With respect to the receipt and payment of interest, there is no distinction between Muslims and non-Muslims or between individuals and states because interest is prohibited not only in Islamic scriptures but also in other religious scriptures of the world. Therefore, prohibitions of interest apply to Muslims as well as to non-Muslims.

The interest is prohibited whether it is consumption loan (loan for meeting day to day human needs) or commercial loan (loan for business purpose). There are quite a number of ahadith which clarify that in the days of Holy Prophet (Peace be upon Him), people not only borrowed for consumption purposes but also for productive purposes.

A few of the ahadith are quoted below for reference:

This is ample testimony that the commercial loan was in practice when Quranic verses on Riba were revealed and the term Riba covers not only consumption loan but also the commercial loan.

There are at least six basic principles that are taken into consideration while executing any Islamic banking transaction. These principles differentiate a financial transaction from a Riba/interest-based transaction from an Islamic banking transaction.

Islamic banking is defined as banking system that is in consonance with the spirit, ethos and value system of Islam and governed by the principles laid down by Islamic Shariah . In practical sense, Islamic Banking is the transformation of conventional money lending into transactions based on tangible assets and real services. The model of Islamic banking system leads toward the achievement of a system that helps achieve economic prosperity.

According to Islamic Shariah, Islamic banking cannot deal in transactions:

Bank AL Habib-Islamic banking focuses on generating returns through investment tools that are Shariah Compliant. Shariah links the gain on capital with its performance. Operating within the ambit of Shariah, our operations of Islamic banking are based on sharing the risk that may arise through trading and investment activities using contracts of various Islamic modes of finance.

The word “Riba” means excess, increase or addition, that correctly interpreted according to Shariah terminology, implies any stipulated excess compensation without due consideration (consideration does not include time value of money). This definition of Riba is derived from the Quran and is unanimously accepted by all Islamic scholars.

Shariah lexically means a way or path. In Islam Shariah refers to the divine guidance and laws given by the Holy Quran, the Hadith (sayings) of the Prophet Muhammad (Peace Be Upon Him) and supplemented by the juristic interpretations by Islamic scholars. Shariah embodies all aspects of the Islamic faith, including beliefs and practices. Islamic Shariah or the divine law of Islam is derived from the following four sources:

The validity of a transaction does not depend on the end result but rather the process and activities executed and the sequence thereof in reaching the end. If a transaction is done according to the rules of Islamic Shariah it is halal even if the end result of the product may look similar to conventional banking product.

The Best example in this regard is that a person who owns Rs.100 and wants to earn Rs.10 from it, he has two options :

In both the cases he can earn Rs.10, however the first case is Haram because it falls into Riba and the second case is Halal because it falls into BAI.

The same is also true for Islamic and conventional banking. Therefore, it can be concluded that it is the underlying transaction that makes something “Halal” (allowed) or “Haram” (prohibited) and not the result itself. Apparently, Islamic banks may look similar to conventional banks, however the contracts and product structures used by Islamic banks are quite different from that of the conventional bank. In the verse 2:275 of the Holy Quran, Allah the Almighty has responded to the apparent similarity between trade and interest by resolutely informing that he has permitted trade and prohibited Riba (though they may look similar to someone).

The Board comprises of Shariah scholars who consider, decide and supervise all Shariah related matters of the bank.

All decisions, rulings, fatawa of the Shariah Board are binding on the Bank whereas Shariah Board is responsible and accountable for all its Shariah related decisions.

Bank AL Habib-Islamic Banking Division Shariah Board comprises of three Shariah Scholars:

The Shariah Board discharges its duties independently and objectively. The members of the Shariah Board continuously assess their relationship with the Bank to identify any situation where any issue related to independence may actually or potentially arise or can reasonably be inferred.

Bank AL Habib-Islamic Banking has a SCD headed by Islamic finance trained and experienced officer recommended by the Shariah Board. The SCD has dedicated an adequate staff as per the advice of the Shariah Board, so as to enable it to discharge its due responsibilities in a proper and timely manner. Further, the SCD is working under the overall guidance and supervision of the Shariah Board and the Head reports to the Shariah Board.

The responsibilities of SCD are as follows:

Bank AL Habib-Islamic Banking Division offers following modes of Islamic banking and finance to their clients:

Financing products are those products offered by the Bank in which Bank takes exposure (Risk) on the client. There are three types of lending products offers by the Bank:

Purchase and sale of goods:
The Bank purchases goods on cash basis and sell to client on deferred, on cost plus Profit, basis.

Purchase and Lease / Ijarah:
The Bank purchase fixed asset, either from market or from client, and leases / makes Ijarah of the same to client for the specified period.

Joint Purchase and Lease / Ijarah:
The Bank and client jointly purchase fixed asset and then Bank leases / make Ijarah of its portion of ownership to the client for the specified period.

Funds for manufacturing:
The Bank provides financing to client for manufacturing the goods required under confirmed sale order of the client’s client.

Partnership:
The Banks provides funds as partner to run the specific segment of business for specific period. The Profit and loss will be calculated in agreed manner.

The operation of all Pakistani Rupee (PKR) and Foreign Currency (FCY) Current Accounts is based on the Islamic principle of Qard. The structure of Remunerative Saving Accounts & Term Deposits is based on the principle of Mudarabah and is strictly in conformity with the rules of Islamic Shariah and is approved by the Shariah Board of BAHL-IBD Islamic Banking.

Murabaha is a sale transaction, whereby the seller (Bank) expressly mentions the cost and the Profit is charged thereon while quoting the price. Furthermore: “Murabaha” is in fact a term of Islamic Fiqh and it refers to a particular kind of sale having nothing to do with financing in its original sense.

