Principles of Islamic banking are represented in the following:
Prohibition of usury (Riba) in financial transactions. It is prohibited to deal by giving or taking interest or to give a loan with interest.
Prohibition of all forms of monopoly and all forms of hoarding.
Directing financial resources to the channels of economic activities that are useful or beneficial to society.
Prohibition of investing financial resources in fields of prohibited activities such as trading in liquor or pork. - Realizing social solidarity through the revival of Zakat (legal alms giving).
Full transparency in all activities.
Concepts of Islamic Banking
Islamic Banking is based on two main concepts:
First: Money is not a commodity that can be bought and sold in kind by more than its value as other commodities but is governed by certain regulations included in a special section of the Jurisprudence entitled
(The chapter on Exchange). This chapter points out that money is an usurious item and therefore it is prohibited to sell it at more than its value (in its kind)
and may not be returned with more than its value in case of being loaned because both cases are cases of the legally prohibited usury (Riba).
Consequently, the function of money becomes restricted to being a means of concluding a transaction, a repository of value and a means of evaluating the price of products, therefore it is not a commodity that
is governed by factors of supply and demand but is a measure of values only and its function is in facilitating the flow of financial transactions without directly affecting the value of goods and services.
The activities of Islamic Banks are based on the exclusion of interest as a source of revenue on invested capital.
The revenue is obtained through dealing by virtue of contracts governing real economic transactions that regulate the flow of money in channels of economic activity of value to society.
These are the Islamic funding instruments applied in the framework of the Islamic Banking system.
Second: Acknowledging that there are differences in income between the different social classes, Islam does not take this as a ground for differentiating between people in rights, duties
and status before Allah but such differences are deemed necessary in order that people will work in different capacities and interrelate as a team to set production in motion.
Within this framework each individual receives an income and all reap a benefit (the employer as well as the employee).
Furthermore, whenever there are people of limited income that is less than can fulfil their basic needs, the rich have to help them with their own money.
That is why Allah prescribed Zakat (legal alms giving) which is a central function in Islamic banks that include specialized departments for Zakat within their main structures.
In the Islamic Sharia the concept of Zakat is not that of charity but the means of purification of the individual's capital assets and hence it is the condition, that he is worthy of owning these assets.
Another avenue for supporting the less fortunate lies in the Qard Hassan which is the loaning of money with no interest or expenses to be paid back within an appropriate period of time.
Investment of Funds in Islamic Banks
Funnelling funds into various investment channels is one of the most important roles played by Islamic Banks which depend on a number of investment instruments derived from Islamic jurisprudence, that are based on the concept of partnership and sale.
The following is a detailed explanation of these instruments that determine the relationship between the bank and the entrepreneurs.
Partnerships
Mudaraba
Sale
Lease (Ijara)
Salam contract
Manufacturing contract
Cultivation & Irrigation
Partnership
Is one of the formulae by virtue of which the bank participates with an entrepreneur in a certain project in which each party has a fixed share in the capital.
Such a project may be a commercial project based on purchasing and marketing a certain commodity, such as cars, printing machines or foodstuffs.
This operation is conducted through a certain deal in which the total cost is agreed upon by the two parties.
The bank makes with the entrepreneur a partnership contract for purchasing and marketing such a commodity.
Each party shall participate with a known equity in the capital such that the profit of such a deal shall be distributed after marketing according to each party's share in the capital
but only after deducting the management share initially agreed upon for the party carrying out the management from the total net profits. As for the loss, it is to be distributed according to each party's equity
share in the capital and nothing else. The project may be in any of the sectors of production whether it be the industrial, the agricultural or service sector. Each party participates with an equity share in the capital of the project
and both set up a joint stock company in accordance with the laws and regulations governing joint stock companies. The basic legal rule in partnership contracts is [sharing in profits and losses] which means that since
the two partners share in the profits of the company, then each party must also assume its share of the losses (if any) without bringing it to bear on one party only.
