3
ISLAMIC BANKING OPERATIONS AND CONTROLS
1.
DEPOSITS / LIABILITIES SIDE
All deposits except Current Accounts would be accepted on the basis of Mudarabah.
Weights to be given to various categories of savings/term deposits must be indicated in advance.
Banks would not be allowed to indicate ‘Expected Rates of Return’. However, they may
disclose their past record in terms of profit payment on various kinds of deposits.
Fund Mobilization
 Contractual relationship:(i) Two-tier Mudarabah (ii) Agency relationship based on
Commission/ Service charge.
 Risk Averse and Risk Prone Depositors. Risk to be borne by Risk Prone depositors.
 Deposits Takaful Corporation.
 Concept of Daily Product.
 Funds of Risk Prone – depositors would be Part of equity; Profit - quarterly distribution
on daily product basis, etc.
Types of Deposits and Products
 Current, Savings, Investment Deposits and Accounts,
 Portfolio Management - individual and multi investment.
 Pooled income; Distribution of Income from Services and Financial Operations.
 Mutual funds, Investment funds, Trusts and COIs.
 Inter-bank financing – Bidding for Sharing ratio.
As a Mudarib, banks can use their own equity with the depositor’s money to make profit.
Banks will be entitled to a return on their investment, besides their share in the profit on
depositors’ funds. Banks, however, will have the choice not to claim return on its equity or pass
on part of its return to depositors, as a gift (Tabarru’e), if circumstances so require.
In respect of various categories of deposits and fund raising schemes, the following may be
kept in view:
1.1.
Current Accounts:Current account/deposits are considered as loans and the bank is bound to return their full
amount on call. As resolved by the Islamic Fiqh Academy of the OIC, the liability to return the
loan (deposit) will not be affected by the bank’s solvency or otherwise. There shall be no return
or mark-up payable on the Current accounts. The relationship between the depositor and the
bank in case of such deposits will be that of a creditor and debtor and as such, the banks will be
obliged to pay the principal amount of current deposits. Banks may indicate in the account open
form that they would invest the funds deposited under Current accounts at their own discretion
in any of the Shariah compliant modes. Further, they will be at liberty to take service charge
from the current account holders.
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The predominant Shariah ruling at present is that such accounts are not eligible for a share
in profits, as they are not subject to risk. A departure here is that some Shariah Boards have
ruled that such accounts may be eligible for gifts but not for profits. The Shariah Supervisory
Board of Faysal Islamic Bank of Sudan, for example, sees it as permissible to give prizes for
deposits that bear no risk and therefore, cannot get dividends. Such gifts may be given without
prior knowledge of the account-holders, so long as the prizes are varied and made on a nonregular basis in order to help mobilization of funds and to achieve a just reward distribution
between account-holders and shareholders. Most Shariah Boards, however, do not favour such
arrangements.
Another consideration is that a part of banks income comprises non-funds income earned
from currency transfers or other customers ‘services’. As the deposits in the Current Accounts
are an important source of financial strength for the banks, they may pass on a part of that
income to their Current Accounts depositors as a gift provided no such prior inducement is given
to such depositors and it does not take the form of an institution or a system of return or earning
on these deposits. Banks income will be pooled and allocated to various categories of deposits/
liability on the basis of weightage assigned in advances. Current accounts will carry no
weightage.
1.2.
Savings Accounts
Saving accounts would continue to be accepted by banks on the basis Mudarabah and
return would be paid on the basis of Daily Products and the Weightage System. As such, savings
deposits would be considered investments of depositors for a share in the profit
1.3.
Fixed/Term/Notice Deposits/Investment Accounts
All those accounts where the client agrees to lock in the money for an agreed time period
would be considered as Mudarabah deposits with the bank. A longer term account may be
given relatively higher weightage.
1.4.
Mutual Funds/Investment Funds/Trusts/COIs
Banks can also mobilize resources by launching mutual or investment funds, trusts or
Certificates of Investment. Mutual funds/Investment Accounts can be both open-ended and
close-ended, general purpose or sector specific, for individual portfolios or Multi investment
accounts. Bank will serve as Fund Manager and share the profit according to the agreed
ratio/weightage. Investors will also share the pooled income. Loss, if any, shall be shared by the
fund providers in the proportion of their capital
1.5.
Cash Management Accounts
These accounts can be continued on the basis of Mudarabah without offering any fixed
profit rate. Further, such account should not be off-balance sheet items.
1.6.
Profit Allocation
For allocation of profits to various items of liabilities side of the banking system, the banks
would be using the concepts of Daily Product and the Weightage System. According to the
principles of Islamic finance, a sleeping partner cannot take a share in the profit which is more
than his share in the investment. In case the bank also provides funds, it would be entitled to get
profit on his own capital in proportion, which such capital has, to the total capital of the
Mudarabah. In addition to such share in the profit, the bank shall also be entitled to share the
remaining profit in an agreed proportion. For example, depositors provide Rs. 2000 for
Mudarabah and the bank contributes Rs. 1000 to the business, and the parties have agreed to
share the profit in the ratio of 50:50. Let us assume that the profit earned by the bank as
Mudarib is Rs. 300. The bank will get Rs. 100 as profit on his own investment of Rs. 1000. The
remaining profit of Rs. 200 will be distributed between the bank and the depositors (Rabbul Mal)
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on the agreed ratio of 50:50. In other words, out of the profit of Rs. 200, bank will get Rs. 100
and the Rabbul Mal Rs. 100.
2.
MANAGEMENT OF PORTFOLIOS – ASSETS SIDE
It is important that Islamic banks design the diversified investment portfolios and
instruments that could generate profitability with sufficient liquidity. To maximize its profits, a
bank needs to look for investments that yield the highest return, minimize risks, and provide
adequate liquidity. It is necessary for liabilities and assets to be matched and in the case of
Islamic banks, the volume of investment deposits should greatly determine their investment
strategies.
A pyramid of financial assets can be built based on liquidity and profitability criteria. At
the top of the pyramid would lie highly risk based and less liquid assets, such as long term
investments. At the bottom of the pyramid would be less risky and highly liquid assets, such as
one-month or even overnight Mudarabah certificates.
