Instruments of Islamic banking in operation
This is a research-based article dealing with various aspects of Islamic finance and its wider application in today’s banking environment. The article was divided in five parts; part-I, II, III and IV already published. This is the final part-V (concludes)
By Dr Shahid Hasan Siddiqui
Ijarah Muntahia Bittamleek

Islamic banks do not purchase / maintain the assets for leasing as in the case of operating lease; they normally purchase the asset in response to specific requests from customers to get the asset on lease that ends with purchase after the lease term expires. This transfer of ownership takes place through gift by lessor at the end of the lease period or at a token consideration or for other amount(s) specified in the lease agreement. The Shariah scholars recommend that lease agreement should not contain a pre-condition of sale or gift after the lease period. The principle, according to them, is that a unilateral promise to enter into a sale contract at a future date is allowed whereby the promisor is bound to fulfill the promise, but the promisee is not bound to enter into actual purchase contract.

It is important to note that the best terminology for normal ijarah operations by Islamic banks is ijarah muntahia bittamleek and not ijarah wa iqtina. Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI) has also used this terminology for leasing operations under Islamic banking system.

It implies that mainly the transaction is only one whereby the lessor leases the asset and fixes the rental in the way that during the lease period its total cost as also rent is duly received. The second part is only a unilateral promise not binding on the promisee and as such it is not a transaction until actually entered into by the parties. AAOIFI Standard on Ijarah provides for promise by the lessor, while many Islamic banks, as in the case of Pakistan, take undertaking from the lessee and deem it binding on him. Abiding by AAOIFI’s standard in this regard seems to be justifiable and nearer to the spirit of the Shariah.

Ownership in Ijarah contract, and therefore the risks and expenses relating to ownership, must remain with the lessor. Operating expenses related to use of the asset have to be borne by the lessee. Banks may take the Takaful cover in order to mitigate the risks, but it should be at the expense of the banks. They can, however increase, with the consent of the lessee, the lease rent to recover the Takaful cost. If the Takaful company does not compensate the entire amount in case of loss / damage, banks have to bear the risk of Takaful claim settlement. This is the key difference between the conventional leases and Islamic banks’ Ijarah contracts culminating into transfer of ownership to the lessee under the separate contracts.

The terminology of operating, finance and other leases does not make any difference; If all essential elements relating to contracting party, subject matter, consideration and the period in ijarah are taken care of, ijarah can be used as the mode of financing by the financial institutions in the form of ijarah muntahia bittamleek. The deciding factors in this regard are: i) the risk relating to ownership that must remain with the lessor; and ii) sale should be separate from the lease.

(D) Service / Agency based modes

Islamic banks may provide a number of services to their clients and charge fee / service charge. These may include: Underwriting, letters of credits, letters of guarantees, remittances and correspondence services etc. It is pertinent to indicate in this regard that no charge can be taken against financial guarantees per se. Only management or agency charges can be taken.

Fixed return techniques: some observations

As murabaha and ijarah modes of financing are now being extensively used by Islamic banks worldwide for bulk of their financing, it is proposed to have a look at some of the views expressed regarding these modes.

(i) The Council of Islamic Ideology, Pakistan observes: (a) “It is, therefore, imperative that the use of these methods (financings on fixed return techniques) should be kept to the minimum extent that may be unavoidably necessary under the given conditions and that their use as general techniques of financing must never be allowed.” (b) “It would not be advisable to use it (Bai’ Muajjal) widely or indiscriminately in view of the danger attached to it of opening a back door for dealing on the basis of interest.”

(ii) The council also observed: “The fact of the matter is that “mark-up” is a crude trading practice which has been permitted by certain religious scholars under specified conditions. Its permissibility is questioned by other scholars. In any case, it is a device, which is relevant in the contract of transactions between a seller and buyer of goods. Banks are not trading organisations. They are essentially financial institutions which mobilise funds from the general public and make them available to productive undertakings”

(iii) Justice Usmani observes: (a) The Islamic banks are using the instruments of murabaha and ijarah within the framework of the conventional bench-marks like London Inter-bank offered rate (LIBOR) etc. where the net result does not materially differ much from the interest-based transactions.

