers using trade, rental, partnership, providing services
against fee and combined modes of financing;
► As Partner under Musharakah/ Mudarabah.
► As Seller in Murabaha Musawamah, Salam & Istisna’a.

► As Owner In Islamic Leasing/Ijarah for transferring Usufruct

Participate in business 1.Trade;

2.Rental;
1.Mudarabah 3.Participation;
2.Musharakah; 4.Investment agency
3.Investment agency;
ISLAMIC
DEPOSITORS CUSTOMERS
BANK
1.Profit in trade
2.Rent in rental;
Share in profit 3.Share in profit in
participation;

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 Islamic model of banking system – receiving of deposits

The conventional method of deposit receiving has two options:

• Return on deposit + guarantee of principle amount;
• Guarantee of principle amount only without any return to depositors;

According to Islamic principles “return on deposit” and “guarantee” are two mutually
exclusive features which means both are not possible at the same time;

If “return” is required then “guarantee of principle” can not be provided;

Under Islamic way an individual or institution can receive deposits (cash) in following
ways:
• Remunerative deposits;
• The fund receiver pays to fund depositor a return on the amount deposited;
• Non-remunerative deposits;
• The fund receiver does not pay to fund depositor a return on the amount deposited;

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 Islamic model of banking system – financing

Islamic banks provide financing using various modes of financing;

These are four modes of financing which Islamic banks use to finance:
• Trade:
• Islamic bank can act as buyer or seller;
• Rental:
• Islamic bank can be a lessor or lessee;
• Partnership:
• Islamic bank provide fund on partnership basis. The profit or loss are shared
according to the mechanism of the modes used;
• Services:
• Provisioning of services against charges /fees;

A summary is given next:

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 Summary of Islamic modes of financing

Islamic Modes of financing

Services Partnership Ijarah Trade

Paid agency Shirka - ‫المشاركة‬ Murabaha - ‫المرابحة‬

Operating
Permanent
Salam - ‫السلم‬
Guarantee Declining

Working Istisnaa - ‫االستصناع‬

Investment agency Mudarabah - ‫المضاربة‬ Finance

Musawama - ‫المساومة‬
Restricted

Unrestricted

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 Summary of types of sale

Exchange of Goods - Trade

Cash sale Cost undisclosed sale General sale

On spot delivery and payment General bargain sale - Musawama

Credit sale – Bai' Muajjal Barter Sale

Cost disclosed sales
Delivery on spot and one payment at the end
Cost + profit sale - Murabaha
Delivery on spot and payment in installments
Below cost sale – Wazee'ah Currency Sale
Advance sale – Bai' Mua'jjal
Cost to cost sale - Tauwliya
Payment on spot with deferred delivery

Future sale Sale of Gold & Silver

Payment and delivery both deferred – illegal sale

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 Funds supply – summary of possible ways in Islam

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 Comparison of Islamic and conventional banking

ISLAMIC BANK
CONVENTIONAL BANK
Relation between bank and depositors is of Partnership
(Mudarabah) i.e. profit and loss sharing arrangement; Relation between bank and depositors is of Lender and Borrowers;

Bank pay a share from profits it earn from its operations; Bank pay interest as fixed return;

Relation between bank and customer is of Lender and borrower also;

The profit can not be of fixed nature;
Bank charge interest from the customers;
Profit is actual and a fixed and not predetermined in terms of
ROI; The difference (spread is bank's earning;

Customer's principle and profit is safe;

The profit can not be of fixed nature;
Interest is the return for depositors and profit for the bank;

Transactions are real asset based; Predetermined and fixed;

Transactions are financial asset based that may not a physical asset;
Merely documents are not considered assets;
Documents, obligations and receivables are considered as assets;
Ethics and moral values play a major role in investment
decisions. Not a choice but a must.

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 Q&A

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