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Thursday, 5 November 2009

Islamic finance and banking: Some basic principles and concepts

Islamic finance is a form of ethical investment and ethical lending. Under this system loans and investments are made Islamic finance is a form of ethical investment and ethical lending. Under this system loans and investments are made without interest. Ethical restrictions include prohibition on alcohol and gambling and the consumption of pork. Islamic funds never knowingly invest in companies involved in gambling, alcoholic beverages, or porcine food products. Elimination of "Riba" or interest is basic in all forms of Islamic financial system. Islamic banking follows the same principles. At the heart of Islam is a sense of cooperation -- to help one another according to principles of goodness and piety (but not to cooperate in evil or malice).

In essence, Islamic finance and banking aim to eliminate exploitation and to establish a just society by the application of the Shari'ah or Islamic law to the operations of banks and other financial institutions. To ensure compliance to the Shari'ah, Islamic banks use the services of religious boards comprised of Shari'ah scholars. Its practitioners and clients need not be Muslim, but they must accept the ethical restrictions underscored by Islamic values.

Islamic banking operates with the same purpose as conventional banking except that it operates in accordance with the rules of Shari'ah, known as Fiqh al-Muamalat (Islamic rules on transactions). Islamic banking activities must be consistent with the Shari'ah. Many of the principles on which Islamic banking is based are commonly accepted all over the world, for centuries rather than decades.

The principal source of the Shari'ah is The Qur'an followed by the recorded sayings and actions of Prophet Muhammad (pbuh) - the Hadith. Where solutions to problems cannot be found in these two sources, rulings are made based on the consensus of a community of learned scholars, independent reasoning of an Islamic scholar and customs. Such rulings must not deviate from the fundamental teachings in the Qur'an.

Islamic finance and banking were practised predominantly in the Muslim world throughout the Middle Ages, fostering trade and business activities. In Spain and the Mediterranean and Baltic countries, Muslim merchants became indispensable middlemen for trading activities. It is claimed that many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businessmen.

Islamic banking operates on some basic principles which include:

l The Sharia'h prohibits the payment of charges for the renting of money (riba, which in the definition of Islamic scholars, covers any excess in financial dealings, usury or interest) for specific terms and also investment in businesses that provide goods or services which are forbidden in Islam (Haram, forbidden).

l The majority of the principles are based on simple morality and common sense, which form the bases of many religions, including Islam.

l The universal nature of these principles is immediately apparent even at a cursory glance of non-Muslim literature. Usury was prohibited in both the Old and New Testaments of the Bible, while Shakespeare and many other writers, particularly those writing in the 19th century, have attacked the barbarity of the practice. Much of the morality championed by Victorian writers such as Dickens -- ranging from the equitable distribution of wealth through to man's fundamental right to work -- is clearly present in modern Islamic society.

l Although the western media frequently suggest that Islamic banking in its present form is a recent phenomenon, in fact, the basic practices and principles date back to the early part of the seventh century.

l The main principle of Islamic Banking is "prohibition of riba" in all transactions and all types of investment and deposit.

Islam not only prohibits dealing in interest and investment in unlawful activities that Islam deems harmful to society, but also transactions involving excessive uncertainty (gharar) and all forms of gambling (maysir). Islamic banking is an instrument for the development of an Islamic economic order. Some of the salient features of this order may be summed up as:· Islam makes a clear distinction between what is halal (lawful) and what is haram (forbidden or unlawful) in pursuit of such economic activity. In broad terms, Islam forbids all forms of economic activities which are morally or socially injurious.· While acknowledging the individual's right to ownership of wealth legitimately acquired, Islam makes it obligatory on the individual to spend his wealth judiciously and not to hoard it, keep it idle or to squander it.

l While allowing an individual to retain any surplus wealth, Islam seeks to reduce the margin of the surplus for the well-being of the community as a whole, in particular the destitute and deprived sections of society by participation in the process of Zakat (a tax on wealth that is distributed to the needy).· Islam, through its laws of inheritance, seeks to prevent the accumulation of wealth in a few hands to the detriment of society as a whole.· Viewed as a whole, the economic system envisaged by Islam aims at social justice without inhibiting individual enterprise beyond the point where it becomes not only collectively injurious but also individually self-destructive.Islam has a unique theory on the theme of wealth, its ownership, distribution and social relationship. Islam enjoins that wealth must not be created for its own sake.

The theme of Islamic dispensation of wealth is treated as a deeply moral study of self and society. Islam gives precise moral injunctions as to what are, and are not acceptable kinds of wealth. These injunctions point out how individual preferences on wealth formation ought to be utilised within the social meaning. Profits are important as ends, but the means by which those profits are earned are even more important. Indeed, the reason for the emphasis in the Shari'ah on proper transaction is that Islam accords great importance to the economic welfare of society.Profit-and-loss sharing is the main concept of Islamic banking under Musharakah & Mudarabah mode of financing.

While Islam employs various practices that do not involve charging or paying interest, the Islamic financial system promotes the concept of participation in a transaction backed by real assets, utilising the funds at risk on a profit-and-loss-sharing basis. Such participatory modes used by Islamic banks are known as Musharakah and Mudarabah. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions.The concept of profit-and-loss sharing in an enterprise, as a basis of financial transactions, is a progressive one as it distinguishes good performance from the bad and the mediocre.

This concept therefore encourages better resource management. The Islamic 'sukuk' system is similar to bonds in capitalist system, but in sukuk, money is invested in concrete projects and profit share is distributed to clients instead of interest earned.The investment must be ethical under Islamic banking financing method. The important principles for Islamic financial instruments for participation and investments that require strict adherence, while providing good returns, are:· Investments must be free of interest, speculation and gambling, all of which are considered as forms of exploitation;· Investments are made in permissible activities.Investments must be separately approved by an independent Shari'ah supervisory board to ensure Sharia'h principles are strictly adhered to and deviations and wayward business practices penalised, for example, Islamic finance requires penalties should be paid to charity. "The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service," the Vatican's official newspaper, Osservatore Romano, said in an article in its March 2009 issue. All products of Islamic banking must comply with Shari'ah, as determined by a competent Shari'ah supervisory board.

If a product's authenticity becomes doubtful, it will be the responsibility of the individual investor or consumer to determine on his or her own that the product complies with the principles and precepts of the Sharia'h.Islamic banking is growing at a rate of 10-15% per year all over the world. Islamic banks have more than 300 institutions spread over 51 countries, plus an additional 250 mutual funds that comply with Islamic principles. The relative stability of Islamic Banking institutions in current recession has received attention. Even the Vatican said banks should look at the rules of Islamic finance to restore confidence amongst their clients at a time of global economic crisis.

by Md. Touhidul Alam Khan (The Financial Express)

Md. Touhidul Alam Khan is the Executive Vice President, Corporate Banking Division of Prime Bank Limited and Associate Fellow Member of Institute of Islamic Banking and Insurance (IIBI),

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