Islamic Banking: A last Ditch to Save Capitalism Published in: New Horizon (London), February 2004 Iraj Toutounchian

Professor of Economics The prevalence of stagnation in todays capitalistic world is unprecedented; a capitalistic world confronted with complex economic issues, which were not so acute in the past. Business cycles, which were played down in the past, no longer can be treated as such. The intensity of business cycles has reached such degrees, within the last couple of decades that advanced capitalistic regimes have to encounter their overriding existence. This is especially true in a world in which communications have expanded enormously as a result of which countries, willingly or not, have come closer to one another for purposes of economic relations. Once it was offered, as a claim, to envisage capitalistic economy as being self-regulating and self-correcting. The intensity and frequency of economic fluctuations have made even the most ardent of economists to withdraw such a claim. The catastrophe has reached points that if one would fail to see the impact of collapse of the capitalistic system as greater than that exerted by war, he would succeed in comparing its unpleasant consequences to those created by warfare. War destroys people and facilities. 1But the great collapse, which is likely to occur in near future, will swamp living human beings. Unemployment, poverty, disease, and hunger are not predetermined events; man is not doomed to accept them as inevitable. Mankind, through the hands of colonialists and strongmen of the capitalistic world has brought about the perilous present situation. The greedy and selfish consumption in major advanced industrial nations, which had been severely and ever-increasingly disturbing the ecological balance, has culminated catastrophically in new heights now imposing a massive threat to all mankind, a threat whose magnitude could have never been imagined by great architects of the Scientific Revolution. The real danger lies in the fact that potentiality of this catastrophe is being played down by some highly influential executive offices, despite the scientific communitys repeated warnings, in order to perpetuate irresponsible exploitation of natural and human resources in a capitalistic mode, which secures the benefit of a few over the planets population. The unjustified and unresponsive acts, disregarding good purposes of humanity, committed by the world capitalism, particularly since World War II, has disgusted the public, creating critical reactions of many kinds, each expressing deep dissatisfaction concerning the status quo, and the world governance. A casual glance through the history of contemporary social thought would reveal a mass of evidence supporting the point just put forward. We resist the temptation to offer a view on 2the social dimension of such dissatisfaction here, in order to make room for economics. Unites States of America represents the prototype of a pure

capitalistic country, and no foreign force as yet has been able to alter its sheer capitalistic course. The immensity of size, power, and the economic complexity of the USA, is unique. It follows, naturally, that its problems do not conform to those of other nations. Thus US economy has to be analyzed as a separate category. This separate treatment does not mean that the other advanced industrial nations are immune to perils that America is doomed to face. Here, while withholding approval of points expressed by the socialists or the Marxists, we quote a sentence from Joseph A. Schumpeter: Marx was wrong in his diagnosis of the manner in which capitalist society would break down; he was not wrong in the prediction that it would break down eventually. The advanced industrial nations have many characteristics in common, and all of them will face, sooner or later, the looming threat America is destined to experience. Nevertheless, the uniqueness of the American economy requires us to point to dire realities concerning this nation. Obviously the act of pointing to the USA comprises a general warning of interest to all advanced capitalist industrial nations. What follows is partially taken from the recent report of the Monthly Review. 3 The economic theorists and experts discuss endlessly Americas federal budget deficit, its negative current account balance, lack of investment, and the breaking of financial bubble. These theorists fail to realize the possibility that these are merely symptoms of recession. The prevailing view regards capitalist economy as naturally tending toward abundant investment, striking economic growth and wealth, thus the authenticity of the view that the capitalist economy intrinsically tends toward recession, is disregarded. The theorists may admit that growth rate of the US economy has been falling since 1960s, yet they attribute this decreasing process to states bad policies not as a reflection of a general process of modern capital accumulation. A more rational treatment of the present situation depends on admitting the view regarding capitalist economy as tending towards recession as a natural event. What created the rapid growth of the 1950s-60s, were historical events like peoples saving during the World War II, the second wave of automobilization of the US economy (which included steel, glass, tire, construction industries, and the inter-state freeway network). Added to these were the economic stimuli created by two regional wars in Asia, and the extraordinary increase of sales organization related to modern techniques of marketing. Most of these factors have either completely vanished ( as peoples saving during World War II) or have reached the point of stability where they can no longer be considered as major stimulants for economic growth. 4During the 1980s the main economic stimulant came from the expansion of financial superstructure of the US economy. This expansion took place particularly in recent years as regards electronics and computer industries and that of the internet. These factors, too, have weakened following the breaking of the stock markets bubble, and decrease of investment in the electronics and computer industries.

The unemployment statistics is indicative of the seriousness of the danger poised by it. The number of employment has reached its lowest since twenty years ago. According to a report by the New York Times of February 6, 2003, since the crisis commenced in March 2001, the US economy has lost more than twenty million job opportunities. Most individuals, confronted with the prospect of prolonged unemployment and the glimmer chance of reemployment, are disappointed and thus have stopped looking actively for jobs. Hence, the official statistics does not include these people, and therefore the unemployment statistics is an underestimation of the real jobless. To obtain the official figure of the unemployed their number is divided by sum of both employed and unemployed individuals, and the result is stated in percentage. According to such a calculation, the official unemployment statistics, for January of 2003 was over 6.5% (disregarding seasonal factors). But if we consider the number of individuals who have recently left--per official definition of--the labor force, and add the number of individuals working part-time yet seeking full-time work, the real dimension of plight of 5unemployment will surface. Considering these individuals, the unemployment figure for January of 2003 (disregarding seasonal factors) has been 11%. It is crucial to note that according to the New York Times, the Federal Reserve Board has lowered the interest rate twelve times within last two years, decreasing interest on the inter-bank loans to its lowest; to 1.25%, inside of last forty years. In spite of these efforts, the Federal Reserve has not been able to motivate investment volume. What determines investment volume in the new output capacity is the prospect of gaining investment profit in the future, viz., when the new output capacity would reach exploitation point. If due to limits of the market, or any other reasons, little were expected of the future profit to be gained from investment, then new investments are simply not made. The recent events must have persuaded the western economists (both, Keynesians and monetarists) that despite their views, investment is not a function of interest rate, but there should be an effort made to search for another factor, a factor that is responsive in normal, as well as, in risk conditions. This point directs us towards interest-free, Islamic banking, to substitute profit rate with rate of interest. In addition, in such a system, attention is paid simultaneously to both; the supply side, and demand side economy. These two points, taken together, constitute a special feature of Islamic banking, a feature lacking in capitalist economy. We should bear in mind that all business 6cycles are rooted in money and are somehow related to interest, which is the result of speculation. Two main subjects are discussed here. First is that economic system should deal with two principle categories, viz., on the one hand, the issue of justice (equity), and on the other, the issue of efficiency. Between these two issues lies their trade-off area. Capitalist economy puts emphasis on efficiency and regards equity as its spillover, that is, it holds that in the process of economic growth, equity will emerge. In discussing justice (equity)

