Prospects of Islamic Banking

Texts Articles Cases Internet References 3 Acknowledgment I would worry to in the provide my extremity gratitude to a number of people, for their generous co-ope dimensionn and c be, in the rail of preparing this monograph. Mr Howard Johnson for reviewing my thesis plan, professor Bob Lee for his invaluable insight on Chapters 1-5 and fin from each oney Dr PaulBridges and Dr Simon Norton for their illuminating views on near(prenominal)(prenominal) materialisations. I dedicate my efforts to Bhaijan, who has always been the inspiration and my glide by by dint of and through and through extinct my support. 4 Preface At present metres, it would non be inappropriate to state that Muslims the world every(prenominal) over face the dilemma that their religion, Islam, prohibits am role in stringent terms and aims at establishing an scrimping that is non difficultly free from completely bugger offs and openhearteds of by-line, b atomic number 18ly too from what soeverthing that get ups all resemblance to it.The fresh-make economy is heavily ground and reliant on delight and it is hard to envisage any stria of economic relations where s polish off does non play a get around, whether directly or indirectly. Resolving the above-menti championd re modus operandiion sees to be a ch whollyenge that Muslim intellectuals, m allnessy boxers, industrialists, worrymen, policy-makers and ordinary consumers face. In a nutshell, this monograph seeks to go away an analysis of the lopings and practices of Moslem curseing patience and the products it offers covering level-headed, political, affable and economic issues as they bear on to it.Chapter 1 commences by providing a rationale to the Muslim blasphemeing and outlining its historical journey, and ends with a discussion on the riba and its prohibition in Islam. Chapter 2 deals with the humors of Moslem pay, which certain(p)ly solicits a detailed reflect, as it is these products that tenor the cornerstone of the stainless Moslem patoising industry. sharia law precepts argon besides introduced at this stage (and be discussed throughout this monograph), as they aid the process of comprehension. This chapter would also serve to introduce a discussion on Moslem communicate pay, dealt deep down the pursuance chapter.Chapter 3 deals with Muslim Project Finance in practice, focussing on the legal and diametric economic issues as they affect to shariah law-Related Documentation, Construction and take up Financing and Muslim Bonds. Chapter 4 consists of ii eccentric-studies, spotlight the Common law developments in sharia law law, as it relates to the Muslim brinking industry. both new judgments (one from UK and an sepa esteem from Pakistan) are unique(predicate) everyy per habituate, reflecting the stance that the judiciary in the two countries film follow towards Islamic precepts, its interpretation and application.C hapter 5 awakens issues relating to structuring and oblation of Shariah-Compliant enthronement products. In specific(prenominal), focussing on the role of monetary institutions, gunstock promoters and Shariah advisors. The chapter give overs by providing a com conservation of paritytive analysis on the legal issues linked to the grocery storeing of Islamic investiture products in different jurisdictions. Chapter 6 provides an insight to the regulatory and supervisory practices of Islamic banking in various countries.Obstacles set about by the Islamic banking industry in their construct as regards their set up in interest- found banking jurisdictions is and addressed, which is supplemented by a case study on the regulatory issues of Islamic banks in India. 5 Chapter 7 is meant to be general, and briefly discusses the lessons that pompous and Islamic banks git learn from each opposite, addressing issues such(prenominal) as the effect of technology air and the Bank-Cl ient relationship, which would at long last lead to the progress of one a nonher(prenominal). Chapter 8 concludes this monograph. It ascertains the merits of introducing Islamic banking internationally.Reforms and suggestions for the Islamic banks are also appended to this chapter, together with a few conclusive remarks on the subject. It is aspired that this work lead be a positive contri besidesion on the subject of Islamic banking and its practices. Suggestions and criticisms are bushelly intended to enhance the progress of this relatively nascent banking industry, which has enquirylessly sh possess major signs of progress. 6 G bolshieary of Arabic Terms This section explains nearly of the Arabic words and terms, around of them appearing in this study, whereas others competency relate to them and would consequently be of interest to the reader. all toldah is Arabic for God. Fatawa (singular. Fatwa) are legal decisions or opinions regressed by a qualified religious lead er (mufti). Fiqh is Islamic Jurisprudence, the learning of religious law, which is the interpretation of the sacred Law, Shariah. Gharar is uncertainty, speculation. Hadith (plural. ahadith) is the technical term for the extension cerebrate to the Sunna the sayings- and doings- of the Prophet Mohammed (pbuh), his traditions. Halal content permitted according to the Shariah. Haram means forbidden according to the Shariah. Jualah is the stipulated scathe (commission) for playing any suffice.Maysir mean gambling, from a pre-Islamic game of hazard. Muslim is on who professes the faith of Islam or is born to a Muslim family. Qard Hasan is a benevolent loan (interest-free). Qiyas means analogical deduction. script is the holy place book, the revealed word of God, followed by all Muslims. Riba is literally excess or increase, and covers both interest and usury. Shariah is Islamic religious law derived from the divine Quran and the Sunna Shirka (or Sharika) is a high society or confede localiseship. Surah is a chapter of the Blessed Quran. Takaful refers to vernacular support, which is the dry land of the sen whilent of insurance or solidarity among Muslims.Umma means the federation the body of Muslims. Waqf is a trust or pious strandation. Zakat is a religious levy or almsgiving as required in the Holy Quran and is one of the Islams fin pillars. (Courtesy Lewis & Algaoud, Islamic Banking, Edward Elgar, 2001, G ventary, x, xi. ) 7 Chapter 1 fundament and the Basis of Islamic Banking A. Rationale from an Islamic perspective It is argued by proponents of the Islamic banking that in todays world, the economic system that is based on interest has resulted in concentrating the riches in the hands of selected few, creating monopolies and and widening the gap surrounded by the affluent and the poor.Islamic finance ope strays in configuration with the Shariah law. Islam is non anti-commerce (the Prophet Mohammad was himself a merchant). In contrast to the youthful westward principles and philosophy, Islam encourages circulation of wealth and considers its role as vital to an economy. As Dr Usmani notes in his book, scarce as clotting of blood paralyzes human body, preoccupation of wealth paralyzes economy. The fact that, today ten richest men in the world pay more than(prenominal) wealth than forty-eight poorest countries of the world is relied by the supporters of the Islamic banking as a testament to the fact that the current economical set up is unjust and has failed to distribute the wealth proportionately, and soly leading to the downfall of humanity. 