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A REPORT

ON

Islamic Economics, Finance and Banking: A

Critical Evaluation.

ANKUSH SHAW

09BS0000323

Faculty Guide

Prof AJAY PATHAK.


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ABSTRACT

Islamic economics in practice, or economic policies supported by self-identified Islamicgroups, has varied throughout its long history. Traditional Islamic concepts having to do with

economics included

y Zakat- the "taxing of certain goods, such as harvest, with an eye to allocating these taxesto expenditures that are also explicitly defined, such as aid to the needy."

y Gharar - "the interdiction of chance ... that is, of the presence of any element ofuncertainty, in a contract (which excludes not only insurance but also the lending ofmoney without participation in the risks)"

The Islamic banking today has become most popular and reliable financial system in the world.It appeared on the world scene as active player over three decades ago. But as many of us knowmost of the principles which is based on Islamic Banking ,commonly accepted by the all over the

world goes for centuries than the decades. Islam as a religion very clearly prohibits the Riba -theinterest, so the basic principle of Islamic banking is the prohibition of Riba (Usury or Interest)base transactions.

While a basic tenant of Islamic Banking the outlawing of Riba , a term that encompasses notonly the concept of usury , but also that of interest -has seldom been recognised as applicablebeyond the Islamic World, many of its guiding principles have. The majority of these principlesare based on simple morality and common sense ,Which form the bases of many religions ,Including Islam.

As the global financial sector experiences fluctuations and uncertainty, the Islamic banking and

finance model has shown resilience and growth penetrating new markets and territories.


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INTRODUCTION

The framework: Shariah or Islamic law

Objectives of the Sharia

The primary sources of Sharia are the Quran and Sunnah. These contain rules andrecommendations on all aspects of individual and social life, dividing actions into three broadcategories: farz (compulsory), halal (permissible), and haram (prohibited). Within eachcategory there are refinements, subtleties and complexities; for example within the halalcategory, there are gradations from highly recommended to highly disliked.. Extending theapplication of Islamic law to a new situation is called ijtihad. Rules by which ijtihad is done(analogy to similar situations, consensus, etc.) are called fiqh. Over the centuries, a large body ofrulings covering applications of Islamic law to different situations encountered in the historicalexperience of Muslims has emerged.

We would not be able to find analogues for fiscal and monetary policy in Islamic sourcematerials, putting these issues outside the scope of Islamic law. However if we assume thatreducing unemployment is an objective then we may deduce that fiscal and monetary policy toachieve this goal is recommendable according to Islamic law. One can argue that price

stabilization via monetary policy falls within the ambit of Islamic law.

OJECTIVES OF THE ISLAMIC ECONOMIC SYSTEM

Following are some of the main objectives of the Islamic economic system

1. Fair and Equitable Distribution:The most important objective of the economic system

of Islam is to make distribution of economic resources, wealth and income fair andequitable. It discourages concentration of wealth in few hands and ensures itscirculation among all the sections of society.

It means that, the wealth should not be allowed to concentrate in few rich hands, rather itshould freely circulate among all the people thus enabling the poor and destitute among thenation to also take benefit from it. Thus it is the primary objective of the Islamiceconomic system to bridge the gap between the rich and the poor..

Islamic economic system ensures fair and equitable distribution of wealth through positiveas well as negative measures, such as: institution of Zakat and Sadaqat, laws of

inheritance, abolition of interest, prohibition of earning of wealth by Haram

(unlawful) means, prohibition ofhoarding.

2. Provision of Basic Human Needs: It is also an important purpose and objective of theIslamic economic system that basic necessities of life like food, clothing and sheltershould be provided to all the citizens of the state. The basic needs of an individual havebeen defined to include a house to live in, clothing and food for survival and maintenanceof health.


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To get the basic minimum necessities of life is one of the fundamental rights of everyhuman being. It is the obligation of the state to provide the basic needs of life to those ofits citizens who are unable to earn due to physical disability, unemployment or any otherreason.

3. Establishment of Social Justice: Another objectives of the Islamic economic system isto establish socio-economic justice among all the members of the nation.However, thedistribution of these provisions does not remain fair among all the human beings, thusmaking some very rich who possess wealth more than their needs and making manyothers very poor who possess nothing or too little to meet their very basic necessities of life.This concept meets this challenge of disproportionate division of wealth by making it

obligatory on the rich to surrender a part of their wealth for helping the poor and

unfortunate members of the community.