the main issue is the equitable distribution of income and wealth. What justice is this, as M. Friedman puts it: That 1% of population owns 50% of everything? And, how is it that after the passage of two hundred years, this justice has not yet emerged? The socialist system claims to have justice as its goal, yet it has a mistaken image of justice. In the meanwhile, the socialist position takes efficiency as a byproduct of the issue of equity. The socialists error is that they do not respect private property. Is it true that ownership is always obtained through theft? Proudhon initiated sanction against private property by stating that property is theft. Nevertheless Proudhon not only does not deny workers ownership but also considers equity important enough to rightly assert that: Justice is equilibrium of opposing forces. And that: Justice is the supreme principle of human life. Proudhon, thus, bestows on justice a certain scientificanalytic aspect. While avoiding the assertion of attributing the demise of the former Soviet Union to the supposed fall of 7philosophy of socialism, it seems necessary to bear in mind that the issue of equity is the issue of rights, and that within rights of the owner of capital (not money) to possess and enjoy the results gained through utilization of his capital. Moreover, justice is not meant to be an issue applicable only to workers, it must encompass all members of a given society. Even when economists talk about efficiency they implicitly consider equity. Specifically, welfare cost of inflation, which has occupied a considerable volume of economic literature, is mainly targeted toward least damage to the society. This is nothing but justice (equity). In Islamic economics, rights of people and those of things have been defined prior and after the distribution of wealth. Then, justice is defined for all members of the community as an uncompromising goal. It must not be difficult to demonstrate that the implementation of justice as such will conduct all affairs in their natural course. The resulting corollary is that simultaneous access to both stable prices and full employment (unlike capitalist economy) is attainable. Meanwhile, natural course of affairs which results from application of such a justice will create a state of equilibrium between human psychological needs and his surrounding environment (something the capitalist economy has been unable to attain). The second subject is that mankind has comprehended justice concept and the joy which is derived from applying justice, in some periods of human history. Then, ever since mankind 8achieved this understanding of justice, using his intellect, which is intrinsically moral, he has struggled against interest (Riba). This struggle goes back to hundred of years before Christ. So that: usury (Riba or interest) had been repugnant to Aristotle. Economists, later, embarked upon more detailed inquiries on interest. Proudhon is one of those who rose against interest in such a manner that he believed: interest being abolished, exploitation through property is abolished, too. Nevertheless, serious scientific discussions on zero interest began in 1930s. Silvio Gesell suggested stamped money in order to omit interest

from economy. Maurice Allais, while publishing a book in 1947, had reached the conclusion that: the optimum real interest rate is zero. We will suffice mentioning three other thinkers who rose against interest in economic literature. After Allais, another economist, namely, M.Sidrauski in 1967, using a dynamic utility function in which money was inserted reached the conclusion that in order zero down welfare cost, interest rate must be equal to that of social marginal cost. Applying it to money it amounts to zero interest. B.P.Pesek, and T.R. Sving (1967) have argued that the essential characteristic of money is its non-interest bearingness, and that if money were to bear interest it would cease to be used as money. Professor M. Friedman, too, in 1969 reached the conclusion that zero nominal interest rate is the necessary condition for optimal allocation of output factors. In 1998, two economists working for the US Federal Reserve, of 9Minneapolis District, showed that for optimal allocation of output factors, not only is zero interest necessary condition, but it is sufficient , too. The result emerging from these studies do not strike Muslim economists as surprises. Yet, the question remains that under these circumstances how banks would operate? If banks, for example, grant interest-free loans, (considering that M.Friedman designates legal reserve rate banks to be 100% for purposes of economic stability), what form, then, banking will assume? Despite valuable efforts made, none of these economists has yet addressed this vital question. We have taken up the task to deal with this question in a book coming out soon. Having discussed briefly the issue of zero interest in economic literature, we realize that mankind has paid a heavy price, within prolonged years, as a result of paying little or no attention to instructions that Islam issued. Yet, one has to admit that man has learned much through these processes of trail and error. What Western economists have reached on this issue is that through designating a certain goal as welfare state, they have attained the necessary condition for realization of justice. In short, this is nothing but zero interest rate. This is what has been carried out in Islam, which begins with sanction against interest (Riba), and ends with the welfare state; the one envisaged in Islam. Then, we argue for the Islamic model of economics, which shows the way to those who believe in the unity of Almighty God, so that they would not be misguided. We would reach the desired 10destination, if the way is taken and traveled through. Thus, Islamic way is the safest and the least costly of all and it is on this score that all humanity, especially the capitalistic society, has focused attention on Islamic economics in general, and on Islamic banking in particular. At this juncture, we would like to present a review of the main challenges and prospects that Muslim economists are facing as listed succinctly below: Challenges: 1-We must gain the courage to implement the divine rules in the form of logical models, coherent enough to be presented to

the worlds scientific community. We have to admit that the world expects us to do more. The history of serious and analytical research on Islamic banking goes back at the most to fifty years ago, while the same divine rules had existed before and have not changed ever since. Having endured many hardships, the western nations catered the tree of modern science. That is why we see that the tree of science has grown to such a bulk over there, and with the passage of every single day the bulk of scientific literature expands even further. It can be argued that if the divine rules were available to the westerners they might have elevated the status of science even higher. 2-It is regrettable that only articles and seminars refer to the benefits of Islamic banking, and that little of Islamic banking 11has been practiced in few Islamic nations so that people could enjoy its benefits. 3-The Western economists reaction to the theory of Islamic banking has been somewhat deficient in character and vigor. I attribute such a benign reaction to the existing differences of perspective and approach among Muslim economists, which is partially normal and acceptable. Yet the remaining part of reason for such a reaction is due to the fact that many Muslim economists have concealed capitalistic economics under the guise of Islamic lexicon and contracts. Interest rate, for instance, has been covered by profit rate and it is not clear while interest has been overtly banned in Islam, how can people discuss LM curves money market and their derivatives? It is the same when many articles discuss loan (not Qard ul-Hasan). In legal definition of loan, the obligatory payment of surplus on the part of the borrower is interest per se, which is Haram (banned). It is obvious that loan does not involve profit; rather it is capital that produces the profit. Or, similarly, when discussing the opportunity cost of capital in Islamic banking, Muslim economists imitating the Western colleagues and without much scientific thinking, consider a positive figure, other than zero, that is debatable. 4-Distinguishing money market from capital market is not an easy task, and this is exactly what professor Joan Robinson has warned us about, so that we do not be misled. Our goal must be to convert M-C-M relation to proper C-M-C, because it is not money market which accomplishes the task of economic growth, rather it 12is capital market which must be reinforced in order to foster economic growth. Once J.M. Keynes showed that interest creates speculation (a subject to which the classical economists paid no attention). It is not hard to show, on the basis of his rigorous analysis, that speculation, too, causes interest. In other words, interest is the necessary and sufficient condition for speculation. In the meantime, there are still those who make a distinction between interest and Riba, and what has been sanctioned against in Islam is, considered by them as prohibitive, Riba. At the same time they surprisingly enough do not consider small interest as Haram! 5-The Western monetary theorists, too, have not shown a considerable reaction to the above shortcoming. It seems that having glanced through articles on Islamic banking models,

written by Muslim economists, the Western monetary theorists have found those models to be very close to capitalistic banking. On this score, they are apologetically happy to have discussed a model not different from the traditional one! That is perhaps why the Western economists have not been cognizant of articles on Islamic banking written by Muslim economists. 6-The Westerners have declared that the science of economics was established in 1776 by Adam Smith. Objecting to this notion, some have considered the French as having devised economics, indicating France as its homeland. Upon supposing a fictitious and unfair stance to the effect of exclusion of the early Islamic period, we would be still faced with Ibne-Khaldoun in 13more than 600 years ago who in his book, The Introduction, as acknowledged by the Westerners, is the first Muslim thinker to discuss ways of administering a nation. Today, we find on the web sites more than 4000 entries on Ibne-Khaldouns material. 7-The indulgence and weakness of Muslim economists (myself included) have made the Western scientists suppose that by banning interest our position is similar to that of socialists in that we would maintain there must be no return attached to capital, while interest is the return attached to money, and profit is the return attached to capital. Having accepted capital market we admit a return to capital. Yet, rejecting money market, we are not prepared to pay anything as return for money. Under an Islamic framework money market has no function to play, that is, it has to be obliterated. It follows that all of money market derivatives, too, would be considered as non-Islamic. This would set limits to transactions in securities exchange market (limitation would be on stocks exchange not on bonds, which would be absent because of interest they acquire). Securities exchange market, contrary to some misconceptions, is money market, not capital market. Money market, by definition, is where loan is the center of transaction, which is administered within a year or less. Thus, even if stocks are transacted in such a market, since the intent of the buyer and the seller is indeed to gain income, which is obtained even daily through the difference on the price of stocks transacted, then, the same M-C-M relation persists in which stocks function as C. In this retained relation, the loan is 14received and paid on a daily basis, while C functions as collateral for the loan, and the differential rate of interest gained thereby is the source of income thus made. Moreover, the pricing of stocks, too, in securities exchange market must conform to the Islamic rules, that is, the prerequisite conditions for realization of a proper transaction must be met. This means that the buyer is entitled to know exactly what he is buying. In current securities exchange markets, the buyer does not exactly know what he owns in the community. 8-The capitalistic economy is fraught with many problems, some of which have been pointed out above. Nonetheless, we must bear in mind that social capital is stronger in the capitalist nations as compared with developing Islamic countries, the significance of which should not be under-estimated in Islamic countries. We should be able to prove that not only will these