The banks and financial institutions can use all modes like Murabaha, Ijarah, Salam,
Istisna’a ‘commission’ or service charge (Joalah), Musharakah and Mudarabah as they deem
fit subject to compliance of the Shariah essentials of each mode. Musharakah and Mudarabah
can be used for short, medium and long-term project financing, import financing, pre-shipment
export financing, working capital financing and financing of single transactions. Diminishing
Musharakah could be used for purchase of fixed assets like houses, transport, machinery, etc.
Murabaha and Musawamah can be used for any kind of purchases of goods that banks clients
may need. In Malaysia, trading finance is provided under debt-trading contracts also wherein
working capital financing under Murabaha is securitized. Salam would be particularly useful for
financing the agriculturists/farmers, commodity operations of public and private sectors and
other purchases of measurable and countable things. While adopting any of the modes it must be
observed that the back door approaches to Riba like buy-back and rollover are not resorted to.
Banks would be required to be more vigilant and prudent in selecting clients, modes and
the projects. The need to assess clients’ position in Islamic finance is more emphasized than in
case of conventional finance. Banks would concentrate on the personality criteria as well as
ability criteria like property/guarantee criterion, profitability criterion, regulatory criterion and
last but not the least, the permissibility or Shariah compliant criterion. With regard to some
specific products, banks and financial institutions may take in view the following:
2.1.
Trade Financing
The banks in order to facilitate trade or working capital requirements may provide facilities
in connection with purchase/import and sale/export of goods and machinery, and acquisition and
holding of stocks and inventories, spares and replacements, raw material and semi-finished
goods. Financing the genuine trading activities could promote a number of performance criteria
in the economy.
Banks can take service charge for opening Letter of Credit (L/Cs). Funds can be provided
for imports on the basis of profit/loss sharing or Murabaha. Similarly, banks can charge fee as
negotiating bank in exports. They can provide pre-shipment export financing on the basis of
PLS or Murabaha. Discounting of bills, as in the case of post-shipment financing, will have to
be replaced by a fee for agency services of the banks that they will render for collection of the
bills’ amount on behalf of the exporters and amount of the bills will be given to the clients as
interest free loans. For working capital requirements, the Musharakah mode can be adopted by
using the concept of daily product subject to fulfillment of relevant Shariah essentials. The bank
and the client can also agree that they would share the gross profits, so that indirect expenses like
depreciation of fixed assets, salaries of administrative staff, etc. shall not be deducted from the
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distributable profits meaning that the client would voluntarily bear all indirect expenses. This
aspect may be kept in view while fixing the sharing ratio between the bank and the client by
allocating more share to the latter. Expenses like those related to raw materials, labour directly
involved in production, electricity, etc. would be borne jointly by the Musharakah.
2.2.
Commodity Operations
Banks can undertake commodity operations of various government institutions on the basis
of Murabaha. For example, presently the Government of Pakistan announces support price of
wheat to be procured by the Provincial Government at the harvest season. State Bank advises
the major commercial banks about the purchase limits for the wheat procurement centres that are
established by the Provincial Governments. The farmers/suppliers supply the wheat at centres
and the Food Inspectors issue purchase bills to them for the quantity received. The banks provide
markup finance to the Provincial Governments and make payment to the farmers/suppliers.
Upon completion of the purchase process, the State Bank adjusts the account by debiting the
amount to the concerned Provincial Accounts.
It is suggested that the major commercial banks of the country should establish a Company
to purchase goods from the farmers/suppliers and sell them to the Provincial Governments with
their profit margin. The Company will undertake trading functions through agencies like Food
Departments/PASSCO who may serve as Agents to the Company. The Company will be having
tangible assets alongwith some inventory of the goods purchased. Shares of the Company could
be traded on the Stock Exchange and the State Bank may allow the Islamic banks to invest in its
shares to meet their SLR requirements.
2.3
Bills of Exchange
The practice of bills discounting being Riba based will have to change. The banks may
provide interest free loans against the bills and take over the bills for collection from the drawee.
As collecting agent of the bills, the banks can receive agreed service charge. Negotiation of the
bills will be at the face value and the service charge would be amount related and not time
related. This will apply to the inland as well as export bills. There would be no objection if they
use any of the Shariah compliant modes like Musharakah, Mudarabah, Istisna’a, etc.
2.4
TFCS
In view of the judgment of the Supreme Court, the use of TFCs as presently in vogue (in
the NIB system) cannot be continued and will have to be replaced by certificates based on PLS
principle.
2.5
Foreign Currency Forward Cover
The contemporary Shariah scholars have observed that forward foreign currency covers
would be permissible subject to the following conditions:
a. The amount of foreign currency is needed for genuine trade or payment transactions.
The need will have to be supported by appropriate documents so as to prevent forward
cover for speculative purposes.
b. The forward cover shall be through an agreement to sell or purchase and it shall not be a
sale and purchase agreement.
It means that sale/purchase shall take place
simultaneously at the agreed time in future at the rate agreed upon initially at the time of
agreement to sell or purchase.
c. While it will be permissible to fix the price of foreign currency in terms of Rupees
according to the agreement, no forward cover fee shall be recovered. However, an
amount may be demanded by the bank from its client in advance by way of earnest
money against foreign currency agreed to be purchased/sold at a future date. If at the
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agreed time the party does not perform, the bank can recover the differential and adjust
the earnest money there against.
2.6
Inter-bank Transactions
The best way would be that the surplus banks providing funds participate in the profits of
the deficit banks on daily product basis. Sale and purchase of Shariah compliant government
securities, as are being considered by the Task Force of the Ministry of Finance, can also be used
for liquidity management by the banks.
2.7
Underwriting
The take-up commission by the underwriter for subscribing to any unsubscribed amount of
shares is not permissible. The underwriter shall bind himself to provide services of procuring
the underwritten amount of capital for which he can charge a fee/commission. Commitments
should be fully backed by either available funds or any other funding arrangements.
Accordingly, underwriter shall be entitled to charge underwriting fee only in consideration of
arranging procurement of the underwritten capital. There should be no separate take-up
commission. Shares to be subscribed by the underwriter shall have to be at the offer price as
applicable to all other shareholders, without any increase or decrease from the face value of such
shares.
