The Greatest Hadits of Riba

Narrated Sumurah bin Jundub ra.: Allah’s Messenger saw very often used to ask his Companions, “Did anyone of you see a dream?” So, dreams would be narrated to him by those whom Allah willed to relate. One morning the Prophet saw said, “Last night two persons (angels) came to me (in a dream) and woke me up and said to me, ‘Proceed! Proceed!’ I set out with them and we came across a man lying down, and behold, another man was standing over his head, holding a big rock. Behold, he was throwing the rock at the man’s head, smashing it.

The rock rolled away and the thrower followed it and took it back. By the time he reached the man, his head returned to its normal state. The thrower then did the same as he had done before. I said to my two companions, ‘Subhan Allah! Who are these two persons?’ They said, ‘Proceed! Proceed!’ So we proceeded and came to a man lying in a prone position, and another man standing over his head with an iron hook, and behold, he would put the hook in one side of the man’s mouth and tear off that side of his face to the back (of his neck), and similarly tear his nose from front to back, and his eye from front to back. Then he turned to the other (second) side of the man’s face and did just as he had done with the first side. He hardly completed that (second) side when the first side returned to its normal state. Then he returned to it to repeat what he had done before. I said to my two companions, ‘Subhan Allah! Who are these two persons?’ They said to me, ‘Proceed! Proceed!’ So we proceeded and came across something like a Tannur (a kind of baking oven, a pit usually clay-lined for baking bread).” I think the Prophet saw said, “In that oven there was much noise and voices.” The Prophet saw added, “We looked into it and found naked men and women, and behold, a flame of fire was reaching to them from underneath, and when it reached them, they cried loudly, I asked them, ‘Who are these?’ They said to me, ‘Proceed! Proceed!’ And so we proceeded and came across a river.” I think he said, “---- red like blood.” The Prophet sawadded, “And behold, in the river there was a man swimming, and on the bank there was a man who had collected many stones. Behold, while the other man was swimming, he went near him. The former opened his mouth and the latter (on the bank) threw a stone into his mouth whereupon he went swimming again. Then again he (the former) returned to him (the latter), and every time the former returned, he opened his mouth, and the latter threw a stone into his mouth, (and so on) the performance was repeated. I asked my two companions, ‘Who are these two persons?’ They replied, ‘Proceed! Proceed!’ And we proceeded till we came to a man with a repulsive appearance, the most repulsive appearance you ever saw a man having! Beside him there was a fire, and he was kindling it and running around it. I asked my two companions, “Who is this (man)?’ They said to me, ‘Proceed! Proceed! So we proceeded till we reached a garden of deep green dense vegetation, having all sorts of spring colours.

In the midst of the garden there was a very tall man, and I could hardly see his head because of his great height, and around him there were children in such a large number as I have never seen. I said to my companions, ‘Who is this?’ They replied, ‘Proceed! Proceed!’ So we proceeded till we came to a majestic huge garden, greater and better than I have ever seen! My two companions said to me, ‘Ascend up’ and I ascended up.” The Prophet saw added, “So we ascended up till we reached a city built of gold and silver bricks, and we went to its gate and asked (the gatekeeper) to open the gate, and it was opened and we entered the city and found in it men with one side of their bodies as handsome as the most handsome person you have ever seen, and the other side as ugly as the ugliest person you have ever seen. My two companions ordered those men to throw themselves into the river. Behold, there was a river (the city), and its water was like milk in whiteness. Those men went and threw themselves in it and then returned to us after the ugliness (of their bodies) had disappeared, and they became in the best shape.” The Prophet saw further added, “My two companions (angels) said to me, ‘This place is the ‘Adn Paradise, and that is your place.’ I raised up my sight, and behold, there I saw a palace like a white cloud! My two companions said to me, ‘That (palace) is your place.’ I said to them, ‘May Allah bless you both! Let me enter it.’ They replied, ‘As for now, you will not enter it, but you shall enter it (one day).’ I said to them, ‘I have seen many wonders tonight. What does all that mean which I have seen?’ They replied, ‘We will inform you: As for the first man you came upon whose head was being smashed with the rock, he is the symbol of the one who studies the Qur’an, and then neither recites it nor acts on its orders, and sleeps neglecting the enjoined prayers. As for the man you came upon, whose sides of mouth, nostrils and eyes were torn off from front to back, he is the symbol of the man who goes out of his house in the morning and tells lies that are spread all over the world.

And those naked men and women whom you saw in a construction resembling an oven, they are the adulterers-fornicators and the adulteresses-fornicatresses; and the man whom you saw swimming in the river, and was given a stone to swallow, is the eater of Riba; and the bad looking man whom you saw near the fire kindling it and going around it is Malik, the gatekeeper of Hell; and the tall man whom you saw in the garden, is Ibrahim (Abraham), and the children around him are those who die on Al-Fithrah (the Islamic Faith of Monotheism).’” The narrator added: Some Muslims asked the Prophet saw, ‘O Allah’s Messenger! What about the children of Al-Mushrikun?” The Prophet saw replied, “And also the children of Al-Mushrikun.” The Prophet saw added, ‘My two companions added, ‘The men you saw half handsome and half ugly were those persons who had mixed an act that was good with another that was evil, but Allah forgave them.’” [Sahih Al-Bukhari, 9/7047 (O.P.171)].

