The Concept of Islamic Banking - Research Paper Example

Islamic Banking System The concept of Islamic banking revolves around the principles of Islamic Law and is put into application through the development of Islamic economics. The concept of Islamic banking was popular in medieval Europe from the beginning of the 13th century. In Islamic banking system there are different terminologies and different concepts in use. Islamic banking is guided by the Islamic laws which prohibit the collection and payment of interest. There are various similarities and dissimilarities between the traditional banking and the Islamic banking system. The Islamic banking has been popular over the ages and contributes a lot to the present world economy. In Islamic banking system Musharaka is the terminology use to denote the contract in the joint venture partnership. Our paper focuses on the concept of Musharaka and the diminishing Musaraka. The problem associated with the application of diminishing Musharaka is also studied in the current paper. A detailed analysis of the Islamic contracts and the terminologies are studied over here. Types of Islamic contracts: Under the Islamic law which forms the guiding principle of the Islamic financial system there are seven different contracts in practice. According to Islamic system or Shariah the formation of contract requires both offer, which is termed as Ijab and acceptance which is termed as Qabul. The contracts are generally in verbal or in written form. The parties of the contract needs to be legally knowledgeable and should be in sound state of mind at the time of entering the contract. The contracting parties should not be forced to enter into the agreement under by any force or compulsion. The popular types of contracts are Al- Tamlikat, Al- Isqatat, Al –Itlaqat, Al- Taqdat , Al- Tauthiqat, Al- Ishtirak and Al- Hifz. The explanations of the different types of contracts are done below. Al- Tamlikat- The contract deals with the acquisition of properties and deals with the benefit associated with the properties. To classification of the contract is done as contract of exchange and contrcts of charity. Al- Isqatat: The matters of dropping of right without exchange are handled by this contract. The release without compensation for the party is termed as absolute release whereas the release involving the compensation is known as release of exchange. Al –Itlaqat: The right to permission is maintained by the formulation of such contract and involves right such as appointment of governors, or providing of permission to administer ones property. Al- Taqdat: This contract prevents and restricts the occurrence of certain functions like dismissing the governors and termination of appointments for special tasks. Al – Tauthiqat: The contract of Al – Tauthiqat is applied to recover the debts outstanding from a party. It provides guarantees of security of money. Al – Ishtirak: The contract of partnership is referred as the Al – Ishtirak. The contract involves investing money in the business with an aim to get a part of the share in the business. Al- Hifz. This contract maintains security of property for the owner and it includes the operations of various agencies1 Mudaraba: The other popular financial contracts used in Islamic financial system is Mudaraba Interest free finance is one of the basic guiding principles in Islamic banking. Among all forms of interest–free finance contract, mudaraba was considered the most suitable and practical mode for mobilizing financial resources to Islamic banks. However the traditional two-partner mudaraba contract could not be depended upon for this purpose. So the contract went for modification and was aimed to established in such a way that it can be used between large number of owners and users. This gave rise to the multiple–partnership mudaraba. The Islamic bank, accordingly would act as a capital user when receiving funds from clients and as a capital owner when financing businesses whether by using clients’ funds or its own resources. The funds arising from banks are brought in together and employed in various modes. The funds were used in financing different projects and the calculation of the profitability is done combining the entire project over a year of time. Another feature of the multiple-partnership mudaraba was its constraint–free nature. In banking finance the multiple–mudaraba contract for purpose of banking finance adopted only the view of Malki and Shafei schools where no constraints should be imposed on the use of capital. This view was considered most suitable for mobilization of funds from hundred of clients. Per capita risk involved in investment activities was bound to be reduced significantly in multiple–partnership mudaraba when compared with the two–partner mudaraba. The mudaraba contract was introduced to add more flexibility in the functioning of the Islamic banking and to mobilize the fund from capital owners and to indulge in various economic activities. The contract can also be applied in special kinds of partnerships. In this contract one party provides the capital and the other uses his knowledge and invests in profitable ventures. The profits between them are shared based on pre agreed terms and conditions. The termination of the contract is done by providing a notice by any one of the partner. 