The Council of the Islamic Fiqh Academy of the OIC in its Seventh session (9-14-May,
1992) resolved that: “Underwriting is an agreement made upon establishment of a company with
someone who undertakes to guarantee the sale of all or part of the shares issued, i.e. undertakes
to subscribe to all shares that remain un-subscribed by others. There is no Shariah objection to
this provided that the underwriter subscribes to the shares at nominal value without any
compensation for the commitment per se though he may receive compensation for services other
than underwriting that he may have offered, such as preparation of studies or marketing of
shares.”
3.
ISLAMIC BANKING SERVICES
Islamic banks have managed to cope with the technological development in banking
services and have presented, in most cases, up-to-date banking services. They can provide
following services:
3.1.
Credit Cards, TCs., Visa Cards, ATM, etc.
Islamic Banks provide such services in return for a fee through agreements they conclude
with international issuers of such documents, such as Visa card. The relationship between the
issuer and the Islamic bank could be that of an agency. Once it sells the Traveller’s Cheques, for
example, it has to debit the account of its customer simultaneously, i.e. accounts should be on a
spot basis and there should be no forward foreign exchange dealings.
In the case of Visa cards and Credit cards in general, Islamic banks should look into what
goods and services these cards are used in buying. Islamic banks can only deal in such cards if
no interest is charged when deferred payment is involved. It is also necessary that an Islamic
bank should restrict the use of such cards to Halal activities and should issue clear instructions to
its customers as to which goods, services and dealings are not allowed. Any breach would result
in invalidation of the use of such a card.
OIC Fiqh Academy defines the Credit card, “A Credit card is a document that a bank issues
to a natural or legal person according to a contract between them. The card holder purchases
goods or services from those who accept the card without immediate payment of the price.
Payment is made from the account of the bank who afterwards charges the card holder at regular
time intervals depending upon the terms of the contract and the situation”.
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The Fiqh Academy in its 12th Session (23-28 September, 2000) resolved that: “It is not
permissible to issue a Credit card or use it if its conditions include imposition of interest. This is
so even if the card holder has the intention to pay (the price) within the moratorium period that
precedes imposition of interest. However, it is permissible to issue Credit cards that do not carry
a condition of imposing interest on the credit. The bank can take from the card holder a specific
amount of money at the time of issuing or renewal of the card as fee that the issuer deserves
according to the services it provides to the card holder and any charge over and above this fixed
amount is impermissible because of being usurious.”
“It is also permissible for the bank to take a commission from the merchant on the goods or
services purchased by the card holder, provided that such goods or services are sold at the same
price whether in cash or credit”.
It, therefore, implies that charging an initial membership or periodic fee on credit cards
does not pose any Shariah problem. However, financing through credit cards on the basis of
interest will be prohibited. Thus, in the new situation, the credit cards will become ‘charge
cards’ where charges for the issuance of the card and recurring annual charges can be recovered
from the card holders and transaction charges and commission can be recovered from the
merchants. If a loan or debt is created, no return could be charged thereon from the card holders.
At present, Islamic banks act as agents to card issuers and they charge fees both to the card
holders and the sellers in return for the services they provide at the point of sale. They allow
their customers free use for a number of days without any provision beyond that. They also take
fee for cash withdrawals, as the bank incurs expenses in respect of each withdrawal.
Some scholars have suggested that credit cards be designed on the basis of Murabaha,
whereby the bank will buy the goods from the store and then sell them on deferred payment to
the customer. This will be when it is issuing its own credit card. Alternatively, a Musharakah
basis could be used whereby the bank would enter with such stores into an agreement according
to which the bank will provide pre-finance to these stores on the basis of profit-sharing and the
bank or a group of banks will issue credit cards which the customers will use to purchase goods
from such stores, the stores administering the act of selling while the banks administer all other
banking services. In return, the bank and the department stores will agree as to how they will
share profits.
3.2
Foreign Exchange Transactions
Islamic banks are allowed to deal in foreign exchange remittances and the buying and selling
of foreign exchange on a spot basis. However, differences in time zones between different
foreign exchange markets necessitate allowing for two days difference for the clearing of such
operations, but the operation will be finalized on the rates of the date on which the transaction
was effected. Banks can undertake remittance transactions domestically and externally.
Externally they will need to have a correspondent relationship with many banks.
Given the predominance of interest based banks, this will pose a great challenge to Islamic
banks. Some banks have managed to strike agreements with such banks without the giving or
taking of interest, on the basis of reciprocal treatment. Islamic banks will keep foreign exchange
balances for agreed amounts and periods, i.e. they will keep credit balances and will, in return,
be allowed debit balances.
3.3
Letters of Guarantee (L/G)
Jurists generally do not allow fees or remuneration based on guarantees. However, some
jurists consider that the bank can take commission and fees, since a guarantee is created as a
service. Banks’ services involve some administrative expenses; therefore, they can recover
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expenses by way of fee or guarantee commission. However, if the guarantee is called, banks
will be entitled to recover their principal amount only.
3.4.
Letters of Credit (L/C)
Letters of Credit are essential banking services in the area of international trade. Shariah
scholars have different views on how letters of credit should be treated. In literature on Islamic
banking, L/Cs are covered under various contracts like Wakalah (agency), Musharakah,
Murabaha and Kafalah (Guarantee). Some say that they should be treated as a service and
charged at a fixed rate that will not vary with the duration or the volume of the letter of credit.
Other scholars allow for the fees to vary with their volume, as more or less work and effort will
be involved. Some Shariah boards have suggested a rate structure based on brackets rather than
on a percentage basis. Other Shariah boards have decided that Letters of Credit should be
treated on the basis of an agency arrangement at a fixed percentage.
It is necessary that we treat L/C as banking services and not as guarantees, except in the
case of standby letters of credit, which are used as a form of guarantee. However, L/Cs differ in
that, some allow partial shipment, some are revolving, some need confirmation, and others have
a red clause. In each case, fee will differ, as the effort exerted will differ with each type of L/C.