The purpose of Murabaha is to cater to your short-term financing requirements.

Under Murabaha arrangement Bank AL Habib-Islamic Banking Division allows you to purchase from time to time goods / commodities (raw material/ finished goods etc.) for commercial use up to a specific limit assigned.

The target Market for Murabaha Finance is Corporate/Commercial/ Retail and SME sectors to meet their working capital needs. These entities must fulfill credit entitlement criteria of Bank AL Habib-Islamic Banking Division

Istisna is a sale contract that is executed for goods that need to be manufactured or constructed as per customer’s specification, with the obligation of the seller (manufacturer) to deliver the goods upon completion.

The purpose is to finance the working capital requirements of the customers.

Bank AL Habib-Islamic Banking Division offers Istisna finance to meet entire working capital finance requirements of Corporate and SME sector that manufactures/ constructs assets to be sold in local and international market.

The Manufacturers in Corporate and SME sectors who qualify the minimum credit criteria of Bank AL Habib-Islamic Banking Division.

Musawama is a sale transaction, whereby the seller (Bank) quotes the price without any reference to cost or Profit.

To cater post manufacturing / shipment financing requirements by purchasing the inventory from the customer and subsequently selling the same by appointing the customer as an agent.

Under Musawama arrangement Bank AL Habib-Islamic Banking Division agrees with customer to purchase goods / commodities (finished goods) from time to time, up to a specific limit assigned.

The target market for Musawama Finance is Corporate/Commercial/ Retail and SME sector to meet their post manufacturing / shipment financing needs. These entities must fulfill Bank AL Habib-Islamic Banking Division credit entitlement criteria.

Ijarah is a term of Islamic fiqh and it means “to give something on rent” or “to acquire service”. Ijarah can be defined as “transferring of usufruct of an asset to another person for an agreed period and agreed rent”. The asset should be valuable, identified and quantified.

To meet the long-term business requirements, such as project financing, BMR activities and fleet financing.

Corporate, Commercial and SME sectors who qualify the minimum credit criteria of Bank AL Habib-Islamic Banking Division.

According to the concept, a bank and customer participate either in the joint ownership of a property or an equipment, or in a joint commercial enterprise. The share of the bank is further divided into a number of units and it is understood that the client will purchase the units of the share of the bank one by one periodically, thus increasing customer’s own share till all the units of the financier are purchased by the customer so as to become sole owner of the property, or the commercial enterprise.

To meet your long-term business requirements, such as project financing, BMR activities, fleet financing car financing, and house financing.

Corporate, Commercial, SME and Consumer sectors who qualify the minimum credit criteria of Bank AL Habib-Islamic Banking Division.

Bank AL Habib-Islamic Banking Division has classified its deposit products into two categories:

The funds under these types of accounts are accepted under the concept of Qard. Withdrawals from these accounts can be made on demand. These funds are utilized by Bank AL Habib-Islamic Banking Division for Shariah compliant financing and investment activities. The following accounts are offered under this category:

The funds under these deposits are invested with the intention to earn returns on invested funds. Bank AL Habib-Islamic Banking Division offers remunerative deposits under Mudarabah arrangements. Under the arrangements the depositor is Rab-ul-Maal and bank is Mudarib. The funds generated under this category become the part of Mudaraba pool and are utilized for Shariah Compliant financing and investing activities. The Profit generated therefrom is shared between the bank and depositors in agreed ratio. In case of loss, the Rab-ul-Maal i.e. depositors will bear the loss, provided loss is not due to negligence of Mudarib i.e. Bank.

Checking deposits

Non-Checking Deposits

The word "Riba" means excess, increase or addition, which correctly interpreted according to Shariah terminology, implies any excess compensation without due consideration (consideration does not include time value of money). This definition of Riba is derived from the Quran and is unanimously accepted by all Islamic scholars. The meaning of Riba has been clarified in the following verses of Quran (Surah Al Baqarah 2:278-9)

"O those who believe; fear Allah and give up what still remains of the Riba if you are. believers. But if you do not do so, then be warned of war from Allah and His Messenger. If you repent even now, you have the right of the return of your principal; neither will you do wrong nor will you be wronged."

The origination of term interest dates back to 17th century with the emergence of banking system at global level. Interest means giving and/or taking of any excess amount in exchange of a loan or on debt. Hence, it carries the same meaning/value as that of Riba as defined in the previous question. Further, it is narrated that "the loan that draws interest is Riba".

There are two kinds of Riba:

There are four sets of revelations about Riba which were revealed on different occasions.

According to Islamic jurists and scholars, there are around 40 different Ahadith on the subject of riba and its prohibition from Holy Prophet (peace be upon him).

Few of these are as follows:

The following references against the prohibition of Riba/usury are drawn from the Old Testament of the bible17:

Deuteronomy 23:19: "Thou shall not lend upon usury to thy brother; usury of money, usury of victuals, usury of anything that is lent upon usury."

Psalms 15:1, 2, 5: "Lord, who shall abide in thy tabernacle? Who shall dwell in thy holy hill? He that walketh uprightly, and worketh righteousness and speaketh the truth in his heart. He that putteth not out of his money to usury, nor taketh reward against the innocent."

Proverbs 28:8: "He that by usury and unjust gain increaseth his substance, he shall gather it for him that will pity the poor."

Nehemiah 5:7: "Then I consulted with myself, and I rebuked the nobles, and rules and said unto them, Ye exact usury, every one of his brothers. And I set a great assembly. against them."