2 Murabaha: Murabaha involved transaction in which the purchases of items are done by the traders for the use of the end user. It is used only the clients of banks purchase a commodity. In this transaction the clients can get no amount of money as loans. In these transactions the financing party purchases the goods as per the client’s requirement. Financing in this type of transactions are always asset based and helps in the creation of real assets and inventories. There is significant difference between the riba based transaction and the murabaha transactions. The contract of Murabaha referred to the sale of goods. The profit margin arrived for the sale is agreed by both the parties and is mentioned clearly at the time of agreement. In the contract a portion of asset is kept as mortgage with the bank. The murabaha contract was framed to start the bank credit system in the Islamic banks. According to the modified contract the Islamic bank would be ready to receive orders made by its clients to purchase for them specific goods on murabaha bases. The bank will be ready to respond to a purchase order made by the client after an agreement is reached on two matters after knowing the purchase cost or current market price of the ordered goods. The new murabaha contract allows for a delayed payment in installments at specific dates instead of payment on delivery as in the conventional contract. The new murabaha system was transformed from a mere current sale contract to be in effect a deferred- payment sale contract.3 Salam sale: Salam is the contract for sale. In this particular mode of sale the seller takes the charge of supplying specific goods to the buyer at a later date in exchange of spot payment. In this contract the supply of the goods takes place at a deferred date. Salam contract was qualified for the Islamic banking purpose. In this operation the bank would be giving trade credit to the salam seller in return for goods which it receives at a future known date and would be able to re-sell in the market. A profit can be obtained from salam provided that the reselling value is greater than the purchasing value of the merchandise. 4 Ijara: The Ijara contract means selling or providing of lease. Under Ijarah the customers of the bank uses the services of the assets for a considerable period of time. The bank purchases real assets which they can provide as rent or ease to the clients. The bank and the client mutually reach an agreement on the amount and other terms and conditions. The client takes the benefit of using the asset and remains responsible for any damage or misuse. To make the contract more practical the banks involved in multiple operation of purchase storing and maintenance. The banks tried to put the asset on rent on the expiry of the leased period to prevent from any under utilization of the asset. The leasing contract however turned out to be more like a hire purchase contract. Musharaka: It is an agreement in the form of joint venture which is carried out in between the two partners. In this form of contract both the partners provides their fund. The profits are distributed in the proportion of their share capital. In the matters of loss encountered in the partnership none of them loses capital in the same ratio. The general term of Musharaka means partnership or company in Arabic. The definition of the term varies in great respect in between the Muslim scholars and Fuqaha. According to Islamic economist Mushsarakha is defined as the partnership between two or more persons to mix their wealth and funds for jointly carrying trade and business with the aim of profit making within the boundaries of Islamic law.5 The aim of these partnwrship acts is to carry out economic activities for producing goods and service and profit making. In the financing of the capital total portion of debt financing is not permitted however debt as a part of total financing is permitted as it cannot be separated the assets which are making the contribution. The funds from current accounts are also presented into the capital as loans to the partnership institution. In case of partners making contribution to the partnership accounts in different currencies, exchange conversion is required. Currency is translated into the currency of Sharika in the current exchange rates. The conversion is required to determine the shares and liabilities of the partners. It is also required in determining the profit of each of the partners. In cased of management of the firm to partners may assign the responsibility to certain partner or to a single partner. If the person is chosen then other partners are not permitted to act on their consent. The partner chosen for managerial responsibilities is liable to get incentives other than his allocated amount of share from the profit. In case the partners decide to assign the responsibility of the management to someone else from them, that manager is entitled to a fixed remuneration which will appear as an expense for the firm. However further payment to the manger cannot be made from the share of the profit. The partners should obtain percentage of their profit and not as a sum of money or percentage of their capital share. Deferring the profit percentage to each partner is not permitted until the profit is realized. The losses realized are actually borne by the partners in the proportion of their partnership capital. The partners are permitted to make changes to the ratio of profit sharing according to their respective shares in the partnership capital. Supporting contracts: Two contracts are there in support of the Miusharakah which are Amanah and Wakalah. Amanah signifies rust between the partners and they carry out activities or transactions on behalf of each other based on the trust, however it does not guarantee in the capital share of any partner. Wakala states that each partner is acting as an agent for the remaining partners. Each partner is acting for the interest of the other partner and is acting as the principal partner. In wakala each partner can act in the interest of the other partner in making spot or deferred sales. The partner can take possession of the goods receivable by the other partner. The partner is also provided with the permission of making and receiving payments on behalf of each other. The partners entering into partnership can ask for payment of debts and even call for legal actions. Each of the partners can process the transfer of rights and debts .Within a partnership any partner is not permitted to act against the partnership. They are prohibited