1 On considering the injunctions of the Holy Quran, it is observable that the system of distribution of wealth hardened down by Islam envisages three objects, viz. (a) The establishment of a executable system of economy. (b) Enabling every one to obtain, what is rightfully collect to them. c) Eradicating the concentration of wealth. The traditional impression of Muslims that Islam is a unique way of life different from all other isms and ideologies extends to the economic life of the Muslims (Umma). In the process of reshaping the economy, the areas of silver, banking and investment are regarded as extremely vital to the process of Islamisation of the economy. The Islamic wildness on co- surgical process as the key concept in economic life has led to reliance on profit- communion and participation as the alternative bases for banking and investments in the Islamic framework. The concept of Islamic banking is regarded as one of the few master copy and creative Islamic thoughts that shake up been successfully tried in young times. In the not too distant past, the entire banking system in all Muslim countries was de subscribe on the Western banking model the last mentioned universe inconsistent with Islamic law primarily due to the reproach of Riba (i. e. interest) in Islam. In other words, the elimination of Riba 1 Meezan Banks Guide to Islamic Banking by Dr Muhammad Imran Ashraf Usmani, Preface, paginateboy 7, Darul-Ishaat, 2002. 2Issues in Islamic Banking, Selected written document by M. N. Siddiqi, knave 9, Preface, 1983. 8 from pecuniary exercises is the raison detre of Islamic Banking3. Attempts to negate dealing in interest led to the introduction of a non-interest based banking system, comm completely termed as Islamic banking. McDowall notes that Islamic banking not only provides services that are compliant in terms of the Muslim faith, but through the fundamental concept of profit and termination sharing with their nodes, experience a highly ethical proposition to stodgy banking. As Islamic banking offers services to its clients free from interest, any dealing or exercise that involves interest is seen as erroneous and olibanum forbidden. Technically, riba refers to the addition in the principal substance of a loan, which the lender receives from the sop uper. This deliberately sim plified picture of the true labyrinthine state of affairs is aboutthing I shall return to in the following chapter in detail. B. History The Islamic financial system has a centuries-old history, as far-famed by Chapra and Khan (2000) From the very early stage in Islamic history, Muslims were able to establish a financial system without interest for mobilising resources to finance productive activities and consumer penurys. The system worked quite effectively during the heyday of Islamic shade and for centuries thereafter. However, over the centuries, the centre of economic gravity inclined towards the Western world, and the Western financial institutions (including banks) became dominant and the Islamic tradition remained dormant. 5 The Muslim society never approbated interest throughout the thirteen enturies of its history prior to supremacy by imperialist powers, it managed its economy and carried on domestic and international avocation without any involvement of interes t. Profit sharing and different kinds of participation arrangements served as tolerable basis for savings and investment and considerable chief city was mobilised for mining, shipbuilding, ocean trade, textiles and other industries. 6 The issue of interest free banking regained the attention of Muslim intellectuals in the 1940s and 1950s. By this time, numerous local and national banks were effected along the lines of interest-based foreign banks.By this time, the government of Muslim countries, in particular, those who gained political independence, found themselves compelled to engage in international financial transactions using banking systems. The fate for commercial banking was realised. The challenge was to 3 Profit and Loss packet, An Islamic experimentation In Finance and Banking by Shahrukh Rafi Khan, Introduction and Overview, varlet 1, OUP, 1987. 4 Islamic Banking A Brief Historical Perspective by Bob McDowall, strain and Finance, 27th May 2004. 5 Islamic Banki ng and Finance by Munawar Iqbal and David T.Llewellyn, Introduction, foliateboy 1, para 1, 2002. 6 Ibid at 1, paginateboy 9, para 2. 9 avoid the concept of interest within commercial banking. The path to this was the development of the concept of profit and loss sharing (Mudarabah), the key concept from which the anatomical structure of some Islamic banking products and services are derived. 7 C. Current Status All over the world, Muslim bankers and economists are faced with the enquiry as to how they should press out interest and evolve new institutions and practices, which would enable economic activities to flourish without resorting to Riba in any form? In recent years, there has been a resurgence of interest in formulating a modern version of the historic Islamic financial system, as many Muslims are endeavouring to avoid interest-based practices and transactions. Islamic banking was most an unknown concept thirty odd years ago. Now, fifty-five create and emerging ma rket countries construct whatsoever nexus with Islamic banking and finance and Riba free has be herald the buzzword for financial institutions that wish to attract the double and attractive customer base in the form of Muslims all over the world who are tone for Shariah-Compliant modes of investments and financial supports.In addition, there are Islamic financial institutions operating in 13 other locations. 9 In Pakistan, Iran and Sudan, all banks mustiness(prenominal)(prenominal)(prenominal)inessiness(prenominal) operate down the stairs Islamic financing principles. As observe by Justice Mufti Usmani, there were 200 Islamic banks and financial institutions in forty-three countries of the world, controlling a financial pool of US$ blow billion,10 increasing at an annual rate of 10-15 percent. The Islamic financial industry is already one of the fastest growing industries and has tremendous potential as discover by academics in general.The unorthodoxy of Islamic ba nking model is apparent from the fact that those who argue in choose of Islamic banking are a lot regarded as utopians and romanticists, but they lead that the best form of realism could be achieved by challenging all those systems that are based on the victimization of man in one form or the other and in seeking to set up a just socio-economic nightspot. Dr Siddiqi argues that an Islamic economy is capable of freeing modern man from the debt-ridden economy in which he survives, and of guiding him towards a society based on justice and equity, and ultimately leading to the path of growth and stability. 1 D. Riba and its Prohibition in Islam As detect by Lewis, in order to conform to Islamic norms, five religious features are well established in the literature, and must be adhered to in investment behaviour. They are as follows 7 Islamic Banking by Mervin K. Lewis & Latifa M. Algaoud, Chapter 2, Islamic Law, scalawags 4 & 5, Brief History, 2001. 8 Banking Without Interest by M uhammad Nejatullah Siddiqi, Foreword, para 1 &2, 1983. 9 Australia, Bahamas, Canada, Cayman Islands, Denmark, Guernsey, Jersey, Ireland, Luxembourg, Switzerland, United Kingdom, United States and the Virgin Islands. 0 New Horizon, No. 82, December 1998, p. 17. He is the Chairman of Centre for Islamic Economics, Pakistan, and a judge of the Islamic Shariah Court. 11 Ibid at 1, rascal 7 & 8. 