Brand is our Identity?

Have you found famous people whose clothes branded ‘anonymous’? Or their shoes found ‘no name’ brand? Or even their body using ‘no branded’ cosmetics? I bet you’ll say, “No!” or maybe “Almost Never..!!”

Absolutely, don’t even try to analyze them, because we, ourselves, couldn't live without “brand”. In fashion, for instance, we will choose the brand besides the style. We will rather choose those made by Calvin Klein than those with anonymous though they are more stylish. Or maybe, we won’t go out without putting up Revlon cosmetics on our faces, though there’re still other cosmetics without famous brand. Well, it’s natural, I guess. You may think that brand can identify how glorious you are or how trendy you are. Or you may think you can socialize and being approved by wearing those branded stuff? Well, again, it’s natural.

But, have you ever thought that we have the brand itself on our own? Yes, you are the brand of yourself.

Brand is made to identify something. We can differ which goods are good or bad by their brand. That’s why we chose A rather than B because A is having good quality than B. Then why we can be the chosen person while others not? Because we have ‘brand’ which have helped making ourselves good, better, or maybe the best. How people can be good, bad, worse, better, it all depends on how we take ourselves to act or to react or to behave on everything. We may find our community as our identity also. You may interest when you find out that most of the people in your community has the same unique behavior as yours. We sometimes called a community as ‘technology community’ or as ‘smart brain community’. That is because they are having good ability in technology or they can react fast to new things on technology. So other people would judge them as people who had brand on technology. So do you, what brand are you? Genius, generous, smart, beautiful, or even you name has a unique brand? Well, I guess it’s all up to you who chose the brand for yourselves.

As when we try to buy something and firstly we remember the brand, just reflect it to ourselves, how others will prefer to choose you to be their friend rather than others. That because we have a good brand that others like. Nevertheless, how people won’t respect you because of the bad image of your brand. So be careful, we have to be smart in deciding which brand is going to be ours. Because when you find difficult in changing the brand that you like to chose another better, then it would also difficult for people to chose you though you are better than others because of their brand has made choice.

Adequacy of Disclosure in Islamic Financial Institutions

Public disclosure through the publication of financial statements has long been the source of information on business performance of financial institutions. In recent years, however, financial institutions, under pressure from market forces, have started focusing on the disclosure of a wide range of information, including management policies, risk exposures and risk management practices. Given that disclosure disciplines management of financial institutions and helps to enhance the efficiency and transparency of the markets, it has acquired great significance in promoting the stability of financial systems.

Moreover, its importance in enabling investors and parties to assess risks and returns of investing in, or dealing with, a particular institution has grown due to the increasing number of risks that financial institutions now take. The expansion in the role of disclosure also encouraged regulatory authorities in various jurisdictions to make it legally binding on financial institutions to follow a set of certain minimum disclosures in their annual reports.

Like conventional banks/financial institutions, Islamic Financial Institutions (IFIs) are engaged in the business of dealing in money (collection of deposits and lending and investing). However, the fact, which distinguishes them, is that their dealings with depositors are based on profit and loss sharing rather than a fixed pre-determined interest. This signifies an IFI's fiduciary role where it is considered to be dealing in trust money. Thus depositors' / investment account holders' trust in an IFI's ability to achieve investment goals (to record profit) and make a fair distribution of the revenues between itself and the investment account holders (according to the Mudaraba agreement) become paramount in the continuity of the IFIs business.

Given this importance, IFIs are obliged to be transparent by making adequate disclosures to their investment account holders, not only with regard to their own financial condition as is the case with conventional banks but also in respect of the management of trust money. This is the area, going beyond disclosure, where topics such as participation of stakeholders in the corporate governance of IFIs and developing effective control and accountability mechanisms to enhance fiduciary relationships in IFIs become relevant.

In order to discuss the adequacy of disclosure in IFI's financial statements we take a brief look at AAOIFI's1 standards2, discuss the role played by these standards in improving the disclosure of information by Islamic financial institutions. We will then move on to review disclosure adequacy with regard to credit, investment and liquidity risks citing examples wherever appropriate.

Before elaborating on disclosure of information desirable in the IFIs financial statements, AAOIFI has set out Objectives and Concepts of Financial Accounting for Islamic Banks and Financial Institutions as a prelude to its financial accounting standards so that varying accounting policies can be harmonised. These statements are in addition to the 12 accounting, 3 auditing and 3 governance standards, which has been published till June 1999. The topics covered by the respective standards are as follows:

Financial Accounting Standards (FAS):

FAS 1 relates to general presentation and disclosure in the financial statements of IFIs. FAS 2-4 relate to different modes of financing (Murabaha, Mudaraba, and Musharaka). FAS 5 discusses disclosure of bases for profit allocation between owners' equity and investment account holders. FAS 6 covers equity of investment account holders and their equivalent. FAS 7 & 8 are about Salam and Ijarah (leasing) transactions, respectively. FAS 9 is about Zakah, FAS 10 relates to Istisna'a. FAS 11 is on provisions and reserves and FAS 12 relate to general presentation and disclosure in the financial statement of Islamic Insurance Companies. Auditing Standards for IFIs cover areas such as objective and principles of auditing, the auditor's report, and terms of audit engagement. AAOIFI's Governance Standards relate to Shari'a Supervisory Board (appointment, composition and Report), Shari'a Review, and Internal Shari'a Review.

