College of Business Administration
Jazan University , KSA
Islamic
Banking
Course code : FIBA 387
th
Prepared By
Dr. Omer Ali Babiker Eltahir
Assistant Professor
Finance & Banking Department
Mr. Mohammed Yasin
Lecturer
Finance & Banking Department
Mrs. Amreen
Lecturer
Finance & Banking Department

Islamic Banking
Course Code: FIBA 387 – 6th Level - BBA Finance & Banking
Max .Marks : 100
Term End Exam : 50
Cont. Assessment : 50
COURSE CONTENTS
Unit-I
Islamic Banking: Historical Evolution and Development, Why Islamic Finance? Riba and Gharar: Meaning and Types.
Principles of Islamic Banking: Riba (Interest) Free Banking System; Profit-Loss Sharing. Governance in Islamic banking. The
Difference Between Islamic Banking and Conventional Banking.
Unit-II
Wadea (Deposit) In Islamic Banking (Domestic Operations)
The Wadea: meaning, types, types of accounts, Operations and journal entries. Teller(Treasury Section), Clearing House.
Unit-III
Finance and Investment in the Islamic Banking (Domestic Operations)
Tools Of Finance And Investment (Permissible Financing Methods): Musharakah (Joint Venture): Meaning, Types. Mudarabah
(Partnerships): Meaning. Murabahah (Cost-Plus Sales): Meaning, Types. Ijarah(leasing) Investment In Fixed Assets: Meaning.
Bai Salam (Islamic forwards): Meaning. Bay be-Theman Ajel (Credit sales) Meaning.
Unit-IV
ISSUES IN ISLAMIC BANKING
Foreign Operations: Letter of Credit (L/C); Letter of Guarantee ( L/G). Final Accounts (Financial Statements: Income
Statement, Balance Sheet). Case study.
Unit-I
Islamic
Banking
INTRODUCTION
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

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The term Islamic banking refers to a banking activity or a system of
banking that is in consonance with the basic principles of Islamic
Shariah(rules and values set by Islam).
In Islamic banking system, a business that offers good interest rates or
services is strictly prohibited and it is in fact considered
Haraam(forbidden).
Islamic banking offers the same facilities as conventional banking system
except that it strictly follows the rules of Shariah or Fiqh al- Muamlat.
Mirza Basheer-ud-Din Mahmood Ahmad was perhaps the first person to
discuss Islamic Economics in detail in his books Nizame Nau (1942)
and Islam ka Iqtisadi Nizaam (1945). Later work included that of Naeem
Siddiqi and Maulana Maududi.
Shariah-compliant assets reached about $400 billion throughout the
world in 2009, according to Standard & Poor’s Ratings Services, and the
potential market is $4 trillion.
Iran, Saudi Arabia and Malaysia have the biggest shariah-compliant
assets.
WHAT IS ISLAMIC
BANKING
1- “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 Sharia’h”.
2- Islamic banking is also known as interest free banking system as the
Shariah disallows the acceptance of “Riba” or interest rate for the
accepting and lending of money.
”
2- Banking encompassing Islamic injunctions
To avoid:
i.
Riba –Earning returns from a loan contract or Selling debt
contracts at discount
ii.
Gharar – Absolute Risk or Excessive uncertainty in contracts,
Gambling and chance-based games (Qimar)
iii. General Prohibitions
iv. unethical practices


Shariah Compliance & Prudent Banking
Achieving the goals and objectives of an Islamic economy.
EVOLUTION AND
DEVELOPMENT OF
ISLAMIC BANKING
An early market economy and an early form of mercantilism, sometimes called
"Islamic capitalism", were developed between the eighth and twelfth centuries.
 The monetary economy of the period was based on the widely
circulated currency the gold dinar, and it tied together regions that were
previously economically independent.
 A number of economic concepts and techniques were applied in early Islamic
banking, including bills of exchange, partnership (mufawada, including limited
partnerships, or mudaraba), and forms of capital (al-mal), capital
accumulation (nama al-mal), cheques, promissory notes, transactional
accounts, loaning, ledgers and assignments. Organizational
enterprises independent from the state also existed in the medieval Islamic
world, while the agency institution was also introduced during that time.
 Many of these early capitalist concepts were adopted and further advanced
in medieval Europe from the 13th century onwards.

origin of Islamic banking
The origin of Islamic banking system can be traced back to the advent of
Islam when the Prophet himself carried out trading operations for his
wife.
The “Mudarbah” or Islamic partnerships has been widely appreciated by the
Muslim business community for centuries but the concept of “Riba” or
interest has gained very little diligence in regular or day-to-day
transactions.
The first model of Islamic banking system came into picture in 1963 in
Egypt. Ahmad Al Najjar was the chief founder of this bank and the key
features are profit sharing on the non interest based philosophy of the
Islamic Shariah.These banks were actually more than financial
institutions rather than commercial banks as they pay or charge interest
on transactions.
In 1974, the Organization of Islamic Countries (OIC) had established the
first Islamic bank called the Islamic Development Bank or IDB.
The basic business model of this bank was to provide financial assistance and
support on profit sharing.
By the end of 1970, several Islamic banking systems have been established
throughout the Muslim world, including the first private commercial bank
in Dubai(1975), the Faisal Islamic bank of Sudan (1977) and the Bahrain
Islamic bank(1979) .
Islamic banking is now one of the world’s fastest-growing economic sectors,
comprising over 300 institutions in over 75 countries.They are
concentrated in the Middle East and Southeast Asia (with Bahrain and
Malaysia being the largest hubs), but are also appearing in Europe and the
United States.Total assets worldwide are estimated to exceed $250
billion, and are growing at an estimated 15 percent a year.
History of Islamic Banking

Local Islamic banks formed in the 1970s in Muslim countries

Originally emphasized joint-venture structures akin to private
equity.