to provide loans and grants without the consent of all the partners .However providing short term loans which will not hamper the operation of the partnership are permitted to be granted6. All the partners in Musharaka can be terminated based on the performance of the contracts which is being concluded by the partners. The musharaka (company) contract had to be qualified to allow for the corporation from of company within Sharia framework. Two forms of Mushsaraka are present in view of extending finance and the participation by the Islamic banks. They are respectively permanent musharaka and diminishing musharaka. In the permanent musharaka there is no fixed termination period, and the partnership of the bank with the company lasts for indefinite period. In case of the diminishing form the contract terminates after a stipulated period time frame. In this case the transfer of bank share to the partner is done. In both forms, the permanent or the diminishing the bank is entitled to profit. The new form of the contract has been much more practical and it has enhanced the financing functions of the Islamic banks as the resources withdrawn from some companies are deployed in developing the others. The concept of Musharka can be linked more with investment than with bank credit. The principle of Musharaka prevents banks from asking about guarantees from the borrower but the Islamic banks do conduct this act. In order to minimize their risk, the banks ask for the money supplied by them to the client. In case of loss encountered by the bank, the bank looks for the equal amount of shares from the company. Musharaka is used to finance the whole part of an enterprise or for particular projects within an organization. It uses both short term trade financing and longer term sharing. The partners of Mushsaraka are entitled not to distribute the profits of the company. The partners are also suggested to keep aside a certain sum of the profit periodically as a solvency reserve which may also be used in meeting up loses of capital. During the termination of the contract the partners can buy all the assets of the business on the market value at the date of purchase but they are prevented to purchase on the basis on the basis of the face value. The partners may opt for a premature termination of the contract. Constructive liquidation may help the premature termination. At the time of liquidation the assets sold will be used for payment of the liquidation expenses and the financial liabilities which has arrived in the partnership. Remaining assets can be distributed among the partners according to their percentage of the contribution in the partnership capital. Two basic types of musharaka are Sharikah al milk and Sahrikah al uqud. The former is based on the partnership of joint ownership whereas the later is based on contractual relationship. There are also five subdivisions of the contracts which relates to authority, obligation, goodwill and skill management. They follow variety in equal and unequal contribution and varied sharing of responsibilities. One of the subdivisions relates to contribution of human effort in the partnership rather than that of capital distribution7. Diminishing Musharakah: It is a type of contract which falls under the type of Musharakah contract. Under this contract, the transactions begin with the formation of the partnership. After the formation of the partnership the partners enter into buying and selling of the equity in between them. In the contract of the partnership, there is a mention for the stipulated buying and selling between the partners. The buying partner of the contract is liable only to purchase. The promise undertaken by the partner is independent of the contract. The entering in one partnership account should not be because of concluding another contract. The partners of the contract should have their contribution in the capital. Partners can contribute either by cash or tangible assets which can be readily converted into some monetary values. Any loss encountered needs to be borne by the parties in the ratio of their participation of the contract. As a result of the loss encountered the equity stake of one partner will rise and the other will fall. The ratio of the profit needs to be determined from before the sharing of the profit should be conducted in such a manner that no partner receives a lump sum amount of the profit. It is not mandatory for the partners to frame their profit sharing ratios based on their ratio of ownership. The partners can decide their own share. It is permitted for the partners for maintaining their profit ratio even if there is a change to the ratio of the equity. The partners can also change the ratio of their profit if there is a change in the ratio of equity shares.8 Diminishing musharakka is culminated in the ownership of the assets by the client. The Islamic banks participate in the in the contract either fully or in part. When the bank enters into the partnership an agreement is formed which decides the share of each party. The principal amount financed by the bank can be repaid through the portion of the net income of the other party while the partner keeps the rest of the amount. As a result of this option, the share of the equity received by the bank reduces and partner turns out to be the owner. The banks intention of entering into the contract of musharaka is not to be in the contract of partnership as long as the company resolves. The bank receives the payment in installment or in lump sum basis for buying out the partnership interest of the bank. As a result the bank receives more payment than stipulated in the partnership contract. The partnership interest of the bank diminishes until it comes out of the partnership. . After the termination of the contract the bank withdraws its position from the business or the property and it transfers the ownership to the partner. The process of diminishing musharaka can be