A major achievement in the area of establishing concepts of financial accounting for Islamic banks & financial institutions, which improved disclosure, is the clarification of the position of investment account holders (depositors). Not a long ago, third party investment accounts were treated by IFIs either as deposits (similar to conventional bank deposits) or as funds under management, reported off balance sheet with no or little disclosure.

AAOIFI upholds that unrestricted investment accounts3, the largest funding source for the IFIs, are part of the financial position (balance sheet) of an IFI to be classified between a liability and equity capital. It is maintained that these investment accounts are not a liability for an IFI because an IFI is not obligated in case of loss to return the original amount of funds received from the account holders unless the loss is due to negligence or breach of contract. This fact alone has a substantial impact on the risk profile of IFIs. As investment deposits are not treated equivalent to conventional bank deposits, where banks are obligated to return principal amount of the deposit to the deposit holders, the risk to the IFI, as an institution, is considerably reduced. Consequently, shareholders' capital has now to absorb only that part of losses which arise as the share of IFI's own funds in lending and investing. At the same time, however, unrestricted investment accounts, despite being a partner in profit and loss sharing with the IFI, are not treated similarly to the shareholders of the IFI. This is because holders of investment accounts do not enjoy the same ownership rights (voting rights and entitlement to an IFI's profits in the form of dividends). The standards only recognise current accounts and other non-investment accounts as guaranteed by an IFI's owners' equity.

Funds provided by restricted investment accounts4 holders are not reflected as part of an IFI's financial position. The relevant information about such accounts is provided in the statement of changes in restricted investments and their equivalent or as a footnote to the statement of financial position (balance sheet), a treatment similar to that for funds under management.

AAOIFI has also clarified concepts and provided guidance for accounting policies to be followed with regard to different financing and investment modes (Murabaha and Murabaha to the Purchase Orderer, Mudaraba Financing, Musharaka Financing, Salam and Parallel Salam, Ijarah and Ijarah Muntahia Bittamleek, Istisna's and Parralel Istisna'a). While examining the standards related to these aspects, we confine ourselves to the assessment of disclosures with regard to credit, market and liquidity risks.

Disclosure of Credit Risk

With regard to credit risk, information on concentrations of financing assets by sectors/industries, geographical distribution, maturity and currency profile of the financing portfolio together with break up of financing facilities by collectability is considered important. General disclosure in the financial statements of IFIs, as required by AAOIFI standard FAS 1, cover concentration of assets risks (economic sectors, geographical areas), distribution of assets in accordance with their respective period to maturity or expected periods to cash conversion, disclosure of related party transactions.

However, the standard is ambiguous on the most critical information from collectability point of view, which helps the reader of financial statements to determine the extent of doubtful (non-performing) financing assets (sales receivables). The related disclosure that FAS 1 requires is that accounting policies adopted by the IFI's management for the recognition and determination of doubtful receivables and policies of writing off debts be disclosed. There is no definition of doubtful receivables given by AAOIFI.

In practice, however, some IFIs avoid making any mention of non-performing financing assets or the basis on which they make provision for doubtful receivables, particularly the specific provision. This is in contrast to the growing practice among conventional banks to give a break up of their overdue/non-performing loans so that to help the reader in analysing the relative level of credit risk.

To illustrate further, a large Islamic bank (Shamil Bank, former Faysal Islamic Bank) did not provide information on overdue or non-performing facilities in their 1999 financial statements (prepared according to AAOIFI standards) whereas the same has been provided in 1998 accounts (prepared in accordance with the IAS5). However, another IFI (Bahrain Islamic Bank) has provided information on non-performing financing facilities in its accounts for the years 2000 and 1999 as it follows both AAOIFI standards and IAS. Given that the information on non-performing/overdue facilities is a key indicator of the credit risk profile of a financial institution, CI believes that this disclosure inadequacy needs to be covered.

Under AAOIFI standards, disclosure regarding Murabaha sales receivables, the major type of financing conducted by IFIs, is largely focused on two factors. One, on the separation between financing jointly financed by the IFI's and unrestricted investment account holders' funds and financing exclusively financed by the IFI's own funds. The purpose of this disclosure requirement is to separate an IFI's own assets from the assets managed for others (investment account holders) and thereby helping in the assessment of fiduciary risk, to some extent. Second, on the maturity profile of assets and liabilities, to help in the estimation of liquidity risk taken by the IFI by identifying maturity mismatches.

