Articles on Islamic Finance

Clarification of Some Misunderstandings about Islamic Banking


Zubair Ahmed bin Naseem Ahmed

When a common person tries to form an opinion about Islamic banking, he hears cliché sayings about Islamic banking, such as ‘Currently, Islamic banking and finance are not truly Islamic’, ‘It is only changing of conventional terms into Islamic terms’ and ‘Islamic banking is an oxymoron as banking cannot be Islamic’. These are some common judgements passed around by critics regarding Islamic banking.

This brief article will discuss some points that will help in better understanding Islamic finance and Islamic banking in particular. It needs to be clarified that Islamic finance does not only consist of Islamic banking, but it is much bigger than that. Islamic banks are part of the Islamic finance industry. Even though Islamic banking is a very significant part of the current Islamic finance industry, there are other institutions as well in Islamic finance industry.

In terms of numbers, the Islamic banking sector constitutes 71.7% of the global Islamic financial Industry. Other sectors in Islamic financial industry include Sukuk (24.2% share), Islamic funds (2.8% share) and Takaful (Islamic Insurance) sector (1.3% share) (Source: Islamic Financial Stability Report, IFSB 2019).

In Pakistan, Modaraba companies also exist which work like investment companies by utilizing the capital injected by the investors in productive investments. Their investments can be in wide ranging activities, such as project financing, financial investments and providing financing solutions.

Thus, it is clear that a wide range of institutions, products and instruments are part of Islamic financial industry. After clarifying that Islamic banking is not the only sector or institution type in the Islamic financial industry, next, we attempt to clarify certain misunderstandings about financing modes used by Islamic banks. The basic foundation of financing modes used in Islamic banking is derived from Islamic jurisprudence.

First, it needs to be understood that Islamic bank is a financial intermediary. Being an intermediary in a supply chain is common in various types of industries, be they financial or non-financial institutions. Even in non-financial sector, the intermediary trades in assets which it does not require for end use. A wholesale merchant would trade in commodities and will sell to the retailer without being the end user of the commodities himself. In his trading operations, the wholesale merchant will try to efficiently manage inventories to reduce inventory storage cost and will also take measures to manage risk, such as non-payment risk in credit sales.

Islamic bank also provides asset backed financing in the form of sale based modes of financing and lease based modes of financing. Besides that, Islamic banks also provide equity financing now in countries like Pakistan.

Acting as an intermediary in sale and lease based modes of financing, Islamic bank takes different roles in two different phases of the transaction. In the first leg, Islamic bank purchases the asset. In the second leg, Islamic bank either sells the asset or provides the usufruct of the asset to the client on lease basis. Since the client has a financial need of asset acquisition, Islamic bank facilitates asset acquisition by allowing the client to make payments usually with deferment of time.

On the deposit mobilization side, mostly, Islamic banks use Mudarabah for mobilizing investment deposits and Qard for mobilizing non-remunerative deposits, such as current account. Islamic banks cannot provide any extra benefits exclusively to the Qard providing depositors and cannot pass on the losses to them as well. Mudarabah is an Islamic finance mode in which one partner provides investment, i.e. Rabbul Mal and another partner (known as Mudarib) provides skills to carry out the business. Distribution of profit is done as per the pre-agreed profit sharing ratio. In case of loss in Mudarabah, the financial loss will be borne by Rabbul Mal, and Mudarib will suffer the loss of efforts.  In the context of the Islamic banking industry, saving accountholders and term deposit account holders act as Rabbul Mal because they invest.

On the financing or asset side of Islamic banking, there are four types of Islamic finance modes which are used in practice: trade-based modes, lease-based modes, partnership-based modes, and fee-based modes. The trade-based modes consist of Murabaha (Trade with profit disclosure), Musawamah (Trade without profit disclosure), Istisna (Order to make an asset) and Salam (Deferred delivery trade of homogenous assets). Ijarah is the main lease-based mode, whereas Musharakah and Mudarabah are the partnership-based modes. Mudarabah has already been discussed above. Musharakah also has sub-types in Islamic banking, which include Shirkat-ul-Milk (Joint ownership of asset) and Shirkat-ul-Aqd (Business partnership). Diminishing Musharakah based financing involves joint ownership in the first step, then lease of the one-party share, and then its sale to the client who had the financial need of using asset in short term and acquiring it over a period of time in long term.

Taking the case of Pakistan, according to September 2020 Islamic Banking Bulletin issued by the State bank of Pakistan, the financing mix in Islamic banking include Diminishing Musharakah (34.5%), Running Musharaka (23.5%), Murabaha (13.3%), Istisna (7.9%), Ijarah (5.3%), Salam (1.5%) and Other modes of financing (13.9%) respectively (Islamic Banking Department – State Bank of Pakistan, 2020). Musawamah is not mentioned separately by the Islamic Banking Bulletin, but it is part of the “other” mode, which altogether has a share of 13.9%.

Islamic finance modes, which are mostly used in financing side operations of Islamic banks, are the combination of prominent Islamic finance concepts and supporting Islamic concepts. For example, Murabaha financing mode in the Islamic banking industry includes Murabaha, which is a well-known Islamic finance concept, and it includes Wakalah (Agency) concept of Islamic finance as a supporting mode in most of the cases.

In most of the Islamic banking transactions, Islamic bank appoints the same client as its agent who requires finance for asset acquisition. For example, in Murabaha financing mode, the client acts as an agent to purchase the asset on behalf of the bank before the actual Murabaha trade contract is executed between the bank and the client. In Istisna and Salam modes of finance, the client acts as an agent to sell the assets on behalf of Islamic bank after the Istisna and Salam transaction is executed and the risk and reward are transferred to the Islamic bank by physical or constructive possession. Sometimes, in Ijarah and Diminishing Musharakah, banks can also appoint the client as an agent to purchase the assets. Therefore, it can be seen that the Islamic finance modes used in Islamic banking are combinations of prominent Islamic finance concepts which are taken from the Islamic jurisprudence literature and the supportive Islamic concepts, such as the Wakalah (Agency) concept.

1 reply »

  1. It is interesting that the author started his article by acknowledging the credibility deficits that many hold about the working of Islamic financial institutions.

    Academics are quite quick to try and dismiss the notion by focusing on the sizable industry that has been built or the variety of product structures that these institutions offer or the theoretical framework of the industry.

    It may be important for academics to seek out the reasons for why Islamic finance is seen more as a form rather than substance. An economist’s approach may be to identify the participants in the system and what economic utility it offers them. For example, should we only focus on wealth owners, wealth users and wealth managers? Or is there a role of government that provides an instrument that is portable, durable, unit of wealth, medium of exchange and store of value? How is it that Interbank rates, used to benchmark returns on Islamic finance instruments, is deceptively aligned to the country’s monetary policy rates which in turn reflects the ability for the government to manage its budget with a predictable inflationary impact.

    As far as the role of banks are concerned, there should be clarity on whether they undertake credit intermediation, or do they truly create form, time, place or possession utilities in trade based activities, or are they truly involved as partners of business and contribute to strategy, operational, and resources management decisions.

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