Ezekiel 18:8.9: "He that hath not given forth upon usury, neither hath taken any increase, that hath withdrawn his hand from iniguity, hath executed true judgment between man and man, hath walked in my statues, and hath kept my judgments, to deal truly; he is just. He shall surely live, said the Lord God."

Ezekiel 22:12: "In thee have they taken gifts to shed blood; thou hast taken usury and increase, and though hast greedily gained of thy neighbors by extortion, and hast forgotten me, said the Lord God."

In these excerpts of the Bible the word usury is used in the sense of any amount claimed by the creditor over and above the principal advanced by him to the debtor. The word riba used in the Holy Qur'an carries the same meaning because the verse of Surah An-Nisaa (4-161) explicitly mentions that riba was prohibited for the Jews Also

The Islamic bank uses its funds in various trade, investment, and service related Shariah compliant activities and earns profit thereupon. The profit earned from such activities is passed on to the depositors according to the agreed terms.

No, Islamic banks accept the deposits either on profit and loss sharing basis or on Qard basis. These deposits are deployed in financing, trading or investment activities by using the Shariah compliant modes of finance. The profit so earned by the bank is passed on to the depositors according to the pre-agreed ratio which, therefore, cannot be termed as interest.

Islamic banks should ideally have their own benchmark system for determination of profit. Since, the industry is in its initial stage of development, it is using the available benchmark for the banking industry. It is expected that once it is grown to a sizable level, it would have its own benchmark. However, using Interest Rate benchmark for determining the profit of any permissible transaction does not render the transaction as invalid or haram. It is the nature/mechanism of the transaction that determines its validity or otherwise.

For example Mr. A and Mr. B are two neighbors. Mr. A sells liquor which is totally prohibited in Islam whereas Mr. B, being a practicing Muslim dislikes the business of Mr. A and starts the business of soft drinks. Mr. A wants his business to earn as much profit as Mr. A earns through trading in liquor. Therefore, he decides that he will charge the same rate of profit from his customers as Mr. A charges over the sale of liquor. Thus, he has tied up his rate of profit with the rate used by Mr. A in his prohibited business.

One may say that Mr. B uses an undesirable benchmark in determining the rate of profit, but obviously no one can say that the profit charged by him is haram because he has used the rate of profit of the business of liquor only as a benchmark. The same is true for Islamic banks, it is most desirable and preferable that Islamic banks develop their own benchmark; however, in the absence of any such alternative, interest rate related benchmark can be used.

The teachings of Islam are not confined to Muslims, rather these equally address the non-Muslims due to their universal nature. The basis of Islamic banks is laid down on ethical values and socially responsible system. The values like justice, mutual help, fee consent and honesty on the part of the parties to a contract, avoiding fraud, misrepresentation and misstatement of facts and negation of injustice or exploitation form the basic principles of Islamic banking. Therefore, the principles of Islamic banking lead the economic system to achieve the common good and economic prosperity. On this premise, Islamic banking becomes a viable option for everyone irrespective of their religion.

The following are the modes of finance which are or three categories:

Musharakah means a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint business. Under Islamic banking, it is an agreement under which the Islamic bank provides funds which are mixed with the funds of the business enterprise and others. All providers of capital are entitled to participate in management but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while each partner bears the loss strictly in proportion to respective capital contributions. The following are the rules with regard to profit and loss sharing in Musharakah:

The following are the Basic rules of distribution of Loss in case of Musharakah:

All scholars are unanimous on the principle of loss sharing in Shariah based on the saying of Syedna Ali ibn Talib that is as follows:
"Loss is distributed exactly according to the ratio of investment and the profit is divided according to the agreement of the partners."

Therefore the loss is always subject to the ratio of investment. For example, if Mr. A has invested 40% of the capital and Mr. B has invested 60%, they must suffer the loss in the same ratio, not more, not less. Any condition contrary to this principle shall render the contract invalid.

Murabaha is typically used to facilitate the short-term financing requirements of the customer. The following are the uses of Murabaha:

Bai' Muajjal is the Arabic equivalent of "sale on deferred payment basis". The deferred payment becomes a debt payable by the buyer in lump sum or in installments as may be agreed between the two parties. In Bai' Muajjal, all those items can be sold on deferred payment basis which come under the definition of tangible goods where quality does not make a difference but the intrinsic value does. Those assets do not come under definition of capital where quality can be compensated for by the price and Shariah scholars have an 'ijmah' (consensus) that demanding a high price in deferred payment in such a case is permissible. The following are the conditions of a valid Bai’ Muajjal:

The customer approaches the bank and expresses his desire for a particular asset/property. The bank acquires that asset as per undertaking of the customer to acquire the said asset on Ijarah basis. The bank leases (transfers the use of the asset) it to the customer for an agreed period of time and against an agreed amount of rentals. An Ijarah agreement, signed between the bank and the customer, stipulates all the relevant conditions with regard to the transaction. According to this agreement the bank is Lessor and the customer is Lessee. During the Ijarah period, the corpus of the leased property remains in the ownership of the bank and only its usufruct is transferred to the lessee. The following main points are considered in the Ijarah transaction:

There are several key differences between conventional mortgage finance and Islamic mortgage finance.

Under conventional mortgage, in order to purchase a property the customer borrows money and repays it with an additional amount over a period of time. The additional amount is the amount of interest which is against the Shariah rulings of Islam. Under Islamic mortgage finance facility, Islamic bank shares with the customer in purchasing his desired property. Accordingly, the customer and the bank become the joint owners of the property in proportion to their share in purchasing the property. In order to own and use the entire property, the customer purchases the share of bank’s property over a period of time and also pays the rent for using the bank’s share of the property. Over a period of time, the customer manages to purchase the entire share of bank in the property. Ultimately, the customer becomes the sole owner.

