Transcript LECTURE 2 File

Lecture 2
Conventional Banking and Islamic
Banking Systems
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BANK
 is a financial institution and a financial intermediary that
accepts deposits and channels those deposits into lending
activities, either directly by loaning or indirectly through
capital markets. A bank links together customers that have
capital deficits and customers with capital surpluses.
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Types of Banks
 There are various types of banks. The necessity for the
variety among these banks is because each bank is
specialized in their own field. Each bank has its own
principles and policies. Different rates of interests are
also noted among these banks.
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Types of Banks
 Commercial banks
 Community banks
 Community development banks
 Land development banks
 Credit unions or Co-operative Banks
 Postal savings banks
 Private banks
 Offshore banks
 Savings bank
 Building societies and Landesbanks
 Spare Bank
 Ethical banks
 Direct or Internet-Only bank
 Investment banks "underwrite“
 Merchant banks
 Universal banks
 Central banks
 Islamic banks
 Savings Banks
 Indigenous Banks
 Mortgage Banks
 Exchange Banks
 Consumer’s Bank
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Types of Banks
 Savings Banks – these banks are suited for employees with a monthly
salary. Low waged people may open an account in the savings bank.
 Commercial Banks – These bank collects money from people in
various sectors and gives the same as a loan to business men and make
profits in interests these business men pay. Since the loan is large the
interest rates are also high.
 Industrial Development Bank – these banks are committed towards
enhancing the growth of industries by providing loans for a very long
period of time. This is vital for the long term growth of the industries.
 Land Development’s Bank – these banks promote growth in the
food sector, by giving loans to farmer at a relatively lower interest rate.
The loan is usually given on the basis of land. If a farmer has lots of
agricultural fields then the more will be the loan provided.
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Types of Banks
 Indigenous Banks – native banks. They are normal moneylenders; only this
time, handling huge amounts of money. They collect money from the
community and provide loans to business men and industrialists for a short
amount of time.
 Mortgage Banks – these banks are specialized in providing mortgage loans
alone. In order to sell loans they depend solely on the secondary market.
 Spare Bank – these banks are present in Norway. They promote both savings
and commercial facilities to the both people and organizations in Norway.
 Federal or National Banks – these banks control the principles and policies
of other banks across the country. These banks are managed and run by the
government. This bank provides benchmarks which other banks should follow.
Co operative banks: co operative banks as the name suggests gets money from
the general community without any bias and provide loans to all sections of
people in the neighborhood. Their motto is not profit alone, but service.
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Types of Banks
 Exchange Banks – these banks will be available in more than a single country.
They provide services for the buying and selling of gold and silver; transactions
will be in foreign currencies.
 Consumer’s Bank – these are consumer friendly banks; they encourage the
consumer in buying commercial products and provide options for easy repay of
the loan amount.
 Community Development Banks – these banks provide services to the
community; where there has been nothing or very little development over the
years.
 Credit Unions – they act just like a co operative bank except that they provide
services to only one employee union in the community. Low interest rates and
easy installment paybacks are features of this bank
Postal savings bank: these banks are oriented with postal services. People save
money for a defined period of time and are paid with standard interest rates.
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Types of Banks
 Offshore Banks – they are also private banks except that they have
little tax to pay for their transactions; there is very little regulation for
this bank.
 Ethical Banks – as the name implies ethical banks promote candid
transactions; between various customers of the bank. Policies and rules
are transparent in nature.
 Internet Bank – provides banking facilities only via internet. There
will be no physical contact with the bank. All transactions are
permitted only through online.
 Investment Banks – these banks are pertinent to large organization’s
investment ventures across the industry. They provide advice in the
investments and promote corporate transactions.
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Types of Banks
 Private Banks – these banks are not for the general public or community. They
serve entirely for private personnel’s assets and transactions alone.
 Merchant Banks – these banks exist for a long time. They promote investing
in organizations that reap huge benefits for a long time rather than brand new
organizations.
 Universal Banks – these banks have a wide spectrum of financial assistances
to provide. Insurances to stocks, they promote everything across all countries
around the globe.
 Islamic Banks – these banks are based on the principles of the religion Islam.
There are no interests for loans acquired from this bank. Service charges may
apply. This means that all operations of Islamic bank mast be based on
regulations and rules of Islam.
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Banking Structure: Simple Model
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History of Islamic Banking
 Islam is not a new religion; it is the same truth that God revealed
through all His prophets. All religions are the same in essence, whether
given, for example, to Noah, Abraham, Moses, or Jesus, or to the holy
Prophet of Islam. For a fifth of the world’s population, Islam is both a
religion and a complete code of life.
 Economic growth is the main transmission channel for development.
Islam does not contradict growth; it promotes sustainable development
and growth.
 Modern conventional banking system came into existance nearly 427
years ago-Banco Della Pizza in Venice 1587
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History of Islamic Banking
 The term Islamic banking became common in the 1960's, but the
mechanisms and concepts of the system were implied and used since
the birth of Islam. Many studies and researches have shown that
Islamic finance mechanisms were used in the Muslim world
throughout the Middle Ages; in conducting trade and business
activities.