Mudaraba
Mudaraba in Sharia is derived from working in order to earn a living. A Mudaraba contract in Sharia is a contract between two parties one of them owns the capital but does not have the expertise to operate and invest it, such a party is called the "owner of capital"
the second party is the one having the expertise to operate funds in the market but doesn't have the capital and is called "the working party".
The owner of capital agrees with the working party to give him an amount of money to be invested such that the profit is distributed among them with known predetermined percentages that are not based on the capital but on the amount of the realized profit itself.
As for the loss (if any), it is to be borne by the owner of capital alone and the working party suffers the loss of his effort and his time without any compensation.
However, if the working party is proved to have been negligent in his work in a way that caused the loss or the loss of the capital or part of it, then the working party shall assume the total loss. This type of contracts relies on the honesty
and earnest on the part of the working party, which is of course a good trait that business men should all have.
Mudaraba is an operation of great benefit to economic activity since there are a lot of people who have the efficiency and the ability to operate funds but do not have the money to do so,
therefore, the Mudaraba contracts open the door of opportunity to many talented entrepreneurs and increases the volume of trade. The Mudaraba contract may play an effective role in raising funds for financing infrastructure projects
and mega production projects of high cost to be carried out by the state or the private companies without resorting to taking loans from the local or international money markets.
This could be done if the cost of financing is submitted in the form of deeds that allow its holders to share in the profits of these projects and can trade them in the stock exchanges.
Sale Contracts
[1] Murabaha
Buying commodities and selling them to clients is one of the forms of transaction contracts that the Islamic banks implement on the basis of credit sale,
which means paying the price of the purchased commodity on instalments paid on terms agreed upon between the bank and the client. The most important types
of these contracts of sale is the Murabaha sale where the purchase contract specifies the actual cost of the commodity to which the bank adds a sum agreed
upon with the purchaser - such an additional sum is considered the profit of the bank from the deal. This means that the bank states the actual cost and
the margin of profit that is added to the value of the commodity to specify the total selling price to the purchaser. The value of the commodity and the profit
are determined by the bank and the client before making the contract of sale. If the two parties reach an agreement and the client demands the bank to buy the commodity
, the two parties shall make a pledge of sale.
When the bank actually buys the commodity, upon the client's instructions, it shall notify the client that the commodity is available at the bank in order to take possession of it.
Upon delivery, a final contract of sale is made by virtue of which ownership of the sold commodity is transferred to the client. Consequently, the client becomes committed to paying
the sale price to the bank according to the terms and conditions agreed upon in the contract and during the specified term. The Murababa sale gives the purchasing client a privilege
that is not given in other ways of sale such as bargaining. This privilege is that of the bank, while purchasing the agreed upon commodity, may obtain a reduction from the original
provider of the goods that reduces the cost price from the one specified in the contract, the client has the right to that reduced sum and the cost price specified in the contract
shall be reduced by virtue of that reduction obtained by the bank. The Murabaha sale also gives the client the right to return the commodity and cancel the contract or sale if
it is proven that the bank has specified a price higher than the one at which it has actually purchased the commodity. The Murabaha sale should be conducted on the basis of honesty
and transparency and not fraud that is why it is called the fiduciary sale.
[2] The Salam Contract
Common contracts of sale stipulate the immediate delivery of commodities to the buyer who, according to the contractual terms of agreement, either pays the price upon delivery
or in instalments over a predetermined time schedule.
This type of contract is in strict compliance with the Islamic Sharia which ordains that an individual cannot sell what he does not possess. This principle of Sharia aims at guaranteeing
the seriousness of the deal, the ability of the purchaser to inspect the commodity prior to the conclusion of the contract and leaving no space for any form of deception or fraudulence.
Nevertheless, owing to the occasional need for financing the production process before the products become available, the Prophet (PBUH) has allowed the institution of the Salam contract,
otherwise, also known as the loan contract which is governed by very precise conditions. Hence, the Salam contract involves the sale of goods that do not exist at the date of concluding
the deal, and therefore, cannot be inspected by the purchaser, however, the commodities are expected to be available at a certain time in the future e.g. dates of sale, grain or rice
for which the time of harvest is anticipated sometime in the future. The precise and strict conditions that govern such a contract are the specification of the kind of commodity, the type,
the amount, the weight, the characteristics, the time and place of delivery. Within the framework of a Salam contract, the seller receives on the date of contract a payment that allows him
to finance the production process, whilst the purchaser obtains a guarantee of possession of the commodity in due time and according to the specifications mutually agreed upon. In this way,
both parties benefit and achieve their goals without any injustice to either side.