Further, in case of Islamic mortgage finance, the rent will be charged after the lessee has taken delivery of the property and it is in workable/usable condition. Rent cannot be charged from the day the price was paid to acquire the property/asset. If the supplier has delayed the delivery after receiving the full price, the lessee should not be liable for the rent of the period of delay. In case of conventional mortgage finance, normally the lease rentals starts from the date the bank make payment for purchasing the property/asset.

The difference between an interest based financing and a valid lease does not lie in the amount to be paid to the lessor. The basic difference is that in the case of lslamic Ijarah, the ownership and title in the asset/property rest with the lessor who assumes the full risk of the corpus of the leased asset. If the asset is destroyed during the lease period, the lessor will suffer the loss. Similarly, if the leased asset looses its usufruct without any misuse or negligence on the part of the lessee, the lessor cannot claim the rent, while in the case of an interest-based financing, the financier is entitled to receive interest, even if the debtor did not at all benefit from the money borrowed. So far as this basic difference is maintained, (i.e. the lessor assumes the risk of the leased asset) the transaction cannot be categorized as an interest-bearing transaction, even though the amount of rent claimed from the lessee may be equal to the rate of interest.

Therefore, the use of the rate of interest merely as a benchmark does not render the Ijara contract invalid as an interest-based transaction. It is, however, advisable at all times to avoid using interest even as a benchmark so that an Islamic transaction is totally distinguished from an un-Islamic one, having no resemblance of interest whatsoever.

It is one of the basic requirements of Shariah that the parties to the contract must exactly know its considerations. Under Ijarah agreement, amount of rent is one of the prime considerations of the agreement. So far as the parties are agreed with mutual consent upon a well-defined benchmark which would serve as a criterion for determining the rent, and whatever amount is determined, based on such benchmark, will be acceptable to both parties, therefore, there should not be any dispute.

However, in order to save the parties from unforeseen losses due to the either way movement in the interest rate, the scholars have advised that there should be a floor and cap for the amount of rentals stipulated in the contract in case variable benchmarks is taken to determine the rental amount.

It is allowed in Shariah that the lessor signs a separate promise, (but not an agreement or contract) to gift the leased asset to the lessee at the end of the lease period, subject to his payment of all amounts of rent. There can also be a unilateral promise by the lessee to purchase the asset at the end of the Ijarah period. Alternatively, there may be an undertaking by the bank to sell the asset to the lessee at the end of the Ijarah period. However, an Ijarah agreement should not be dependent either on the promise by the lessee (to purchase) or the undertaking by the bank (to sell). This arrangement is called “Ijarah wa iqtina” and it has been allowed by a vast majority of contemporary scholars and is widely used by the Islamic banks.

However, the validity of this arrangement is subject to two basic conditions:

Salam means a contract in which advance payment is made for goods to be delivered at a future date. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. Bai Salam covers almost everything which is capable of being definitely described as to quantity, quality and workmanship. For Islamic banks, this product is ideal for agriculture financing, however, this can also be used to finance the working capital needs of the customers.

The permissibility of Salam is an exception to the general rule that prohibits forward sale. Bai-Salam has been permitted by the Holy Prophet (PBUH) himself, without any difference of opinion among the early or the contemporary jurists, notwithstanding the general principle of Shariah that the sale of a commodity which is not in the possession of the seller is not permitted. Upon migration from Makkah, the Prophet (PBUH) came to Madinah, where the people used to pay in advance the price of fruit or dates to be delivered over one, two or three years. However, such sale was carried out without specifying the quality, measure or weight of the commodity or the time of delivery. The holy Prophet (PBUH) ordained: “Whoever pays money in advance for fruit to be delivered later should pay it for a known quality, specified measure and weight (of dates or fruit) of course along with the price and time of delivery”

The Salam transaction is subject to the strict conditions as follows:

Under Istisna, the manufacturer either uses his own material or he arranges for the material himself whereas under Ijara the material is provided by the customer and the manufacturer uses only his labour and skill meaning that his services will be hired for a specified fee paid to him. Further, under Istisna the purchaser has the right to reject the goods after inspection if these are not according to the specifications agreed at the time of contract whereas under Ijara this right of inspection does not exist.

The following are the main differences between Istisna' and Salam:

In Islamic law it is permissible to penalize a debtor who is financially sound but willfully delays payment of debt without any genuine reason. Such act of the debtor is unjust as the Prophet (PBUH) has said,

"A rich debtor who delays payment of debt commits Zulm".

A heavy non-performing portfolio and default on the part of clients is a serious problem confronting the financial institutions all over the world including Pakistan. This problem may be a threat to the success of Islamic banking system if not properly addressed. If clients do not honour their commitments in respect of timely payment of a debt created in installment sale, Murabaha, leasing or do not pay banks’ share of profit in participatory modes or do not deliver goods at stipulated time in Salam and Istisna, it could cause irreparable loss to the system. The banks, financial institutions, depositors and ultimately the economy will have to suffer its consequences.In order to ensure that client will honor its commitment, customer undertakes to pay additional amount as charity which will be utilized for charitable purposes and cannot become source of income for the bank in any manner.