 Early experiments with Islamic Banking took place in Malaysia in the
mid 1940s, in Pakistan in the late 1950s and Egypt’s Mit Ghamr Savings
Bank (1963) and Nasser Social Bank (1971).
 In the Arab world the 1st modern experiment with Islamic banking was
undertaken in Mit Ghamr, Egypt in 1963. The experiment combined
the idea of German Savings banks with the principle of rural
cooperative banking within the general framework of Islamic
financing, to cater for those unwilling, for religious reasons, to deal
with the conventional banks.
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History of Islamic Banking
 In fact, in 1976, Mit Ghamr Savings bank was closed and its operation taken
over by the National Bank of Egypt and made interest based.
 Similar political antagonism to Islamic financial institutions, occurred
elsewhere in the Muslim world; Iraq, Oman, Syria and even Saudi Arabia. Two
institutions that however survived this early period were the Nasser Social
Bank established in 1971 in Egypt and Tabung Hajj, established in 1963 in
Malaysia.
 From the mid 70s a new era was witnessed in the history of Islamic Banking in
the wake of oil wealth. Energy price rises provided the financial capital to
support an expansion of both conventional and Islamic Banks and oil resources
enabled a wide range of institutions to participate in the social and economic
development of Muslim countries, the result was a change in the political
climate in many Muslim countries hence largely dispensing the need to operate
Islamic financial institutions under cover.
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History of Islamic Banking
 A visible achievement arising from oil-related resource boosting is the
establishment of the Islamic Development Bank (IDB) in 1975.
 An important development in the 80s is the restructuring of the whole
financial system of Iran, Sudan and Pakistan to accord with Islamic precepts:Iran in March 1984, Sudan in July 1984 and Pakistan a gradual transition from
1977.
 Another important development in the 80s is the establishment of two groups
of companies; Dar al-maal al-Islam in 1981 and Al-Baraka group in 1982. Dar almaal al-Islam was founded in Bahamas, headquartered in Geneva and operates
10 Islamic banks, 7 Islamic investment companies, 7 trading companies and 3
Takaful (Islamic Insurance) companies in 15 countries around the world while
Al-Baraka group was established in Saudi Arabia in 1982 and currently has
activities in 43 countries. It has over 2000 companies including 15 Islamic
banks and several Islamic insurance companies.
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History of Islamic Banking
 The IMF issued first study on Islamic banking in 1987.
since then more research papers have come.
 Traditional banks opened Islamic units
 Major conventional banks establishing Islamic
branches dealing exclusively with Islamic products.
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Islamic Banking Activities in
accordance with Shariah:
 Different Accounts in IB
 Musharakah
 Mudarabah
 Murabahah
 Ijarah
 Qard Hassan
 Salam and Istisna
 Sukuk
 Zakat
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Different Accounts in IB
 In Islamic banking each customer is a partner with the
Islamic Financial Institution (IFI). This relationship is
classified as a Mudarib Partnership. Profits resulting
from the account are divided between the parties. An
IFI receives a certain percentage of the net profits, as a
return for the amounts deposited in different
investment accounts as its share, being a Mudarib, as
agreed between the customer, who is the investment
account holder, and the IFI.
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Current Accounts
 Current accounts are an interest-free loan by the
account holder to the Islamic bank, which maintains
these funds and pays them to the customer on
demand. These accounts are similar to a loan in
guarantee and the payment of the same amount. An IB
has the right to invest the funds it is holding in current
accounts without the customer bearing any loss. For
this reason, the customer does not get any profit on
this type of account, but he also does not bear any loss.
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Investment Savings Accounts
 Many Islamic banks offer savings accounts to their
customers. This account allows the account holder to
place funds in a safe environment till such time when
they may wish to withdraw them. Profits and losses
under investment savings accounts accrue on the
minimum monthly balance. Profits are paid, or losses
are deducted, after the expiry of the financial year and
the net profits are determined.
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Musharakah
 Musharakah is an Islamic mode of financing in the form of a
partnership between the bank and its client whereby each party
contributes to the capital of the partnership in equal or varying degrees
either to establish a new project or share in an existing project.
 The accruing profit is divided between the partners pre-agreed
formula, while losses are shared on pro rata basis.
 The word Musharakah is derived from the Arabic word Sharikah
meaning partnership. Islamic jurists point out that the legality and
permissibility of Musharakah is based on the injunctions of the Qur'an,
Sunnah, and Ijma (consensus) of the scholars.
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Musharakah
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Mudarabah
 Mudarabah is an Islamic mode of financing between the bank,
providing a specified amount of capital, and the Mudarib, providing
management for carrying out the venture, trade or service with a view
to earning profit. It is a special kind of partnership where one partner
gives money to another for investing it in a commercial enterprise. The
former is called Rabb - ul - mal and the latter is called Mudharib.
 Thus, Mudarabah is a contract between those who have capital and
those who have expertise, where the first party provides capital and the
other party provides the expertise with the purpose of earning Halal
(lawful) profit which will be shared in a mutually agreed upon
proportion. This type of business venture serves the interest of the
capital owner and the Mudarib (agent).