summarized in the following steps. The bank finances a part of the capital demanded by the project and comes to an agreement with the partner regarding the gradual selling of the share capital to its partner. The partner in turn also finances a part of the money for the project and enters into an agreement to pay the amount in exchange of the full ownership of the property. The bank also sells it share of the capital. The partner of the contract pays for the cost of the percentage of capital to the bank and the transfer of ownership takes place to the customer. The clauses of the diminishing partnership should be such that it should not eventually turn out to be loan financing operation. In the contract the bank should take a part in the shared ownership and should own its share in the partnership. The bank can sell its share in the company if the partners of the contract pay for the value of the shares.9 Diminishing musharaka can be conducted both in contractual partnership and in respect of ownership partnership. The feasibility of the agreement can be achieved only in respect of fixed and other types of assets that are leased over a period of time. In simple terms the contract of diminishing musharaka is a partnership in which one of the partners takes the charge of the equity share of the other partner until the transfer of ownership takes place to the buying partner. The transaction process is independent of the contract. The contract of diminishing musharaka can also be used as a purpose of financing. In case of financing a house a creation of joint ownership takes place. The share of the financier to the client is provided on rent. Leasing of the share of the house to the client takes place and the rent is charged. The client promises to purchase the units of the share of the financier. The purchase of the units takes place at different stages of time. The rental is adjusted based on the remaining amount of share of the financier in the property. The banks part of the property is divided in various units which are ultimately sold to the partner during the course of time .The ultimate owner can purchase the units as per the agreement or depending upon the suitability of the ultimate buyer. The duty of responsibility and insuring the product is passed on to the en buyer through an agreement. The concept of diminishing musharaka can also be used in carrying a business or trade. In the contract the partners accept the fact that an extra payment should be given to the bank from any profit realized for reducing its share in the company. The concept of diminishing musharaka appears practical and has created new financing options for the Islamic banks. The contract optimizes the profitability and the objectives of both the parties into the contract. The transfer of ownership property of the contract creates interest within the entrepreneur and the sharing feature benefits the financer of the contract. 10 Problems with diminishing Musharaka: The concept of diminishing musharaka though has highlighted its importance in the Islamic financing mode still it has some discrepancy or limitations in its practical use. As observed diminishing musharaka has a wide application in financing the housing contract projects. The rules for the contract vary in a great deal with the conventional contracts framed for the house financing. In studying the limitations associated with the contract, various aspect of housing contract has been considered. The commencement of the agreement in diminishing musharaka starts at a future date and an effective forward contract takes place which is prevented in Islam. The nature of the contract makes the repayment of the amount due on occupying of the property. In matters of termination of the contract the power lies in the banks hand and the bank can move out of the contract without any consent form the other party. A failure by the client in paying the profit to the bank or a delay in buying the shares of the bank can persuade the bank to terminate the contract. Such measures by the bank could harm the other party seriously. It is to be understood that such measures could hamper the relation between the client and the bank and would raise an alarm for the other parties in entering into such contracts in future. In the housing finance contract of Diminishing musharaka the financer takes part in profit accumulating from the contract and but he is not a part of the loss if any and this creates disparity among the parties which should not be promoted and is harmful for any partnership contract. However the client is also benefitted to some extent. The client and the bank have joint participation in buying the house on the basis of the debt equity ratio. The client buys the unit periodically which reduces the share of the bank and helps the client to increase his own share. On the contrary all expenses are paid by the client and the bank does not participate in meeting up the expenses. In diminishing Musharaka the clients are not permitted to get the house released from the bank on paying off the debt. The contract of diminishing musharaka favors the client in certain respect and the bank in some other, the limitation of the contract lies in the fact that the contract failed to provide equal distribution of power to the both parties in all the respect of the agreement.11 Diminishing musharaka is also susceptible to various types of financial risks. The financial risks faced by the concerns in the application of the contract are credit risk, market risk and operational risk. The bank faces high probability of credit risk due to the delay in payment from behalf of the client or at the time of default. The contract suffers from the market risk as the contract faces threat from equity price risks, besides the house or the asset under lease is under the exposure of commodity rice risk. In certain case overdue rentals add up to form the mark up risks. Operational risk persists in the