[3] Manufacturing contract (Istissnaa)
Is a contract made with a manufacturer for buying commodities that will be manufactured such as windows, doors, ships, planes etc. Such a contract is the basis of many contracts of sale nowadays.
The agreed upon commodity is delivered on the future date specified in the contract along with the payment of the full price or part of the price and the rest to be paid upon delivery.
[4] Al-Tawaroq Sale
In this type of sale, the purchaser of a commodity in instalments may re-sell it in cash amounts less than the purchase amount. This instrument is important for many people,
who occasionally face emergency cases and need money to cover costs of marriage, housing, medical treatment … etc.
Cultivation and Irrigation
Cultivation contract is made when a person gives his land to another one to cultivate it, whereby the produce is to be distributed as agreed upon between them. An Irrigation contract
is made when a person takes care of another person's land that is cultivated with palms or fruits for example, in return for an agreed upon share of the harvest.
Services lease
Ijarah aims at leasing a utility in return of compensation, and the lessee has the right to sell this usufruct to others, subject to the consent of the original owner and against an equal or more or less the amount paid to him.
Hence, the lease of a utility means selling a certain service involving utility against an amount paid by the purchaser for its full price from the onset or in instalments according to the terms agreed upon. The lessee may also re-sell
this service to a third party for a higher amount or different terms within the framework of the initiated agreement.
The Islamic Bank buys the usufruct of many services offered by lessors such as : Trips of travel and tourism agencies, educational programs in schools and universities and medical treatment in hospitals in return of specified cash amount.
Then, the bank re-sells this right to its clients by virtue of leasing contracts at a suitable profit margin.
This instrument helps in covering the expenses of education, travel, religious tourism, medical treatment, surgeries, maintenance and cleaning service and participation in the sporting clubs in a manner meeting individual needs.
Ijarah (Lease)
The lease contract is one of the famous contracts in Islamic Jurisprudence and is based on selling the utilities of things keeping the assets in possession of the seller. By virtue of the Lease contract, the owner sells a utility or a service provided by the asset,
while he retains the ownership of that asset, for a certain term in return for a fee paid by the lessee agreed upon by the two parties.
When the term expires, the asset returns to the owner who after that has the right to sell that asset to any party whether it is the lessee or to another and also has the right to lease to any other party. In addition, there is a lease contract that ends in transference of ownership.
The real benefit from the lease contract is that the capital assets which the clients need such as loaders, cranes, equipment or expensive machines may be of a very high cost that the businessmen cannot afford. In which case, the bank can purchase such assets and lease them to the entrepreneurs
for a certain term specified in the contracts. In this way, the lessee obtains the service provided by that asset for a certain term at a certain price affordable to him. This type of dealing is of great value to lessees since it does not impact their cash liquidity that could be directed to operations without resorting to loans for buying such high cost assets. Moreover, the cost of leasing is added to the profit and loss balance
of the entrepreneur and as such is not taxable. In addition, the leasing of the assets enables the lessee to update the required assets according to the latest technological developments, in the field of equipment and machines.
Furthermore, the maintenance cost is usually assumed by the lessor in order to keep it in shape for the lessee.
Zakat Funds
The word “Zakat” in Arabic language means increase and growth. Zakat is defined by jurists as “payment of a specified part of a specified sum of money that has reached
a certain amount annually. Zakat is the third pillar of Islam”.
Channels of spending Zakat are:
To the poor, the needy, those who collect them (salaries of those sent by the ruler to collect the Zakat and deliver it at the Muslim state treasury) and those whose hearts have been reconciled
(those who have recently joined Islam and may serve the nation with their contributions) to free slaves, to the debtors (those who pay off the debts of Muslims in order to avert disputes and achieve
social harmony so they are given part of the Zakat in return for what they have paid)… in the cause of God (In any field that serves Islam)… and to travellers (a traveller who is away from his home
and has no money or access to his money and his family).