10 (a) the absence of interest-based (riba) financial transactions (b) the introduction of a religious levy or almsgiving, (zakat) (c) the prohibition of the production of goods and services that contradict the value pattern of Islam (haram) (d) the avoidance of economic activities involving gambling (maysir) and uncertainty (gharar) (e) the readiness of Islamic Insurance (Takaful).These five elements give Islamic banking and finance its typical religious identity. 12 For the marks of our present chapter, we need to focus briefly on element (a), i. e. absence of interest-based transactions, wh ich is indeed the central element among the latter. Islamic finance, like Islamic commercial law in general, is dominated by the philosophical system of riba, and it is absolute that we discuss this in some detail, as to its nature and prohibition. The literal meaning of the Arabic word riba is increase, excess, growth or additional.According to Sahacht (1964), riba is s implicate a special case of unjustified enrichment or, in the terms of the Holy Quran, consuming (i. e. appropriating for ones own practice) the stead of other for no good author, which is prohibited. Prohibition of interest is ordained in Islam in all its forms. The latter prohibition is strict, absolute and certain. The whole concept of interest is fundamentally repugnant to the spirit of Islam, as could be observed from the following verses of the Holy Quran O, believers, fear Allah, and give up what is tranquilize due to you from the interest (usury), if you are true believers. (Surah 2 Aayat 278) And If y ou do not do so, consequently take notice of war from Allah and His Messenger. But, if you repent, you batch have your principal. N any should you commit injustice nor should you be subjected to it. (Surah 2 Aayat 279) 12 Ibid at 7, page 28, para 2, 2001. 11 Chapter 2 Islamic Modes of Financing Introduction One can vividly perceive the transition in the global banking sector, from core/retail banking, to the complex and detailed role of financing, which clearly depicts edification and organisation of international banking alliance.With the passage of time, the banks have doubtlessly become multifunctional bodies, performing various roles and providing their clients with numerous desired products. Speaking of the international banking community, Islamic banking is undoubtedly a part of it. To keep up with this modernised community and to debate with their fellow-competitors, Islamic banking has introduced and refined some alternative Islamic financing products, to the ones g etable in the formal markets, in order to cater for the Muslim community around the globe.Having verbalize that, it is open to anyone, whether a Muslim or a non-Muslim, to take advantage of these products, as long as they comply with the requirements and precepts of Islamic Shariah. At this instance, it helps to add that the prohibition of interest in Islam does not imply that the swell is not to be rewarded, nor that risk is not be expensed. The Islamic system has both repair and variable return modes to toll the capital and add risk premia in relation to the degree of risk involved.Islamic banks provide financing using two methods. The first is based on profit-sharing and the encourage one deals with modes, which rely on fixed return (mark up) and often conclude in creating indebtedness of the political party seeking finance. The Islamic modes of finance are unique as the debt related with financing using mark-up modes results from real trade good sale/ buy operations, rather than the alter of money for interest-bearing debt. Furthermore, different the Conventional debt, such debt is not marketable except at its design value. 3 The whole view behind the Profit and Loss Sharing (PLS) is seen as an innovation, a modern trend if you like, and it is aspired that it depart bring several merits to the industry of investment and finance, thus benefiting the community at large. It must be borne in mind that the Islamic Shariah does not prohibit Islamic banks from bare assures. However, the question of the legality of the commissions and charges received by banks in issuing the guarantees has been a subject of much debate and discourse.Several banks in the Middle eastern have sought to tackle the latter issue by agreeing to issue guarantees at no charge, epoch simultaneously asking for cash related of a specific percentage (30 %) of the guaranteed totality, which is then invested by the bank for its own account and benefit for the while of the g uarantee. 14 13 Progress and Challenges of Islamic Banking by Abbas Mirakhor, Review of Islamic Economics 4 (2) 1997. 14 select Guarantee in the Arab Middle East, J. I. B. L, 7, page 271, 1997. 12In order to circumvent the ambiguities raised, a group of Muslim scholars gave their opinion on the legality of Islamic banking practices as regards guarantees. Their opinion is summarised in two segments and is as follows. 1. The legality of the issuance of a bank guarantee relies on the legality of Shariah principles of the consume in question, in respect of which the guarantee was issued. It is evident that no Islamic bank should issue guarantees in relation to items that are prohibited beneath the Shariah, including guarantees for the compensation of usurious interest, the sale of alcohol, drugs, the construction of gaming places, etc.The latter may seem to be an obstacle towards an entirely independent guarantee, but its scope should not be overstated. As long as the adjure in que stion is considered lawful by the standards of Shariah precepts, a guarantee stipulated to be blunt and payable on first demand would be deemed legitimate and in military capability on a lower floor Shariah, notwithstanding the performance or termination of the underlying contract. . Banks are entitle to receive remuneration for the issue of a guarantee. Having say that, the amount of remuneration, to be in accordance with the Islamic Shariah, ought not be fixed in accordance with the amount of the issued guarantee, but should instead be calculated to provide a reasonable compensation to the issuing bank for the time and effort that the latter spent to issue and manage the guarantee. 5 This chapter result focus on the Islamic modes of finance, other than guarantees, namely Musharakah, Mudarabah, Murabaha, Bai Muajjal, Ijaraha, Ijaraha Wa Iqtina, Salam, Istisna and Istijrar, which are uncommitted in the global financial market today, whilst providing a comparison with the Con ventional finance products, wherever possible. A(i). Musharakah The literal meaning of the Arabic word Musharakah is sharing, or Shirkah, which means world a partner. at that place are several kinds of partnership, and they all come under the heading of Shirkah. Musharakah is perceived as an apotheosis alternative for the interest based financing with far reaching make on both production and distribution. 16 The term Musharakah as used in the modern terminology, has been recently introduced by Islamic Scholars writing on the subject and is normally restricted to a particular type of Shirkah, which is Shirkat-ul-Amwal, where two or more persons invest some of their capital in a articulatio commercial venture.However, at times it could also include Shirkat-al-Aamal, where partnership takes place in the business of services, whereby all the partners jointly try to render some services for their customers, and a fee is charged from the latter and is distributed among the partners a s per an agreed ratio. 17 15 Shariah Related Documentary Issues in Islamic Project Finance proceedings, J. I. B. L. R 2003, page 272, para(s) 2, 3 & 4. 16 Meezan Banks Guide to Islamic Banking by Dr Muhammad Imran Ashraf Usmani, 2002, page 87, Chapter 13 (Definition and Classification of Musharakah). 7 Ibid at 11, page 90. 