Islamic banking is in its early stage and is in the process of strengthening its base in the economies having conventional banking rooted deeply in the current interest-dominated system. The volume of business captured by the conventional banking system gives it an edge over Islamic banking in terms of cost due to its ability of having achieved economies of scale. The conventional banks can avail the economies of scale due to their wide network and huge volume of business which the Islamic banking, in its nascent stage cannot avail given the present volume of their business. Further, Islamic banking has to maintain some additional documentation which adds to the cost of its operations. While Islamic banking may appear to be marginally costlier at this stage, the incremental cost is not prohibitive in relation to the benefits.

A promissory note or a bill of exchange represents a debt payable by the debtor to the holder. This debt cannot be transferred to anybody except at its face value. Discounting of bill or a Note or a Cheque, therefore, involves interest. In an Islamic financial market, the papers representing money or debt cannot be traded (except at face value). However, the papers representing holder’s ownership in tangible assets, like shares, lease certificates, Musharkah certificates, etc. can be traded due to the underlying assets they represent. Islamic banks have various modes of finance through which the business needs of the customer can be satisfied without discounting the bill.

As a matter of principle, all the financial transactions between the parties are lawful in the eyes of Islamic Shariah as long as they do not violate Islamic principles. Islamic Shariah provides several interest-free modes of finance that can be used to satisfy various business needs of the customer. These modes can be clubbed into two broad categories.

The first category may include modes of advancing funds on a profit-and-loss-sharing basis. Examples of profit and loss sharing category are Mudarabah, Musharakah and participation in the equity capital of companies. The second category may include the modes of finance which are used for the purchase/hire of goods (including assets) and services on a fixed return basis. Examples of this type are Murabaha, Istisna, Salam and Ijarah.

Therefore the financial needs can easily be met through interest-free legitimate modes of finance. These can be used to finance the trade, industry or a budget deficit through domestic or foreign sources. The following would further elaborate in detail.

Modes for financing trade and industry:

Murabaha, Musawama, Ijarah and salam are particularly suitable for trade while istisna is especially suitable for manufacturing or construction industry. Further, the trade and industry needs financing for the purchase of raw materials, inventories (stock in trade) and fixed assets as well as to meet some working capital requirements. Murabaha can be used for the financing of all purchases of raw materials and inventory. For the procurement of fixed assets including plant and machinery, buildings etc. either Dinimishing Musharaka or Ijarah can be more feasible. Funds for continuing/recurrent expenses can be obtained by the advance sale of final products of the company using Salam or Istisna and even Musharika in appropriate circumstances.

Modes for financing a budget deficit:

It is noted that in an Islamic state, all the efforts should be made to avoid the budget deficit. However, in case of unavoidable circumstances, the budget deficit may be kept to the possible minimum limit. Sometimes the budget deficits are seen as a result of either extravagant (and/or unproductive) expenditure or insufficient and/or inefficient effort to generate tax revenue due to political, economical reasons or otherwise. There is a need to win public confidence about these needs and to create transparency in government expenditure. There is also a need to prevent the leakage of revenue generating streams for the Government. This can serve better in keeping budget deficits to a minimum level. In case of unavoidable deficits, governmentowned enterprises can obtain finance by way of Mudarabah, Musharakah or Sukuk certificates, just like private companies do.

An alternative to foreign loans:

Seeking Islamic solution to foreign borrowing, arrangements could be made to attract foreign as well as domestic funds through the following two ways:

The issue of certificates

Musharakah (partnership) or Ijara certificates can be issued to finance the projects of the Government. Such certificates can be denominated in foreign as well as domestic currencies and they would carry a predetermined basis for sharing the profits earned through the respective projects. The certificates issued can be restricted to a particular project or earmarked to a group of projects.

The establishment of funds

Funds can be created to finance the economic activities of public and private enterprises on equity, partnership, and Ijarah basis. These funds can attract funds through the issue of shares and certificates of various values and maturities and in domestic as well as foreign currencies. These can be established either to finance a certain sector (for example agriculture, industry and infrastructure), a particular industry (for example textiles, household durables, etc.), or a conglomerate of projects.

Islamic bank like other banks is an institution whose main business is to mobilize funds from savers and use these funds to finance the economic activities of businessmen/entrepreneurs. While a conventional bank uses the rate of interest for both obtaining funds from savers and lending these funds to businessmen, an Islamic bank performs these functions using various financial modes which are compatible with the Shariah. For mobilizing resources, it uses either the contract of Mudarabah or Wakalah with the fund owners. Under the first contract, the net income of the bank is shared between fund user (Mudarib) and fund providers (Rabul Maal) according to a predetermined profit sharing formula. In the case of loss, the same is shared by fund providers in proportion to the capital contributions. As far as the nature of investment deposits are concerned, these could be either general investment deposits or specific investment accounts in which deposits are made for investment in particular projects. In addition, there are current accounts that are in the nature of an interest-free loan to the bank. The bank guarantees the principle in case of current accounts but pays no profit on such accounts.

Under the wakalah contract, clients give funds to the bank that serves as their investment manager. The bank charges a predetermined fee for its managerial services. The profit or loss is passed on to the fund providers after deducting such a fee.

On the assets side, the bank uses a number of financial instruments none of which involves interest. A wide variety of such modes of financing is available as discussed before.

The question may be divided into following two parts for proper understanding:

Do we need bank?

In order to assess the need of the bank, we need to look at the functions it performs. In any society, be it a secular or Islamic one, the main function of the bank is to mobilize funds from the surplus units and allocate these to the shortfall units or to the units having budget constraints. This function is performed through the process of financial intermediation in the financial markets where banks are the most important operators. Financial intermediation enhances the efficiency of the saving/investment process by eliminating the mismatches inherent in the requirements and availability of financial resources of savers and entrepreneurs in an economy.