Time will not be an element in the variation of fees, except as it involves more or less
administrative work.
Letters of Credit could be opened on the basis of Murabaha or Musharakah. In the former
case, the bank would open the L/C for itself and when it possesses the goods, it could sell them
to the customer either on an FOB or on a CIF basis. Fee could be added to the total cost of
goods.
Musharakah is more flexible, as the L/C may be in the name of the customer or the bank,
when the goods are received, the partner may sell them and the Musharakah liquidated or the
partner may buy the share of the bank. In the case of Musharakah, either the bank or the
customer can administer the L/C; this will give more flexibility to both parties and solve some
legal Shariah and procedural problems which are encountered by Murabaha L/C. It is also
possible for the bank to act as an agent to the beneficiary on behalf of the issuing bank and, in
return, charge fee against the L/C.
However, the general view so far is that banks may be allowed to charge commission or fee
for Letters of Credit as service charge which shall not be time related. In the words of the CTFS,
“To guard against the practice of Riba, no charges can be recovered where guarantee or
commitment is given for repayment of a debt or a loan”.
3.5.
Cash Transfer/Payments
Transfer of funds in a specific currency to be paid/effected in the same currency is allowed
with or without a fee. In traditional Islamic finance literature, for cash transfer/ payment we
come across the instrument of ‘Suftajah’ which is the act of depositing a certain amount of
money with someone for settlement to the benefit of the depositor or his representative at
another place or in another country. In case it is made against a fee, then it is considered as an
agency service against remuneration.
If the transfer involves payment in a currency other than the one in which it has been paid
or deposited, then the transaction involves currency exchange as well as transfer of funds. The
currency exchange operation is carried out before the transfer. The customer hands over the
amount to the bank and the bank credits its register with that amount after agreement on the rate
of exchange as fixed in the receipt delivered to the customer. Afterwards, the transfer operation
is carried as indicated in the above Para.
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Arbitration Clause
Banks, in order to resolve the disputes, can put an arbitration clause in almost all contracts
based on participatory or debt creating modes with mutual understanding of their clients. The
Commission for Islamization of Economy (CIE) in its Report of 1992 had suggested a clause for
Review Committee in the Musharakah agreement, with mutual understanding of the parties.
The OIC Islamic Fiqh Academy in its 9th Session (1-6 August, 1995) resolved the following
about Arbitration: “Arbitration is an agreement between the two parties to any possible conflict
in the course of effecting any contract to mandate a third party to arbitrate between them and
settle their difference through a binding verdict. It is permissible, whether it is amongst
individuals or in the field of international conflicts. Arbitration is mandatory neither for the
conflicting parties nor for the arbitrator. Either of the parties may decline it as long as the
arbitration has not started, and the arbitrator may dissociate himself from the matter – even after
consenting once – as long as he has not initiated issuing any verdict. He may not designate
someone else as a substitute for himself without the authorization of the two parties concerned,
for their consent is tied up to his own personality.”
“The arbitrator must meet the prescribed conditions for qualifying as a judge. The verdict
issued by the arbitrator should be carried out voluntarily. In the case of refusal by either party,
the matter may/must be submitted for implementation to the law courts. The court may not
repeal the verdict unless it is found to constitute an obvious inequity or departure from Shariah
rules”.
5.
Penalty CLAUSE
A heavy non-performing portfolio and default on part of the clients is a serious problem
facing the financial institutions all over the world in general and in Pakistan in particular. This
problem may continue in interest free banking that could be a threat to success of the new
system. If clients do not honor their commitment in respect of timely payment of a debt created
in installment sale, Murabaha, leasing, do not pay banks’ share of profit in participatory modes
or do not deliver goods at stipulated time in Salam and Istisna’a, it could cause irreparable loss
to the system, the banks and financial institutions and ultimately to savers and the economy. In
view of the severity of the problem, the Islamic Fiqh Academy of the OIC and the Shariat
Appellate Bench of the Supreme Court of Pakistan have approved the provision of penalty
clause in the contractual agreements that keeps a balance between the requirement in view of
severity of the problem and that of the Shariah conditions/principles to maintain the fine
difference between interest and profit, as in case of Murabaha, intact. However, the penalty
proceeds will be used for charity because penalty on default in repayment cannot become an
automatic source of income for the creditor.
The Council of Islamic Fiqh Academy in its 12th session (23-28 September 2000) discussed
the issue of Penalty Provision in contracts entered into by Islamic banks and decided the
following: “A penalty Provision in legal terminology is a condition agreed to by the two parties
of a contract as to how compensation stipulated for one of them in case of default or delay on the
part of the other can be assessed”. The Council also observed that “It is not permissible to
include a penalty provision for delay in providing the commodity since a commodity sold
through Salam is a debt and it is impermissible to impose an additional charge for delayed
repayment of debt. It is permissible to include a penalty provision in Istisna’a contract except
for inevitable circumstances. In Installments Sale, when the purchaser delays payment of due
installments, no additional charge should be imposed on him whether by virtue of a
predetermined condition or otherwise. Such a practice amounts to commitment of usury”.
However, the Islamic Fiqh Academy differentiated the pure debt contracts and the contracts
involving performance of certain obligations/acts by the client, and decided that penalty clause
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can be put into original contract or in a separate agreement in all financial contracts except
where the original commitment is a debt, as imposing a penalty provision in a debt contract is
usury in the strict sense. However, if the client does not deliver in time the goods as in the
delivery contract or the manufacturer in an Istisna’a contract fails to or delays in meeting its
commitment, he may be subjected to penalty.
Banks can be compensated for liquidated damages based on actual financial loss or the loss
caused by any act of the client including default or delay. If required by any of the parties, the
court may reasonably adjust the amount of compensation. According to the decision of the Fiqh
Academy, the penalty provision should become null and void when a client proves that his
failure to meet an obligation was due to reason beyond his control, or when he proves that the
bank as a result of his breach of the contract has incurred no loss. It implies from the above that
liquidated damages to be given to banks in case of defaults on the part of bank’s clients should
be based on actual financial loss. The ‘actual financial loss’ cannot be the loss in terms of
conventional ‘opportunity cost’. It has to be determined by the bankers themselves to the
satisfaction of the court or any arbitrator. However, some Shariah boards allow Islamic banks to
charge from the defaulter the rate realized by them on their Murabaha transactions during a
specific period. They also recommend that the financial condition of the client be taken into
account.