problems be solved in the light of Islamic banking but also new fields be opened to Muslim economists: A: One of the conditions to attain sustained growth (development) is the equitable distribution of income and wealth. It has been demonstrated (by Westerners) that capitalistic economy will not reach such equity. B: The capitalistic economy is faced with a conflict between efficiency and equity. This, among others, makes one of the fallacies of capitalism. Whereas, in Islamic economics there is no goal higher than establishing justice and fairness. We should be able to demonstrate that through implementation 15of the Diving Rules of Islam, by which efficiency is attained, we can also reach equity. Islamic banking will accelerate this goal. We should also remember that Islamic community is a cooperative entity in the wider sense of the word cooperative. C: The Western economists have recognized as genuine the fact that capitalistic economy is unable to increase aggregate demand (AD) and aggregate supply (AS) simultaneously. That is why their monetary and fiscal policies cannot depart from stagnation and unemployment. The cooperative Islamic economics, particularly where Islamic banking is concerned, is capable of such a task, and again, we should demonstrate this capability. Prospects: 1-Profit & Loss Sharing (PLS), as a principle, constitutes the backbone of Islamic banking. The expansion of this principle throughout a community transforms that community into a large cooperative within which every Muslim individual would try his/her utmost efforts and thereby through benefiting others, he/she would gain benefit. If the interaction of individual efforts were utilized in a proper way then the communitys welfare would be high enough not to let these interactions be mutually exclusive. This is also true of workers remuneration through which workers can share the profit gained by Islamic banks contracts with productive firms. In addition, the depositors will enjoy the profit 16gained through banks participation with investors. This point becomes clearer if we remember that the profit rate is frequently higher than that of the interest. These two factors will help the equitable distribution of income and wealth; the necessary condition for sustained growth. The price of manufactured goods would fall due to two reasons. On the one hand, price decrease is due to the omission of interest (Riba), on the other , it is a function of decrease of wage expenditure (brought about by workers participation in profit). Pursuing a policy accompanied by participation of Islamic bank with productive firms and by dividing the proportionate profit among the depositors, simultaneous increase of AD and AS will be made possible. 2-It is interesting to notice that professor M.Weitzman, imitating Japanese workers participation in production has amateurishly considered it quite fit to overcome stagnation (as he admits to be inherent) in capitalistic societies. Whereas participation of workers is not compatible with the elementary

principles of capitalism. Professor Weitzman, aside from mixing subjects, has neglected the point that interest constitutes the prime fallacy of the capitalistic societies, a fallacy which will be followed by yet more complex and larger fallacies. It is difficult to envisage that Islamic economics, having eliminated such a fallacy, would encounter similar problems. 3-Based on existing literature, it seems that for the sake of modeling in Islamic economics, in general, and Islamic banking, in 17particular, we possess more than enough criteria and procedures to act upon. 4-Marx once, lacking relevant expertise, omitted capitals share in the Industrial Revolution era and thereafter, and worried solely about the proletariat. Whereas Islam worries about all individuals; workers and investors both. Could Marx have ever imagined that interest would penetrate the economic life of the Western societies that, for instance, in contemporary Germany, for every 100 Marks spent in a family as expenditure, 1/3 goes for interest? The elimination of interest, supposing it were inert in other areas of Muslims social life, will have the least effect of raising their purchasing power to up to 1/3. 5-Having banned interest (Riba), and having logically eliminated money market, speculation and all related affairs in secondary market, which involve artificial risks, Islam attempts to emancipate all men (Muslim and non-Muslim) from being dominated by wealthy individuals who have always lived a life exploiting others. This emancipation comes by through establishment of Islamic banking. By the omission of interest from the whole system, money whirlpool will disappear and thus the necessary condition for full employment (that is, the equality of saving with investment) will be created. We should not be misled by Japans experience. Although interest rate in Japan is nearly zero, yet unemployment rate has been declared as 5.4%, which is expected to reach 7% within five years. Two reasons can be offered for not reaching full employment in Japan (despite 18workers participation in profit or income gained by productive firms). First, Japanese bank do not operate on the basis of participation, rather they lend and borrow loans, (that is, they function as fund intermediary) like any other capitalist system. Second, stock exchange (of bond, stock, and commodity) is active as ever. Speculation in these markets creates interest in terms of same goods. In other words, interest (Riba) has not been eliminated in its wider sense in Japan. The mere existence of these interest rate create money whirlpool, which has prevented the equality of saving and investment. In short, as an economic system is farther removed from capital market, getting closer to money market and its derivatives, the more unstable it becomes. 6-A general equilibrium model can be constructed in which there would be three markets of labor, capital, and of goods, on whose coordinate diagram profit rate and national income are made possible to be demonstrated. 7-The world today has reached the point that realizes that capitalistic system, despite claims put forward by its early founders, is not a self-regulating or self-adjusting system, and that

capitalistic economic models must be devised based upon disequilibrium (this is being done for some time by certain Western economists). This is the time for Muslims to be alert and vigil to use this historic opportunity for devising and presenting a logical Islamic banking system without having any reservations whatsoever. 19 8-In the final analysis, we reach the conclusion that the research on Islamic economics, in general, and in Islamic banking , in particular, has grown within the past several years, and that in some instances this growth has been much beyond the expectations of researchers of the field. This growth rate is the result of the work done by Muslim as well non-Muslim economists. We should be proud of it. Economic problems and difficulties of many nations have become so complicated that capitalistic economics, as admitted by Western economists, cannot possibly respond accordingly. The Western economists thought has been so contaminated by concepts such as individualism, profit seeking , and interest (Riba) , that it is hard, if not impossible, for them to imagine any other workable system. In order to find answers to ever growing problems of the capitalistic world, their theorists once in a while find a subject here and there, and try to patch it up to or inject it into the ailing capitalistic system. Among these injections we can point to labor unions, syndicalism, creation of cooperatives, and The Share Economy. A scientific approach to Islamic banking has been added in recent years to the list just offered. Evidently, these are not ways to completely cure the institutionalized problems faced by capitalism. These short-term solutions may act to pacify the wounds inflicted on the system. To describe a definite resolution as to the issues and a way for freeing from the capitalistic ailment a quote is in order: It takes a theory 20to kill a theory. The remedy cannot be anything but that offered by Islamic economics. Islam and its Divine Rules are not nationspecific; they contain the message of hope for all men in all nations. It is only through Divine Rules that mankind can overcome his terrestrial problems. Mens own solutions seem not getting through in this complex sphere. Mankind has paid a heavy price for neglecting the Divine Rules, which are for his own welfare and salvation. In this setting, the modern man should prepare an alternative approach to administer his economic affairs. Muslim scientists should use their thinking capacity, and the capacity of their interacting with one another, and through avoiding mixing the content of capitalism with that of Islam, they can present mankind an alternative route. This is not a farfetched goal because Muslims enjoy absolute advantage in this area. For this reason, we can hope to restore the glory of our past in near future. This goal is attainable given closer, further, and continued cooperation among scientific figures of Islamic, as well as non-Islamic, nations.