Normally the surplus units/savers are the small households or individuals who save relatively small amounts whereas the entrepreneurs are firms which often need relatively large amounts of funds. Financial intermediation removes this size mismatch by collecting the small savings and packaging them to suit the needs of entrepreneurs. In addition, entrepreneurs may require funds for periods relatively longer than would suit individual savers. Intermediaries resolve this mismatch of maturity and liquidity preferences again by pooling small funds. Moreover, the risk appetite of savers and entrepreneurs are also different. It is often considered that small savers are risk averse and prefer safer placements whereas entrepreneurs may wish to deploy funds even in risky projects.The role of the intermediary again becomes crucial. They can substantially reduce their own risks through the different techniques of proper risk assessment and risk management. Furthermore, small savers cannot efficiently gather information about opportunities to place their funds. Financial intermediaries are in a much better position to collect such information which is crucial for making a successful placement of funds.

The role and functions of banks outlined above are indeed highly useful and socially desirable. Hence, we reach to the point where the banks become the need of any economy.

Why the bank should be on the basis of Islamic Shariah?

Commercial banks normally operate on lending basis. They may not be unduly much bothered about the use of funds as long as the borrower pays back the loan regularly. This does not ensure that the amount advanced to the borrower was used for the productive or unproductive purpose. Thus the impact of commercial banking on economic development, therefore, may remain below potential. Whereas, Islamic bank provides finance which has a greater focus on the productive use. Islamic banks’ financing targets both the equity as well as the working capital needs of enterprises. It is expected that its impact on economic development will be more pronounced. The avoidance of interest by Islamic banking is an additional plus. It is mentioned that allocating financial resources on a productive basis is more efficient than their allocation on a purely lending basis. It has also been argued that the whole banking system would be more stable and less liable to suffer from financial crises. A monetary system based on riba is also unjust as it allows savers and banks to get away with interest (guaranteed fixed rate of return on their loans) without bearing a fair part of the risks faced by entrepreneurs.

Islamic banking is still in the stage of evolution. No one disputes that there is a definite desire amongst Muslim savers to invest their savings in the venues which are permitted by the Shariah. Nevertheless, they must be provided with halal returns on their investments. Islamic scholars and practical bankers took up this challenge and have made commendable progress in the last few decades in providing a number of such instruments. However, the concepts of Islamic banking and finance are still in their early stages of development and Islamic banking is an evolving reality for continuously testing and refining those concepts.

Islamic banking and financial institutions have now spread across several Muslim countries as well as non-Muslim countries. Various components of the Islamic financial system are now available in different parts of the world in varying depth and quality. A detailed and integrated system of Islamic banking and finance is gradually evolving. Theoretical arguments and models developed by Islamic economists and the successful practice of hundreds of institutions in heterogeneous conditions both testify to the viability of Islamic banking as Islamic banking model provides a complete banking solution to all the business needs of the customers while remaining with the boundaries of Shariah. The average growth rate of assets in Islamic banks over the past twenty years has been around fifteen percent per annum. Islamic banking institutions have come of age now and are realizing a high degree of success in respect of market penetration. This is considered remarkable in view of the fact that the markets in which these Islamic banks were established have had highly developed and well-established commercial banks as their competitors.

Another manifestation of the success of Islamic banking is the fact that many conventional banks have also started using Islamic banking techniques in the conduct of their business, particularly in dealing either with Muslim clients or in predominant Muslim regions.

The approach of Islamic banking to satisfy the business needs of the customers is entirely different from that of the approach adopted by conventional banking. Basically Islamic banking satisfies the business needs of the entrepreneurs by the following two modes:

On the other hand conventional banking satisfies the business needs of the entrepreneurs by charging fixed interest which raises several questions. Although the results of operations of an enterprise in which such loans are to be invested are by no means certain, yet, guaranteeing in advance, a fixed return on a loan without taking into consideration the actual results of the operations of the borrowing enterprise puts all business risks on the entrepreneur/borrower.

The Islamic banking philosophy is not based on interest because according to Islam, interest is haram and a curse in society. Islamic banking focuses on the common good, encourages highest ethics such as universal brotherhood, collective welfare and prosperity, social welfare and justice. On the other hand, interest based system accumulates money around handful of people and it results inevitably in creating monopolies, opening doors for selfishness, greed, injustice and oppression.

Further, the allocation of financial resources on the basis of profit-and-loss sharing gives maximum weight to the profitability of the investment whereas an interestbased allocation gives it to credit worthiness. It is expected that the allocation made on the basis of profitability would be more efficient than that made on the basis of interest.

Moreover, a system based on profit sharing would be more stable compared to the one based on a fixed interest rate on capital. In the latter, the bank is obliged to pay a fixed return on its obligations regardless of their fate, should the economic conditions deteriorate. In the former, the return paid on the bank's obligations depends directly on the returns of its portfolio of assets. Consequently, the cost of capital would adjust itself automatically to suit changes in production and in other business conditions. Furthermore, any shock which might befall the obligations' side of the balance sheet would be automatically absorbed. This flexibility not only prevents the failure of the enterprises seeking funds but also ensures the existence of a necessary harmony between the firm's cash flow and its repayment obligations. This is the main element which enables the financial system to work smoothly. Since bank assets are created in response to investment opportunities in the real sector of the economy, the real 42 factors related to the production of goods and services (in contrast with the financial factors) become the prime movers of the rates of return to the financial sector. The transformation of an interest-based system into profit sharing system helps in the achievement of economic growth which results in increasing the supply of venture or risk capital and consequently encourages new project owners to enter the realm of production as a result of more participation in the risk-taking.