contract as the bank may face a shortage of skilled manpower to carry on with the Islamic financial operations. This may result in failure from the banks point of view in monitoring the performance as per the contract and fail to take steps against the client for the failure to deliver as per the agreement12. The banks entering into the agreement may also face legal risks as there is no provision to handle the refusal from the clients in matters of rent payments. Another major problem or limitation of the diminishing musharaka is its limited use in the Islamic banks. The use of such financial instruments is not promoted by the Islamic banks and so there lies a problem with getting the right amount of exposure needed. Another main limitation of the contract is that the contract failed to improve the secondary market of Islamic finance. The three main issues which still lie unaddressed are types of shares, need for issuing bonds and the reselling of the shares in the market without any restrictions. Use of preference shares is prevented under the Islamic laws and as per the contract preferential treatment has to be provided to most of the employees in order to inculcate a positive effect within the organization. However this preferential treatment is geared only to production and not to the wealth factors. The financing activity under the contract is not carried out by issuing of bonds which would have led to the growth of the secondary market. Solutions to the Problem faced by diminishing musharaka: As observed in the discussion above the problems and the limitations of the musharaka contract is highlighted over here. The recommended solutions for the problems noted are mentioned below. The contract of diminishing musharaka was found against the law of Islam as being a type of forward contract. So to remove the limitation it can change its clause and the contract can be made effective from the very first day of the agreement. The facility provided to the bank in matters of termination of the contract should be reviewed. Other than empowering the bank to terminate the contract in case the client fails to pay the profit or buy the shares in time, the bank should try to consider the reasons for the failure and after analyzing should implement their decisions. The distribution of the profit and loss should be shared by both the clients and banks and the banks should not refrain away from the losses suffered in the contract. Provisions should also be provided for the client to claim back the possession of the asset on repayment to the bank. The contract should be framed in such a manner that there should be equal distribution of the powers between both the parties. The banks should also bear a part of the expenses which are solely handled by the client. In order to counter the risks in the implementation of the contracts proper risk management and mitigation techniques should be incorporated. However handling of risks is difficult under the Islamic banking systems. The intermingling of risks and the change of one risk into another creates further difficulties. The risk management under Islamic banking should also be framed keeping in adherence to the sharia’s policy. Various measures are incorporated in handling risks. Measures like internal and external audit and GAP analysis should be incorporated which are under the compliance of Islamic law. In order to eliminate the credit risk payment of substantial commitment fees can be introduced. In order to reduce the occurrence of the disputes arising among the partners, they can mutually agree to follow a process in handling such matters. To handle operational risks the banks should deploy proper manpower and should review the performance of the contract to focus on the faults and the failures. In order to enhance the payment from the client the contract may incorporate providing rebate or incentives if such are performed. It may also try to involve other risk mitigation techniques like swaps and options to be more effective in nature. The use of the contract should be more into practice to highlight its importance and find ways for further development. Conclusion: The study on the Islamic banking system and the various types of contracts in use highlights their significance of their use. A detailed study of the diminishing musharaka highlighted its importance and its limitation in its application. The significance of the contract lies in its wide application in housing finance. Apart from the few shortcomings as a contract for housing finance, the contract proved very houseful. It is effective due to the fact that the contract cited lesser difference than other generalized contract for housing finance. The use of the contract should be promoted and ways for improvement should be derived. The contract may be reframed to expand the secondary market under Islamic traditions. References Ahmad, Abdel – Rahman yousri “Islamic Banking Modes of Finance”, Alexandria University, Egypt Salam, kantakji, November 3, 2011 from: https://docs.google.com/viewer?a=v&q=cache:i01ilfxMqakJ:www.kantakji.com/fiqh/Files/Finance/N392.pdf+salam+sale&hl=en&gl=in&pid=bl&srcid=ADGEESjHMp-RsBRISPAbaVUT2HBdj-H_MijfN-3_Om4yOVf_SooTbt3Xqe2bpkXX5dl-Dg6UacY6_ix1a-NQDmjW8XdY9OdVC5NglPcsV6y5ehWLtzDKRJ-Sqw8yhTDQOIpzz_v-TNFM&sig=AHIEtbQCsOy2QxL-OvxFrOkm2jpnzXa5Lw&pli=1 Ahmad, Abdel – Rahman yousri”, Introduction to mushsraka and various forms of contract,” Alexandria University, Egypt Ahmad, Abdel – Rahman yousri, “Musharaka,Additional Notes on Partners’ Capital Contributions and Supporting Contracts” Ahmad, Abdel – Rahman yousri, “Diminishing musharka, Alexandria University, Egypt Hassan, Kabir & Mervyn Lewis, Handbook of Islamic banking, Camberley: Edward Elgar Publishing, 2007 Instrument of Islamic banking and finance islamicworld, November 3, 2011, http://islamic-world.net/economics/instrument_bank_finance.htm Kettell, Brian B. 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