(b) By not even gradually enhancing the financing on PLS basis, the basic philosophy of Islamic banking seems to be totally neglected by the Islamic banks. (c) In some cases even murabaha and ijarah are not affected according to the procedures required by Shariah.

(iv) Justice Usmani also observes: (a) Murabaha is only a device to escape from “interest”. The murabaha is a border-line transaction and a slight departure from the prescribed procedure makes it step in the area of interest-based financing. (b) Murabaha is not an ideal instrument for achieving economic objectives of Islam. (c) Murabaha should be used as a transitory step. (d) Murabaha’s use should be restricted only to those modes where mudarabah or Musharakah are not applicable. (e) It should never be over-looked that originally murabaha is a particular type of sale and not a mode of financing.

(v) Prof. Nijatullah Siddiqui says: “The payment obligations of the firms operating with murabaha – financed goods and services are independent of the profitability of the enterprise, unlike Profit-Sharing, thus exposing it to the charge of being inequitable, as in the case of debt financing.” He had also earlier observed: “I would prefer that Bai’ Mu’ajjal is removed from the list of permissible methods altogether. Even if we concede its permissibility in legal form, we have the over-riding legal maxim that anything leading to something prohibited stands prohibited. It will be advisable to apply this maxim to Bai’ Mu’ajjal in order to save interest-free banking from being sabotaged from within.”

(vi) Dr. Hasanuzzaman says: “___ ghost of interest is haunting banks to calculate a fixed rate percent per annum in many modes of financing including Murabaha (Bai-Mu'ajjal, Mark-up) etc. The spirit behind all these contracts seems to make a sure earning comparable with prevalent rate of interest and as far as possible, avoid losses which other wise could occur.” He also adds: “They (Second line techniques), have failed to do away with undesirable aspects of interest thereby they have retained what an Islamic bank should eliminate.”

(vii) Maulana Maududi observed: “Islam says in clear terms that the lender is not justified in earning a fixed rate of profit, irrespective of the operational results of the business.”

(viii) The Shariat Appellate Bench of Supreme Court of Pakistan in it’s historic judgment observed: “We are conscious of the fact that the transaction of a sale of murahaba based on mark-up, even after fulfilling its necessary conditions is not an ideal mode for the extensive use of Islamic banks, Still, the banks will have to resort to this transaction in certain cases, especially in the initial phase of transformation.”

(ix) Henry and Wilson say: (a) “And indeed a principal form of credit extended by an Islamic bank, the murabaha, involves a simple mark-up on a sales price. The bank buys you a car for $30,000/- and you owe the bank $33,000/- a year from now, for example. This arrangement is perfectly acceptable from the standpoint of Islamic financial theory but looks to the outsider like a simple loan at 10 percent. Repaying by five yearly installments of $7913.92 would be equally acceptable and also implies an interest rate of 10 percent”.

They also add that financial transactions modelled on the murabaha constitute well over half of the assets of Islamic banks and since any fixed return can be understood as implied interest, there seems little to differentiate Islamic from conventional banks.

(x) In some Muslim countries interest-based banks are now being converted into Islamic banks. This process includes conversion of existing advances into financing on the basis of trade and lease financing etc., change of security and execution of fresh sets of documents. This type of conversion does not appear to be according to the spirit of Shariah. The right approach would therefore, be to sanction a fresh limit under Islamic Banking system only after the previous advance has been fully adjusted.

Points to ponder

Maulana Maududi while recounting the evils of interest-based banking observed that a financier who advances money at fixed rate of profit is selfish as he is not concerned with the operational result of the business. He adds that the depositors of Islamic banks would hope to get unspecified but unlimited profit instead of fixed rate of interest. It is therefore, obvious that MaAulana Maududi visualised large scale financing only on PLS basis and not on fixed rate of returns (like in murabaha and ijarah etc.,) which in any case is not dependent on the operational results of the entrepreneur.