Quickly evolved to provide short-term credit facilities by
using the murâbaha structure
With increase in scale, Islamic banks began to branch out to
more complex financing schemes, including:
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Retail banking, including, deposit taking and consumer
lending
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Bonds (sukûk)

Medium- and Long-term leases (ijâra)
History of Islamic Banking

Impact of 11/9 – Reverse Capital Flight
1. Perception of hostile climate in many Western
jurisdictions, in particular, the United States, led to
repatriation of dollars by Arab investors to Middle Eastern
banks
2. Islamic banks, along with conventional banks in the
region, benefited from this reverse flight of capital
3. Increase in Oil Prices Led to Dramatic Increase in
Liquidity in the Gulf

Conventional Banks Open “Islamic Windows”
A. Conventional banks began to respond to requests from
Muslim clients to offer products that complied with
Islamic law
B. As the size of the potential market became clear,
conventional banks responded with the creation of
divisions dedicated to Islamic banking
History of Islamic Banking

Conventional International Banks
with Islamic Windows:
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Citigroup
HSBC
Deutsche Bank
UBS
ABN AMRO
Standard Chartered Bank
CONCEPT OF ISLAMIC
FINANCE
Although the concept of Islamic finance can be traced back about 1,400 years,
its recent history can be dated to the 1970s when Islamic banks in Saudi Arabia
and the United Arab Emirates were launched. Bahrain and Malaysia emerged as
centres of excellence in the 1990s.
 It is now estimated that worldwide around US $1 trillion of assets are managed
under the rules of Islamic finance.
 Islamic finance rests on the application of Islamic law, or Shariah, whose primary
sources are the Qur'an and the sayings of the Prophet Muhammad. Shariah, and
very much in the context of Islamic finance, emphasizes justice and partnership.

The main principles of Islamic finance are that:
1.
2.
3.
4.
Wealth must be generated from legitimate trade and asset-based investment.
(The use of money for the purposes of making money is expressly
forbidden.)
Investment should also have a social and an ethical benefit to wider society
beyond pure return.
Risk should be shared.
All harmful activities (haram) should be avoided.
RIBA AND GHARAR MEANING AND TYPES
Riba means Interest. Riba is forbidden
in Islamic economic jurisprudence fiqh and
considered as a major sin. Simply, unjust gains in
trade or business, generally through
exploitation.
There are two types of riba discussed by
Islamic jurists:
1- An increase in capital without any services
provided and speculation (Maisir), which is
prohibited by the Qur'an
2- Commodity exchanges in unequal quantities,
also prohibited in the Qur'an.

RIBA AND GHARAR MEANING AND TYPES

i.
ii.
Gharar
refers to any transaction of probable items whose existence or characteristics are not
certain, due to lack of information, ignorance of essential elements in the transaction to
either party, or uncertainty of the ability of one party to honor the contract.
The Prophet (S.A.W) has forbidden the purchase of the unborn animal in the mother’s
womb, the sale of the milk in the udder without measurement, the purchase of spoils of war
prior to distribution, the purchase of charities prior to their receipt, and the purchase of the
catch of a diver.
TYPES OF GHARAR
1. Gharar Yaseer (minor or slight)
This type of gharar is tolerated and will not invalidate a contract.
2. Gharar Fahish (major or excessive)
This type of gharar is not tolerated and may result in contract void ability.

All jurists agree that gharar should be avoided in commercial exchange contracts. As Islamic Shari’a forbids riba
(interest) because it leads to exploitation and injustice in the society, it also forbids gharar in any transaction
to protect the two parties from deceit, ignorance and uncertainty.
DIFFERENCES AND
SIMILARITIES BETWEEN
ISLAMIC AND
CONVENTIONAL BANKING
There are two major difference between Islamic Banking and
Conventional Banking:
1)
Conventional banking practices are concerned with
"elimination of risk" where as Islamic banks "bear the risk"
when involve in any transaction.
2)
When Conventional banks involve in transaction with
consumer they do not take the liability only get the benefit
from consumer in form of interest whereas Islamic banks
bear all the liability when involve in transaction with consumer.
Getting out any benefit without bearing its liability is declared
Haram in Islam.
Major Differences between Islamic
and Conventional Banking System
Islamic System
1- Real Asset is a product. Money is just a medium of exchange.
 Conventional System
1- Money is a product besides medium of exchange and store of value.
 Islamic System
2-Profit on exchange of goods & services is the basis for earning profit
 Conventional System
2- Time value is the basis for charging interest on capital

Islamic System
3- Loss is shared when the organization suffers loss
 Conventional System
3- Interest is charged even in case, the organization suffers losses

Major Differences between
Islamic and Conventional Banking
System
Islamic System
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4- No expansion of money takes place and thus no inflation is created.

Conventional System
4- The expansion of money takes place, which creates inflation.

Islamic System
5- Due to control over inflation, no extra price is charged by the entrepreneur

Conventional System
5- Due to inflation the entrepreneur increases prices of his goods & services

Islamic System
6- Real growth in the wealth of the people of the society takes place, due to
multiplier effect and real wealth goes into the ownership of lot of hands.