13 Musharakah is a mutual contract between the parties, and thus all the mandatory ingredients of a validated contract must be present. Furthermore, the capital in Musharakah agreement should be quantified, qualify, but not necessarily merged or in naiant form. If all the partners agree to work for the joint venture, each one of them shall be contended as the agent of the other, in all librates concerning the business. Any act carried out by a single partner, in the normal course of business, shall be deemed as authorised by all other partners. 18All scholars are unanimous on the principle of loss sharing in Shariah, which is based on the saying of Syedna Al i ibn Talib, which 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. 19 vector sum of the Musharakah agreement Musharakah agreement will be dismissd in the following plenty. 1. If the purpose of forming the Shirkah has been achieved. 2. Every partner can exercise his/her right to give the sack Musharkah at any time after giving his partner a reasonable notice. . In the case of a demise of any one of the partners or any partner becoming insane or incompetent of effecting the commercial transaction. 4. In the case of malign to the share capital of one partner beforehand mixing the analogous in the total investment and before affecting the purchase, the partner will stand terminated and the loss will be borne by that particular partner. However, if the share capital of all the partners has been mixed and could not be identified singly, then the loss will be shared by all and the pa rtnership will not be terminated. 0 Termination of Musharakah without the closure of the business If one of the partners intends to terminate the Musharakah, in disagreement with the other partners, the latter issue could be stubborn by mutual consent. The partners intending to run the business may purchase the share of the partner who wants to terminate his partnership, as the termination of Musharkah with one partner does not affect the Musharkah between the other partners.The latter seems to be a just and a viable approach, especially in the modern military posts, where the success of a particular business is conditional upon its continuity, and the liquidation or separation at the instance of a single partner may only shake up irreparable damage to the other partners. 21 18 Ibid at 11, page 91 & 92. Ibid at 11, page 94 (Rules of Distribution). 20 Ibid at 11, page 95 (Termination of Musharakah). 21 Ibid at 11, page 96. 19 14 warranter in MusharakahAs regards a Musharakah agre ement between the bank and the client, the bank should in its own right and discretion, obtain adequate security to delay that the capital invested/financed and the profit that may be earned are safe. As part of the usual practice, the securities obtained by the bank, are kept comprehensively see at the partys represent and expenses, till the Islamic mode of insurance (Takaful) becomes in operation(p). It is understood that the purpose of the latter security is a preventative measure to cover for damage(s) or loss of the principal amount due to the clients slight. 2 Differences between interest-based financing and Musharakah 1. As regards interest-based financing, a fixed rate of return on a loan, advanced by the moneyman is pre resolved, irrespective of the profit earned or loss suffered by the debtor. Mushrakah agreement does not envisage a fixed rate of return, it is in fact based on the actual profit earned by the joint venture. 2. The financier cannot suffer loss in an i nterest-based financing. The financier under a Musharakah agreement can, possibly suffer a loss, if the joint venture fails. 3.It is argued by Islamic scholars and other academics that the interest-based financing results in injustice, each to the creditor or the debtor. If the debtor suffers a loss, it is unjust on the creditors part, to convey a fixed rate of profit. And, if the debtor earns a high rate of profit, it is injustice to the creditor to provide him with only a small proportion of the profit, while the debtor taking the chunk of it. As regards a Musharkah agreement, the returns of the creditor are even up with the actual profits earned through the enterprise, which he/she financed.The greater the profits of the enterprise, the higher the rate of return to the creditor. If the enterprise earns substantial profits, the creditor cannot achieve all of it, but has to share it with the common people, e. g. depositors in the bank. 23 land tenure of Musharakah As regards t he determination of the period of the Musharakah agreement, the following conditions operate. (a) The partnership is fixed for such a duration that at the end of the tenure, no other business can be mannersed. 2 23 Ibid at 11, page 97 (Security in Musharakah). Ibid at 11, page 98. 15 (b) The partnership can be for a very short term, during which nevery partner can resolve the partnership. 24 A(ii). Diminishing Musharakah Another form of Musharakah, which has developed in the recent years, is known as Diminishing Musharakah. It involves the participation of a financier and his client, either in the joint proprietorship of a property/equipment, or in a joint commercial enterprise.The financiers share is further divided into several units, and it is intended that the client will purchase the financiers units of the share, one at a time, periodically, increasing his own share, until all the units of the financier are purchased by him, so as to make him the sole owner of the property o r the commercial enterprise, whichever be the case. 25 B. Mudarabah This is also a kind of partnership, whereby one partner provides finance to the other for investment in a commercial enterprise.The investment is provided by the first partner called the Rab-ul-Maal, while the entire responsibility for the management and work falls upon the other partner, who is called the Mudarib. The profits generated, are shared in a predetermined ratio. There are two kinds of Mudarabah restricted and unrestricted. Rab-ul-Maal may specify a particular business for the Mudarib, in which case he shall invest the money in that specified business only. This is known as Al-Mudarabah-alMuqayyadah (restricted Mudarabah).But if he leaves it open for the Mudarib to undertake whatever business he wishes, the Mudarib shall be authorised to invest the money in any business he wishes. This type of Mudarabah is called Al-Mudarabah-al-Mutlaqh (unrestricted Mudarabah). A Mudarib cannot forward the money lent t o him, or carry out any action that is beyond the course of his business, without the Rab-ul-Maals express allowance or consent. Rab-ul-Maal is entitled to oversee the activities carried out by the Mudarib. The former can also work with the Mudarib, provided the latter gives his consent.A Rab-ul-Maal can contract Mudarabah with more than one person through a single transaction, for instance, he can offer financial assistance to X and Y both so that each of them becomes a Mudarib, and the capital of the Mudarabah transaction shall be utilized by both of them, jointly. 26 It is imperative that both the parties should decide in advance, on the proportion of profit that each one of them should receive. However, the parties cannot suggest a lump sum amount of profit, nor can they determine the share of any party at a 24 Ibid at 11, page 102 (Tenure of Musharakah).An Introduction to Islamic Finance by Muhammad Taqi Usmani, Chapter 2, page 82, para 1 (Diminishing Musharakah). 26 Ibid at 11, pages 105-108. 