Disclosure of Investment / Market Risk

The assessment of risk that arises from investments in equities or other investments (e.g., property) is as important as financing or credit risk due to the high proportion of such assets in the financial position of IFIs. This is because these investments are considered more Shari'a compliant than Murabaha financing which differs from conventional lending only in semantics. AAOIFI's standard on such items (FAS 1: general presentation and disclosure in the financial statements of IFIs) limit itself to the statement that 'disclosure should be made of the net realisable value of an asset if such value is less than the asset's recorded amount. However, all expected losses should be recognised when reasonably measurable'.

If we look at the financial statements of IFIs which have adopted AAOIFI standards, we observe that investment in shares/securities has been classified into marketable securities, related/associated companies investments, investment in funds portfolios and short term/long term Mudaraba investments. From a risk assessment point of view, the market value of marketable securities has been provided together with movement in provisions for securities. However, it is observed that IFIs do not disclose NAV of their investment in mutual funds (either their own or managed by third parties) or fair value information about their Mudaraba investments (a partnership in profit between the IFI and business owners where funds are provided by the IFI). Both these investments are substantial in the case of some IFIs and therefore limited disclosure in the financial statements force users of financial statements to make subjective assessments of the riskiness of such investments. IFIs should be encouraged to provide adequate disclosure in this regard.

In the case of Mudaraba, this disclosure may include an explanation of the reason for not giving fair value, principal characteristics of the investment, information about the market for such investment as is required under IAS 32. This can assist users to make their own judgements about the possible differences between the carrying amount of these investments and their estimated fair value. As regards investment in real estate, the current market value of real estate is disclosed in the notes to the financial statements of IFIs, a disclosure that appears adequate.

Disclosure with regard to Liquidity Risk

Liquidity of IFIs is generally good because of the concentration of their financing operations in self-liquidating short-term Murabaha financing and commodity backed placements with banks. However, there are serious concerns regarding their macro level liquidity - ability of these institutions to generate funds from other banks (including central banks) in the event of financial distress. The fears arise principally because of IFI's rejection of interest as a cost for the use of money. Although, by practice, majority IFIs does have arrangements to keep compensating balances6 with other financial institutions and even with central banks, to meet or provide for the urgent liquidity needs of the respective counterparties, these balances are not disclosed in the financial statements.

AAOIFI's disclosure requirements (FAS 1) demand that disclosure be made of any amount an IFI is obligated to deposit with others as compensating balances. However, we observed that financial statements of IFIs that follow AAOIFI standards never state anything to this regard. A good example of adequate disclosure in this regard is Kuwait Finance House which discloses such compensating balances as 'balances with banks and financial institutions - exchange of deposits, both on the assets and liabilities sides of the balance sheet. CI believes that such presentation of compensating balances alleviates the fears of other counterparties regarding the inability of IFI's in obtaining funds from the inter-bank market due to the non-payment of interest. This necessitates the need for making such disclosure mandatory by the regulators of IFIs in their respective jurisdictions.

Islamic Banking: True Modes of Financing

Prohibition of interest is ordained in Islam in all forms and intent. This Prohibition is strict, absolute and unambiguous. The Holy Qur'an in verse 278 of Surah Al-Baqarah states:

"O ye who believe! fear Allah and give up what remains of your demand for riba, if ye are indeed believers." and verse 2: 279 says "If you do it not, take notice of war from Allah and His Messenger. But if ye turn back, ye shall have your capital sums. Deal not unjustly and you shall not be dealt with unjustly."

It therefore, follows that interest is prohibited as it leads to injustices (zulm) and Islam is against all forms of injustices and exploitations and pleads an economic system, which aims at securing extensive socio-economic justice. The Islamic law of prohibition of riba, which includes interest, was originally not based on economic theory but on Divine Authority which considers the charging of interest as an act of injustice.

There could be no denying of the fact that under the interest-based system of banking or in a system not strictly based on the principles and spirit of Shariah, depositors as well as borrowers are exploited in one form or the other. It is however, significant to note that, as in the case of conventional banking, the depositors are being exploited most under the system and practices enforced by banks and financial institutions operating world-wide under the banner of Islamic banking.

Islamic banking made its debut over a quarter a century ago. At present 200 Islamic banks and financial institutions, operating in 27 Muslim and 16 non-Muslim countries, are managing a portfolio of about $200 billion. It is now the time to pose the following questions:

i) Whether banks operating under the banner of Islamic banking have succeeded in the elimination of injustices of the interest-based system as ordained by Holy Qur'an (2:279)?

ii) Whether banks operating under the banner of Islamic banking have contributed to the attainment of socio-economic justice in line with the objectives of Islamic economic system?

iii) Whether banks operating under the banner of Islamic banking are, for all practical purposes, not following the bench marks of interest-based system under Murabaha, Bai-Mu'ajjal or the like modes of financing?

iv) Whether the net result in modes referred to at (iii) above really differs much from the interest-based loaning?

v) Whether by adopting the modes referred to at (iii) above, banks assume any responsibility for the operational losses of the party availing finances from them?

vi) Whether sharing in the operational losses are not the essence of Islamic system of banking?

vi) Whether large scale financing on a perpetual basis, on modes approved for "Sale transactions", can continue to be made for an indefinite period by Islamic banks which are not trading houses but are financial institutions?