6.
REGULATORY ISSUES IN ISLAMIC FINANCIAL SYSTEM
Like the Conventional financial system, Islamic financial system too requires to be
regulated for the following reasons:
1.
2.
3.
4.
Increasing the information available to investors
Protecting interests of savers and ensuring Shariah compliance
Ensuring the soundness of the financial system
Making monetary policy effective.
In order to foster stability of Islamic banking, there is a need to develop uniform regulatory
and transparency standards that are tailored to the specific characteristics of Islamic financial
products and institutions. This task, whilst taking into consideration the national financial
environment, would also include the adaptation of the international standards, core principles,
and good practices to the specific needs of Islamic finance. For strengthening the regulatory
setup and making them acceptable for multinational financial institutions, development of
Shariah compliant liquid money market instruments, designing prudential rules to reflect the
specific risk characteristics of Islamic financial contracts and development of internationally
accepted accounting standards are necessary.
The supervisory authorities in countries where both systems operate side by side should
recognize the need to set up a regulatory framework that, while consistent with Islamic precepts,
would be pragmatic and flexible enough to meet internationally accepted prudential and
supervisory requirements. In Western countries where Islamic banks have set up branches or
subsidiaries, the supervisory authorities should approach Islamic banks with an open mind,
recognizing the potential gains that this already sizable and growing market can bring to the
global economy. Effective prudential supervision of Islamic banks in their home countries is also
key to fostering closer integration between Islamic and conventional banking systems.
6.1.
1.
2.
3.
4.
Pre-Requisites for Regulation
Standardized contracts.
Uniform and appropriate accounting system.
Frequent financial reporting
Following steps would also be needed:
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a. Increasing the amount of information available to investors is required to reduce the
adverse selection and moral hazard problems in financial markets, so as to increase the
efficiency of these markets.
b. The need of increasing the amount of information for investors will be more in the
Islamic financial system.
c. A new set of prudential rules and regulations will be needed after thorough study of the
regulatory and supervision needs in the new system.
d. In addition, vigorous training of concerned Central banks staff will be required.
e. A research and training center for banking regulations and supervision, rating institution
and a feasibility studies institution are the infrastructure of the new system.
6.2.
Regulatory Framework and CAMEL Rating
Any central bank that has allowed Islamic banking operations has the responsibility to
ensure that Islamic banks are adequately regulated and supervised so as to maintain and enhance
confidence of the participants in the financial market and its functioning. It would have to
modify Prudential Regulations for Islamic banks accordingly. The main objective of such
regulations would be to use information contained in various Returns to monitor the operations
of the banks and to help identify any signs of deterioration of banks performance. The
monitoring would mainly base on the assessment of capital adequacy, asset quality, management
of investment accounts, earning quality, profit and loss of Islamic banks and liquidity
management (CAMEL).
Capital Adequacy: Islamic banks, like conventional banks, are required to maintain an adequate
level of capital. The Basel Committee has set this level at 12%. The AAOIFI has approved and
recommended a Statement on the Purpose and Calculation of the Capital Adequacy Ratio for
Islamic banks. The AAOIFI Statement on capital adequacy focuses on two main issues: (a)
Investment Accounts of Islamic banks are not liabilities, but are used to finance assets managed
by the bank as Mudarib, and (b) Whereas legally banks’ own capital is not exposed to the risk of
the assets under management (except where they are attributable to the banks’ misconduct or
negligence), banks may be under pressure commercially to absorb some of that risk in order to
compete (displaced commercial risk). There is also the risk of misconduct or negligence and its
implications for risk to the banks’ own capital (fiduciary risk).
Asset Quality: Like conventional banks, Islamic banks are expected to maintain assets which
are of sound quality. They are also expected to have policies and procedures in place to ensure
that any impairment of assets is timely identified and provisions are maintained to reflect such
impairment. In this regard the Bahrain Monetary Agency has laid down criteria for banks in
their monitoring and control of large exposures. Banks are required to notify the BMA where an
exposure to counterparty would be equal to or exceed 10% of the eligible capital base. Where
the exposure would exceed 15%, prior approval of the BMA to accept the exposure would be
required.
Management of Accounts: It is responsibility of Islamic banks to ensure that there are firm
policies and procedures in place to safeguard the interest of the shareholders as also those of the
PLS/Investment Account holders. Financial Accounting Standard No. 11, issued by AAOIFI
covers the provisions and reserves recognition measurement and disclosure for Islamic banks.
This Standard needs to be followed by Islamic banks and the regulatory authorities.
Earnings Quality: Maintaining a consistent level of quality earnings is essential for the longterm health of a financial institution. Risks of economic losses, or losses as a result of poor
investment decisions are readily apparent in the earnings trend of a bank. Economic losses not
only would be reflected in the depreciation of the value of investment account holders funds, but
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also in the bank’s profitability. If not corrected in due course, such an economic downturn could
threaten the bank’s soundness.
Liquidity: Monitoring liquidity is one of the most critical responsibilities of any bank
management. Maturity transformations, e.g. taking short-term deposits to make comparatively
long-term investments may expose the bank to the risk that investment account holders demand
for payment might outstrip its ability to transform assets into cash. The central bank is required
to lay down a mismatch monitoring policy and the criteria for reporting inflows and outflows of
deposits of various maturities.
7.
OPERATIONAL CONTROLS
Islamic banks may finance projects on the basis of equity participation and profit-sharing in
addition to debt-based modes. Therefore, soundness of their operations needs a type of control
that goes beyond merely ensuring the solvency of debtors. To ascertain operational soundness,
the central bank needs to undertake the following procedures:
8.

The application of consolidated and acceptable accounting standards suitable for Islamic
modes of financing.

A review of project financing operations to ensure the soundness of the bank's
performance in preparing feasibility studies and evaluations and follow-ups on project
implementation.

