Introduction to Islamic Banking and Finance. M Kabir Hassan

averse investors who invest in a limited way by sharing in the financing of real assets where the returns are linked to the asset’s sale or use rather than their long-term productivity.

      At the outset, it is important to know that Islamic banking is a set of principles, rules and product structures that are compliant with Islamic laws and principles. Islamic law or Shari’ah is embodied in the Qur’an and the Sunnah (teachings) of Prophet Muhammad (pbuh). Since the contemporary financial and banking system did not exist 1,400 years ago, the foundational principles in Islamic Shari’ah are used to prescribe the true Islamic viewpoint with regard to contemporary products and practices by the Shari’ah advisors. The term Shari’ah compliant in Islamic finance refers to an instrument, transaction or contract which is compliant with the principles of Shari’ah.

      The basic structure of Islamic banking looks like this. First, an Islamic bank establishes an asset pool. In that asset pool, the investment comes in the form of the bank’s equity and deposits. The deposits in Islamic banks have two further categories, i.e. return-generating deposits and nonreturn-generating deposits. Investors expect to gain profits on return-generating deposit accounts, such as savings deposits and fixed/time deposit accounts. On the other hand, investors expect to gain no profit on non-return-generating deposit accounts, such as the current account. Such accounts are used for safekeeping of deposits as well as facilitating payments and remittances.

      Return-generating deposits are mobilized by using Mudarabah structure. It is a form of partnership in which one party Mudarib provides management expertise and the other party Rabb-ul-Maal provides the investment capital for the partnership. Profits are shared between the two partners on the basis of a pre-agreed profit-sharing ratio. In case, there is a loss in partnership, it is exclusively borne by the investing partner, i.e. Rabb-ul-Maal.

      In deposit mobilization operations of Islamic banking, bank’s shareholders act as Mudarib, i.e. working partner and depositors act as Rabb-ul-Maal, i.e. investing partner to form the partnership. Profit-sharing ratio is agreed at the start of this partnership. Non-return-generating deposits are mobilized by using Qard (interest-free loan) or Wadiah (safekeeping deposits).

      The pool of assets established for the investment purpose is then used to provide asset backed financing to the individual and corporate clients. In accounting terminology, the asset pool is the liability side of the Islamic bank’s balance sheet; whereas, the asset backed financing assets and receivables comprise the asset side of the Islamic bank’s balance sheet. Asset backed financing comprises various financing assets based on different underlying lease and trade based modes of financing.

      Islamic banks generate income through rents and profit on credit sale. The distribution of income takes place first between the shareholders of the bank and the depositors as one category. Then, the income is distributed among the different category of deposits based on a weightage mechanism. Among the depositors, the horizontal distribution of profits makes the use of a weighting mechanism to provide an opportunity to earn higher profits on larger and long-term deposits. Weights are pre-assigned to different types of depositors depending on the magnitude and maturity profile of the deposit category. The detailed illustration of profit distribution will be discussed in Chapter 3.

       2.5Islamic Banks in the Islamic Economic Framework

      Islamic economic principles are very much open and favourable towards a market-based economy. By enabling the market economy to run competitively, an Islamic economy provides market-based solutions for employment creation and improvement in living standards through effective and efficient utilization of resources. The market competitiveness is achieved by removing from the economy those factors which lead to concentration of wealth and underutilization of given labour and non-labour resources in the economy. In an Islamic economic framework, private investment is incentivized by the institution of Zakat which favours private investment/spending rather than hoarding wealth.

      In a market following Islamic norms and values, the market forces will determine which Halal goods and services should be produced and offered at what price. Firms produce goods with resources provided by the household sector. Households are paid a return on their labour. If households provide investment capital, then they are provided a share in profits. Firms produce and sell goods in the goods market which are purchased by the households. These households obtain purchasing power by providing rentable factors of production like labour services (Ijarat-ul-Ashkhas) or usufruct of a naturally existing or produced real asset (Ijarat-ul-A’yan) in the production process and earn compensation in terms of wage and rent, respectively. As per Islamic rules of trade, the subject matter should be Halal and the price once determined cannot be changed in a credit sale after the sale is executed.

      Since contemporary businesses require expensive and long duration capital goods for achieving efficiency and economies of scale, sourcing capital from individual households having surplus investible capital might be cumbersome. Islamic banks exist to reduce transaction cost, mitigate moral hazard and provide asset backed financing. Islamic banks monitor the investments made by households and share the profits on investments with them.

      Since there is no provision of earning money by simply loaning fiat money, all the financing provided is backed by real assets in the Islamic economic framework. This mitigates the moral hazard problem and the misuse of funds. It also ensures that the real assets are traded or leased when a financing contract is executed. Thus, it strengthens the link with the real economy and links the payoffs with the outcome of real economic transactions rather than fixing profit for one party in investments.

      As per Islamic principles, for earning money on monetary investments, the money capital has to be invested in a productive enterprise to earn a share in actual profit/loss out of the productive enterprise in which it is used. Rather than concentrating risk with only the borrower, the risk is widely shared in Islamic banking instruments and contracts.

      By ensuring that financial intermediaries cannot simply earn interest on money capital alone, they necessarily have to ensure that they provide asset backed financing and these assets are purchased from the resource markets (such as raw materials, equipment, and machinery) or goods market (such as cars and consumer appliances).

      Finally, the institution of Zakat ensures that the poor and hungry people who earn below subsistence level incomes are provided with income support so that they can fulfil their basic needs. Producers and rich households who are required to pay Zakat, Ushr (10% levy on the value of produce requiring either labour or capital for production), Khamsa (5% levy or half Ushr on value of produce requiring both labour and capital for production), and Khums (20% levy on value of produce requiring neither labour nor capital for production) share their incomes with the poor households.

      Figure 2.6. Islamic economics framework.

      Thus, the Islamic economic framework ensures that the investible capital is invested in the real economy and through which, a greater magnitude of employment opportunities are created against an interest-based financial system in which the funds can be invested in financial derivatives and money market to earn a risk-free return. Finally, those households which remain unable to earn sufficient incomes to meet their needs are supported through the second phase of circulation of endowments which is not based on the profit motive, but which is driven by pure altruism. Figure 2.6 shows the Islamic economic framework in which the dashed lines represent monetary flows and the solid lines represent the commodity flows.

       2.6Conclusion

      This chapter discussed the Islamic viewpoint on interest and its economic rationale. It also introduced how the institution of interest causes problems in the allocation of resources and income distribution. The chapter also presented