While attempting to firm up views in respect of above questions, it must be kept in view that Islamisation of banking system is a part of overall Islamic value system and is not merely refraining from interest-based transactions. The objective of Islamic banking system is to make a positive contribution to the fulfilment of socio-economic objectives of the society in all spheres, including trade, industry & agriculture etc.

True Modes of Financing

An Islamic bank is a financial institution which identifies itself with the spirit of Shariah, as laid down by the Holy Qur'an and Sunnah, as regards its objectives, principles, practices and operations. An Islamic bank does not normally lend money except interest-free loans which are termed as Qard Hasanah (Benevolent Loans) while loans on service charge, not exceeding the actual administrative cost of such loans, have also been permitted by Muslim Scholars.

To replace interest, the ideal mode of financing under the Islamic banking system is "Financing on Profit & Loss Sharing" (PLS) basis. Qard Hasanah are for the benefit of the individuals and the society at large. To safe-guard the interest of depositors/investors, these type of loans, as a matter of policy, do not constitute a significant source of financing by Islamic banks. However, if in any country, the Islamic System of Zakat is established and the Islamic State treasury starts functioning, the requirements of Qard Hasanah would primarily be met by the treasury.

The bulk of financing by Islamic banks has to be equity oriented. In this mode of financing, the losses are shared by the financier along with the entrepreneur in the ratio of their respective capitals. The profits are, however, shared in an agreed ratio. The rates of returns are thus replaced by ratios.

While designing an alternate to interest-based system, it was realised that large scale resorting to PLS system of Islamic banking could pose serious risks and hazards to Islamic banks due to wide-spread tendency to adopt un-ethical accounting practices to conceal true profits, high rate of illiteracy and host of other reasons.

It was therefore, considered necessary to devise various other modes of financing in addition to Mudaraba & Musharka based on PLS system and of course, Qard-Hasan. These modes being the second line fixed return techniques include the following:

i) Murabaha (Cost-plus sale).

ii) Bay Mu'ajjal (Deferred payment sale).

iii) Bay' Salam (Purchase with deferred delivery).

iv) Bay' Istis'na (Made to order).

v) Ijara (Leasing).

vi) Ju'ala (Loans with a service charge).

It may be mentioned that the above mentioned six modes cannot be expected either to remove the injustices of the interest-based system or to contribute to the achievement of socio-economic objectives which Islam seeks to achieve. The fact however, remains that these modes bear pre-determined fixed rates wherein neither the operational losses are shared by the banks nor the returns charged are dependent on the operational result of the entrepreneur.

It is important to note that Islam wants that in case the entrepreneurs earn profit from the finances provided to them by banks, these must be shared with the banks. The banks, on the other hand, must share their profit with their depositors / investors. A large number of depositors would thus hopefully be able to get significantly higher rates of return from the banks leading to over-all prosperity. It will be only then that justice would be ensured between the parties and the banks would start moving towards the path of making a positive contribution towards the achievement of socio-economic objectives.

Islamic banking is now over 25 years old. It is however, observed that, despite all the good intentions, Islamic banks world-wide have generally sheltered themselves in comfort zone by persisting with the second line fixed return techniques for bulk of their financing operations and that too within the bench-marks of interest-based system.

As the single largest mode of financing adopted by Islamic banks is on the basis of Murahaba, it is now proposed to briefly examine this mode.

Murabaha

Murabaha in ancient Islamic connotations referred to a particular kind of simple sale and had no relevance whatsoever with a transaction of financing. In view of the difficulties and risks visualised in adopting PLS system of Islamic banking on a large scale, in recent times, the Murabaha, for all practical purposes was transformed from the sale transaction to a mode of financing.

In this mode, the bank, at the request of its client, purchases the specified goods from a third party against payment. Immediately on the transfer of ownership of the goods as also obtaining its physical or, in most cases, the constructive possession, the bank sells these goods to the client at cost plus an agreed fixed profit margin. The client then takes physical possession of the goods and undertakes to pay the price to the bank either in instalments or in lump sum, at an agreed later date.

The instances are not lacking where customers of the bank and the seller of the goods are sister concerns. In yet many other cases, the customers of the bank purchase the commodities themselves as agents of the bank and then they repurchase the same commodity from the bank for a cost plus profit to be paid at a mutually agreed later date. In many cases of Murabaha, there is therefore, only a change of name.

It is however, felt that there would be no objection if an Islamic bank, in addition to its normal banking business, separately establishes a Merchant Banking Division wherein various types of goods are purchased and then offered for sale to other prospective buyers at a profit. There are however, serious reservations to the wide spread use of murabaha technique as a mode of finance where the bank purchases the commodity only after the customer has agreed in principle to purchase it from the bank at a profit - mark-up. It must therefore, be appreciated that under Murabaha, a trading transaction is being transformed into a mode of finance just to meet the Shariah requirements.