An evaluation of the performance of the bank in monitoring and controlling the
enterprises it finances by way of equity participation. This would also include looking
into the ability of the bank to deal with the problems facing enterprises, and to provide
them with necessary technical assistance. (Jarhi & Munawar Iqbal, 2001).
SHARIAH COMPLIANCE AND RELATED SUPERVISORY ISSUES
Shariah compliance of the business of Islamic financial institutions is of crucial importance
for integrity and credibility of Islamic banking industry. Therefore, existence of religious
scholars and of Advisory (or Supervisory) Boards in Islamic financial institutions has been of
great importance for the success of Islamic banking over the last three decades.
The credibility has to be established not only in international spectrum but also at the
national levels. Many stakeholders in countries where Islamic banking has visible existence are
of the view that Islamic banks have deviated to a great extent from their philosophical basis and
the concept of Islamic banking and finance has changed visibly from the concept envisaged in
1970s. Islamic financial institutions come in all shapes and forms: banks and non-banks, large
and small, specialized and diversified, traditional and innovative, national and multinational,
prudent and reckless, strictly regulated and freewheeling, etc. Some are virtually identical to
their conventional counterparts, while others are markedly different. Some are driven by
religious considerations; others use religion simply as a way of attracting customers. In this
perspective, they cannot escape criticism on Shariah matters because as per Shariah principles
they are required to involve in real sector business while the common man understands that
Islamic banks normally do not actually carry out businesses like trading, leasing or construction
activities and hence they end up doing only financial operations. This necessitates the launching
of public awareness programs with active participation of the Shariah scholars.
As such, difference between the theory, as we find in the relevant literature, and the
practical approaches taken by the practitioners and financial experts poses a big challenge as it
would determine the level of credibility of the new system. As there has been no visible
difference between present Islamic banking and the conventional banking, the business has
already been slipping to the control of conventional banks operating ‘Islamic Windows’ where a
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fool proof system for ensuring Shariah compliance is generally considered to be missing. There
is all the risk that Islamic banking may get diluted with the conventional banking unless Islamic
banks do something to establish their distinction as "Islamic Banks". Islamic banks need to
ensure that all of future financing has some underlying goods and services to be the objects of
modes of financing.
Shariah Board’s role should be of a facilitator for developing products for banking
business. It must always be in position to answer whether or not the new/proposed products
conform to Shariah. It should also offer constrictive advice and give recommendations as to
how to amend the proposed structure in order to make it feasible as also Shariah compliant.
Islamic Shariah has provided flexibility for Ijtihad to respond to changes and diversity in day to
day life. But it has its own limitations. It is neither a source of anarchy nor a means of
transforming the Islamic Shariah from Divine to a man-made law. The concepts of Custom,
General Good, Utility or Necessity are taken into consideration in the process of Ijtihad but they
are relevant only when basic principles given as Nass (Clear and unambiguous texts of Qur'an
and Sunnah) are taken care of and are based on proper analogy. It is, therefore, believed that
remaining within the Shariah boundaries, a great deal of Ijtihad is possible and very much
needed to infer from the original sources the appropriate rules relating to transactions of business
and finance. In that way only any Shariah Board can play an Innovative role along with Shariah
compliance of the system.
Philipe Moore, in ‘Islamic Finance’ a Euromoney publication (1997) contends that Shariah
Board will typically ask four questions in relation to any given transaction. These will generally
be:
Do the terms of the transaction comply with Shariah law?
Is this the best investment for the client?
Does the investment produce value for the client and for the community or society in which
the client is active?
As an asset manager, is this a transaction in which the banker as an individual would be
prepared to invest his own money?
If the answer to any of these four questions is no, the proposed transaction will usually be
rejected, although the committees only have the power to reject the transaction on the grounds
that it does not comply with Shariah law.
It is in this perspective that an active role of Shariah Board and Shariah scholars carries
importance in terms of developing Shariah compliant Islamic banking products. In addition to
Islamic Fiqh Academy of the OIC, Shariah Boards / Committees of IDB, and IIFM, there are
central Shariah boards in Malaysia, Bangladesh, Pakistan, Sudan, etc. All individual Islamic
banks operating in various countries also have Shariah committees/board. Pakistan has recently
allowed Islamic banking institutions to have a Shariah Advisors and the constitution of a Shariah
Committee or Board is not necessary.
In order to ensure the Shariah compliance in all respects, the Shariah Boards should
supervise the activities of Islamic banks. To this end, they should finalise the model agreements
for the modes of financing and try to ensure that banks follow them in all their transactions in
letter and spirit. Whenever a case arises where there are difficulties in applying any of these
forms, the management of the bank should bring the problem to the notice of its Board, who will
look into it, come to a decision and issue a decree (fatwa), which the management must obey. A
large number of these fatwas now exist, covering many of the current practical problems of
Islamic banks.
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The staffs of Islamic banks have often been trained in conventional banking and are not
very familiar with interest-free banking. Because Islamic banking is still in a process of
evolving, even the management may not be very experienced or up-to-date in the latest
applications of the principles. Quite unintentionally, they may fail to carry out their Board's
resolutions. For this reason, some Shariah Boards inspect the details of their bank’s transactions
and give advice as to where they could be improved in regard to compatibility with Islamic
principles. This not only ensures that the bank is operating in accordance with Islamic law, but
gives the Shariah Board itself an opportunity of gaining a deeper insight into the practical
problems that arise. In addition, both the staff and the management are given an opportunity to
increase their understanding and competence.
8.1.
AAOIFI’s Shariah Standard on ‘Shariah Supervisory Board’
Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) has
prepared a standard for ‘Shariah Supervisory Board’, its composition and related aspects like
rulings, report, etc. According to this standard, Shariah Board should be an independent body of
specialized jurists in Islamic commercial jurisprudence. It may also include other experts in
areas of Islamic financial institutions with knowledge of Islamic jurisprudence relating to
commercial transactions.
The Shariah Board is entrusted with the duty of directing, reviewing and supervising the
activities of the Islamic financial institution in order to ensure that they are in compliance with
Islamic Shariah Rules and Principles. The fatwas, and rulings of the Shariah supervisory board
are binding on the Islamic financial institution.