In the post –9/11 global scenario anti money laundering measures by regulatory authorities of banking and finance have gained extraordinary importance. It is pertinent to indicate in this regard that Islamic banks, by their nature, are less likely to engage in money laundering and other illegal activities. They cannot undertake activities which are detrimental to society, because to ensure the adherence of moral values, it has to go through an exhaustive test of Shariah compliance. Islamic banks are not allowed to invest in narcotics, casinos, nightclubs, breweries etc. This requires that the clients of Islamic banking must have business which should be socially beneficial for the society, creating real wealth and adding value to the economy rather than making paper transactions. Therefore, a more stringent ‘Know Your Customer’ (KYC) policy is an in-built requirement for an Islamic bank.

Islamic modes of financing and deposit-taking discourage questionable or undisclosed means of wealth which form the basis of money laundering operations. Islamic financing modes are used to finance specific physical assets like machinery, inventory and equipment etc. Further, the role of Islamic banks is not limited to a passive financier concerned only with timely interest payments and loan recovery. Islamic bank is a partner in trade and has to concern itself with the nature of business and profitability position of its clients. To avoid the loss and reputational risk, the Islamic banks have to be extra vigilant about their clientele. As such, Islamic banks are less likely to engage in illegal activities such as money laundering and financing of terrorism than conventional banks.

However, the existence of rogue elements cannot be ruled out in any type of organization. Keeping this in view, Pakistan has adopted a strategy by adopting uniform international standards to ensure fair play by all kinds of banks and financial institutions including Islamic banks. After reviewing its existing systems and procedures, it has developed a multiple-track strategy in its financial war on terrorism and money laundering. It has also put in place stringent regulations in order to effectively curb money laundering. The ‘Know Your Customer’ (KYC) regulation has been sharpened to provide more detailed guidelines to banks/DFI’s for due diligence in respect of customers. All banks are required to properly investigate transactions which are out of character with the normal operation of the account involving heavy deposits/withdrawals/transfers.

The conventional banking still holds sway over the overwhelming part of the banking operations internationally. However, over the last thirty years, some of the Muslim countries have started Islamic banking which is running parallel to the conventional banking system. Islamic banking is yielding a reasonable success. The current success of Islamic banking and finance has been accomplished despite the unavailability of an ideal legal and institutional set up which is imperative to support the operation of these banks. There is no doubt that once an appropriate institutional infrastructure is completed, their degree of success will be even greater. Provision of enabling framework which may include compatible national and banking laws, rules and regulations, tax regime, accounting system and relevant disclosures etc. are the prerequisites of Islamic financial system.

In case all interest based transactions are abolished from the economy, the implications at the national and international level may be visualized as follows:

A. Implications at the national level:

The following will be the implications at the national level.

B. Advantages of Islamic Financing at the International Level

The present age of globalization has witnessed the narrowing/eliminating the gaps of communication. Further, the market disclosures are also getting enhanced which would expose the economies to the influences of external factors that pass through trade as well as capital flow channels. A single country cannot place trade controls without consulting the World Trade Organization (WTO). After repeated international financial crises, especially that which befell the South East Asian countries, economists found themselves compelled to reconsider their preference for free capital flows, especially short-term. We cannot also ignore the fact that such flows are associated with interest-based financing, where debt becomes marketable and free moving.

In a conventional economy, debt financing comes in a pyramid-shaped chain, where foreign banks lend local banks, which in turn lend individuals and local enterprises. Most of this lending is on short-term basis. Once foreign banks face a problem, they recall their loans from local banks, which in turn recall their loans from domestic borrowers. Thus the pyramid of debts starts to collapse and a financial crisis ensues. An Islamic economy would receive external capital flows using only Islamic modes of finance. Whether based on partnership or markup, those flows would be contractual and are neither marketable nor recallable on notice. We can, therefore, imagine that those who wish to provide external capital flows to an Islamic economy would have to wait until the maturity dates of their debts before withdrawal. Those interested in providing external funds on a partnership basis would have to abide by the partnership contracts. Therefore, Islamic financial system is not prone to those risks which the conventional banking system is exposed to.

This question has three parts as follows:

Each of these three dimensions is discussed as follows:

Dealing with current debts

To begin with it should be noted that the shift to the Islamic economic system does not mean the outstanding debt under conventional system would not be settled. It is a basic principle of the Shariah that Muslims should fully honour their contracts/promises. Therefore, the principal and interest amount of such debts that had risen from past contracts and obligations should be settled regardless of whether they were contracted with domestic or foreign parties.

Should a country find it difficult to secure the liquidity required to settle all its outstanding debts, it could resort to one of the following courses of action:

The outstanding debts of developing countries facing economic difficulties are usually offered in markets at prices less than their nominal value. The amount of discount given varies with the economic conditions of each indebted country. It is therefore possible to negotiate directly with creditors swapping debts with equity participation and at the same time achieve some discount.

Meanwhile, governments of developing countries usually have a large public sector, which could be privatized during a comprehensive structural adjustment program. Part of the proceeds obtained from selling some of its public enterprises can be used in purchasing foreign debt at a discount. In addition, debt can be swapped for equity in public enterprises within the desired limits of keeping the majority holding of key enterprises in the hands of nationals.