While referring to alternate modes of financing based on Murabaha and Ijara (Leasing) etc., Justice Taqi Usmani observes that if designed to fulfill the Shariah requirements, these modes can be adopted as transitory measure. He however, cautions that " .... there should be a gap between purchasing the commodity and selling it to the customer and the risk of owning the commodity during the period should be borne with all its basic components and all its essential consequences."

In actual practice, practically there is no gap as in many cases, the bank makes the payment almost simultaneously or even after the goods are delivered at the premises of the client. The bank thus does not in fact assume any risk including even the risk of the goods, during the short period, the bank is supposed to own and possess these goods. The bank however, gets a return at a pre-determined fixed rate, which is not dependent on the operational results of the entrepreneur. This in any case, does not appear to be in conformity with the requirements of Shariah.

Taqi rightly observes: -

a) Islamic banks are using the instrument of Murabaha and Ijarah within the framework of the conventional benchmarks like Libor etc. where the net result does not differ much from interest-based transactions.

b) By not even gradually enhancing the financing on PLS basis, the basic philosophy of Islamic banking seems to be totally neglected by the Islamic banks.

c) The Shariah Scholars have allowed the use of fixed return financing techniques i.e. Murabaha & leasing etc only in those spheres where Musharaka can not work.

d) When the common people realise that the net result in the transaction of the Islamic banks is the same as was in the transactions of conventional banks, they become sceptical towards the function of Islamic banks. It therefore, becomes very difficult to argue for the case of Islamic banking before the common people, especially before the non- Muslims who feel that it is nothing but a matter of twisting documents only.

Nijatullah Siddiqui says: -

"The payment obligations of the firms operating with murabaha - financed goods and services are independent of the profitability of the enterprise, unlike Profit - Sharing, thus exposing it to the charge of being inequitable, as in the case of debt financing".

While commenting on "Mark-up" system he opines: -

"I would prefer that Bai' Mu'ajjal is removed from the list of permissible methods altogether. Even if we concede its permissibility in legal form, we have the overriding legal maxim that anything leading to something prohibited stands prohibited. It will be advisable to apply this maxim to Bai'Mu'ajjal in order to save interest-free banking from being sabotaged from within."

At this point it is important to mention that Maududi observes: -

"Islam says in clear terms that the lender is not justified in earning a fixed rate of profit, irrespective of the operational results of the business."
It therefore, appears that, in most cases, the fixed returns charged by banks on transactions which are financial in nature are not permissible simply by providing them a cover of Murabaha or the like modes which are in fact transactions of sale.
It was over two decades ago that The Council of Islamic Ideology, Pakistan observed: -
" ... ideally the real alternatives to interest under an Islamic economic system are profit / loss-sharing and Qard-Hasan."

While referring to other modes of financing such as Bai-Mu'ajjal, Hire Purchase & Leasing etc. the Council observed: -

"It is, therefore, imperative that the use of these methods should be kept to the minimum extent that may be unavoidably necessary under the given conditions and that their use as general techniques of financing must never be allowed."

The Council in this report cautioned:

"It would not be advisable to use it widely or indiscriminately in view of the danger attached to it of opening a back door for dealing on the basis of interest."

"The basis of this technique, though not prohibited according to Hanafi and Hanabali Schools of Fiqh and that too in exceptional circumstances, its wide spread use is not permissible as mark-up does not differ in essence from the interest system."

The Council however, observed: "It is unfortunate that this warning was disregarded and the mark up system was made the pivot of the new arrangements."

The Federal Shariat Court, Pakistan in its Judgement dated November 14, 1991 also referred to the following observations of the Council: -

" The fact of the matter is that "mark-up" is a crude trading practice which has been permitted by certain religious scholars under specified conditions. Its permissibility is questioned by other scholars. In any case, it is a device, which is relevant in the contract of transactions between a seller and buyer of goods. Banks are not trading organizations. They are essentially financial institutions which mobilise funds from the general public and make them available to productive undertakings."

Hasanuzzaman says:

" ..... the ghost of interest is haunting banks to calculate a fixed rate percent per annum in many modes of financing including Murahaba (Bai-Mu'ajjal , Mark-up) etc. The spirit behind all these contracts seems to make a sure earning comparable with prevalent rate of interest and as far as possible, avoid losses which otherwise could occur."

He adds that "they (Second line techniques), have failed to do away with undesirable aspects of interest thereby they have retained what an Islamic bank should eliminate."

The Supreme Court of Pakistan (2000) in its' historic judgement delivered on December 23 1999 i.e. after about sixteen years of the observations, of The Council of Islamic Ideology, referred to above, inter-alia gave the following verdict: -

a) "The major condition for the permissibility of a mark-up transaction is that it should not be charged on lending or advancing money. It must be based on the genuine sale of a commodity with all its substantive consequences."

b) " ...... murabaha or Bia Mu'ajjal is a transaction of sale effected on the basis of deferred payment."

c) "We are conscious of the fact that the transaction of a sale of murabaha based on mark-up, even after fulfilling its necessary conditions is not an ideal mode for the extensive use of Islamic banks, Still, the banks will have to resort to this transaction in certain cases, especially in the initial phase of transformation."