Conventional System
6- Real growth of wealth does not take place, as the money remains in few hands.
DIFFERENCE BETWEEN
ISLAMIC AND
CONVENTIOANL BANKING
Islamic Banking
1) Functions and
operations are
based on
Sharia’h
principles
Conventional
Banking
1)Functions and
operations are
based on fully
man made
principles
DIFFERENCE BETWEEN
ISLAMIC AND
CONVENTIOANL BANKING
Islamic Banking
2) Promote risksharing between
provider of
capital
(investor) and
user of funds
(entrepreneurs)
Conventional
Banking
2) Investor is
assured of predetermined
rate of interest
DIFFERENCE BETWEEN
ISLAMIC AND
CONVENTIOANL BANKING
Islamic Banking
3) Aim at
maximising
profit but
subject to
Sharia'h
restrictions
Conventional
Banking
3) Aim at
maximising
profit without
any restrictions
DIFFERENCE BETWEEN
ISLAMIC AND
CONVENTIOANL BANKING

Islamic Banking

4) Partners,
investor and
traders, buyer or
seller
relationship

Conventional
Banking

4) CreditorDebtor
relationship
DIFFERENCE BETWEEN
ISLAMIC AND
CONVENTIOANL BANKING
 Islamic

Conventional
Banking
 5)

5) Based on money
trading. Money is a
medium of
exchange and not a
commodity, its sale
and purchase is
prohibited in
Islam.
Banking
Encourage
asset-based
financing and
based on
commodity
trading
DIFFERENCE BETWEEN
ISLAMIC AND
CONVENTIOANL BANKING

Islamic Banking

6) No right of
profit if there is
no risk involved.
The profit and
loss sharing
depositor may
lose money in
case of loss.

Conventional
Banking

6) It is almost
risk free banking
and depositor
has no risk of
losing its money
because interest
is guaranteed.
PRINCIPLES OF
ISLAMIC
BANKING
a) Prohibition of Interest :
Riba best translated today as the charging of any
interest, meaning money earned on the lending
out of money itself.
B. The prohibition on paying or receiving fixed
interest is based on the Islamic tenet that money
is only a medium of exchange, a way of defining
the value of a thing; it has no value in itself, and
therefore should not be allowed to give rise to
more money, via fixed interest payments, simply
by being put in a bank or lent to someone else.
C. The human effort, initiative, and risk involved in
a productive venture are more important than
the money used to finance it.
A.
PRINCIPLES OF
ISLAMIC
BANKING
b) Profit and Loss Sharing :
i.
ii.
iii.
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,
utilizing the funds at risk on a profit-and- losssharing 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.
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.
PRINCIPLES OF
ISLAMIC BANKING
c) Sharia’h Approved Activities
Islamic financial system encourages,
performing only those business
activities which conform to Islamic
Sharia’h.
B. All the activities which do not conform
to the Islamic rules and laws are not
permissible and dealing in such activities
will be dealt with serious consequences.
A.
CRITICISM OF ISLAMIC
BANKING
I.
II.
III.
IV.
V.
VI.
Some Islamic banks charge for the time value of money, the
common economic definition of interest (riba).These
institutions are criticized in some quarters of the Muslim
community for their lack of strict adherence to Sharia’h.
The concept of Ijarah is used by some Islamic Banks to
apply to the use of money instead of the more accepted
application of supplying goods or services using money as a
vehicle.
A fixed fee is added to the amount of the loan that must be
paid to the bank regardless if the loan generates a return on
investment or not.
The reasoning is that if the amount owed does not change
over time, it is profit and not interest and therefore
acceptable under Shariah.
Islamic banks are also criticized by some for not applying
the principle of Mudarabah in an acceptable manner.
Where Mudarabah stresses the sharing of risk, critics point
out that these banks are eager to take part in profit-sharing
but they have little tolerance for risk.
CRITICISM OF
ISLAMIC BANKING
The majority of Islamic banking clients are
found in the Gulf states and in developed
countries.
II. The majority of financial institutions that
offer Islamic banking services are majority
owned by Non-Muslims.
III. With Muslims working within these
organizations being employed in the
marketing of these services and having little
input into the actual day to day
management, the veracity of these
institutions and their services are viewed
with suspicion.
I.
SCOPE OF ISLAMIC
BANKING
 Islamic
banking is one of the growing domains of
banking which shows promise for the future.
Furthermore, it has so far remained undeterred
to a larger extent from the current financial
crises.
 It is about time to develop even more innovative
Islamic instruments which can meet the needs of
the customers in a religiously viable way.
 It is important that these instruments do not defy
the laws of Islam and the confidence of the public
at large is not shattered.
 Islamic banking is one beacon of hope for all the
conventional banks that have suffered the crunch
due to high speculation and ethical violations of
business norms.
The Performance of
the Islamic Banks
 Islamic
banking has become today an
undeniable reality.
 The number of Islamic banks and the
financial institutions is ever increasing.
 New Islamic Banks with huge amount
of capital are being established.
 Conventional banks are opening
Islamic windows or Islamic subsidiaries
for the operations of Islamic banking.
The Future of Islamic
Banking
Islamic banking is here to stay.

 financial
institutions predict that Islamic
finance will be the world's fastest-growing
banking sector for years.
 with a predicted modest estimate of 20
percent annual increase in deposits.
 bankers are realizing that Islamic banking
is big business that is only getting bigger
 Japan is also planning to start Islamic
banking
Unit-II
Wadiah (Deposit)
In Islamic
Banking (Domestic
Operations)
Introduction
There is no doubt that each bank needs financial
sources for funding, money bank rate is small
relative to the total funds used.
 In general Banking Deposits is one of the most
important sources of funds in banks , it has been
offered through Bank definition that has two ways
borrowing from depositors , and lending to
borrowers.