The direct role of Zakat is realizing social solidarity and peace by giving help to the poor and the needy, in addition to spreading compassion between people and averting disputes. The Indirect role of Zakat
is increasing demand on goods and services which leads to more investments and eventually to greater economic activity.
Zakat Funds are one of the main characteristics of Islamic banking system. Islamic banks set up Zakat Funds for the purpose of providing social services to people. Zakat money provides help to the needy besides purifying the money of the rich who pay Zakat. The balance sheets of Islamic banks comprise independent accounts for Zakat Funds that include on the resources side all Zakat contributions,
the Zakat of the shareholders, depositors and all those who deal with the bank in addition to the Zakat of individuals,
and bodies who wish to authorize the bank to spend their Zakat. All the eight legal channels of spending Zakat are put in the applications side.
The Zakat Funds of Islamic banks are independent departments that have their own financial as well as human resources.
Zakat Funds have the most up to date technical capabilities which ensure their full autonomy; in some banks they have developed new activities such as setting up scientific
as well as vocational training centers of great benefit to the public.
The organizers and concerned parties of the Islamic banking industry have successfully established a large group of infrastructure organisations and associations that help
incubating and supporting the Islamic banking activity and its instruments. This infrastructure has developed channels of understanding and cooperation with other conventional banks,
the monetary authorities, and international organisations supervising the financial and banking affairs worldwide.
The Infrastructure Organisations and Associations for the Islamic Banking Industry
The organizers and concerned parties of the Islamic banking industry have successfully established a large group of infrastructure organisations and associations that help
incubating and supporting the Islamic banking activity and its instruments. This infrastructure has developed channels of understanding and cooperation with other conventional banks,
the monetary authorities, and international organisations supervising the financial and banking affairs worldwide.
List of International Islamic Infrastructure Institutions
General Council for Islamic banks and Financial Institutions (www.cibafi.org).
Accounting & Auditing Organisation for Islamic Financial Institutions (www.aaoifi.com).
Islamic Financial Services Board - Malaysia. (www.ifsb.org).
Islamic Development Bank. Jeddah (www.isdb.org.sa).
International Islamic Financial Market. (www.iifm.net).
Islamic International Rating Agency. (www.iirating.com).
Islamic Corporation for the insurance of Investment & Export Credit. (www.iciec.com).
International Islamic Center for Reconciliation and Arbitration(www.iicra.com).
General Council for Islamic Banks and Financial Institutions (CIBAFI)
CIBAFI was established as an international independent non-profit organisation in May 2001.
The main objectives of the council:
Defining Islamic financial services and disseminating the knowledge of their
Enhancing cooperation amongst members of the council and similar institutions.
Making available all information and data pertaining to Islamic banks and financial institutions and other related Islamic Organisations.
Taking care of the interests of its members, facing obstacles and challenges, enhancing cooperation amongst institutions and also with other supervisory entities.
Issuing bulletins, books, periodicals, banking jurisprudent encyclopaedias, and other studies and researches.
Organising conferences, Seminars, Lectures, meetings and workshops.
Cooperation with entities concerned with issuing laws for Islamic banks and financial
institutions and other related organisations, and also encouraging the issuance of governmental and non-governmental financial instruments.
Establishing a data base to introduce the council's message and that of the Islamic economy and finance in an active manner using the available technological tools.ents.
Participation in preparing the training programs to raise the professional expertise of the Islamic banking human resources.
Accounting & Auditing Organisation for Islamic Financial Institutions (AAOIFI)
Given the duality that exists in banking practices in each country at different levels namely,
national, regional and international Islamic banks and financial institutions need the support of the accounting
and auditing standards that are compatible with the principles and rulings of Islamic Sharia.
This professional role is assumed by the Accounting & Auditing Organisation for Islamic Financial Institutions,
which provides one of the major cornerstones for the sound progress and development of Islamic Financial pracies.