According to AAOIFI standard, Shariah Board should consist of at least 3 Shariah scholar
members. It may seek services of consultants having expertise in business, economics, law,
accounting and/or others. It should not include directors or significant shareholders of the
Islamic financial institution. Following is the illustrative wording of any Shariah Board’s report
on operations of Islamic financial institutions:
“We have reviewed the principles and the contracts relating to the transactions and
applications introduced by the Islamic Financial Institution (IFI) during the period ended ……..
We have also conducted our review to form an opinion as to whether the Institution has
complied with Shariah Rules and Principles and also with the specific fatwas, rulings and
guidelines issued by us.”
“We conducted our review which included examining, on a test basis of each type of
transaction, the relevant documentation and procedures adopted by the Islamic Financial
Institution. We planned and performed our review so as to obtain all the information and
explanations which we considered necessary in order to provide us with sufficient evidence to
give reasonable assurance that the Institution has not violated Islamic Shariah Rules and
Principles.”
The Shariah Board should particularly focus on Shariah compliance of financial structures
including products, documentation and the process of transactions. Where appropriate, the
Report of the Board should include a clear statement that the financial statements have been
examined for the appropriateness of the Shariah basis of allocation of profit between the equity
holders and the depositors.
Shariah Board’s Report should also include a clear statement that all earnings that have
been realized from sources or by means prohibited by Islamic Shariah Rules and Principles have
been disposed of to charitable causes. In case of violation of any Shariah rules or rulings of the
Shariah Board, the Board should indicate the violations in its Report. The central Shariah boards
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also approve the Fit and Proper Criteria for Appointment of Shariah Adviser in Islamic banking
institutions.
Shariah compliance audit of Islamic banking institutions by the respective regulators is
another important area in ensuring Shariah compliance of Islamic banking and finance
transactions. Pakistan has taken lead in this regard. So far, arrangements of Shariah compliance
audit, in addition to conventional risk / CAMELS based audit have been only in Pakistan. State
Bank of Pakistan has finalized Shariah Compliance Inspection Manual on the basis of which it is
conducting Shariah audit of IBIs operating on the basis of licence issued by it for conducting
Islamic banking in Pakistan. Such audit is very important for promotion and supervision of
Islamic banking and finance as it would enhance credibility of the system.
Accordingly, Shariah compliance framework adopted by the State Bank consists of the
following components: (i) A central Shariah Board at SBP that advises SBP on issues referred to
it by the Bank; (ii) Appointment of a Shariah Adviser/Board in Islamic banks/Islamic banking
branches (IBBs) for ensuring Shariah compliance in product development, policies and
procedures; (iii) Periodic internal Shariah review by Islamic banking institutions (IBIs), and (iv)
Shariah compliance audit of IBIs by the State Bank as a part of inspection. Issuance of license is
also subject to certification by the Shariah advisor of the applicant bank that the modes,
products, procedures and manuals to be used by the bank are in conformity with tenets of the
Shariah.
8.2.
Internal Controls for Shariah Compliance
The experience of Islamic banking in various countries has shown that Shariah
Boards/Advisors of Islamic Financial Institutions (IFIs) should have a proactive role in
supervision of Islamic banks’ transactions for the purpose of Shariah compliance. Islamic banks
are generally using modes involving fixed rates of return. Non-fulfillment of any of the Shariah
essentials of such modes may render the transactions un-Islamic. The passive role for approving
the products or their procedures and leaving their applications totally on the banks opens door to
interest in the garb of asset-based transactions like Murabaha, Tawarruq, Hire-purchase, etc.
Therefore, experts deem it necessary Shariah Boards should thoroughly inspect at least once a
year the activities of Islamic banks to ascertain their Shariah compliance.
Similarly, a large part of Islamic banks assets comprises investments in equities/capital
markets. Shariah Boards must ensure compliance of criteria for Islamic banks investments in
shares, equities, Sukuk and other avenues of business. This aspect of Shariah controls would
include prohibition of investment in companies with unacceptable business lines which produce
prohibited products and provide prohibited services like:
 Alcoholic beverages and tobacco products
 Grocery stores dealing in Haram goods
 Restaurants, casinos and hotels with bars for prohibited activities
 Amusement and recreational services
 Financial institutions which deal with interest
 Companies of which:
o
Interest income ratio is more than (5)%
o
Debt ratio (leverage) is less than (10 - 33)%
o
Total illiquid assets less than 10 % of its total assets
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If investment is made in equities of such companies, Haram or interest related income
will have to be given in charity and the Shariah Boards must ensure its credit to charity
Accounts.
8.3.
Shariah Control in Respect of Various Modes
In order to ensure Shariah compliance, Shariah Boards should specify detailed controls
for modes which respective banks are using particularly in respect of commonly used modes like
Murabaha and Ijarah which are susceptible to be used as back-door to interest. Murabaha in
various goods may involve different aspects needing close monitoring. For example, Murabaha
in perishable goods, shares of Joint Stock Companies, particularly when the transactions involve
dual side agency agreements, Tawarruq and other by - products of major Islamic modes. We
give internal control in respect of some modes as hereunder:8.3.1
Murabaha:
1.
Shariah Board should ensure that accounting in Murabaha is made similar to that of a
trade transaction instead of financial transaction. In this respect, AAOIFI’s
Accounting Standard on Murabaha may be consulted. Some banks record only the
disbursement of the total amount including mark-up. This is against the substance of
Shariah compliant Murabaha.
2.
To ensure that banks are not involved in Rollover of Murabaha transactions, strict
internal controls be applied. Price of the goods cannot be changed if the customer
does not pay on time. Accordingly, there is no opportunity for a rollover of Murabaha
transactions. Nevertheless, it should also be kept in mind that a Master Murabaha
facility entails multiple Murabaha transactions, and in case it is necessary to extend
credit, a new Murabaha should be initiated against new goods with a complete
process of purchase offer and acceptance. Against this, some banks resort to
arrangement in which they disburse the amount payable by their client against a new
Murabaha, credit the amount to the client’s account; and then debit his account
against the old Murabaha. This is merely a book entry. In some cases, banks might
not be making even the book entry and there might be simple rollover of the previous
Murabaha including the previous receivable plus mark-up for the new term. Shariah
Board will have to restrict the bank from such operations. Return on such Roll-overs
must go to charity fund.