 Bank
Deposits have two types:
1) Deposits of certain things like gold or
documents at the bank where placed in safes Pay.
2) Cash deposits, which is that we are talking
about.
And cash deposits in Islamic banks vary in terms
of recovery time.
Wadiah
Wadiah is a contract ( Aqed ) between
the owner of goods and custodian of the goods.
1- To protect the goods from being stolen,
destroyed etc.
2- To ensure the safe custody of the goods.
3- Operates under the contract of Wadiah Yad
Dhamanah (guaranteed custody), The al-wadiah yad
Amanh contract says that the bank will provide
deposits protection and honor all withdrawals on
call provided that it is allowed to use deposits to
generate earnings.
4- The bank accepts deposits from its customers
looking for safe custody and convenience.
5- The bank requests permission to make use
of the customers’ funds for investment purposes.
Wadiah
6- The customers may withdraw their balances
at any time.
7- Profit generated from the use of the customers’
funds belongs to the bank. However, the bank may
at its absolute discretion rewards the customers
by declaring profits to them.
Under the contract of Wadiah:
1- The custodian i.e. the Bank is not allowed to
mention or to promise any reward on the deposit
received.
2- The owner/depositors too cannot demand any
rewards or return from their Bank on their savings.
3-Wadiah is purely a contract on safe custody of
goods without any promise on rewards or returns.
Types of Bank Deposits in
Islamic Banks

Islamic banks provides many types of
deposits that meet the needs of the
world , and fit all segments of society
from individuals and companies,
including (Islamic current account Islamic Savings Account - Islamic
Investment Account), and is handled
these types according to regulations of
Islamic law.
Types of Bank Deposits in
Islamic Banks

Demand Deposits (Current Accounts)
Current accounts are based on the principle of al-wadiah ,
and it defines that:
“The current account, a service offered by Islamic banks to
customers, and through the customer can keep his
money in the bank, with full warranty provided by the
bank, and can withdraw it at any time they want without
notice and without getting any benefit, or payment or
any financial obligation on it - through the bank - at any
time, either through issuing checks, or debit balance, or
through the bank's branches, or through automated
teller machines (ATM), which operates throughout the
day, as a customer can pay for purchases through POS
machines (POS) deployed in the market”.
Demand Deposits
(Current Accounts)
1- All Islamic banks operate current accounts on behalf of
their clients: individuals and business firms.
2- These accounts are operated for the safe custody of
deposits and for the convenience of customers.
3-The bank guarantees the full return of these deposits on
demand and the depositor does not gain any share of
the profit or any other return in any form.
There are two dominant views about
Current Accounts:
1- To treat demand deposits as Amanah. A "Trust
Account" instead of a current account.
2- The other view is to treat demand deposits as Qard
Hasan (or interest free loan).
According to this view the bank is free to utilize these
funds at its own risk without return to, or authorization
from, the depositors.
Current Accounts
1- Current accounts are based on the principle of al-wadiah ,
whereby the depositors are guaranteed repayment of their
funds.
2- At the same time, the depositor does not receive
remuneration for depositing funds in a current account,
because the guaranteed funds will not be used for Profit and
Loss Sharing (PLS) ventures.
3- Current Accounts can be opened either in domestic
currency or foreign currency.
4- Current Accounts holders have the right to draw cheques
on their accounts.
5- This account consists of several types, that are: Individual
Account, Joint Account, Partnership Account, Government
Account , Private Company Account, Company Account,
Association Account.
Current Deposits In
Islamic
Banks
-Very Similar to standard commercial
banks
- No return paid back to depositors
- Checking facilities
1- Are Current deposits a loan to the
bank from depositors ?
2- Are Current deposits a trust by
depositors to banks ?
3- Use of Current deposits by the banks
on their own risk.
Islamic Savings
Account
 Savings Account
Islamic Savings Account defines as “that combines
the advantages of the current account and
investment account, where the client can draw
from the account whenever he wants, from both
branches or through automated teller machines
(ATM), or pay for purchases through POS
machines (POS), and at the same time the
customer can get a return on the remaining
balance in the account, according to Mudaraba
contract, which includes distribution Ratios
between the bank and the client at the beginning
of the contract, as a percentage of the profits
resulting from customer financing”.
Savings Accounts



Savings accounts also operate under the alwadiah principle.
Savings accounts differ from current deposits in that:
They earn the depositors income: depending
upon financial results, the Islamic bank may decide
to pay a premium ,hiba ,at its discretion, to the holders
of savings accounts.
Saving Deposits Operates In Different Ways:
1- Saving deposits without authorization to
invest.
In the Islamic Banks the depositors allow the banks to
use their money but they obtain a guarantee of getting
the full amount back from the bank, but no profits
promised from the bank.
Saving Deposits
2- Saving deposits with authorization to
invest.
In other banks saving accounts are treated as
investment accounts , the banks request a
permission to use this funds so long as these
funds remains with the bank ,but with less
stringent conditions as to withdrawals and
minimum balance.
Return to depositors who provide authorization
to invest.
3- Saving deposits as a part of trust accounts.
4- Saving deposit as Notice account.
Investment Accounts
 Islamic
Investment Accounts: is
"money deposited by their owners with Islamic
banks in order to obtain a return“.
 These accounts subject to “hold speculative
legitimacy", where the BID to invest these funds
in the areas of work are legitimate.
 Distributed profits generated between the bank
and the customer, depending on the proportions
percentage to be determined when the contract
signed.
 The bank gets a share of the profits for the
effort, and the customer gets a share of the
capital return.