Islamic Banking System, Islamic Banking Concept, IslamicBanking, Afghanistan, Kandahar

Abdullah Haiwad
affiliation not provided to SSRN October 12, 2008 Abstract: SUMMARY: The project identifies the concept of Islamic Banking, from its origin as mentioned in the Holy Qur'an and reforms being introduced to meet the requirement of today. Section one, outlines the aims of the project. The Second section, deals with methodological issues and attempts used to justify the choice of research variables, reasons why they were most appropriate to my project undertaken. Section Three, of the project looks at what the Quran says about Islamic finance. It raises the question that Islamic finance is divinely revealed and must follow the Shari'a (Islamic law), and therefore, financial transaction can only be conducted within certain boundary. Section Four, will investigate the origin of Islamic banks, how it has evolved with time, and also why there is this resurgent for this kind of financial intermediary. Section Five, will involve a full description of the reasons for the banning of interest in Islam and its implication. This will directly lead to Section Six, which will look into what is Islamic bank and requirement necessary to be classified as a bank for Muslims, and also how is the concept different from the conventional banks. This chapter will also look into the many ways thatIslamic bank provide services which is within the Shari'a. Section Seven, will look at the practices of the Islamic banks and the permissible forms of transactions. This will lead to section eight, which will look at the problems facing Islamic banks. It will focus on aspect in terms of reforms and improvement required in order for this kind of banking system to be effective. Finally, Section Eight concludes the project by discussing briefly the how the system is doing well and how it still needs to improve. Furthermore I will also evaluate my methodology. INTRODUCTION: This project will give me the opportunity to undertake a study of a particular Business and Financial Services subject. According to Islam, God has created man virtuous and pure; He has given man intelligence and knowledge; He has surrounded him with all sorts of instruments of His grace and mercy. In return, God has asked man to act in a certain way in this world not to harm other fellow human. This being the belief of Muslims, an attempt has been made to serve over billions of Muslims in their financial needs. Thus, my project aim is to identify the concept of Islamic Banking System. In addition, it will look at how Islamic banking was created and why there is a need for such finance. In order to do this I will begin by defining some of the key terms and concepts, and will provide a background and an overview of the nature of the Islamic Bank.

Finally, I will investigate the current situation and necessary reforms and improvement required for this kind of system to become successful in meeting the needs of the Muslim people. RESEARCH METHODS: The research methods used to gain the best possible knowledge and information about Islamic Banking System was to conduct a literature research. Initially I had anticipated using two types of methods to do my project, in addition to research into secondary materials, I had also intended to undertake Unstructured Interviews - to enable me to gain an insight into the Islamicbanking system. Clearly there are many advantages attached to this type of research method. Firstly it would have enabled me to understand and find out my respondents personal views and concerns more effectively, by probing deeper into the question and answers. This is because they would be able to talk freely, and eager to speak out about their experiences of Islamicbanking systems. This in return would have been very informative and useful for me as the researcher. However, I did get the opportunity to visit mosques and borrow literature, and ask the Imam for explanations on issues concerning Islamic banking, particularly issues to do with interests and the Islamic rules and regulations. As with all methods, disadvantages in constructing 'unstructured interviews', could have posed for me the following problems. To begin with, I would have probably gained opinionated response, as the interview is very open and doesn't necessarily mean answers will be objective. Also added to the issue of being open and broad, respondents would talk about irrelevant issues. Thus, this can become very timeconsuming, as one has to patiently listen, until respondents give you something relevant, in between issues that are unrelated to researcher's area of interest. Moreover, it is also difficult and time consuming, when it comes to actually gaining access to the person(s) you want to interview, as well as difficulties faced when analyzing results forming quick conclusions or even summary. (Floyd& Fowler, 1984). SECONDARY MATERIALS: The main method used to gather information and accounts for the project were through means of secondary research, which can also be referred to as indirect method of data collection. Here I consulted academic books and journals from the university and public libraries, these included literature such as: Encyclopaedia of Islamic Banking & Insurance, Islamic Economics, & the information on the Financial Times etc. Furthermore, I also gathered information through searching the Internet into relevant websites. Interviewing and the use of questionnaires are two methods of data collection that rely very much on the involvement, participation and contribution of the respondents. These methods act directly on the respondents, who in turn provide information about themselves or other people. There are methods, however, that does not rely on the direct participation ofrespondents. In these methods data are obtained without the knowledge of the subjects, in an indirect and non-disruptive way - these methods are called 'indirect' or 'unobtrusive methods'. (Sarantakos), 1998). Documents have always been used as a source of information in all kinds of research, either as the only method or in conjunction with other methods. They are employed in the context of many diverse studies, such as quantitative studies, qualitative methods and case study research. It is most unusual that any research study is carried out without employing some form of documentary method (e.g. a library search). (May 1997). Documents are usually referred to as 'secondary materials'. Thus their analysis is therefore called secondary analysis. They are called secondary because they are not primarily developed for the study in which they are used. Documentary research can take many forms, of which the following seem to be very popular: Qualitative research, Quantitative research, Descriptive-comparative research, Content analysis. (Sarantakos, 1998). Secondary Literature research (documentary methods); demonstrate a number of strength and weaknesses. They are therefore used only if and when the strengths outweigh the weaknesses. The advantages most commonly mentioned, include: gaining quick and easy accessibility to information - with availability of the Internet, electronic media and spread of personal computers. Also the availability of data banks and sophisticated computer programs. Retrospectively- documentary methods enable researchers to study past events and issues. Furthermore, in most cases, writers produce documents without being requested to do so by researchers. This reduces researcher bias significantly and it can be highly objective. This also gives relevant academic arguments and provides work of academic scholars, and also gives current debates. Literature research is also low cost, and more economical than most other types of research. Often they are the sole source of information (e.g.

when studying past events). And the quality of information obtained is of high quality and it is possible for it to be retested. In this way the methods itself and the act of measurement do not affect the results. A literature research can be undertaken, quite easily as books and other literature can be obtained at ones own time and convenience, rather than having to rely on a respondent i.e. in the case of interviews. It saves a great deal of time, and at the same time gain access to information that might otherwise be impossible i.e. through participant observation. However, secondary research methods also demonstrate some limitations, of which the researcher as myself was aware. Firstof all it can be time consuming and difficult to analyze the results. Therefore time constraints make it difficult to look at all relevant literature. Another drawback to secondary data is that it does not provide detailed accounts. Furthermore, problems ofreliability and validity as with all literature, is geared to a specific group therefore are one sided and perhaps biased. Some materials are not complete, up to date or may be difficult to get access to. (Sarantokas, 1998). Despite these limitations, literature research is a very useful tool for researchers and an indispensable one, particularly when the research is focused on events of the past. In such cases this method is the only way of collecting data on this issue. WHAT COULD HAVE BEEN DONE: I could have attempted to make the project more interesting, by using other methodologies whilst undertaking my research. However, what is important to remember is that - it is not so important the number of research methods used, but which is the best and appropriate and reliable for the particular project interest. Thus, participant observation, quantitative interviews and questionnaires, and ethnographic interviews on the Islamic bankingsystem, would have all been either inappropriate or not suitable due to time and resource constraints. Participant observation is a qualitative method, which is a useful method to gain an insight into an organization such as banks - as William Whyte (1996) suggests: participant observation can obtain a deeper level of knowledge and more insight. The way of understanding a context is through interactions and meaning, understand it from your own point of view the meanings of setting, culture, values and norms. Nevertheless, the problem with this method is that from the observers point of view, it is one sided, thus could be biased as one is participating for a short time, generalization cannot be made. WHAT THE HOLY QURAN SAYS ABOUT ISLAMIC FINANCE: The Qur'an and Sunnah have both placed tremendous stress on justice, making it one of the central objectives of the Shari'a. It is important that the term Shari'a, which will appear many times in the project, is understood. Shari'a literally means a straight path. In Islamic terminology, Shari'a means the way of life prescribed by God through Prophet Muhammed. The Qur'an teachings and the practices of the Prophet, called the Sunnah, make up the Shari'a. (Chapra, 2000). One section of the Shari'a is related to beliefs, while the other is related to individual and collective life. Fiqh (Islamic Law) is the part of the Shari'a, which deals with the latter. It specifies the Do's and Don'ts, the Permissible (Halal) and the Forbidden (Haram). (Chapra, 2000). Since Shari'a is a comprehensive term in Islam and covers all aspects of human interaction, irrespective of whether it relates to the family, the society, politics or economics. Also irrespective of whether the object is a human being, animal or the environment. This has wide implications, the most important of these is that resources provided by God to mankind are trust and therefore must be utilized in a manner that the well-being of all is ensured, irrespective of whether they are rich or poor, male or female, and Muslim or non-Muslim. (Chapra, 2000). In the field of economics, Islam demands the use of resources in an equitable manner that the humanitarian goals of general need-fulfillment, optimum growth, full employment, equitable distribution of income and wealth and also economic stability are realized. Therefore Islamic Banks have unique characteristics because of their specific nature and setting their principles and rules from Islamic Law (Shari'a). In Islam everything is owned only by Allah and man has been permitted to use this, only according to the Shari'a. (Chapra, 2000). The main regulation governing utilization of funds in the Islamic context: 1) Prohibition of transactions on a 'Riba' (interest) basis. Shari'a prohibited usury absolutely, regardless of its percentage, whether it was high or low. The usury gain is forbidden. (Interest will be looked upon in more details in later chapter). Those who devour (take) interest (riba) cannot stand as the one whom the Satan, by (his touch, drives