3.
The client who is being paid the amount for purchase of the commodity on behalf of
the bank may not purchase the commodity for a long time and use it for any other
asset that might not be permissible e.g. for purchase of interest-based securities or
shares of interest based companies. Therefore, there must be effective controls that
client purchases the commodity within a given minimum time and gives declaration
to the bank followed by acceptance by the bank and sale to the clients. For effective
control, Shariah Board may also advise the bank to make payment directly to the
supplier.
4.
For genuine Murabaha, it is necessary that legal title of ownership is transferred to the
bank before it sells the commodity to the client on Murabaha basis. But banks, in
order to avoid payment of transfer charges, purchase the goods in the name of the
client; thus the banks do not become owner of the goods in any way. Shariah Board
must ensure that not only title of goods is in the name of the bank at the time of its
sale to client, but also that bank retains all risk and rewards related to ownerships till
the goods are sold to the client.
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5.
Shariah Board must ensure that all documentation requirements particularly in case
the client is also agent of the bank are being fulfilled properly. The Board should not
allow any change in the Master Agreement without its prior approval.
6.
Mark-up should be charged from the time bank sells the commodity on credit to the
client. Shariah Board must ensure that it is not charged from the date of disbursement
to the supplier or to the client (as agent). Any part of the mark-up should not be
referable to the intervening period i.e. between disbursement and
declaration/acceptance by the bank. Islamic banks should calculate their Murabaha
profit from the date they sell the commodity to the client.
7.
Bai’al Inah/Buy-back arrangement is not allowed in Shariah. Shariah Board should
put in place effective controls that banks do not resort to buy-back technique in case
of Murabaha transactions.
8.
Banks, upon financing, normally take Demand Promissory Notes (DP Note) from the
client. As Islamic banks financing is based on the underlying trading/leasing
contracts, they should get DP Notes only after executing the Murabaha sale and
creation of liability e.g. after the sale of goods. Shariah Boards should ensure that
banks do not take DP Note at the time of disbursement to the client/agent. If such
Note is necessary at the time of disbursement for the sake of Security, it can be of the
principal amount only i.e. excluding the mark-up or profit margin.
Some Shariah Boards have also allowed in Murabaha structure the use of Tawarruq i.e. the
client selling the goods purchased from bank on Murabaha to get cash for any other business
activity. In this case, Shariah Board must ensure that the process of genuine Murabaha is
completed fulfilling the Shariah essentials and that the cash realized by the client is used for any
Halal business/purpose.
8.3.2
Shariah Controls for Ijarah
The other major mode Islamic banking are using is Ijarah alongwith its variants. Following
may be some of its controls:
1.
The Shariah Board should ensure that ownership title of the leased asset is transferred
to the bank i.e. Lessor. In case it involves import, banks should import in its name
directly or through agent/client. It has been observed that to avoid some
taxes/charges the assets are imported in the name of client/lessee. It is not
permissible and the minimum that should be ensured is that a Counter Deed should be
signed between the Bank (Lessor) and the Client (Lessee) for transfer of ownership to
the Lessor.
2.
Ijarah and Bai are entirely different types of transactions in terms of their implications
for the parties involved. Therefore, the two transactions should not be mixed in such
a way that their respective Shariah essentials are not fulfilled. Transfer of ownership
to lessee should not be an integral condition of the Lease Agreement. It could be a
unilateral promise, not binding on the other party.
3.
Shariah Board should ensure that expenses relating to purchase and ownership of the
asset are borne by the bank. As such, expenses that are necessary to maintain the
overall corpus of the asset are lessor’s responsibility.
4.
As per AAOIFI’s accounting standard for Ijarah, accounting for Ijarah based
financing should be similar to that of the operating lease and not that of finance lease.
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It should be ensured that if rentals are received in advance, the same should not be
treated as a liability. This is because no rentals will be due before the asset is handed
over to the client capable of being used by him.
Similarly, for all other modes which an Islamic bank is using, Shariah Board should
identify the Shariah controls which must be ensured so as to maintain sanctity of Islamic
business products. For example, in Diminishing Musharaka different documents relating to
creation of partnership, leasing and sale of units to the other party must be independently
enforceable. All expenses relating to ownership must be borne by the parties in the proportion
of their ownership. The rate of Musharaka payments should be net of such expenses and not
directly linked to any benchmark like LIBOR/KIBOR etc. If the jointly purchased asset is not
capable of being leased (like a plot of land), no rental should be charged because it is only a
commercial asset and can give profit only upon its sale. Commercial asset or its units can be
revalued only keeping in view its actual value/per units value. If it is pre-stipulated that units
would be revalued by ( )% per month/annum, without regard to actual value, the transaction
would become usurious.
In case of Musharaka agreements, expected profit rates are projected in the agreements. Shariah
Boards will have to ensure that payments to banks under projected rates have been subjected to
final adjustment procedure as approved by it and the bank’s management treatment of loss, if
any, is also very important and it must be ensured that loss is borne by the partners exactly in
proportion of their share in the joint investment. It should also be ensured that Islamic banks
investments in shares of joint stock companies is subject to the screening criteria approved by
the Shariah Board and in case of any non-compliance, the dividend income or the capital gain
from non-Shariah compliant investments must go to the Charity Fund.
Shariah Board must also ensure that Islamic bank’s placements with other institution are only on
any of the Shariah compliant basis and any income from non-Shariah compliant placements
must go to charity. It also should be ensured that the bank fulfills necessary disclosure
requirements and profits are distributed among shareholders and various categories of depositors
according to already disclosed criteria/ratios/weightages.
Finally, the use of Charity Fund proceeds must also be overseen by the Shariah Board.
Generally, it has been left to Islamic banks themselves as to whom and how they disburse such
funds. However, if regulators in respective countries do not advise any procedure/avenues for
disbursement of Charity funds, Shariah Boards must ensure that these are used for uplift of the
poor or for social welfare projects in the respective economics/societies and are not used for any
other purpose not conforming to the Shariah tenets.
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