Investment Accounts
 The
subject of this investment accounts
to base legitimacy “It means
participation in the profits and losses, and
this does not mean that the client
vulnerable to lose part of its capital.
 Islamic banks provide funding to
customers through Murabaha or
participation they get guarantees for the
preservation of funds depositors.
 Funding is granted to the customer after
do feasibility studies that show the
success of the project.
Investment Deposits
1- Investment accounts identify timed a year - in most
cases, and can add profits to the customer's account.
2- Investment account is not entitled to the client
withdrawals from the investment account during that
period.
3- Investment account in emergency situations, the client
can draw with a discount portion of the profits for the
amount that has been withdrawn from the account.
Investment Account
An investment account operates under the mudaraba
al-mutlaqa principle, in which the mudarib (active
partner) must have absolute freedom in the
management of the investment of the subscribed capital.
Investment Deposits
Islamic Banking counterpart of Fixed Deposits.
 Withdrawal allowed only in special cases
Investment deposits as Mudarabah Accounts.
 Depositor; Rabbal Mal; Bank: Aamil
Share profit on agreed basis, bear full loss.
Investment pool
Distribution of profits on pro rata basis.
 Special investment accounts
Special investment accounts also operate
under the mudaraba principle, and usually are
directed towards larger investors and
institutions.
Bank Teller
A Bank Teller
is a member of the staff of a bank who
deals directly with the public and handles
routine banking transactions like deposits,
withdrawals, and so forth. For many people,
bank tellers are iconic figures, since they
represent the face of the bank to the
public.
1. Employment in this profession is actually
shrinking, because some people have
turned to Automated Teller Machines
(ATMs) and online banking since they find
these services more convenient.

Bank Teller
The job requirements for becoming a bank
teller are fairly minimal.
3. He or she must have a University Degree,
diploma ,high school and exhibit an ability to
perform basic math functions.
4. Bank tellers must also be comfortable with
members of the public and with handling
large amounts of money.
5. They are also expected to be extremely
attentive and discreet, and in some regions a
bank teller may need to pass a law
enforcement background check before he or
she can be hired.
2.
Bank Teller
In a workday, a bank teller might accept cash or
checks for deposit, cash checks drawn on his or
her bank, issue funds like money orders and
traveler's checks, and handle transactions
related to savings accounts.
7. A bank teller also usually promotes services
offered by the bank, such as loans, retirement
accounts, and insurance; if a customer expresses
interest in these services, the teller refers him
or her to another bank employee who
specializes in these offerings.
8. A bank teller might also provide access to safe
deposit boxes, if a bank offers this service.
6.
Clearing House
a place or institution where mutual claims and accounts are
settled, as between banks.
or
a central institution or agency for the collection, maintenance,
and distribution of materials, information, etc.
Development of clearing and settlement
arrangements (1)
What banks clear and settle: claims on other
banks
II. Can have banks without having interbank
settlement!
III. Over time, banks increasingly redeemed claims
on other banks
I.
I.
Differs according to payment instrument
Clearing House
Development of clearing and
settlement arrangements (2)
Economic pressures for banks to
accept claims on other banks:
i. Demand from customers – to make
bank money more liquid
ii. Accepting bank can issue its own
money
iii. Disciplines other banks
Clearing House
Development of clearing and
settlement arrangements (3)
But costs in accepting claims on
other banks;
1.
2.
3.
4.
Credit risk
Clearing the payments
Holding the settlement asset
Transferring the settlement asset
Clearing House
Development of clearing and settlement
arrangements (4)
But costs in accepting claims on other
banks:
A. Credit risk (frequent settlement rounds)
B. Clearing the payments (route payments
via ‘nodes’)
C. Holding the settlement asset (netting)
D. Transferring the settlement asset
(exchange paper or book entry claims)
•
•
•
•
•
•
•
•
•
•
Automated Clearing
House
(ACH)
Nationwide wholesale electronic payments
system
Transactions not processed individually
Banks send transactions to ACH operators
Batch processing store-and-forward
Sorted and retransmitted within hours
Banks
Originating Depository Financial Institutions
(ODFIs)
Receiving Depository Financial Institutions
(RDFIs)
Daily settlement
Posted to receiver’s account within 1-2
business days
Automated Clearing
House (ACH)
I.
II.
III.
IV.
V.
VI.
VII.
High-volume, small value payment orders
between financial institutions
largely recurring payments: payroll,
mortgage, car loan, Social Security
Automated Teller Machines (ATM)
Debit-card point-of-sale payments
Telephones or PC bill payments.
Direct deposit (e.g. payroll)
Electronic benefits transfer
Automated Clearing
House (ACH)
Wholesale Payments
SWIFT (Society for Worldwide Interbank Financial
Telecommunications) (non-profit, Brussels).
 Financial messaging system, not a payment system,
Settlement must occur separately Instructions
between financial institutions.
 7125 institutions, 193 countries.
 1.27 billion messages per year: $5 trillion per day.
2/3 are banks trading for their own accounts.
Settled through transfers in respective currencies
(must have accounts in both currencies).
Herstatt risk (pay out one currency before
receiving the other -- cascading effect).

Unit-III
Finance and
Investment in
the Islamic
Banking (Domestic
Operations)

Permissible
Financing
Methods
Cost-plus sales (murabaha).
 Credit

sales (bay‘ bi-thaman-ajil) .
Leasing (’ijarah or ’ıjar).
 Partnerships
 Islamic
(musharaka and mudaraba).
forwards (salam and ’istisna‘) .
Cost-plus sales (Murabaha)
THE CONCEPT
Murabaha is a contract of sale where the
seller discloses to the buyer the actual
cost of the item to be sold in addition to
the profit margin (mark up) added, to
be mutually agreed upon with the buyer.
 It is important to note that in classical
fiqh, murabaha refers to sale (bay’), with
all its implications and prescribed
Shari’a conditions pertaining to sale, and
has nothing to do with financing in the
conventional sense.
Cost-plus sales (Murabaha)
Murabaha financing is a widely used
contract in contemporary Islamic
banking and finance; and it is limited to
cases where the customer actually
needs to purchase some commodity.
Its used in modern day trade financing
With regard to Islamic banking, Murabaha
is an agreement wherein the bank
purchases, at the request of a customer,
a specified item, and then sells it to him
at a mutually agreed marked-up price.
Cost-plus sales (Murabaha)


In this sale, the buyer knows the price at which the seller
obtained the object to be financed, and agrees to pay a
premium over that initial price.
Basic concept: Sale on mutually agreed profit margin on the
known cost of goods; payment of sale price is deferred.