him to madness. That is because they say: Trade is just like riba, whereas Allah permitted trade and forbade riba. The one to whom an admonition from his Lord comes and he refrains (in obedience thereto), he shall keep (the profits of) that which is past, and his affair (henceforth) is with Allah. As for him who returns (to usury), such are rightful owners of the fire. They will abide therein eternally. (AlBaquarah: 275 - Cited in Nabhani, 2000, P: 26). 2) Trusteeship: The idea of trusteeship has been central to all religious views of the economy; Islam reinforced the view that man's ownership of resources is held as a trust, the real owner being God, to whom the trustee is accountable. Men are only acting as trustee and therefore they should try with all his capabilities to invest funds and develop the national resources in such a way that the outcome is orientated to serve the community. Basically material pursuits should go with moral pursuits. Hallowed be He in whose hand all dominion rests, since He has the power to will anything: He has created death as well as life, so that He might put you to a test (and thus show that) He alone is Almighty, Truly Forgiving. Believe in God and His Apostle and spend on others out of that which He has made you trustee: for, those of you who have attained to faith and who spend freely (in God's cause) shall have a great reward. (Nabhani, 2000, P: 28). 3) Making money out of money is contrary to Islamic law. Wealth should be achieved through legitimate trade and the creationof real assets. Islam looks at economic well being as a means to peace, freedom from hunger and freedom from fear of, or domination by, any other than Allah. Beyond the satisfaction of basic needs, the ultimate objectives of earning and spending money are moral and spiritual. This rules out the seeking of economic gains at the expense of moral and spiritual values. It is against Islamic value to hoard money. Oh you who have attained to faith! Behold many of the rabbis and monks do indeed wrongfully devour men's possessions and turn (others) away from the path of God. But as for all who lay up treasures of gold and silver and do not spend them for the sake of Allah- give them tidings of grievous suffering (in the life to come). On the day when that (hoarded wealth) shall be heated in the fire of hell and their foreheads and their sides and their backs branded therewith, (those sinners shall be told:) 'These are the treasures which you have laid up for yourselves! Taste, then, (the evil of) your hoarded treasures'. (Siddiqui, 1995, P: 08). 4) Moderation: Consumption should be rationalized and expenditure should be conducted with thrift, avoiding extravagance. Islam discourages 'show-off' living and involving too much in luxuries. Muslims should take into consideration what is available to his fellow human beings before enjoying. Oh Children of Adam! Beautify yourselves for every act of worship, and eat and drink (freely) but do not waste. Verily, He does not love the wasteful. (Siddiqui, 1995, P: 08). 5) Wealth should directed in the 'Halal' (religiously acceptable) way, which will benefit all individuals. It must not be spent with a motive of exploitation or in 'Haram' (religiously forbidden) way, or harming the society or individuals. Funds are not to be employed to monopolize the resources, utilities or necessities of the society. Islam opposes monopolies and cartels. Oh you who believe! Verily khamr (alcohol/intoxicants) and gambling and idols and diving arrows are only an infamy of Satan's handiwork. Leave them aside in order that you may succeed. Satan seeks only to cast among you enmity and hatred by meansof alcohol and games of chance, and to turn you away from remembrance of Allah and from the prayer. Will you then stop (doing that)? ( Nabhani, 2000, P: 28). 6) Care for others or helping behavior is a fundamental aspect of Islamic economic behavior. In Islam helping behavior is required because human beings are social creatures and therefore being selfish in social relation is counter productive. Men serve their interests best when each individual cares for the welfare of others while striving to protect and promote his own interest. Thus, when they are told, 'spend on others out of what God has provided for you as sustenance', those who are bent on denying the Truth say unto those who believe, 'shall we feed anyone whom, if (your) God had so will, He could have fed (Himself)? Clearly, you are but lost in effort. (Manzoor, 1999, P: 33). 7) Zakat (charity), one of the five pillars of Islam must be deducted from wealth and given to the poor and the needy and distributed according to the Shari'a. In Islam, social wealth increases when the rich give part of their wealth to the needy. Maximization of private wealth as the main reason therefore means people are only seen as a profit. Islam states that in society, which has such people, the weak are

vulnerable against the strong. That which you give in usury in order that it may increase on (other) people's property has no increase with Allah; but that which you give in charity, seeking Allah's countenance, has increase manifold. God deprives usurious gain of all blessings, whereas He blesses charitable deeds with manifold increase. And God does not love anyone who is stubbornly ingrate and persists in sinful ways. (Khan, 2000, P: 44). 8) Wealth should be acquired through legitimate trade and the creation of real assets. A fixed charge on capital is unjust, since the results of productive enterprise in which borrowed capital is invested are not certain. Risk and reward go together. Therefore 'no risk no return'. The Prophet said. Islam has a positive attitude towards wealth. The Prophet is reported to have said that if wealth is properly acquired then it is a good thing for all mankind. He also said that a productive enterprise is looked upon as a means of serving the cause of Allah. And spend (freely) in god's cause, and let not your own hands throw you into destruction; and persevere in doing good; behold, God loves the doers of good. (Nabhani, 2000, P: 27). HISTORY OF ISLAMIC BANKS: It is well known that Islam strictly prohibits interest both the giving and charging of interest. In the early history of Islam, the prohibition against interest was strictly observed, but with the decline of values, financial practices based on interest began to influence Muslim society. The period of colonial rule, the interest system became established as the norm in Muslim countries. After freedom from colonization and the resurgence of Islam, the demand in Muslim countries to follow their economic system based an Islam increased. One of the significant developments in the Muslim world during the last two-decade is the emergence of Islamic banking. Even though attempts have been made to organize normal banking activities in more Islamiccontext during the sixties, the concept of Islamic banking is even older. The strong disapproval of interest in Islam led many Muslim thinkers to find ways that banking activities can be done without interest. (Manzoor, 1999). The practice of Islamic banking did not start at the national level; instead individual Islamic banks were established in many countries during the seventies. These Islamic banks had to operate with the economic and legal constraints of the country. They also had to face competition from interest-based banks, which were already established in the system. This environment gave little protection to Islamic banks, which are based on sharing (or partnership). Therefore the low levels of honesty and trustworthiness in the market, the poor system of audits and accounts, lack of means for monitoring a business and the failureof legal system to help the finance providers in case of default by the fund-users, were some of the reasons preventing Islamicbanks from applying the practice of profit-sharing. Instead they turned to trade and industry as partners, sometimes even as sole proprietors, so that they could have full control over the use of funds. (Khan, 2000). Although Islamic banks are seen as another latest innovation in the financial world, In fact it has a very long history; the origins can be traced back to the very beginning of Islam. The 'Mudaraba' (will be looked in more depth later) is an ancient financial instrument, which was used by the Prophet himself; who acted as an agent for his wife. Such partnership performed important economic function; they combined the three most essential factors of production, namely: capital, labour and entrepreneurship. The latter two factors usually can be combined into one. The basic structure of the current Islamic bank is based on this. (Usmani, 2002). A special mention must be given to Tabung Haji in Malaysia, a financial institution, which played an imperative role in the evolution of Islamic banks. The reason for the creation of this institution was due to the demand that money for pilgrimage (Hajj) to Mecca (one of the pillars of Islam) should be clean of interest, which wasn't possible with conventional bank. The objective of Tabung Haji was firstly, to enable Muslims to save in order to provide their expenses for performing the pilgrimage. Secondly, to enable Muslims, through their savings, to participate in investment according to the Sharia. Thirdly, to provide for the welfare of Muslims on pilgrimage. (Ahmed, 1995). In 1963, Tabung Haji started with 1281 depositors and a total of 46,600 Malaysian dollars as deposits. By 1985, this had increased to 867,220 depositors with total deposits over one billion Malaysian dollars, and had 65 branches. Although strictly speaking, Tabung Haji is not a bank but it operates similarly. It performs two important banking functions, accepting deposits and making investment. However, due to its success it gave courage and confidence to Muslim thinkers that Islamic banking can work. (Ahmed, 1995). Some pioneering Islamic banks on a very modest scale were established in Egypt in the 1960s and operated as rural social banks along the river Nile, where banking didn't exist at the time. The