The Organisation is an Islamic international independent and non-profit entity focusing on establishing the standards of accounting,
auditing and good governance as well as the ethics of banking activity in accordance with the rulings of Islamic Sharia.
The Organisation was established by the incorporation agreement signed by a number of Islamic financial institutions on February 1990,
and is located in: In its efforts to realize its objectives, the Organisation provides training, organises seminars, undertaking researches
and issues publications as follows:
Issuing an integrated group of accounting and auditing standards.
Good governance rules for Islamic financial institutions.
Rules and legitimate requirements for the Islamic investment and finance.
Purpose of capital adequacy ratio for Islamic banks and method of calculation.
All these previous efforts have led to introducing many Islamic instruments for investment and financing, some of which were never addressed by traditional banking school of thought.
Islamic Financial Services Board (IFSB)
IFSB was established in November 2002 as an independent board supervising the Islamic financial services industry worldwide. The Board is supported by the central banks and monetary authorities of some countries as well
as some organisations and international institutions supervising and controlling the international banking industry. The Board is comprised of 65 members;
19 of which represent international supervisory bodies such as World Bank, International Monetary Fund and the International Bank for Settlements.
The main function of the Board is to supervise, organise and set the rules of Islamic Financial Services Industry:
Establishing origination of the principles and foundations governing the Islamic financial services industry and harmonizing them with
the applied international standards guaranteeing their compliance with Islamic Sharia.
Cooperation with international institutions responsible for setting the standards and principles governing financial and monetary stability.
Supporting practices of Islamic financial services in risk management through researches, training and technical knowhow.
Encouraging cooperation among member states to develop the Islamic financial services industry and support research work in Islamic banking.
Establishing a data base for Islamic banks and financial institutions covering their products and services.
Islamic Development Bank (ISDB)
ISDB is an international financial institution incorporated in accordance with the resolutions of the Islamic Countries Finance Ministers' conference held in Jeddah. The Bank was officially inaugurated in October 1975 corresponding to Shawal 1395 H.
The Bank aims at supporting economic development and social progress of the member states as well as other Islamic communities in non-member states subject to the rulings of Islamic Sharia.
- Participation in capital of projects, providing financing to institutions and productive projects in the member states, besides offering financial help to these states through other channels for the purpose of socio-economic
development.
Establishing and managing specific purpose Funds, receiving deposits and mobilizing financial resources in different legitimate methods.
Enhancing foreign trade development of member states, together with commercial exchange amongst them especially for productive commodities and providing technical assistance for them.
Encouraging member states to practice financial, economic and banking activities according to the rulings of Islamic Sharia.
The Bank's head office is located in Jeddah - Saudi Arabia, and it has 55 member states and three regional offices in each of Malaysia, Morocco and Kazakhstan.
Liquidity Management Center (LMC)
LMC is incorporated in July 2002 and regulated by the Central Bank of Bahrain. It aims to provide optimal Islamic Financing and Investment solutions which contribute to growth of the Islamic capital market. LMC is committed to play a key role in the creation of an active and geographically expansive
Islamic inter-bank market which will assist Islamic financial institutions in managing their short-term liquidity. The establishment and depth of such inter-bank market will further accelerate the development process of the Islamic banking sector.
In addition, LMC will attract assets from governments, financial institutions and corporates in both private and public sectors in key target Markets.
LMC enables Islamic financial institutions to manage their liquidity mismatch through short and medium term liquid investments structured in accordance with the Sharia principles. It also facilitates investment of surplus funds with Islamic banks and financial institutions into quality short and medium
term financial instruments structured in accordance with Sharia principles. LMC plays an active role in the primary and secondary Islamic financing market delivering innovative, adaptable and tradable Islamic Sharia-compliant short term and medium term financial instruments
to Islamic financial institutions.
International Islamic Trade Finance Corporation (ITFC)
ITFC is an autonomous entity within the Islamic Development Bank Group created with the purpose of advancing trade to improve the economic condition and livelihood of people across the Islamic world. ITFC has consolidated all the trade finance businesses that used to be handled by various windows within the IDB Group.