25 16 specific rate tied up with the capital. If the business has suffered loss in a few transactions and do profit in some others, then the profit should be used to offset the loss/ losses incurred, and whatever remains, shall be a distributed between the parties according to the agreed ratio. 27 Roles of Mudarib He is an Ameen (trustee), who is responsible to look after the investment, with an exception of natural calamities.He is a Wakeel (agent), as he makes the purchases from the funds provided. He is also a Shareek (partner), thus sharing the profits with Rab-ul-Maal. He can also possibly be a Zamin ( nonimmune), and thus will have to compensate for any loss suffered during the course of Mudarabah, due to any erroneous act on his part. 28 Termination of Mudarabah The Mudarabah will come to an end when the specified period in the contract expires. It can also be terminated by either of the two parties, at any time, by giving notice.Furthermore, in case Rab-u l-Maal has terminated the services of Mudarib, the latter will continue to perform his acts under the contract, until he is informed about the termination. 29 C. Murabaha In this particular kind of sale, the give awayer clearly mentions the cost of the sold commodity, and then sells it to the buyer by keeping a profit margin. Thus, Murabaha should not be seen as a loan accustomed on interest, it is rather a sale of a commodity for cash/deferred harm. As regards Bai Murabaha, the bank purchases a commodity, on a clients behalf, and then resells it to the latter, on the basis of plus-profit.Under this kind of agreement, the bank discloses its cost and profit margins to the client. Thus, unlike Conventional banks (which advance money to a borrower), the bank will buy the goods from a ordinal party and sell it onwards to a customer for a pre-agreed hurt, thus abstaining from interest. The growing use and vitality of Murabaha agreement is testn by the fact that in Islamic banks wor ld over, 66% of all investment transactions are through Murabaha. 30 It is argued by critics of Islamic banking that Murabaha agreements are in reality interest-based contracts, under the garb of a notional sale and buy ack transaction, profit being synonymous to interest in this case. Islamic scholars have reverted to this argument by stressing that a true Murabaha financing structure is quite different 27 Ibid at 11, 109-111. Ibid at 11, page 111, para 5. 29 Ibid at 11, page 112, para 2 (Termination of Mudarabah). 30 Ibid at 11, page 125, Chapter 16 (Murabaha). 28 17 from an overdraft provided by Conventional banks and the former offers various benefits to the bank and its customers, namely that depositors have a share in the banks profits.Furthermore, the pass contravention is the Aqd (contract), which specifies the Islamic conditions, as against the interest element in Conventional banking transactions. 31 Basic Rules for a Murabaha transaction 1. The subject of sale must be in existence at the time of the sale. 2. The vendor must have the ownership of the commodity in question. 3. The subject of sale must be in physical or constructive possession32 of the seller while he is selling it. 4. The sale must be clamorous and absolute no provisions for contingencies should be made part of the contract. . The goods/commodity to be sold, must reflect a value and must be specified to the buyer, leaving no room for ambiguities or bewilderment as between the parties. 6. The sale must be unconditional and the price of the commodity should be certain. 33 If a client inadvertences on any requital(s) by the due date, the price cannot be changed nor can the penalty fees be charged, as against him. Nevertheless, as regards dishonest clients, who knowingly and deliberately slackness, they should be made liable to compensate the bank, subject to the following two conditions. a) The defaulter must be given a grace period of at least(prenominal) a month. (b) It must be proved beyond reasonable doubt that the client is a defaulter, and he has no justifications for his latter behaviour. 34 Murabaha can only be used when a commodity is to be purchased by a customer/client. It is highly pertinent to peruse the subject matter of the Murabaha, as the documents must be signed for obtaining funds for a specified purpose only. It needs to be stressed that the Murabaha consists of several different contracts and they all play their part one after another, in respective stages. 5 31 Ibid at 11, page 126, para 2 (Arguments against Murabaha). It refers to a situation where the possessor has not notwithstanding taken the physical actors line of the commodity, yet all rights and liabilities of the commodity are passed on to him including the risk of its destruction. 33 Ibid at 11, page 126-127 (Murabaha Rules). 34 Ibid at 11, page 129, para 1 (Penalty for Default). 35 Ibid at 11, page 130-131 (Basic Mistakes in Murabaha Financing). 32 18 D. Bai Muajjal This is baseally a sale on deferred payment.The deferred payment becomes a loan, which the buyer pays in a lump sum or instalment (as agreed between the parties). In Bai Muajjal all those items/commodities can be sold on a deferred payment, which come under the heading of capital, where quality does not make a deflection but the natural or intrinsic value does. The price to be paying(a) must be agreed and fixed at the time of sale. The buyer must be given complete possession of the commodity in question, whilst the seller is free to ask the buyer to provide him with guarantee in the form of a mortgage or any other item. 6 E. Ijaraha In an Islamic leasing (Ijaraha), the owner of the addition, while retaining the corpus of the asset, transfers its usufruct to another person for an agreed period, at an agreed good will. All the liabilities arising from the ownership must be endured by the lessor. The period of lease must be determined in clear terms and the asset must be clearly identi fied as between the parties. 37 The lessee is liable to compensate the lessor for all the damage(s) caused to the contract asset by any misuse or negligence on his part.The letting should be determined at the time of the contract for the whole duration of the lease. The lessor cannot increase the renting uni posteriorally, and must consult the lessee in that regard. 38 Lease was not originally a mode of financing, til now, certain financial institutions have adopted leasing as a mode of finance instead of a long term lending arrangement, which is based on interest. The transaction of financial lease may be used for Islamic financing, subject to certain conditions. It does not suffice for the latter purpose to understudy the term interest by rent and mortgage by leased asset.It must be emphasised that there is a difference between leasing and an interest-bearing loan, as regards Islamic Shariah. 39 Unlike the contract of sale, an Ijaraha agreement can be based on a time to come date, thus it is different from a Murabaha agreement in that respect. In majority of the cases concerning financial lease, the lessor (financial institution) will purchase the asset through the lessee himself. The lessee makes the purchase on behalf of the lessor who then pays the price to the supplier, either directly or through the lessee. 0 The lessor, being the owner of the asset, and having purchased it through his agent (lessee), is liable to bear all the expenses incurred in the process of its purchase and its import to the country of the lessor (if that is the circumstance), e. g. expenses of dispatch and customs duty etc. 41 36 Ibid at 21, pages 102-103 (Bai Muajjal). Ibid at 21, pages 158-160. 38 Ibid at 11, pages 148-149. 39 Ibid at 11, page 149 (Lease as a Mode of Finance). 40 Ibid at 11, page 150 (The Commencement of Lease). 