Maulana Mufti Muhammad Shafi (Late), Grand Mufti of Pakistan while referring to conventional banks observed:

“A person whose own worth is Rs.100,000/- engages in business employing Rs. 1 million. Of the hefty profit earned through such business, a small portion is paid to the bank by way of interest and the rest is pocketed by the businessman. The bank, in turn, distributes an even lesser amount to the depositors.”

Justice Taqi Usmani while referring to modern conventional banks and repeating the above points observes:

“---- our banks are really acting as the blood banks from which forum these capitalists are sucking the blood of the entire nation and the entire nation is rendered half dead economically.”

The position now is that bulk of financing by Islamic banks is being made on fixed rates of profit and that too on the bench-marks of interest-based banks. The rates of returns being paid by Islamic banks to their depositors are also on the bench-marks of conventional banks. The number of persons availing financing from Islamic banks is also a small percentage of total number of depositors of these banks.

For example, in Pakistan, the total number of advances accounts of all conventional banks is 20.7 percent of total deposits accounts whereas in the case of Islamic banks, the total number of financing accounts is only 9.4 percent of total deposits accounts. The conventional banks in Pakistan have been paying real negative rates of returns to their depositors (rates of returns on deposits less inflation rate in the country). The Islamic banks in Pakistan have also accordingly been paying real negative rates of returns to their depositors notwithstanding that some of these banks have been enhancing their profitability. It was in 1993 that the then Governor, Central Bank of Pakistan in the context of interest-based banks said “A banking system that gives a rate of returns to small savers which is negative in real terms is exploitative one.”

It was only in the initial stages of the transformation of the conventional banking system into Islamic banking system that the second line fixed return techniques could have been adopted by Islamic banks with a proviso that gradual shift to PLS system would take place. Unfortunately the modes on fixed rate techniques have been allowed to be perpetuated by Islamic banks and financing on PLS basis is not gaining momentum. The fact of the matter is that Islamic banks have deviated to a great extent from the philosophical basis. There have been no visible differences between Islamic banking and the conventional banking. This is harmful to the cause of Islamic banking.

The position can improve only when bulk of financing is made by Islamic banks on the basis of musharakah, the profit between the bank and the entrepreneur is shared in the ratio of respective capital employed and financing policies of these banks are designed keeping in view the objectives of Islamic economic system.

In view of the difficulties in allowing large scale financing on PLS basis, it is suggested that a Model Islamic Bank should be established in some Muslim countries. The proposed Model Bank should undertake all normal banking business and allow financing only on PLS basis according to true spirit of Shariah. These Model Banks would hopefully pay much higher rates of returns to depositors as compared to the rates being paid by existing Islamic banks.

This proposal was also made before the Shariat Appellate Bench of Supreme Court of Pakistan (SAB). The judgment of SAB says that Dr. Shahid Hasan Siddiqui, an economic expert and Chairman of the Karachi-based Research Institute of Islamic Banking and Finance appeared to state that a model Islamic bank should be established in Pakistan which should operate 100 percent on PLS basis. The establishment of Model Islamic Banks in some Muslim countries would motivate other Islamic banks to enhance their share of financing on PLS basis.

If Islamic banks in Muslim countries succeed in demonstrating a practical example of socio-economic justice by rapidly enhancing their share of financing on PLS basis and achieve satisfactory operational results, with the blessings of Almighty Allah, the dawn of an era of justice would be witnessed where the fruits of Islamic system would be available to large number of people leading to over-all social and economic prosperity.

— The author is Chairman & Chief Executive, Research Institute Of Islamic Banking & Finance. Karachi.

(Courtesy: Journal of Strategic Studies, Published by Bahrain Centre for Studies and Research)