It commenced operations in (January 2008 corresponding to Muharram 1429H. The consolidation of the IDB Group’s trade finance activities under a single umbrella increased the Corporation’s efficiency
in service delivery by enabling rapid response to customer needs in a market-driven business environment.
As a leader in Sharia-compliant trade finance, ITFC deploys its expertise and funds to businesses and governments in its member countries. Its primary focus is to encourage intra-trade among OIC member countries. ITFC’s catalytic role in enhancing the member countries’ trade,
intra-trade and international trade potentials is clearly reflected in its mission statement.
International Islamic Financial Market (IIFM)
IIFM was established in April 2002 in Bahrain as a result of the coordination between financial and supervisory entities namely;
Bahrain Monetary Authority, Islamic Development Bank, Central Bank of Sudan, Central Bank of Indonesia, Ministry of Finance in Tanzania and Foreign Investments Authority in Malaysia.
IIFM principal activities and current focus:
Tackling the absence of Islamic financial instruments and liquidity problems in Islamic Banks.
Introducing new financial investment instruments to help create a secondary market capable of attracting investments of Islamic countries as an alternative to conventional markets.
Organize specialized events, market consultative meetings and standardization specific seminars and workshops
Research and reports on Sukuk.
Islamic International Rating Agency (IIRA)
IIRA was established during 2004 in Bahrain. It is the first agency specialised in classifying Islamic Banks and financial institutions. IIRA has been set up to provide independent assessments to issuers and issues that conform to principles of Islamic finance. IIRA's special focus is on development of local capital markets,
primarily in the region of the Organization of Islamic Countries (OIC) and to provide impetus through its ratings to ethical finance, across the globe.
IIRA was founded as an infrastructure institution for the support of Islamic finance as conceived by the Islamic Development Bank (IDB). This puts IIRA in league with system supporting entities like AAOIFI and IFSB. The IDB remains a prominent shareholder, and maintains oversight through its nominee,
as Chairman to the Board of Directors.
Capital is USD 10 million, with a majority shareholding allotted to the Islamic Development Bank amounting to 42%, and the remainder is distributed as follows: 11% to each of the Islamic Bank of Bahrain, Kuwait Finance House, Islamic Bank of Abu Dhabi and Takaful Company of Malaysia, 5% to Al-Baraka Group,
5.3% to J.C. rating - Pakistan and 2% to Capital Intelligence - Cyprus.
The main objective of the Agency is to assist Islamic Banks in developing their Business and having their papers accepted by international markets. It will equally provide greater transparency of the activities of Islamic financial institutions in a manner that would help ascertain the volume of risks facing them.
The role of the agency is expected to increase with the application of Basel II standards as of the beginning of 2007.
Islamic Corporation for the Insurance of Investment and Export Credit (ICIEC)
ICIEC is a member of the Islamic Development (IDB) Group. ICIEC was established on 1st August 1994 corresponding to 24 Safar 1415H. as an international institution with full juridical personality.
The idea for the establishment of an entity to provide investment and export credit insurance for Islamic Countries originated from the Agreement for the Promotion, Protection and Guarantee of Investment among Member Countries of the Organization of the Islamic Cooperation (OIC). This Agreement provided that the OIC, through the Islamic Development Bank,
establishes an Islamic Insurance Company operating under Sharia principles, to provide insurance products for investments and export credits.
Banks in general and Islamic Banks in particular shall benefit greatly from these services, especially the banking policy which provides direct insurance against
the risks of non-payment. They can also benefit from the export opportunities in the high risk.
International Islamic Centre for Reconciliation and Arbitration (IICRA).
The International Islamic Centre for Reconciliation and Arbitration (IICRA) is an international independent non-profit organization that aims at organizing settlement of all kinds of financial, commercial, banking, investment and real estate disputes with compliance of Sharia Law through institutional reconciliation and arbitration.IICRA was established under an international agreement dated on 5th April 2005 corresponding to 26th Safar 1426H.