idea of Interest-free banking in these rural areas proved successful and therefore gave the boost to promote a more substantial movement towards a new Islamic economic and financial system. The very first Islamic bank to be developed as a result was the Nasser Social Bank, which begun operating in Cairo, Egypt, in 1972. Then in 1975 Dubai Islamic Bank was established. (Ahmed, 1995). The late King Faisal of Saudi Arabia played an integral part towards the development of current Islamic Banking System. It was his belief that that since the Qur'an prohibited interest and laid down specific rules and regulations on how Islamic economic should be conducted. He felt that Islamic nations must create a structure, which would comply with Islamic Law and also modern financial techniques in order to produce a viable financial system, free of what is prohibited in Islam. (Khan, 2000). In 1970, during the second Islamic conference of Foreign Ministers, it was proposed that ways of establishing an internationalIslamic Bank for Trade and Development, together with a Federation of Islamic Banks should be studied and examined. Experts from eighteen Muslim countries examined the proposal and recommended that interest-based financial system should be replaced by a system of participation schemes linked with profit and loss sharing. Also it was decided that a Federation ofIslamic banks together with an International Islamic bank should be established. (Ahmed, 1995). In 1975, the Islamic conference of Finance Ministers in, Saudi Arabia approved the establishment of the Islamic Development Bank (IDB) with capital of two billion Islamic Dinars. The member states of the Organization of Islamic Conference became members of the bank. The creation of the Islamic Development Bank (IDB), gave push to the Islamic banking movement. The IDB was established as an international financial institution according to the declaration made in the 1973 Conference ofFinance Ministers. The purpose of the IDB is to promote the economic development and social progress of the Muslim community, individually and jointly, in accordance with the principles of the Shari'a. It was the first time an international financial institution was allowed to conform to the Shari'a. The official publications of theIslamic Development Bank declares that it is clearly and unequivocally committed to the principles of the Shari'a in its conduct of all its financing operations and the performance of its activities, and it tries constantly to identify the modes of financing that conform to the Shari'a. With the development of the IDB, a number of Islamic banking institutions have been established around the world. Currently as many as 53 countries have Islamic banking institutions and Iran, Pakistan and Sudan have reorganized their entire banking system along the Islamic lines. When the concept of Islamic banking with its ethical values was propagated, financial world were very skeptical and treated the idea as a Utopian dream. However, Islamic banking is no more just a wishful thinking. Today, Islamic banking is estimated to be managing funds of around $200billion. Its clientele are not just confined to Muslim countries but spread over Europe, United States and the Far East. (Mirakhor, 1995). THE CONCEPT INTEREST IN ISLAM: One may wonder why interest is getting a special mention. The reason is that interest is very important when dealing withIslamic banking and therefore will need to be explained from an Islamic point of view. It must be understood that interest freebanking alone cannot be termed Islamic, there are other conditions which must be met before it can be fully classified as anIslamic bank. Interest may be defined as "the payment made by borrower to lender for the money borrowed and is normally expressed as the rate percent per year". (Rickett, 1999). From an Islamic point of view, interest is defined as "a prefixed rate for use or borrowing of money". It is this 'prefixed rate', which is known as 'riba' in Islamic economics, which has been termed as 'something undesirable'. (Usmani, 2000). There are two types of interest which exist: Riba An Nasiyah; this is defined as excess, which results from predetermined interest which a lender receives over and above the principle the premium which is paid to the lender in return for his waiting as a condition for the loan and is technically the same as interest. This is the main type of interest as it is directly mentioned in the Qur'an. Riba Al Fadl; this is defined as excess compensation without any consideration resulting from sale of goods. (Usmani, 2000). Interest in the Qur'an (Refer to Appendix 1).

1.First revelation (surah al-Rum, verse 39). "That which you give as interest to increase the peoples wealth increases not with God; but that which you give in charity, seeking the goodwill of God, multiplies manifold." (30:39). 2.Second revelation (surah al-Nisa, verse 161). "And for their taking interest even though it was forbidden for them, and their wrongful appropriation of other peoples property. We have prepared for those among them who reject faith a grievous punishment." (4:161). The Reason behind the Prohibition of Interest: The Islamic law of prohibition of interest is not based on economic theory but on Divine Authority, which considered the charging of interest as an act of injustice. Islam recognizes that everything in the world has some usefulness, goodness or utility in them. However, in Islam just like any other way of living recognises that some things have more benefits and less harms and therefore are called beneficial. However, there are also things that have more harm and less benefit, therefore considered harmful and useless. Even in the Qur'an, while declaring liquor and gambling to be prohibited, proclaimed that they have some benefits but the harm they do is far greater than the benefits they provide. Therefore, these cannot be called good or useful. (Khan, 2000). In the case of interest in Islam it is not seen as any different. Interest does have some benefits however the harm it does in this world and the hereafter is too severe compared to the benefits from a Muslim perspective. It is said that even if borrower faces a loss, he still has to pay an excess amount over the amount borrowed, which is seen as exploitation, whereas the lender on the other hand gets an increase without any effort. When Muslim countries were colonized and followed the west in their economic field, some westernized Muslims in the 19th century, saw the increasing progress of the west in trade and industry and the shattering economic condition of Muslims states and became aware of the fact that banking is inevitable in the field of trade and industry not only on national level but also internationally. This prompted them to say that commercial interest was not interest because without it there would be problems in terms of industrialization and economic progress. Only interest prohibited in the Qur'an and Sunnah is forbidden in Islam. (Khan, 2000). However, Muslim scholars explain that modern theories of interest only attempts to justify the existence of institution (i.e. Banks), which has become deeply established in modern economies. Their argument against some of the general reasons given for the existence of interest: 1) "Interest practiced during the days of the Prophet was only Usury" The argument against this is that in Islam when prohibiting something it doesn't only prohibit one form but all forms that might erupt in future. The change doesn't change the ruling, for example Qur'an has prohibited the following: Liquor: During the time of the Prophet its form and the way of production was totally different from that of the present day but the ruling remains unchanged even though the form has changed drastically. Pork: Irrespective of how clean the present day breeding of pigs may be, pork will stay prohibited. Corruption/Immorality: Although a lot of sophisticated ways have been developed from the time of Qur'an revelations banning it, the ruling stands forever. Therefore the same applies to interest. By claiming that it was in a different during the Prophet's time does not change the ruling. In Islam time is irrelevant and therefore if something is forbidden then it remains forever. (Mirakhor, 1995). 2) "Interest is a reward for savings" Muslim scholar responds that such payment could only be explained, from an economic position, if savings were used for investment to create additional capital and wealth. They argue that the answer to the question of whether there is an increaseof wealth due to the savings depends on what he does with the money he saves. He may hoard it or use it to buy a bond without they're being an increase of capital wealth created as a result of his savings. When an individual saves, his savings gives rise to creation of an asset or a debt, however, as a rule, he has no say to decide which it will be. According to the scholars, in the absence of parallel increase of new investment either a debt is created or an asset will change hands but there will be no rise to wealth. Therefore, the act of abstaining from consumption should not entitle anyone to a reward. (Mirakhor, 1995).