Looking at the Murabaha from yet another angle, it is important to note that Almighty Allah has condemned riba in harshest possible terms perhaps only second to "Shirk". It does not appeal to the mind that by simply assuming some risks by banks in financing through murabaha and the like during "shifting of stocks" from the godown of the seller to the entrepreneur (party availing finance from the bank) which can also be practically avoided and ensuring a fixed return on financing while not sharing in the operational losses of the entrepreneur, which is the essence of Islamic banking, the objectives of the Shariah are met.

It is obvious that the wide spread and persistent use of the second line techniques has neither contributed in removing the injustices of the interest-based system as ordained by Holy Qur'an (2:279) nor in securing the socio-economic justice in the society. If Islamic banks persist with these modes for bulk of their operations, the cause of Islamic banking would never be fulfilled.

It was only in the initial stages of transformation of the conventional banking system into Islamic banking system that the second line fixed return techniques could have been adopted by Islamic banks with a proviso that gradual shift to PLS system will take place. With the passage of time, the second line techniques should have been adopted only where PLS is not possible or feasible including say leasing of machinery or vehicle etc. which are not trading items of the enterprise availing funds from the banks. Unfortunately these modes have been allowed to be perpetuated by Islamic banks. This is injurious to the cause of Islamic banking.

During the last few years, a number of Western bankers, economists and journalists have posed to this writer a rather cynical question about what the real difference between the interest-based system and it's Islamic counterpart, as being practised by Islamic banks actually is. However, even they concede that the PLS system of Islamic banking, if practised in earnest, could ensure socio-economic justice across the globe.

It is therefore, seriously apprehended that if the present sad state of affairs is allowed to continue, even many innocent Muslims may develop doubts about the feasibility, practicability and usefulness of the "Islamic system of banking" notwithstanding that the fault lies with us and not with the system.

The large scale financing by banks on second line techniques is some times advocated on the ground that the size of Islamic banks is too small. The combined assets of 200 Islamic banks and financial institutions are almost 1/3 of the quantum of individual assets of some of the largest conventional banks. Since Islamic banks have to compete with these banks, they generally tend to avoid indulging in risky financing based on PLS. To make the situation worse, some of the Islamic banks find it more feasible to divert part of their funds received from Muslims to multinationals and large corporations of the West.

The Arab world including GCC countries and rich citizens of many others Muslim countries are reported to be maintaining huge deposits with conventional banks operating in the West. The quantum of these deposits is estimated to be more than the total external debt of Muslim countries.

The placement of these funds by Muslims is enabling the imperialistic powers to exploit the Islamic world by simply providing them loans and credits out of these deposits. The placement of funds in this manner by Muslims is clearly not in conformity with the directives of Qur'an and Sunnah.

The Ummah must keep in mind that according to the injunctions of Islam, surplus wealth of Muslims can no be utilised for strengthening the Capitalistic System or for the benefit of non-believers or enemies of Islam. This wealth should therefore, be profitability invested for the common benefit of Ummah, initially in their own country / region. The need of the hour is that a 'Fatwa' is issued on the subject immediately.

If only a portion of these funds is brought back to the respective Islamic countries, the size of many Islamic banks would become large enough to enable them to diversify their financing portfolio including more and more financing on PLS basis with greater sense of confidence.

Financing on PLS Basis

The real alternate to interest on loans in an Islamic framework is financing on PLS basis- a shift from debt based transaction to investment based funding. It is believed that the financing on PLS system of Islamic banking in a conducive environment would not only ensure a healthier financing portfolio and of course higher rates of return to depositors but would also lead to optimum allocation of resources for over-all economic growth and welfare of the society, individually and collectively.

It is however, accepted that the banks allowing financing on PLS basis are exposed to risk of losses as even a profitable company may sustain genuine loss due to various factors even beyond their control. The assuming of this risk is the essence of PLS mode of financing as all business transactions have an inseparable risk factor. It should not therefore, deter banks from making funds available on PLS basis to sound entities in feasible projects in the normal course of business.

In actual practice however, we find that traders and industrialists etc. generally earn substantial profit with the funds of a large number of depositors but they do not share these profits with the banks for onward passing on the share to the depositors. This injustice can be avoided if banks accept deposit on PLS basis according to its true spirit and also allow bulk of financing on the same basis. This will bring prosperity in the society, as a large number of depositors will be receiving higher rates of return on their deposits.

In the Islamic banking system, the concept is that of ratios in which profits and losses are shared instead of fixed, pre-determined interest and mark-up / profit rates. The issue of possible injustice due to inflation and recession, in money lending transactions, was settled by Islam over 1400 years ago, as PLS system absorbs the impact of inflation as regards the sharing of operational results are concerned. A glaring example is that of partnership where there is no dispute between partners due to high inflation or other-wise.