41 Ibid at 11, page 152, para 3 (Expenses Consequent to Ownership). 37 19 Variable Rentals in Long Term LeasesSeveral Islamic banks use the rate of interest as a benchmark to calculate the rental amounts, e. g. London Interbank Offered Rates (LIBOR), which is the rate of interest at which Conventional banks borrow funds from other banks, in marketable size, in the London interbank market. The idea is to earn the same amount of profit through the mode of leasing, as earned by the Conventional banks by advancing loans on interest. or else of fixing a definite amount of rental, the Islamic banks calculate the cost of purchasing the asset that is to be leased and intend to earn an amount equal to the rate of interest.Thus, the agreement between the parties provides that the rental will be equal to the rate of interest or to the rate of interest in addition to something. Since the rate of interest is variable, it cannot be set for the whole duration of the lease. The latter arrangement has been objected to on the following two grounds42 (a) By subjecting the rental payments to the rate of interest , the transaction is made to check an interest-based financing. The modern Islamic scholars have denied that argument and have stressed that the rate of interest is only used as a benchmark.As far as the requirements of Shariah are concerned, they must be fulfilled for a valid lease to be executed, and it is the latter that counts, as regards the legality of the Islamic financial lease. The vital difference between an interest-based financing and a valid Islamic lease does not lie in the amount that has to be paying(a) to the financier or the lessor. However, it is recommended that the use of rate of interest as a benchmark must be avoided at times, where possible, so as to distinguish it with the non-Islamic transaction. 3 (b) The moment criticism relates to the situation that the variations of the rate of interest are not determined and the tying up of rental with that rate of interest implies Jahalah and Gharar (uncertainty, especially in a contract that may lead to disputes later on), which are not permi ssible by Shariah precepts. It is one of the basic tenets of Islamic Shariah that the parties must be well aware of the consideration in every transaction they enter into.This objection has been responded by looking at the reasons of prohibition for Jahalah, namely that Jahalah may lead to disputes between the parties and it might render the parties susceptible to an unforeseen loss. As regards the first objection, both parties make their decisions with mutual consent upon a welldefined benchmark serving as a criterion for determining rent, thus no question of dispute arises. Relating to the second objection, several contemporary scholars suggest that the relation between rent and the rate of interest is subjected to a limit.E. g. the base contract may provide that the rental amount given after a specified period will be altered according to the change in the rate of interest, but in no instance, it will be higher than 15% or lower than 5 % of the previous monthly rent. The latter i mplies that if the increase in the rate of interest is more than 15%, the rent will be increased only up to 15%, and if it decreases by more than 5%, the rent shall not be decreased to more than 5%. 44 42 Ibid at 11, page 154 para 1. Ibid at 11, page 155. 44 Ibid at 11, pages 155 & 156. 43 20 F.Ijaraha Wa Iqtina It is permissible in Islamic Shariah that instead of there being a sale, that the lessor signs a evidence agreement, making a pledge to gift the leased asset to the lessee at the end of the lease period, on condition that the lessee makes all the payments due for his/her rent. The latter arrangement is known as Ijaraha Wa Iqtina. It has been affirmed by a large number of contemporary Islamic scholars and is widely practiced by the Islamic banks and financial institutions. Although, the validity of this arrangement is subject to two conditions.They are (a) The agreement of Ijaraha itself should not be subjected to signing of sale or gift. The promise should be made in a se parate document. (b) The promise must be unilateral and binding on the promisor only. If the leased asset is used by numerous users, the lessee cannot sub-let the asset, except with the express permission of the lessor. The lessor can sell the leased property to a third party, whereby the lessor is replaced by the new owner, and the lease agreement would then be between the new owner and the lessee. 5 This form of financial leasing has been subjected to criticism as it is not compatible with the modern financing agreements, as a non-binding promise cannot be en hurtled before courts and is thus not a legally suitable solution. In an attempt to reconcile Ijaraha Wa Iqtina with the modern financial structure, it is suggested that the lessors failure to honour his non-binding promise should be subjected to a pre-contractual liability, or culpa in contrahendo.In civil law jurisdictions, this concept of pre-contractual liability contemplates that the contracting parties will conduct the ir pre-contractual dealings in good faith and also points to any pertinent facts, which are within the commercially usual limits, to the other party. If a party is unsuccessful in carrying out its duties, and thus in breach of contract, then it will have to pay the damages to the other party for not fulfilling the agreement. By adopting this suggestion, the promisor in breach, is made liable for the promisees cost, in finding another similar object to purchase. 6 G. Salam This mode of financing can be used by modern banks and financial institutions, especially in order to finance the agricultural sector. In Salam, the seller undertakes to sum specific goods to the buyer at a future date, in exchange of an advanced price fully paid at the spot. The payment is made in cash, and the supply of purchased goods is deferred. 45 Ibid at 11, pages 161-162 (Ijaraha Wa Iqtina). Construction and Lease Financing in Islamic Project Finance by Klarmann, J. I. B. L. R, page 65 (Lease Financing Ij araha Wa Iqtina). 6 21 Purpose of Salam Contracts The purpose is to meet the need of farmers, who operate on a small scale, and thus need the finance for farming purposes, so that they can carry out their day-to-day activities. Moreover, it is designed to assist the traders, in their export/import transactions. Salam proves good to the seller, as he receives the price in advance, and at the same time, profitable to the buyer, as the price under the Salam arrangement is normally lower than the price in spot sales. 7 The permissibility of Salam is seen as an exception to the general feel that prohibits forward sale and thus it is subject to certain stringent conditions, which are as follows Conditions of Salam 1. The buyer must pay the full price to the seller at the time of effecting the sale. The basic idea behind the Salam agreement, is to satisfy the instant need of the seller. If it is not paid in full, the latter purpose is not achieved. 2. The quantity and the quality of the goods must be specified. 3. Salam cannot be effected on a particular commodity or on a roduct of a particular field or farm. 4. The contract must expressly state the quality of goods, thus leaving no room for ambiguities, which might lead to disputes later on. Same is the case as regards the quantity it must be agreed upon in absolute terms. 5. The exact date and place of the delivery must be specified. 