Real, tangible goods to be traded and not papers of debt or
credit documents.

Murabaha cannot be used as mode in case no commodity is
purchased by the client.

Buy-back arrangement: not allowed.

MUAJJAL; Credit price may include margin of mark-up, taking
into consideration the deferred payment. As a debt, no return
can be charged on the amount of Note/Bill.
Cost-plus sales (Murabaha)
‫تذكير الطالب بحفظ على االقل اربع فروق‬
1.
2.
Thus, one may approach an Islamic
financial institution and say “purchase
this item on my behalf at this price, and
I shall give you a profit (’urbihuka)
margin of $10”, or “purchase this item on
my behalf at this price, and I shall give
you a profit (’urbih.uka) margin of 10%”.
The fact that the latter statement may
be perceived to make explicit a
percentage payment should not be of
concern, since it is not Riba if the sale
satisfies the conditions of Murabaha.
Cost-plus sales (Murabaha)
3.
Notice that in this contract, the Islamic
bank or financial institution must own
the item at the time the customer buys
it from them with the specified profit
margin.
 Examples of Murabahah
 Two contracts:
I. A contract of intent to conduct a
Murabaha Sale.
II. Another contract to buy the good
ordered in previous contract.
Cost-plus sales (Murabaha)
1.
I.
II.
2.
3.
4.
The word MURABAHA is derived from the word Ribh,
meaning profit in Arabic.
Sale with a profit.
Cost-plus financing.
Promise is not a legal binding. It introduces an
element of risk in the transaction.
The element of risk justifies the profit in
Murabaha sale : Fiqhi principle : Al Kharaj bi
Daman.
Applications of Murabaha:
i. In domestic trade
ii. In foreign trade
iii. In financing consumer durables
iv. In financing Real Estate
Credit sales (bay‘ bi-athamn
aajil)
Definition
It is a sale contract in which the payment of the
price is deferred and payable at a certain
particular time in the future. and receipt the goods
immediately.
 Installments Sale permissible, even if the
deferred price exceeds the spot price.
 Deferred prices can vary so long as price not
finalised.
 Sale cannot take place until the parties agree to a
particular price & mode of payment.
 Not permissible to fix the spot price on cash
basis, then to charge interest expressly tied with
different periods.
 Commercial papers are lawful types of
authentication of a debt by putting it down in
writing; - Treated by Shariah near to mandatory.
Credit sales (bay‘ biathaman ajil)
1)
2)
Very rarely is Murabaha used by
Islamic banks with the price paid
immediately by the customer.
In such cases, there would be no
financing included and the Islamic
bank would simply be a middle-man
or broker-agent (simsar).
Leasing (ijarah or ıjar)
1)
2)
3)
4)
5)
6)
Legally, the lease contract is not a sale of the object,
but rather a sale of the usufruct (the right to use the
object) for a specified period of time.
The sale of usufruct is permissible in Islam, as
evidenced by the verses.
The corpus of the leased asset should exist till the expiry of
lease period.
The corpus of the leased asset should remain in the
ownership of the lesser during the whole period of lease; in
case of Shirkah pro-rata ownership.
The lesser must accept responsibility of any defect in leased
asset (without negligence of the lessee) which hinders the
intended use of asset.
Sale – Separate and independent contractor
Leasing (ijarah or ıjar)
The most important financial difference between
Islamic permitted leasing and conventional
financial leasing is that the leasing agency must
own the leased object for the duration of the
lease.
i.
Ijarah is emerging as a popular technique of
financing amongst the Islamic banks
ii. Elements of a lease contact: Lesser, Lessee,
instrument and period of lease.
iii. The asset remains in the ownership of the
lesser. Maintenance is the responsibility of the
owner.
iv. Ijarah muntahi bit tamlik ‫االيجار المنتهي بالتملك‬
Partnerships
(Musharaka
and
Mudaraba)
MUDARABA
Definition of Mudaraba
Mudaraba is a partnership in profit
whereby one party provides capital
and the other party provides skill
and labour.
The provider of capital is called
“Sahib al-maal” while the provider
of skill and labor is called “Mudarib”.
Types of Mudaraba
Mudaraba Contracts are generally
divided as under:
 Unrestricted Mudaraba and
 Restricted Mudaraba.
A. Unrestricted Mudaraba:
Unrestricted Mudaraba may be defined
as a contract in which the Sahib almaal permits the Mudarib to
administer the Mudaraba fund without
any restriction.
Types of Mudaraba
B.
Restricted Mudaraba
Restricted Mudaraba may be defined as a
contract in which the Sahib al-maal restricts
the actions of the Mudarib to a specified
period or to a particular location or to a
particular type of business.
Terms and elements of Mudaraba:
 Contracting
Parties
There are two contracting parties in Mudaraba:
1. The provider of the capital i.e. ‘Sahib al-maal’
and
2. The Mudarib.
Terms and elements of
Mudaraba
 Capital
Capital is the amount of money given by
the provider of funds i.e. Sahib al-maal to
the Mudarib with the purpose of investing
it in the Mudaraba business.
 Profit & Loss
Profit should be for both Sahib al-maal and
Mudarib as per agreed ratio. Loss should
be borne by the Sahib al-maal.
The main features of
Mudaraba
a) There should be two parties: Sahib al-maal
(financer/Investor) and businessman is Mudarib (Who
provides skill and labor).
b) There should be written agreement/contract between
the Bank and the businessman which includes nature of
business, period/time, sharing of profit etc.
c) Bank will finance and the businessman will run the
business by providing his labor & skill.
d) The Bank will not interfere in the business.
e) The businessman will appoint employee(s) and he will
run the business independently.
f) The Sahib al-maal /Financier/Investor reserves the right
to check/verify the accounts of the business at any time.
MUSHARAKA
Definition of Musharaka
Musharaka is a contract of partnership
between two or more parties in which
all the partners contribute capital,
participate in the management, share
the profit in proportion to their capital
or as per pre-agreed ratio and bear the
loss, if any, in proportion to their
capital/equity ratio.
Types of Musharaka
In the context of Islamic Banking financing,
Musharaka may be of two types:
A. Permanent Musharaka
B. Diminishing Musharaka
 Permanent Musharakah:
partners can sell - as in case of Shares of
Joint Stock Companies.
 Temporary (Redeemable) Musharaka:
for limited time period, e.g After agreed
time period(s),
 Diminishing Musharakah:
one partner promises to buy the share of the
other partner gradually until the title to the
property is completely transferred to him.
Permanent Musharaka
Permanent Musharaka may be defined
as contract of partnership business
between the Islamic Bank and its
clients in which the Bank participates
in the equity and share the profit at a
pre-agreed ratio or bear the loss, if any,
in proportion to the ratio of
capital/equity where termination
period of the contract is not specified.
This is also called continued Musharaka.