A comparison of the salient features of the financing on PLS Basis and the second line fixed return techniques is given below:-

Financing: PLS Vs Second Line Fixed Return Techniques

S. NO. Financing On PLS Basis Financing On Second Line Techniques

1. Unanimously held as an ideal mode of financing in an Islamic framework. A sale transaction which has ecently been transformed as a second line mode of financing and that too for transitory period. Reservations are expressed by many scholars about these mode.

2. Inequitable distribution of income and wealth will be significantly removed. Inequitable distribution of income and wealth continues like interest-based system.

3. Depositors are likely to get higher returns leading to prosperity. Returns are practically based on the bench marks of the interest based system. Depositors continue to be exploited.

4. Justice between the parties is ensured as the return to the bank on finance is dependent on the operational results of the entrepreneur. Injustice of interest-based system continues as bank is guaranteed a fixed return irrespective of the loss sustained by the entrepreneur. The return to bank is positive and pre-determined in the shape of agreed price.

5. Inflation is likely to be controlled to some extent. Same as under the interest-based system.

6. Progress towards Self-reliance will hopefully be made through enhanced
rate of savings. Same as under the interest-based system.

7. May lead to more efficient and optimum allocation of resources as compared to interest-based system. Same as under the interest-based system.

It is now about the time that the performance of Islamic banks worldwide should be judged from the contribution it is making in achieving the objectives of Shariah in the real sense and not merely by the number of Islamic banks or the quantum of their deposits portfolio.

MODEL ISLAMIC BANK

It is important to appreciate that the requisites for total implementation and success of Islamic banking in a country, include re-shaping the society, re-structuring of the economic system and re-framing of the laws according to the dictates of Islam. The most important and difficult task however, is the reformation of society which has to be undertaken as an on-going process.

We therefore, need to change our priorities and at least as much emphasis should be laid on improving the ethics, honesty and values of the society as is being done for expansion of " riba-free banking". This will then create a conducive environment for more and more financing under profit and loss sharing system of Islamic banking.

Mirakhor observes, "Perhaps the most challenging issue facing the implementation of an Islamic financial system is the development of risk-bearing instruments that can provide the investors with a sufficient degree of liquidity, security and profitability to encourage their holding". Islamic banks also face a challenge of developing innovative services and products for utilising these funds effectively and efficiently for financing under PLS system.

In view of the position explained here-in-above and considering the real difficulties in presently adopting the PLS system of Islamic banking for bulk of the financing for trade, industry and agriculture, it is felt that the need of the hour is to establish Model Islamic banks in all GCC countries as also in other Islamic countries where a large number of interest-free banks have been operating for a number of years.

The Proposed Model Bank would be a commercial bank. While the objective of the Bank would be to earn profit, it would identify itself with the Shariah as regards objectives, principles, practices and operations. The Proposed Bank would undertake all normal banking business as is done by interest-based banks but the Provisions of Shariah would be kept in view at all times.

The proposed Model Bank would accept deposits/investments on PLS basis (other than demand deposits) and would also allow financing only on this basis. The operations of the Bank will be supervised from Shariah point of view by a board of religious scholars.

The proposed Bank would develop risk-bearing but competitive products for deposits / investments wherein depositors / investors are given reasonable assurance of higher returns as also of safety of their funds. This Bank would also develop innovative but competitive products for financing which are not only compatible with Shariah but also cater to the needs of traders and industrialists etc., in the modern complex world which is ever - changing.

The sponsor directors of the Proposed Model Bank should be Muslim Scholars, Jurists, chartered accountants, economists, bankers and investors. All these persons should be men of integrity and of highest reputation. They should also have unshakeable faith and commitment in the Islamic banking system and should have good knowledge of it's principles, products and procedures.

These persons would take up the challenging assignment for the pleasure of Allah and for proving that Islamic banking in its totality is not only workable but would In sha Allah also pay rich dividends in material terms to all those who deal with or work for the Bank.

It is sincerely believed that the proposal of Model Islamic Bank is not only feasible but is the need of the hour. The successful operational results of this Bank would also motivate the existing Islamic banks to enhance their share of financing on PLS basis.

The first full-fledged Islamic Bank was established in Dubai in 1975. In 1995, GCC countries accounted for 15 percent of the paid up capital, 27 percent of the assets, 34 percent of the deposits and 28.8 percent of the net profit of the Islamic banks world-wide. The Islamic banks in GCC countries are therefore, in an ideal position to take a lead to shift the bulk of financing operations to PLS system of Islamic banking.

It is now time that Islamic banks and financial institutions resolve to gradually enhance their share of financing on PLS basis and reduce the share of financing on the basis of Murabaha, Bai Mu'ajjal and the like modes of financing.

If Islamic banks succeed in demonstrating a practical example of socio-economic justice by gradually enhancing their financing on PLS basis and also achieve further satisfactory operational results, there is no reason why more cooperation would not be extended to them by the European, American and other interest-based banks. Some of these conventional banks may even be tempted to adopt PLS system of financing in their subsidiaries & affiliates operating under the banner of Islamic banking.

The dawn of an era of justice can, therefore, be visualised where the fruits of the Islamic system would be available to a large number of people leading to over-all social and economic prosperity.