6. Salam cannot be effected in respect of things, which require them to be delivered at the spot. 7. Since the price in Salam agreements is generally lower than the price in spot sales, the difference between the two prices may be a valid profit for the bank. . A security in the form of a guarantee, mortgage or hypothecation may be required in order to ensure the delivery from the seller. 9. The seller must deliver to the buyer, the commodity, and not the money at the time of the delivery. 48 H. Istisna Istisna is a sale transaction whereby a commodity is transacted before it comes into existence. It is an order for a becomer to manufacture a certain kind of commodity, to be used by the purchaser. The shaper uses his own material to 47 48 Ibid at 11, page 133 (Purpose of Use).Ibid at 11, pages 134-135 (Conditions of Salam). 22 manufacture the required goods. The price must be fixed with consent of all the parties involved. All other vital specifications of the commodity must also be fully settled. Subject to the acknowledgment or receipt of prior notice, either party can cancel the contract before the manufacturing party has begun the work. The time of delivery need not be fixed, however a time limit may be imposed as between the parties. 49 I. Istijrar Istijrar means purchasing the goods from time to time, in different quantities.It is an agreement, whereby the purchaser buys something at regular intervals, without any formal offer or acceptance mode or bargaining. There exists one master agreement, which contains all the terms and conditions of the purcha ses in a finalised form. There are two kinds of Istijrar (a) where the price is determined after all the transactions/purchases are completed (b) where the price is determined in advance, but the purchase payment is made from time to time. As regards the Islamic mode of financing, only (a) is relevant. Istijrar can be adopted as a viable mechanism, in the case of suppliers of the borrower.In the latter case, the bank enters into a Murabaha agreement (Agreement to Purchase) with the suppliers (mainly trading companies), that it will purchase the assets from them at a market price or at a pre-determined discount from the market price. Whenever the customers demand, the bank can purchase that particular asset from the suppliers on the basis of Istijrar, and sell it onwards to the customer, on the basis of Murabaha. 50 49 50 Ibid at 11, pages 139-142. Ibid at 11, page 143-145 (Istijrar). 23 Chapter 3 Application of the Islamic Modes of Finance A Research on Islamic Project Finance A. Sh ariah-Related Documentary and Other IssuesIn recent years, Islamic financial institutions have actively started to structure and participate in transactions, which are associated with long-term trade, as contradictory to the short term trade related transactions (e. g. Murabaha). This transition has given rise to a number of important Shariah and documentary issues. The general backdrop is that the Islamic bankers and their advisers now face even more stringency, regarding the consideration up of Shariah-compliant structures that are accepted commercially and are also in conformity with the existing governing law of that particular jurisdiction where they operate. 1 As noted earlier, one of the basic principles of Islamic finance is that at a particular stage in the transaction, the financial institution will be the owner of all or part of the asset that is being financed, and under Shariah precepts, several forms of risk related with being an owner cannot possibly be passed on t o the customer or a third party. The latter is the most defining difference between an Islamic financial system and a Conventional one. These additional ownership risks become more serious when the transaction involves complex capital assets, e. . a power prove or an aircraft, as the potential exposure faced by the Islamic financier as an owner can be very searing and significant. It is expected that since the Islamic financial institutions are willing to take greater risks as compared to their Conventional counterparts, this should result in greater rewards for the former. It is submitted by the academics that this is not necessarily the case. 52 In several countries, e. g. the idea of interest is sanctioned by an Act of Parliament, and the latter being affirmed by the courts.Having said that, it is imperative to notice that laws of several states are embedded in Shariah law and concepts, if not in whole then in part. It is observed that a proposed Islamic structure that has the approval of a Shariah come on must be examined against the local statutes of that particular state to check whether the structure raises any adverse issues under those laws, and if so, then the proposed structure will surely need amendment and another approval from the Shariah Board.For example, under the Shariah precepts, a transfer of an interest in real estate is effective upon an agreement, signed between the buyer and seller. However, such an agreement may not be recognized by the local laws (at least as regards the bona fide third parties) until and unless the transfer is recorded in the concerned land registry. Sometimes, the problem might be such that a person to whom a real estate interest has been validly transferred under Shariah principles, would not necessarily be recognised as the legal owner under the local municipal 51 2 Ibid at 14, page 317. Ibid at 39, page 317 (Risk Reward Issues). 24 laws. In such situations, the legal and financial consultants, giving their expert advice on such structures, are required to strike a balance, so that the Shariah conditions and requirements are satisfied and are also accepted and applicable under the governing law. 53 There are certain issues relating to the nature of Islamic financing that come up too often and thus need to be discussed. Some of these are discussed below but the list is not intended to be exhaustive. IndemnitiesThe Shariah principle governing the operation and conditions of Islamic financing expressly prohibits indemnity for a loss or damage that is not caused by the customers default. Shariah sees the whole idea of seeking indemnity from the customer as unfair, notwithstanding the fact that the particular asset may have been chosen by the customer. Matters relating to the title to the asset, its physical fitness for its intended purpose and taxes that are imposed on ownership raise some serious and significant credit issues when one is dealing with a major capital asset, e. . aircraft or a vessel. Having said that, there must be some alternate basis for an Islamic financier to claim indemnity. Suggestions have been forthcoming in the form of seeking indemnities based on the concept of public need or necessity or by other methods, to cover the risks. E. g. such methods could include obtaining the benefit of warranties from the supplier or the manufacturer of the asset and assurances that the asset(s) are in perfect condition and have been validly perfected for the intended use.The financial position of the assignor (and any available insurance protection relating to the assignor) would also have to be assessed. 54 In contrast, in the case of Conventional financing, the customer often provides wideranging indemnities in order to protect the bank from any risks related with the ownership or use of the asset. The banks are not concerned with the issue of fault and are more keen to ensure that they are insulated from credit risks, arising from the ownership, use or op eration of the asset. 