Diminishing Musharaka
Diminishing Musharaka is a special form
of partnership in which one of the
partners promises to buy the share of the
other partner gradually until the title to
the equity is completely transferred to
him.
 In Diminishing Musharakah: Loan of Service Charges. Only
administrative expenses can be charged.
 Interest free loans are provided as a
social service.

Musharaka
Contracting Parties
There are two or more contracting parties
known as partners, It is a condition that all
the partners should be competent to give or
be given power of attorney.
1. Capital:
Capital contributed by the partners may be
in the equal or unequal and in the form of
cash or cash equivalent, goods &
commodities, assets or properties etc.
2. Distribution of Profit:
Profit should be distributed among the
partners as per their ratio of capital or as
per agreement.
•
Some Important
Features of Musharaka
Capital should be specific.
2) Equal share is not a must.
3) Nature of capital may be money or
valuables.
4) Active participation of partners.
5) Ratio of profit prefixed.
6) Variation in share of profit permissible.
7) Participation and sharing profit & loss.
8) Partners retains the ownership and
right to management.
1)
Musharakah
 Musharakah is from the word Sharikah.
1. More than one partners: Partnership in
capital proportion and project
supervision.
 A partner may waive his right of
supervision or delegate it to another
partner.
2. Arrangements: Sharing of Profit and
loss in accordance with capital
proportion agreed proportion.
3. Variant: Share of profit in agreed
proportion, share of loss in capital
proportion.
4. Applications of Musharakah:
i. in Import trade
ii. In Agriculture
Difference
between
Mudaraba and
Musharaka
Difference between
Mudaraba and Musharaka
a)Mudaraba
1.The capital in Mudaraba is the sole
responsibility of Sahib al-maal.
2. In Mudaraba, the Saheb al-maal has no
right to participate in the management
which is carried out by the Mudarib only.
3. In Mudaraba the loss, if any is suffered by
the Sahib al-maal only, because the
Mudarib does not invest anything, His loss
is his labor and skill.
Difference between
Mudaraba and Musharaka
b) Musharaka
1. In Musharaka it comes from all the
partners.
2. In Musharaka, all the partners can
participate in the management of the
business and can work for it.
3. In Musharaka, all the partners share
the loss to the extent of the ratio of
their investment.
Salam and Parallel Contracts
(Future Sale)
1)
Prepayment of price in full for goods to be
delivered in future.
2)
Allowed by Holy Prophet (SAW) himself to meet
farmers’ money need.
3)
Banks will receive contracted commodities, not
money.
4)
Parallel Salam:
a bank can sell a commodity
purchased through Salam for even the same date
of delivery or the quantity;
As long as the two contracts are not made
conditional on each other.
Purpose of Salam
To meet the need of farmers who need
money to grow their crops and to look
after their family up to the time of
harvest.
ii.
To finance someone who is in need to grow
something or acquire something for further
sale.
iii.
To meet the need of traders for import
and export business.
iv.
The buyer also enjoys a lower purchase
price, since he pays in advance.
v.
Acceptance of Time.Value of Money
through pricing of goods.
i.
Salam Conditions
I.
Fungible – homogeneous goods
II.
not where delivery has to be simultaneous, e.g. Gold, silver
or currencies.
III.
Date and place of delivery must be specified in the contract.
IV.
In case of a number of commodities, the amount and
delivery period should be separately fixed.
The bank can sell the Salam Commodity through a parallel
contract of Salam for the same date of delivery.
For a parallel Salam, the two contracts should be
independent and separately enforceable.
Bank can also obtain a unilateral ‘promise to purchase’ from
a third party.
Agency
To sell anywhere in the market
V.
VI.
VII.
VIII.
IX.
Unit-IV
ISSUES IN
ISLAMIC
BANKING
The Concept of Letter of
Credit in Islamic Banking
1.
2.
3.
4.
5.
6.
It is a facility extended by the banks to the traders and the
businessmen.
The purpose of opening letters of credit is to facilitate speedy
and simple payment and the transfer of money from one
particular spot to one more.
This facility, currently being a lawful support, has to be
effectively compensated in terms of Shariah.
If the payment of compensation or remuneration is connected
with the quantity of services, the Shariah has no objection.
In this case it will be a kind of service cost which has’ been
already thought to be and approved by nearly all the
contemporary scholars and learned bodies.
In this situation it will be necessary that the rate of support
charge is established maintaining in watch the magnitude of the
service, quickness of the payment and the stage of credibility
and performance of the lender concerned.
Parties in Letters
of Credit
Can be summarized as follows:
i.
The Applicant (Demanded opening credit)
Demanded Opening Credit that means the bank's
customer (importer), which gives instructions to the
bank to open a letter of credit for the supply of
certain material for a demanded.
ii.
A Bank that Opens a Letter of Credit
Which is committed to the correspondent bank
According to the formula and terms of credit to pay
the value when submitted documents which required
to be identical to the accreditation requirements.
iii.
iv.
Parties in Letters
of Credit
(The beneficiary) or the so-called (The seller)
The beneficiary of the opening credit (seller) be obliged
to create the goods agreed with the buyer (The buyer)
within a specified period agreed upon in.
Confirming Bank ) Advance Bank installer)
This installation adds the Bank (reinforcement) on the
letter of credit for a commission obtained from (buyer
or seller) which in fact gives a true guarantee for the
vendor to receive the value of the documents provided
by the seller , even if the buyer does not pay for the
value of those documents.
Types of Letter of
Credit
Irrevocable Documentary Credits can be
divided into two types :1/ Letter of credit is irrevocable and is not installed
The so-called (Irrevocable unconfirmed L / C).
2/ Letter of credit is irrevocable (enhanced) installed.
3/ convertible or Transferable L / C.
4/ Revolving credits are called (Revolving L / C) can
be divided into two types :
a) (Cumulative Revolving).
b) (Non Cumulative Revolving) .
Types of Letter of
Credit
5/ Back to back (L / C).
6/ Agreed Documentary Credits , called
(Standby credit) used only in American
banks.
7/ Prepayment Credits.
8/ Payment on Credit Allocations
called (deferred payment).
9/ Red Clause Credit.
Mechanism to Open Letter of
Credit
How to open letter of credit can be summarized as follows:
A) Demanded letter of credit open a current account to the section that
deals with him.
B) Financial Balance of the Account is sufficient to cover the value of
documents.
C) The client requires some special procedures for the purpose of opening
a documentary credit.
Form open a letter of credit, which includes the following
information:
- Name of the buyer.
- The name of the beneficiary.
- Commercial lists.
- Shipping documents.
- The type of insurance.
- Shipping type (single shipment or multiple shipments).
- Port forwarding.
- Final destination.
Letter of Guarantees