The harmful effects of borrowing

Having said that all outstanding debt must be settled, Muslim governments should strictly avoid future borrowing because of interest. In this regard, the global debt crisis can be recalled that started during 1982 which was accompanied by the inability of developing countries to settle their debts. The crisis continued until 1990 when the developing countries returned quickly to borrowing. The debt problem rose again in 1997 in the Asian countries, and it was accompanied this time with a crisis in the foreign exchange market. This renewed heated discussions among economists. Some suspected that those crises indicated that a number of developing countries had fallen victim to the greed of some creditors on the one hand and to the unsound economic policies of these countries on the other.

Generally, leveraged economies face the open economy dilemma under which the countries that allow free capital movements have to choose between independent monetary policies and fixed exchange rates. Nonetheless, Southeast Asian countries 49 fixed their exchange rates, while attempting to have independent monetary policies. What compounded their problem was the fact that heavily leveraged economies inevitably face two problems. The first is that business borrowers face disproportionately high risks (in relation to the size of equity) during periods of slow economic activities as debts must be repaid regardless of business conditions. This scenario increases the rate of business failures. Secondly, expectations in the debt market are non-segmental, implying that when debts in one part of the market (a sector or a whole country) become non-performing, pessimistic expectations would not be restricted to that segment as it will spread all over. This phenomenon of contagion is basically because conventional debt is marketable. It exposes heavily indebted economies to business problems. The problem is compounded when the debt is short-term and when lenders of a group of countries are the same. It has become evident from the last debt crisis that Southeast Asian countries allowed excessive borrowing that was short-term. As shown above, there are reasons that would make foreign capital flows a source of instability resulting from the herding effect. It would, therefore, be wise to steer away from borrowing as much as possible and to use Islamic modes of financing instead.

Alternatives to foreign borrowing

What could an Islamic country do to benefit from foreign financial resources? The key to answering this question lies in the innovative utilization of financial markets to attract foreign capital. Such innovative utilization should be made alongside a dialogue with foreign financing institutions to familiarize them with the advantages of using the Islamic modes of finance. Those modes directly finance the purchase of real assets and commodities in contrast with conventional lending which provides enterprises with general funds which could be used on bureaucratic expansion or inefficient conglomeration. The use of foreign funds through Islamic modes would have a direct impact on economic activities, thereby impacting economic development in a more efficient and effective manner. If Muslim countries can put their houses in order, there is no reason why they cannot attract some of these funds.

In this context, the following methods may be considered for attracting foreign capital:

Examples could be:

While functioning within the Shariah framework, Islamic banks can perform a crucial task of resource mobilization and efficient allocation using either profit sharing (Musharaka and Mudaraba) or trading & Ijarah based categories of Islamic modes of financing. Profit sharing modes can be used for short, medium, and long-term project financing, import financing, pre-shipment export financing and working capital financing transactions. To ensure maximum role of Islamic finance in the development of economy it would be necessary to create an environment which may induce financiers to earmark more funds for Musharakah/Mudarabah based financing.

The non-PLS techniques, as acceptable in the Islamic Shariah, not only complement the PLS modes but also provide flexibility of choice to meet the needs of different sectors of the society based on their risk profile. Trade-based techniques like Murabaha with lesser risk and better liquidity options have several advantages vis-à- vis other techniques but may not be as fruitful in reducing income inequalities and generation of capital goods as participatory techniques would do. Ijarah related financing which requires Islamic banks to purchase and maintain the assets and afterwards dispose them off according to Shariah rules, require the banks to engage in activities beyond financial intermediation.

Salam has a vast potential in financing the productive activities in crucial sectors, particularly agriculture, agro-based industries, and the rural economy. It provides incentive to enhance production as the seller would spare no effort in producing, at least the quantity needed for settlement of the loan taken by him as advance price of the goods. Salam can also lead to creating a stable commodities market especially the seasonal commodities and therefore to stabilize their prices. It would enable savers to direct their savings to investment outlets without waiting. This would help them to invest their surplus funds till the harvesting time of agricultural products or the time when they need industrial goods and without being forced to spend their savings on consumption.

On the basis of the above it can be said that supply and demand of capital would continue in an interest-free scenario with additional benefit of greater supply of risk based capital along with more efficient allocation of resources and active role of banks and financial institutions as required in asset based Islamic theory of finance. Islamic banks can not only survive without interest but also could be helpful in achieving the objective of development with distributive justice by increasing the supply of risk capital in the economy, facilitating capital formation, growth of fixed assets and real sector business activities.

Banks might engage in fund and portfolio management through a number of asset management and Ijarah and trading companies. Such companies/entities can exist in the economy on their own or can be an integral part of some big companies or subsidiaries. They can manage Investors Schemes to mobilize resources on Mudarabah basis and to some extent on agency basis and use the funds so collected on Murabaha, Ijarah or equity participation basis. Subsidiaries can be created for specific sectors/operations which would enter genuine trade and Ijarah transactions. Low-risk ‘Funds’ based on short-term Murabaha and Ijarah operations of the banks in both local as well as foreign currencies would be best suited for risk-averse savers who cannot afford losses in PLS based investments. Under equity-based funds, banks can offer a type of equity exposure through specified investment accounts where they may identify possible investment opportunities from existing or new business clients and invite accountholder to subscribe. Instead of sharing in the bank’s profit, the investors would share the profits of the enterprise in which funds are placed with the bank taking a management fee for its work.

Small and medium enterprises (SME) sector have an enormous potential for expanding production capacity and self-employment opportunities. Enhancing the role of financial sector in development of SME sub-sector could mitigate the serious problems of unemployment and low level of exports.

Keeping in view the above, it can safely be said that Islamic banking has a great potential of playing an effective role in the development of the country.