3) "Commercial interest did not exist in the days of Prophet" They respond by glancing through the Islamic and pre-Islamic history of Arabia, it will show that this type of interest did exist at the time. They provide the following example to argue their case. History of the city of Makkah and Ta'if shows that they acted like clearing houses. They advanced cash for commercial purposes and charged interest in case of default by traders, and this earning of interest was their trade. The tribe of 'Saqeef' advanced cash on interest, which was not only restricted to cash but also to commodities between wealthy tribes (who were usually traders and businessmen) for commercial purposes and not for consumption and personal needs. One of the ways of receiving interest was to double the principle amount plus interest in caseof non-payment of loan and this practice was applied to both cash as well as commodities. They argued when the Qur'an prohibited interest that interest based loans is a type of trade just like rent received from assets. At the time of signing the peace treaty with the people of Ta'if, the Prophet imposed two conditions; first that they give up of interest owed to and from them; secondly total elimination of interest-based transaction. (Mirakhor, 1995).

4) "Interest is justified as productivity of capital" Scholars respond that although the marginal productivity of capital may enter as one factor into the determination of interest rate, interest per se, has no relation with capital productivity. Interest they argue, is paid money, not on capital, and has to be paid irrespective of productivity. In distinguishing between interest as a charge for the use of money and a yield from the investment of capital. The scholars argue that it is an error of modern theory to treat interest as the price of return for capital. They say money is not capital; it is only potential capital, which first needs to be transformed into productivity, for example, by entrepreneurship. The lender has nothing to do with the conversion of money into capital and using it productively. (Khan, 1999). 5) "Interest arises as an inevitable consequence of the difference between the value of capital goods today and their value tomorrow" While Muslim scholar don't deny the difference of value between present and future goods. They say this only explains its inevitability and not its rightness. It explains why borrowers are willing to pay interest and why lenders are able to get this. They argue that interest based on this aspect is only theoretical rather than a reality and that the so-called 'pure rate ofinterest', resulting from the time factor in valuation may never enter into the calculation of suppliers of funds and interest is never paid for that reason. Even if the basis for time preference is the difference between the value of commodities this year and the next, Muslim scholars argue, it seems more reasonable to allow next year's economic conditions to determine the extent of the reward. (Nabhani, 2000). 6) "Reward for lending money" Muslim scholars maintain, when a person loans money, the funds are used to create either a debt or an asset (i.e., by investment). In the first case, there is no justifiable reason why the provider of fund should receive a return. Nor is there a justification from the point of view of the economy, nor from the point of view of social justice, for the State to force an unconditional promise of interest payment regardless of the use made of the borrowed money. However if the money was used to create additional capital wealth, then they argue why should the lender be entitled to only a small fraction (represented by interest rate) of the wealth created by his loan. Therefore in Islam the lender should be rewarded for the extent of the involvement of his financial capital in creating the wealth. The scholars argue in Islam there is no objection to profit as a return on entrepreneurial effort and on financial capital; in fact, they say it is encouraged. Only the concept of interest as reward for the mere act of refraining from consumption is against the law of Islam. (Siddique, 1995). THREE TYPES OF ISLAMIC BANKING SYSTEMS: Islamic banking system can be grouped into three categories, each representing a distinct model. Firstly, in the private sector, there are banks, financial institutions, investment companies, leasing companies and mutual funds trying to operate without interest. They are mostly owned by entrepreneurs and private investors, however some governments and international financial institutions provide some financial support. In some countries, special laws have been introduced to help interest-free banks to function effectively. The two major financial groups are Dar al-Mal al-Islami and al-Barakah Dallah belong to this category. The Dar al-Mal al-Islami Group consists of 21 operating subsidiaries, including 3 Investment banks, 4 Investment companies, 4 Takafol/Retakafol companies (Islamic alternative to insurance/reinsurance) and 4 business companies. And are based in the Arabian Peninsula, Bahrain, Malaysia, Indonesia, Bangladesh, Egypt, Pakistan, Sudan, Senegal, Niger, Guinea, West-Africa and Luxembourg. (Rahman,

1996). The Dallah Al-Baraka Group of Islamic financial institutions consists of several Islamic commercial and investment banks and associated companies located in the UAE, Tunisia, Turkey, Bahrain, Pakistan, India, Jordan, Bangladesh, Yemen, Sudan, Mauritania, Algeria, Thailand, South-Africa, Luxembourg, and several other countries. (Rahman, 1996). Secondly, at least three countries have tried to develop a state sponsored process for the removal of interest from the entirebanking system. Pakistan, Sudan and Iran have converted their financial systems according to the Shari'a. All the financial institutions in these countries are conducting their transactions on an interest-free basis. Instead of establishing interest free banks in the private sector, the idea was to first establish 'interest-free counters' within the system. Then extend the interestfree system to the whole banking sector, so as to operate on new principles under the protection of state policy and central bank guidelines. The aim is not just one or two Islamic banks but to change the entire financial and banking system and eventually the whole economy so as to conform to Islamic way. (Manzoor, 1999). The third kind is the mixture of the two, for example Malaysia. They have established under the country's law a totally interest-free Islamic bank with a distinct law and identity. They also have conventional banks, which can have interest-free system within them. So far 52 conventional banks have opened such system. WHAT IS ISLAMIC BANKING? Modern commercial banking activity is based creditor-debtor relationship between the depositors and the bank on the one hand, and between the borrower and the bank on the other hand. Interest is viewed as the price of credit. The Islamic view about loan is that they should be provided free of charge and that the creditor should not take any advantage of the borrower. Therefore commercial banking in an Islamic framework is not based on the creditor-debtor relationship. To understand what constitutes Islamic banking, the crucial point is that whether it is a direct investment or financial intermediation, there cannot be a fixed predetermined return on capital, loans or credits. (Usmani, 2002). This doesn't mean that Islam stands for zero rate of interest, which causes a lot of confusion. Islam doesn't prohibit return on capital because there has to be a reward for it; however capital is considered as being productive and therefore is entitled to a share from what is being produced, in which capital plays a major part. Expecting a reward from capital is seen as just and reasonable. However what Islam challenges is the right of money or loans to a predetermined fixed and assured reward without taking a share in the risks or a stake in the project. Therefore in Islam it is ok to provide a loan to someone as long as the return is stated before hand but there can be no increase on the loan. However if return is expected then risk sharing must involve, in Shari'a reward and risk go together. As all forms of interest is prohibited, whether it is simple or compound, low or high rate, personal or institutional, private or public; therefore whatever the category any predetermined fixed increase without sharing the risks of the project is classified as interest which is prohibited in Islam. In Islam if you want to share the fruits then you have to be willing to share the risks, otherwise it is seen as exploitation of one person, i.e. the lender or the creditor. (Rahman, 1996). CHARACTERISTIC OF ISLAMIC BANKING: The major characteristic of the Islamic system of banking involves five major elements. Firstly, Islamic finance involves a system of equity sharing and stake-taking. It works by the principle of a variable return depending on the actual productivity and how well the project performs. The project can be in different forms such as specific or general, individual or institutional, private or public. However the Islamic principle remains of equity and reward sharing unlike the western concept of loan-interest relationship. Secondly, a very crucial point relates to the whole vision of an Islamic economy. Islamic banking plays a major part in that vision, which is to an extent a revolutionary change as it calls for new approach to the economy. Islam wants the economy, its major monetary and business dealings, to move away from debtbased partnership to an equity based and stake taking relationship. While their will still exist some debtbased transactions in the Islamic system but it will be based on the principle of'Quard Hasana' (where the principle amount is assured, but no increase on that). The overall purpose of the economy will be arranged towards equity based and risk sharing. (Chapra, 2000). Thirdly, in the Islamic way ethics will play a key role. The ethical and social dimensions will be crucial to all economic activities, there will exist framework of 'Halal' (permissible) and 'Haram' (prohibited) within