In order to make distribution of economic resources fair and just, the Islamic economicsystem has established an elaborate system of Zakat and Sadaqat. In addition to that,

many restrictions have been placed barring an individual to earn wealth through unfair,illegal and unjust means. Besides that the Islamic state can also levy taxes.

4. Achievement of Moral and Material Development: The economic system of Islamaims at material as well as moral development of the Muslim community. It achieves thisobjective through its system of taxation and fiscal management particularly throughZakat.

Zakat discourages hoarding of wealth and encourages its circulation. Those personswho possess hoarded wealth know that if they keep it like that, it would be consumed byZakat. So they would not keep it lying idle, rather they would per force bring it intocirculation by investing or spending it.

Thus the consumption and investment would have multiplier effect on the growth of thenational income. The poor people now having purchasing power in their hands willdemand more goods. The industrialists would produce more in order to meet theincreasing demand. Thus the increase in demand and supply will encourageindustrialization and thereby expand the scope of employment in the country. In thisway, the human and material resources of the country would be fully exploited and nationalincome would grow rapidly.

5. Circulation of Wealth: Another important objective of economic system of Islam is todiscourage hoarding and ensure the constant circulation of wealth.

The economic system of Islam achieves this objective through Zakat. Zakat is a great

enemy of hoarding. If it is paid regularly on the hoarded wealth, it would eat away thewhole or main portion of such wealth in a few years time. Thus a person possessing suchhoarded wealth is forced to bring it into circulation by investing it or spending it. Theobjective of circulation of wealth is also achieved through other compulsory and voluntarySadaqat, through laws of inheritance and will and through monetary atonements.


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6. Elimination of Exploitation: The last, but the most important, objective of Islamiceconomic system is elimination of exploitation of one human by another. To achieve thisend Islam has taken many effective measures. First such measure is the abolition of interestor usury which is and has been perhaps the worst instrument ofhuman exploitation.


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ISLAMIC FINANCE

y The Islamic law (Shariah) prohibits taking or giving interest (Riba) which is the

most essential feature of Islamic banking.

y The basic sources of Shariah principles are the Quran and the Sunnah,which are followed by the consensus of the jurists and interpreters of Islamic law.

y Profit sharing and fee-based financing approaches have developed incompliance with Shariah laws.

y These special modes of financing have emerged in retail, private andcommercial banking for debt and capital markets, insurance, assetmanagement, structured and project financing, derivates, etc.

Prohibitions are as follows

y Riba, which is taking or giving of interest

y Gharar, which is uncertainty about the terms of contract or the subject

matter,e.g. prohibits selling something which one does not own.

y Investment in businesses dealing in alcohol, drugs, gambling, armaments,

y etc. which are considered unlawful orundesirable

y Masir, which is involvement in gambling transactions

IISLAMIC FINANCE FACTS AND FIGURES

More than 300 Islamic Financial Institutions in more than 50 countriesTotal assets under management (AUM) exceeds USD 500 billion10-15% growth over past 10 yearsPrevalent in all dimensions of financial services: Debt and capital markets including mutual funds InsuranceAsset Management Structured and Project Financing

Derivates, etc.Market mainly concentrated in Islamic countries of the Middle East, North Africaand South-east Asia

Gained popularity in Muslim-minority countries, e.g. United States of America,England and Germany

Contrasting principles of Islamic and neoclassical economics


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Neoclassical economists base their analysis of markets on cut-throat competition between selfish individuals. At the heart of Islam is the promotion of cooperation betweenindividuals who can be motivated to be generous.

1. In general, Islam stresses co-operation and harmony, and the spending of wealth andmaterials to achieve this goal. This contrasts with the neoliberal economic vision of the freemarket as a jungle where enterprises and people compete to achieve maximum wealth.Nevertheless, although the dominant views have favoured individualism, competition andselfishness, many well-knowneconomists have wrestled with the conflict between these views and the value of

social interests, community and cooperation.

2. Social interests take precedence over personal ones. The commons dispute inEngland was resolved by, favouring private interests over public, and the rich over poor.Thedispute was resolved in the opposite way in the Islamic era, by banning rich people with large

herds from use of the commons for grazing.Because of the restriction on interest-earning investments, Islamic banks must obtain theirearnings through profit-sharing investments or fee-based returns. When loans are given forbusiness purposes, the lender, if he wants to make a legitimate gain under the Shariah, shouldtake part in the risk.

If a lenderdoes not take part in the risk, his receipt of any gain over the amount loaned isclassed as interest. Islamic financial institutions also have the flexibility to engage in leasingtransactions, with purchase options.