LETTER OF GUARANTEE
is a written promise issued by a bank to compensate (pay a sum
of money) to the beneficiary (third party, local or foreign) in the
event that the obligor (customer) fails to honor its obligations in
accordance with the terms and conditions of the guarantee /
agreement / contract.
 A bank guarantee is an undertaking by the bank at the request of
a party, whereby the bank – in the event of default by the
principal in the fulfillment of his obligations to make payment to
the beneficiary within the limits of specified sum of money and
within the specified period of time. So, bank guarantees are
usually limited with respect to amount and time. As for as the
time is concerned - a grace period is usually granted to the
beneficiary to claim under the guarantee. This is basically given
for the time taken by the beneficiary to present his claim.
Letters of Guarantee can be in the form of Bank Guarantees,
Performance Bonds, Bid Bonds, Shipping Guarantees or Standby
Letter of Credit.
Types of Letter of
Guarantees
Types of Letter of Guarantees:
1.Conditional and Unconditional Guarantees.
2.Fixed and Fluctuating Guarantees.
3.Financial Guarantees.
4.Performance / Non-financial guarantees.
Need for a Letter of Guarantee
1.To provide an assurance of the intention of the
principal to sign the contract.
2.To safeguard against the principal failing to meet
his obligations under such a contract
3.To protect interest of a party awarding the
contract (beneficiary) in respect of the repayment
of payments and advances made by him in the even
of principal not fulfilling the contract terms.
Letter of Guarantee Parties and their differs interest
1.The beneficiary: He is the party inviting the tender or He is
the party awarding the contract or He is the person who wants
to receive a compensatory sum of money incase the tendered
fails to perform his obligations or fails to perform the contract
in accordance with its terms or to secure repayment of any
payment or advances made by him if the principal fails to
perform the contract.
2.The principal : He is the party tendering the contract or
He is the party to whom the contract has been awarded.
3.Guarantor : Guarantor is a party who will meet his
commitment in terms of the guarantee, without becoming
involved in possible disputes between beneficiary and principal.
4.The Instructing Party : The new rules recognize the
existing widespread practice whereby an instructing party may
forward to the guarantor instructions received from or on
behalf of the principal and counter-guarantee such instructions.

General Aspects of Letter of Guarantees
Benefits to the parties:
1. Benefits to the bank : It gets commission
income.
2. Benefits to the principal / Instructing
party :
(a) It enables better liquidity by deferring payment
and making it contingent on non-performance.
(b) Cheaper than fund-based facilities except where it
involves credit substitution.
3. Benefits to the beneficiary : Certainty of payment,
in the event of non-performance, guaranteed by the
bank.
2.
Important points to be noted before issuing
a guarantee :
Principal need to indemnify the bank
against all losses that the bank may incur in
the performance of its obligation to pay.
The bank can obtain further comfort by
specifying the place of payment under a guarantee
and the governing law.
1.
General Aspects of Letter of Guarantees
3. Date of expiry of the guarantee.
4. A bank guarantee can be amended.
5. Bank guarantee expires when the validity
period has ended or the BG is returned for
cancellation or the entire amount of BG is
paid by the bank or the bank is released
from its obligations.
6. Documents required :
For grant of Bank guarantee limits
Hypothecation / Pledge agreement for
collateral security formalities connected
with registration charges where necessary.
Thank
You