55Warranties As the owner of the asset, the Islamic financier may not be able to exclude the benefit of some warranties to its customer under the Shariah principles. In few instances, the Islamic financier has the benefit of the warranty from a third party that can be assigned to the customer (i. e. from a manufacturer). It has been permitted that the Islamic financier could expressly exclude any warranty from the Islamic financial institution in the customers favour to the period that it is covered by the assigned warranty.This does not seem to be an adequate solution in that it is often impossible to describe with accuracy the terminus of the warranty being assigned. Inevitably, some of the warranties may not be covered by a third party assignment and thus the Islamic financier will still be providing the benefit of some warranties to the customer. In a Ijaraha (leasing) transaction the balance of such warranties, which cannot be excluded under Islamic prin ciples may possibly be covered by insurance. 3 Ibid at 39, page 318, para 2 & 3. Ibid at 39, page 319 (Indemnities). 55 Ibid at 39, page 319. 54 25 Thus, if warranties will raise Shariah related issues, the Islamic financier must immediately try to identify those residual warranties that cannot be covered to decide whether or not this renders the transaction commercially unacceptable, particularly, if its financial return will not reflect these additional risks. 56 Compensation and Liquidated damagesIn Conventional financing, if the borrower defaults on any payment due on him, default interest is charged as against him, thus compensating the banks. This approach is unacceptable as regards Islamic financing, due to the obvious reason of any such compensation/liquidated damages tantamount to charging interest. Unfortunately, the experience of Islamic financiers in trusting their customers, that they would pay on time, has not really been successful, and there is a general agreement th at there must be some form of penalty if a customer does not pay on time.The Islamic financier can only claim compensation if it suffers loss or damage due to the true fault of the customer. The compensation must reflect the actual loss of the financier. Most Islamic financings have a compensation provision dealing with failure to pay on a due date and which uses a benchmark linked to LIBOR, as discussed above. The entire purpose of such provisions is not to compensate the financier, but to treat it as an incentive to the customer to make payments by the due date. 57 Events of defaultIn a Conventional financing, there will be a progression of events of default, which will give rise to rights in the favour of the banks, and in particular, the right to demand the repayment of outstanding debts. As a general principle, the latter view is accepted by the Shariah law, as long as the customer is at fault. In a Conventional financing, there will be events of default that are not within the customers control. It is considered as unviable to include such events of default in an Islamic financing, and each event must be diligently drafted to take account of the latter. 8 This, however, raises credit risks, which if not compensated for by the customer in the form of an increased return to the Islamic financier, may force the latter to take on extra risk, which will be without any reward. This issue becomes even more vital in the case of a co-financing that involves both Islamic and Conventional financing. The Conventional banks will surely not like the idea of Islamic facility not going into default at the same time as them, and this could possibly have adverse effects on the security sharing under inter-creditor arrangements.It has been argued that in these circumstances the Conventional banks should accept the position of Islamic financiers, however, the prevailing position is that the Conventional financing is the controlling financial force in the world and thus it i s often arduous for Islamic financial institutions to have their views stand in a co-financing. Examples of events of default that can potentially cause dispute between Conventional and Islamic financiers would be nationalisation, requisition, loss of air traffic rights and force majeure. If there is disagreement as regards any of the above mentioned events of 56Ibid at 39, page 320, para(s) 2 & 3. Ibid at 39, page 321, para 1. 58 Ibid at 39, page 321, (Events of Default) para 1. 57 26 default, then it is advised that they must be put into a separate category of events called by some other name, such as events of mandatory prepayment. 59 If there is an event of default the customer may be obliged to purchase the asset, at a predetermined price. That obligation must not be listed in the same document (i. e. the lease) to avoid concerns regarding conditionality but should be contained in a separate document, e. g. an option or a deed of covenant.If the event of mandatory prepayment ar ises, the customer will not be in default but the misfortune of such an event will enable the financier to exercise a right or option granted to it by the customer in a separate document requiring the customer to purchase the asset. The conclusion to this whole procedure being that, on the face of the document, the events of default will be Shariah-compliant and for events of mandatory prepayment, there will be a Shariah-compliant system that results in the asset being purchased, thus clearing the amount that the customer owed the Islamic financier. 0 Set-off It has often been disputed that the grant of set-off rights that are solely in favour of the Islamic financier, is against the Shariah precepts, which require an Islamic finance transaction to be fair and reasonable when taken in the context of the customer. The aforementioned(prenominal) issue has been resolved in various transactions by providing that there are statutory set-off rights that cannot be waived and which keep a n acceptable balance as regards favouring the financier and the customer. 61 B. Construction and Lease FinancingSpecific Issues in Relation to Ijaraha (Leasing) Transactions Insurance and Maintenance Obligations As per the Shariah principles, the lessor must remain liable for several insurance and major maintenance obligations. Obligation and the financial consequences cannot be transferred on to the lessee, pursuant to the terms of the lease. The insurance obligations relate to the structural or property insurance. However, the lessee can be held responsible and liable for the cost of operational insurance, such as the business interruption insurance and third party insurance (to the extent that it relates to operational risks).The latter mentioned principles can possibly have serious implications for an Islamic financier. The direct costs involved in, e. g. maintaining an aircraft and the indirect costs and liability resulting from the failure to perform such maintenance can prove to be very significant. 62 There must be some mechanism to transfer some risk on to the lessee, or sharing of risk if you like, which, on the face of the document is Shariah-compliant. 59 Ibid at 39, page 321, para 3. Ibid at 39, page 321, para(s) 4 & 5. 61 Ibid at 39, page 321, (Set-off), para 1. 62Ibid at 39, page 322, (Insurance and Maintenance Obligations). 60 27 The most obvious approach is to appoint the lessee as the service agent of the lessor (Islamic financier) in order to perform these activities, which would include paying the insurance premiums and the maintenance costs. The service agency agreement must specify that the service agent will indemnify the lessor for any default on his part, in the performance of these obligations. However, on the basis of general precepts, an agent must be compensated for any costs properly incurred on behalf of its principal.Usually, a nominal fee is paid to the se