Traditionally an Islamic bank offers two kinds of services:

those for a fee or a fixed charge, such as safe deposits, fund transfer, trade financing,

property sales and purchases or handling investments;

those involing partnerships in investments and sharing of profits and losses.

RECOVERY IN CASE OF DEFAULT


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Conventional financing transactions usually provide for default interest on late payment ofamounts due, which is not possible in Islamic financing. In Islamic financing, the same effect canbe achieved in different ways. For example, some form ofdiscount formula can be provided forwhere an agreed rate of discount is

applied for each day that payment is made prior to a backstop date.The backstop date is chosento reflect the latest date in which funds might be expected to be paid. However, if payment ismade after the backstop date then the financiercannot recover any additional amount. In othertransactions, we have seen late payment fees replace the conventional default rate of interest.

Given the added complexity and uncertainty, it may be asked why non-Muslims would agree touse Islamic finance structures? The principal answer is that Islamic finance provides anopportunity to tap into the significant funds of Islamic investors seeking Shariahcompliant investments.

In addition, Islamic finance can be combined with conventional funding sources and export

credit agency (EC

A) support. Forexample, Dubais Emirates airline recently closed aninnovative transaction combining Islamic investment with ECA support.Islamic finance has continued to expand both geographically and in product richness despitethe difficult conditions in the global financial markets and the regional uncertainties. Retainingconventional style documentation and a bankable governing law together with a greaterconsistency in approach among the Shariah boards seem to be key aspects in the growth ofIslamic finance.

GROWTH IN THE PRODUCT PORTFOLIO AND INCREASE IN MARKET SHARE


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ISLAMIC BONDS

The international Islamic bond (sukuks) market, which did not exist in 2000, reached $6.7bnin 2004, up from $1.9bn in 2003. 2003 was itself was a record year, in which the landmark

$400m IDB global sukuk was brought to the market in August and was the first AAAratedIslamic bond ever launched.

In the conventional system of bond issues and trading, interest is at the centre of anytransaction. In the Islamic alternative, the underlying income stream for the bond must not bebased on interest, while the sukukmust avoid the obvious system of interest in bond trading.Different forms of Islamic bonds based on the acceptable methods of financing and purchasing inIslamic law, are widely accepted

Ijarabonds are securities representing the ownership of well-defined existing and well-knownassets that are tied up to a lease contract. Ijara bonds are negotiable and can be traded in

secondary markets.Ijara bonds offer a high degree of flexibility from the point of view oftheirissuance, management and marketability. Financial intermediaries orboth public and

private assetowners can issue bonds.


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ISLAMIC FINANCE IN INDIA: A PROSPECTIVE

In the globe, Islamic Finance it is growing with more than 10% growth rate and currentlyIslamic Asset is nearby USD500-billion in the world as per Forbes.

But, in India it is in the embryonic stage. However, there are some non-banking cooperativesocieties being operated across the India that follows the fundament finance law. But, still nobanks as perReserve Bank of Indias norms has been settled in India. The RBI in this regardhad set up a committee headed by Anand Sinha, chief general Manager in-charge, in 2005 toseek out the scope of Islamic banks in India but the committee in its presented report had deniedany chance to open any banks in present existing condition of RBI.

But, due to estimating massive revenue in Islamic financial sector, some foreign banks includeCitibank, Standard Chartered Bank and HBSC have opened Islamic windows in some of thewestern countries like US and Europe and several West Asian countries. They are operating

on interest-free banking.

But, in India there are only few non-banking financial corporates include Al Ameen IslamicFinancial & Investment Corp. (India) Ltd, Al-Falah Investment Ltd, Al-Barr Finance

House Limited (India), Bank Muscat International (SOAG) and Seyad Shariat Finance(according to Academy for international Modern studies, Canada) are working successfully.These banks work on no-profit-no-loss basis and provide a wide range of loans as well.

These banks provide housing, consumer, personal, educational, automobile and several otherloans as per banks individual terms and conditions. They usually invest in governmentsecurities, small savings schemes or mutual funds.

At present Parsoli Corporation ltd is the biggest known investment company that is listed onBombay Stock Exchange since 1990. IDAFA Investment Pvt. Ltd is another investment firmconstituted in 1994 invest money in Mutual Funds and stock market.


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ISLAMIC BANKING

The thrust for Islamic Banking is founded on the desire to submit to the Divine Instructions,particularly those involving exchange of money for money. However, it would be quite unfair to

limit Islamic Banking to elimination ofRiba only.