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Mudarabah
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Murabahah
 Murabaha is one of the Islamic Finance modes and it is very popular
worldwide nowadays. Murabaha; sometimes referred to as
“Murabahah” is also known as “corporate asset support”. The concept of
murabaha can be summed up as; “Bank finances the needed purchase,
buys it, and resells it with a mark – up”. murabaha financing means,
“cost plus financing”.
 Murabaha is an Islamic finance instrument which of course does not
include interest (usury – riba) in it. The philosophy laying in the roots
of murabaha financing is to supply a needed service, good or
commercial right. Bank; Islamic bank in this situation, buys that
needed property or service in advance with cash money than resells it
to the client with an added profit as deferred payment base
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Murabahah
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Ijarah
 Ijarah is an operating lease contract whereby the bank
avails assets to the customer against a periodic rental
fee for a specified period of time. The asset continues
to be owned by the bank, and will revert back to the
bank at the end of the lease contract. Ijarah is
commonly used for the finance of expensive
equipment.
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Ijarah
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Salam
 Salam is a future contract. It is the purchase or sale of a commodity
according to defined specifications and conditions for deferred delivery
on a specified date in the future in exchange for immediate payment.
 Parallel Salam allows the bank to buy a product through a Salam
contract with one customer for deferred delivery, extending the cash
immediately to the customer so that they can procure or produce the
product, and sell the same product for future delivery on another
contract to another customer.
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Salam
 This is allowed provided the two contracts are not legally related. The
bank would thus have facilitated a deal between two customers by
availing funds immediately to the producer/seller while providing a
form of guarantee to the buyer towards the fulfillment of the sale. Like
Istisna’, Salam can be combined with other Islamic financing products
to form a derivative that allows for the financing of the full
production/procurement – sale cycle.
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Salam
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Istisna
 Istisna’ is a contract whereby the purchaser asks the seller to
manufacture a specifically defined product using the seller’s raw
materials at a given price. The contract is a future contract by nature, in
that it allows for the sale of a product that is not available at the time of
sale. The price may be paid on credit.
 Istisna’ has many uses, and can be applied in construction contracting
and manufacturing finance. It can also be combined with other Islamic
financing products to form a derivative that allows for the financing of
the full production – sale cycle.
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Istisna
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Zakat
 A term used in Islamic finance to refer to the
obligation that an individual has to donate a certain
proportion of wealth each year to charitable causes.
Zakat is a mandatory process for Muslims in order to
physically and spiritually purify their yearly earnings
that are over and above what is required to provide the
essential needs of a person or family.
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Zakat
 There are comprehensive descriptions in religious
texts describing minimum amounts of zakat with
regards to farm produce, cattle, business activities,
paper currency and precious metals such as gold and
silver.
 The most common level of zakat on wealth from cash,
equities and gold is 2.5% of the total value.
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What is Shariah?
Quran
Ijmah
Sunnah
Qiyas
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SHARIAH
 QURAN – holy book of Islam and understood by
Muslims literature word of God.
 SUNNAH- sayings, actions and approvals of prophet
Muhammed (pbuh).
 IJMAH- this is consensus reached on particular issue
by Islamic Scholars.
 QIYAS- analogy, simply to say decisions made by
Islamic scholars on particular issue by comparing with
similar situations may have happened before.
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Islamic Banking and Finance Basic Principles
 Contracts are considered to be permissible assuming
no Shariah violation is proved
 Therefore Shariah is not restricted to any specific
forms of contracts.
 Shariah made changes to the prevailing contracts of
that time by adding additional conditions.
 Any arrangement leading to a prohibited practice is
also prohibited.
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Main Prohibitions
RIBA
(interest)
Impermissible
Activities
GHARAR
(uncertainty)
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Main Prohibitions: Riba(Interest)
 Riba is a well known prohibition in Islamic Banking
and Banking and Finance
 Interpreted as interest but actually refers to any
stipulated increase over and above the principle of a
loan or debt transaction.
 A sale of an item on a deferred payment for a price
higher than the spot price is allowed as long as the
price is not linked with the time for repayment.
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Main Prohibitions: Gharar(Uncertainty)
 Non Existence: sale of crop of a specific field
 Non deliverability: sale of some thing before it’s in
one possession.
 Ambiguity in specifications: sale on credit without
specifying the maturity date.
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Main Prohibitions: Impermissible Activities
 INSURANCE: conventional insurers.
 BANKING: banks and organizations whose principal activity is
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conventional finance.
ALCOHOL: producers, distributers, liquor stores, businesses that
derive income from these area(hotels).
NON HALAL FOOD: producers, distributers, meat stores,
companies that are involved with handling non halal products.
GAMBLING: casinos, betting clubs and other companies that are
involved in gambling.
ADULT ENTERTAINMENT: companies involved in the
production or distribution of pornography.
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Key Objectives of Islamic Banking and Financial Principles
TRANSPARENCY
SOCIALLY
RESPONSIBLE
CURBING
SPECULATION
FINANCING
REAL
ECONOMY
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