Islamic Banking & Interest Free
Banking
Lecture Objectives
• What are misgivings about Islamic Banking?
• To be able to define Islamic banking.
• To draw difference between conventional
banking and Islamic banking.
• To define different types of Islamic modes of
financing.
• Some basic modes of Islamic financing.
Interest-Free Banking--Some misgiving Clarified
• The first misgiving which has been expressed is whether bank
interest is that interest at all which is prohibited by Islam.
• The second misgiving which has been often expressed is that
interest is the kingpin of the modern banking system.
• The third misgiving is how the profit sharing system could work
when so many firms and individuals in business either do not
maintain accounts due to the high level of illiteracy.
Interest-Free Banking--Some misgiving Clarified
• The fourth misgiving and a very serious one, is that a system based
on profit & loss sharing may lead to collapse of the banking system
as banks will have to share in losses also.
• The fifth misgiving which has been expressed in some quarters is
that profit & loss sharing system will make the banking system less
liquid and hence there will be a great risk of banks to meet the
withdrawals of funds.
• Finally, the sixth one it has been pointed out that interest free
banking amounts to capital being provided free while capital has a
scarcity value.
Implication of interest free Banking
• Introduction
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Islam prohibits “ interest”
“Riba” means “ Interest”
In force in Pakistan & Iran
Islam believes in profit & loss sharing or participation,
conceptually & logically
All funds in the form of equity
No capital fund in the form of debt
Capital & Enterprise combined together
Constitute the factor of production & profit would be
its reward
Islamic Banking
• Islamic banking has been defined as banking in consonance with the
ethos and value system of Islam and governed, in addition to the
conventional good governance and risk management rules, by the
principles laid down by Islamic Shariah. Interest free banking is a
narrow concept denoting a number of banking instruments or
operations, which avoid interest. Islamic banking, the more general
term is expected not only to avoid interest-based transactions,
prohibited in the Islamic Shariah, but also to avoid unethical
practices and participate actively in achieving the goals and
objectives of an Islamic economy.
Source: http://www.sbp.org.pk/ibd/faqs.asp#q1 dated: 12/07/12
Concepts & Models of Islamic Banking: An
Assessment
• The concept of Islamic Banking
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Intermediary between Savers & Investors
Creates credit
Interest ( Riba)
Transactions based on interest are severely condemned in the holy
Quran & Sunnah( pg:62,63)
• Undesirable Features of an interest- based banking system
▫ Transactions based on interest violate the equity aspect of economic
organization
▫ Loss situation leads to a number of bankruptcies resulting in loss of
productive potential & unemployment
▫ The interest system dampens investment activity because it adds to the
costs of investment
▫ The interest –based system discourages innovation, particularly on the
part of small-scale enterprises
▫ Under interest-based system banks are only interested in recovering
their capital along with the interest
Concepts & Models of Islamic Banking: An
Assessment
• Alternatives
▫ First to decree that no return would be paid on any
type of deposits in banks & all loans & advances will be
provided on an interest free basis
▫ Second is that banking should be conducted on the
basis of profit/loss sharing
• Fundamental features of a profit /loss sharing
arrangements are
▫ Islamic Literature on Fiqh Muamla-ul-Malia
▫ Mudarbah or Qirad or Muqaradeh
▫ Sharakah
Concepts & Models of Islamic Banking: An
Assessment
• Some techniques which are not prohibited in Islam
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Bai Muajjal (Cost-plus trade Financing)
Ijara ( Lease or Hire)
Ijara wa Iqtina ( Hire-Purchase)
Bai-Salam
• Models of Islamic Banking
Some Aspects of Interest Free Banking
• Introduction
• Capital, Capitalistic & Capitalism
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A misconception
Capital Formation
Capitalists
Deposit Holders
Correcting the misconception
Interest & Profit Distinguished
Interest free Economy
Ensuring Justice in an interest-based system
Ensuring justice under popular version of interest-free system
Lack of Participatory managerial rights
Disclosure of operating results
Inflationary risks
Rate of Return of Capital
Some Aspects of Interest Free Banking
• Impact on Banking
▫ Pattern of Credit allocation
▫ Deposit Mobilization
▫ Income accounting
• Conclusion
Islamic Banking in Pakistan
 Islamic Banking
Means such a bank where all the financial, trade, business matters are done
according to the Islamic Rules & Regulations and it is free from Interest.
 At the time of independence Muslims had thought to root out Riba
(Interest) in financial matters in this Islamic State.
 1947 to 1960:
No possible decision could be taken in this era to eliminate
interest from the Banking World.
 1960 to 1977:
In this era, the Council of Islamic Ideology (CII) put a lot of reports in
front of Government to guide the Govt. that Interest is prohibited in Islam.
• 1977 to 1980:
the Council of Islamic Ideology (CII) and State Bank of Pakistan took
some steps to remove interest from the economy. The steps are:
 In Feb, 1979 financial institutions which are (ICP, NIT, HBFC) were
targeted for elimination of interest
Islamic Banking in Pakistan
• On July 1, 1981 Govt. directed to all the commercial
banks to open profit and loss sharing deposit counters
• In 1980, Mudarbah Ordinance took place.
• On July 1, 1984, the SBP directed all the commercial
banks.
• On January 1,1985, the SBP asked the commercial banks
to not accept interest bearing deposit.
Basic Principles of Islamic Finance
• Riba is prohibited.
• Faith Based: Islamic banking is on faith based system.
• Un-Islamic activities are not allowed in trading and
business.
• Socially beneficial business is allowed to be invested
in the businesses.
• Discloser of means
• Bank is partner in business
Main Instruments of Islamic Finance
• Participation Term Certificate:
It was designed to replace debenture financing. A
company is authorized under the companies ordinance
to issue Participation Term Certificates (PTCs) for
balancing, modernization and expansion of the existing
industrial units.
• Musharika:
It is the most efficient and effective non interest based
instrument to meet the working capital requirements of
a business Musharika is an arrangement in which the
banks and their clients agree to join in temporary
participation for carrying on a business within an agreed
period of time.
Main Instruments of Islamic Finance
• Features of Musharika:
▫ Short term financing
▫ Overdraft facility
▫ Management
▫ Sharing of Profit
▫ Sharing of Loss
▫ Security
Main Instruments of Islamic Finance
• Modaraba: it is another important from of
Islamic financing. Modaraba means a business
in which the subscriber participates with money
and the manager (Modarab) with the knowledge
and skill. Modaraba is an effective method for
raising large amounts of resources.
Main Instruments of Islamic Finance
• Features of Mudarbah:
▫ Registration
▫ Types
▫ Public or Private Sector
▫ Separate Business
▫ Paid up Capital
▫ Religious Capital
▫ Religious Board
▫ Regulatory Control
• Promoters should be knowledgeable
• Resource mobilization
• Operations
Mudarbah Business Activities:
• Financing Operations
• Resource Mobilization
• Others
Main Instruments of Islamic Finance
• Leasing:
It is also a minor instrument of Islamic financing. A
leasing is arrangement whereby an asset owner called
lessor confers the right of use of asset to the lessee (one
to whom lease is meant) for a specific period of time. In
leasing the ownership of the property or asset remains
with the lessor.