Riba is but one of the major undesirable elements of an economic transaction, the others beingGharar (uncertainty) and Qimar (speculation). While elimination of these objectionable aspectsin a transaction is indeed a critical aim of Islamic banking system, it is by no means its ultimateobjective. At the heart of Islamic Banking is a system of commercial transactions that not only provides Halal modes of commercial transactions by avoiding that which is obnoxious andobjectionable, but also fosters ethical, fair and just practices.

A key element of Islamic economics is distribution of equitable rewards to the differentfactors of production. Islamic economic system seeks system of Redistributive justice where

concentration of wealth in a few hands is countered and flow of money into economy is fluent.Islamic Banking is, seen as a lynchpin to achieving the economic and social goals of the Islamiceconomic system.

Another important element of Islamic finance is that profit or reward can only be claimed in theinstance where either risk of loss has been assumed or effort has been expended. Profit istherefore received by the provider of capital and wages/remuneration by labour/manager.

A depositor in an Islamic bank can therefore make earnings on his or her deposit in severalways. Through return on his capital when that capital is employed in a business venture;through sharing of profit when his capital is part of the capital that is employed in a

partnership, and finally through rental earnings on an asset th

ath

as been partially financedby his capital.

Islamic financing: Asset-based financing

A key feature of Islamic banking is that unlike conventional banks which deal primarily inmoney and financial securities, Islamic financing is related to an asset that is a feature of thetransaction, and quite often the principal feature itself. From this springs an importantdistinguishing feature of Islam wherein Islamic financing is always based on illiquid assets thathave intrinsic value. Profit to Islamic financing is generated through bonafide sale of these

assets.

Conventional banking, on the other hand, is free of such limitations. It lends money and makesits earnings through this act of lending. Its earnings are unconcerned with the economic fateof its lending.

.


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PRINCIPAL BANK INSTRUMENTS

Musharakah:

Musharakah is one of the two ideal modes of Islamic financing. . Musharakah is a contractualrelationship formed through mutual consent of the parties forsharing of profits and losses in a joint venture. Assets in the venture are jointly owned in proportion to each partnerscontribution. The profits are shared in a pre-agreed ratio. Losses, however, are incurred inproportion to each partners investment. Islamic Bank representing share of its depositors investsfunds in the joint venture alongside other investors. For example, suppose that an individual(A) wants to begin a business but has limited funds. Individual (B) has excess funds and wishesto be the financier in musharakah with A. The two people would come to an agreement to theterms and begin a business in which both share a portion of the profits and losses.

Mudarabah

:

Mudarabah is also a form of partnership. Whereas all partners in Musharakah contribute capital,under Mudarabah partnership is formed between provider of capital and provider of expertiseor human resource. Proportions for sharing profit are decided upfront. Losses are incurredsolely by the partner contributing capital.Furthermore, the amount of profit ascribed to either ofthe parties must be independent of the capital amount, dependent solely on the actual profitrealized.

Murabaha:

Murabah

a is a non-participatory mode of Islamic financing where the bank sells the assetrequired by its client to the client on cost-plus basis.The asset is first purchased by the bank andthe bank incurs the risk of any loss or damage to the asset as long as the asset remains under itsownership. Upon sale of the asset, the Islamic bank is obligated to inform the client of the exact

cost incurred in the purchase of the asset and the margin of profit incorporated in the saleprice. Payment by the client of the sale price may be deferred .

Ijara

Under this facility a client may take on rent, property, vehicle or any other real asset belonging to the bank. The bank transfers the right of use of the asset to the client, while

retaining th

e ownersh

ip of th

e asset. The client pays periodic rent to the bank for the use of theasset. Basis for rentals can be fixed as well as floating.

Salam:

Salam is a contract ofadvanced payment against deferred delivery of goods. Goods paid for inadvance by the buyer are delivered by the seller after an interval of time. The Seller receives inadvance fully paid price of the goods at the time of contract undertaking to deliver the goods


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specified by the buyer at a future date.

Istisna

Manufacture of a specific product against precise specifications by a manufacturer for deliveryto buyer. It is necessary that the price of the product and product specifications are fully agreedupon by the manufacturer and the buyer, and that the material required for manufacture isarranged by the manufacturer.


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REFERENCES:

y Islam and economic Challenge - M.U.Chapra

y Critical Issues on Islamic banking - S.A.Rosly

y Commercial banking in inflation - A.L.M. Gafoor

y Overview of Islamic Finance- Nijatullah Siddique

y Towards a Just monetary System- M.U.Chapra

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Mrp Interim Ankush 09bs0000323