which all economic activity, private and public, has to take place. The ethical issue will operate at different levels and therefore morals will play effect the conscience of the entrepreneur and the firm, the society, the legal framework and the supervisory of the state. This means activities which would be treated in the capitalist system as productive because it has some demand (e.g. pornography, gambling, prostitution, the promotion of alcohol, etc), however in the Islamic system will be prohibited. (Chapra, 2000). Social and ethical will be part of the Islamic economic system. It will ask question such as: what are the objective for which money is being acquired? Will it benefit individuals, society and humanity? Will it lead to the establishment of a just, honorable, sustainable society; or will it result in exploitation, moral degeneration, social tensions and inequalities? These questions will be as relevant as the profitability and economic viability of the project in the Islamic system. (Khan, 1999). Fourthly, Islamic Banking is entrepreneurial driven. It is directed not just towards financial expansion but also towards physical expansion of economic production and services. In the Islamic economy money will not produce money; it is expected to finance talent, innovation and new ideas, skills and opportunities. Whereas, conventional banking operates predominantly on the basis of financial collateral, therefore the more money you have, the more you can get. This means that the viability of a project mainly depends on the financial worth of the borrower; meaning that low collateral can reduce the chance of getting a loan, even if the project is viable and the person has impeccable character. Whereas, in the Islamic system collateral is not ignored but it is reduced, through the trustworthiness of the person, the viability and usefulness of the project; which is more important then the financial worth of the borrower. This means in the Islamic system greater emphasise is placed on human needs such as fair distribution, equity, community and individual development. The result being small savers, investors, trader and producer becoming more important. Islamic banking is more oriented towards the community, talent and entrepreneurship. (Usmani, 2002). Finally, the Islamic system is non-inflationary; this is a very important and fundamental aspect of Islamic banking. The linkage between financial expansion, money supply and the physical expansion of the economy is a result of the financial and bankingdynamics of the current time, whereas the Islamic banking and finance restores the balance between these three variables. Stability in the value of money is a primary goal of an Islamic economy. ISLAMIC BANKING BUSINESS PRACTICES: Like conventional banks Islamic banks attract financial resources from individual and institutions, and direct them to people who requires them. Even though Islamic banks act like financial intermediary as normal banks, however the big difference lies on how those functions are conducted. It is well known that interest-taking banks has deposits of different maturities, paying different rates of interest on them. Islamic bank would operate the following ways on deposits: 1) Current Account All Islamic banks has current account. They are very similar to the one's available in conventional banks, i.e. the deposit is to be returned on demand. The bank may use the funds for other things at its own risk. No profit is paid to the depositor but they enjoy facilities such as cheque, money transfer, etc. 2) Savings Account The procedures and formalities is identical to the conventional system. However, in Islamic saving account, the depositor may allow the bank to invest the money deposited in which case it becomes a profit-and-loss sharing account. As interest is forbidden, profits will depend the investment of those accounts. 3) Investment Account These accounts may be opened either by individuals or companies for any specified period. The depositors do not receive any interest; instead they are entitled to a share in the profit. The profits are shared by the depositors in an agreed proportion according to the amounts of their deposits and the period they are held by the bank. Usually withdrawals are not allowed from these investment accounts except under special circumstances, for which some notice is required. Therefore the depositor looses out on the profit on the amount withdrawn. 4) Limited Period Investment Deposits Some Islamic banks also accept investment deposits for a specified period, which is determined by the depositor and the bank. The contract can be terminated at end of the period, but the profits are distributed and accounted at the end of the financial year. 5) Joint/General Investment Accounts

Islamic banks establish an investment pool. The investment pool takes the form of a general investment account in which investment deposits of different maturities are pooled together. They are not tied to any specific investment project but are utilized in the different financing operations of the bank. 6) Unlimited Period Investment Deposits These investment deposits are automatically renewable without specifying the period. Giving a specific period of notice to the bank, usually three months, can terminate them. No withdrawals or increases in the amount of the deposit are permitted during this period. (Usmani, 2002, P: 105 - 110). PERMISSIBLE FORMS OF TRANSACTIONS: Islamic financing technique is significantly different from traditional banks. Conventional banks accept deposits and lend them to the borrowers. The bank's profit is the difference between interest paid to depositors, and interest earned from borrowers. Interest is always predetermined, and if delay occurs in repayment, penalty interest is usually charged, which is higher than the original rate of interest. In the Islamic financial system money does not earn money without collaboration between capital and effort. Return for the investor (who provides the capital) and the bank (which makes the effort) depends upon the actual profit made on the transaction. In disallowing interest but permitting profits, the Shari'a has developed six specific forms of financial transaction as means of earning profits without resorting to charging interest. (Usmani, 2002). 1) MUDARABAH Mudaraba is a contract in profit sharing, with one party providing funds and the other providing expertise. The funds are used for Islamically permitted activities and their use is subject to scrutiny by the fund provider. Therefore mudaraba is a contract between the fund provider (Rab al-Maal) and the management agent (Mudarib). The agent is provided with financial resources to run a particular project. The profit is shared between the fund provider and the agent in an agreed amount. Loss that may occur is the liability of the fund provider and the agent loses his share of the profit. However, if it is found that the agent was breach of his contract, frauds or there was deliberate negligence, then the agent is responsible for the losses. Also the agent is not allowed to buy or sell Mudaraba assets against/for his own possessions. There are two types of Mudarah that exist: Al Mudaraba Al Muqayyadah (Restricted Mudaraba): The fund provider may specify a particular business or a particular place for the agent; therefore the agent will invest the money in that specific project. Al Mudaraba Al Mutlaqah (Unrestricted Mudaraba): In this instance the fund provider gives full freedom to the agent to undertake whatever project he feels is most suitable. However the agent cannot lend money without the consent of the fund provider. (Manzoor, 1999, P: 49). Mudaraba is best suited for project and trade financing. For this kind of financing, an Islamic bank may use its own funds or its client funds but not together as it will become another form of financing (Musharaka). If the bank uses the client's funds without using any of its own then the bank acts as an agent for the fund provider. After the conclusion of the project the bank gets an agreed share of the profit for acting as the agent. In the case of the bank being the fund provider (acting as Rab al-Maal), before providing finance the bank has to check the project's feasibility, as the agent cannot be responsible for genuine business loss. Also the bank should monitor the project after the funds have been given. (Hasanuzzaman, 1995). Mudaraba is usually only for certain period. It is necessary for the validity of Mudarabah that both parties agree the proportionof the profit that each is entitled right at the beginning. The lender or the agent cannot allocate a lump sum amount of profit for any party nor can they determine the share of any party at a specific rate tied to the capital. (Usmani, 2002). 2) MUSHARAKAH The literal meaning of Musharaka is sharing. Musharaka is described as a joint venture between an Islamic bank and individual, groups or business entity for a specific project. Both parties in the arrangement participate in the capital of the project and the profit is allocated according to the capital provided and predetermined proportion. In the case of loss they are shared by the partners in exact proportion to the ratio of capital invested. The essential features of Musharaka: Capital to be invested by the partners may be in equal or unequal ratio. Musharaka is run and managed by the 'will and equal rights of participation' of all partners and every partner is an agent to the other.

Any condition regarding participation in the administration of Musharaka and variation in the share of profit is valid. Every partner has the right to participate actively in the project if he wishes to do so. However, the partners may agree that only one of them should take care of the project. The basis for entitlement to the profit of a Musharaka is capital, active participation in the project and responsibility. A partner or a shareholder can be entitled to more profit compared to other partners if he performs more duties and takes greater responsibility then others. Every partner enjoys equal rights in all respects in the absence of any condition. If the Musharaka is a longer period than, say one year, up-to-date profit could be paid at an expected rate less a contingency reserve, as interest free loan, subject to periodical adjustments and a final adjustment at the conclusion of the project. (Usmani, 2002, P: 105-106). Keywords: Islamic Banking, Islamic Banking concept, Abdullah Haiwad, Kandahar, Afghanistan Working Paper Series
Date posted: October 14, 2008 Suggested Citation
Haiwad, Abdullah, Islamic Banking System, Islamic Banking Concept, Islamic Banking, Afghanistan, Kandahar (October 12, 2008). Available at SSRN: http://ssrn.com/abstract=1283093