Sources of Funds of Islamic Banks
It is well known that interest-based banks accept deposits of different maturities, paying different rates of interest on different kinds of deposits. Islamic banks do not pay interest on deposits. How Islamic banks operate different kinds of deposits is described below:
All Islamic banks operate current accounts for their customers as traditional banks do. These accounts govern what is known as demand deposits, i.e. these deposits are payable on demand without a notice being given to the bank. The bank guarantees full return of these deposits on demand. The bank may use these funds in its business operations at its own risk. Since all risk is borne by the bank, the depositors are not entitled to any share in profits earned by the bank.
Islamic banks also accept saving deposits from individuals. Four different methods of operating saving accounts by Islamic banks have emerged: (i) accepting saving deposits on the principle of al wadia requesting the depositors to give the bank permission to use the funds at its own risk, but guaranteeing full return of the deposits and sharing any profits volun tarily; (ii) accepting saving deposits with an authorisation to invest and share profits in an agreed manner for the period in which a required minimum balance is maintained; (iii) treating saving deposits as qard-e- hasan (benevolent loan) from the depositors to the bank and granting them pecuniary or non-pecuniary benefits; and (iv) accepting saving deposits into an investment pool and treating them as investment deposits which are explained below. Generally speaking, the depositors are given a right of withdrawal without notice in saving accounts but are not entitled for any share in the profit for the period in which withdrawal is made.
Investment deposits are the Islamic banks’ counterpart of term deposits in the conventional system. They are also called profit-and-loss sharing (PLS) or participatory accounts. These accounts could be opened either by individuals or companies for any specified period such as six months, one year or even longer. The depositors do not receive any interest. Instead, they are entitled for a share in actual profit accrued from the investment operations of the bank. The profits are shared by the depositors according to their amounts and the period they are held by the bank in an agreed proportion. As an accounting practice, the amount held in the account is multiplied with the period for which it has been employed. The profits are distributed on a pro rata basis on this product. Usually withdrawals are not allowed from the investment accounts except under special circumstances for which some notice period is required. The depositor will have to forego his share of profit for the withdrawn amount.
Joint or General Investment Account
Some Islamic banks establish some kind of an investment pool in lieu of fixed term deposits. The investment pool takes the form of a general investment account in which investment deposits of different maturities are pooled together. They are not tied to any specific investment project but are utilised in dif fcrcnt financing operations of the bank. The profits are accounted and distributed at the end of the period on a pro rata basis.
Limited-Period Investment Deposits
Some Islamic banks also accept investment deposits for a specified period determined by the mutual consent of the depositor and the bank. The contract may terminate at the end of the period but profits are distributed and accounted at the end of the financial year.
Unlimited-Period Investment Deposits
These investment deposits are automatically renewable without specifying the period. They could be terminated by giving a specified notice to the bank. Usually the notice period is three months. No withdrawals or increases in the amount of deposit are permitted during the period. Profits are calculated and distributed at the end of the financial year.
Specified Investment Deposits
Some Islamic banks have evolved an investment deposits scheme with specific authorisation to invest in a particular scheme or a specific trade. In this case the profits of this specific activity are distributed between the depositor and the bank. In this case the bank works as an agent of the investor. It may agree to perform this function against an agreed fee or may opt to have a share in the profit.
Uses of Funds by the Islamic Banks
Islamic financing techniques on the uses of funds side of the balance-sheet marked a more significant departure from the traditional banking. This is mainly because of the prohibition of interest rate. Most of the traditional banks use lending on interest as their major financing tool which is modified with respect to interest rate charged, period of loan, conditions of repayments, etc. to suit the requirements of various clients and different sectors. Since Islamic banks cannot use lending on interest as a financing device, they were compelled to find out innovative ways of financing which would not involve interest.
Consequently, Islamic banks have drawn up the rich treasure of Islamic theory of contract to come up with the financing techniques which would conform to various requirements of the Islamic Shari'ah. These contracts were originally devised for commodity trade and deal with the contracts between two individuals. The application of these contracts at the institutional level and in the financial sector is a new phenomenon. In course of these applications, some of the contracts have been slightly modified from the point of view of Islamic jurisprudence. However, this is not the place to discuss tiic judicial nature of these contracts. Instead, present discussion shall remain confined to application of these contracts to financial sector as actually put into practice by contemporary Islamic banks.
Financing techniques used by Islamic banks may be summarised as follows:
Murabaha (Mark-Up Or Cost-Plus-Based Financing)
This is the most popular technique of financing among the Islamic banks. It has been estimated that 80 to 90 percent of financial operations of some Islamic banks belong to this category. It works in the following way:
The client approaches the Islamic bank to get finance for the purchase of a specified commodity. The bank, either itself or through some agent (who could be the client himself), collects all the required information about the commodity itself, such as price, nature and specification of the commodity, names of dealers, etc. The bank informs the client of these details as well as of the margin it would like to charge on the original price.
In case, these conditions are acceptable to the client, a contract of murabaha transactions will be signed between the bank and the client. The bank will purchase the specified commodity from any seller of its choice paying the price of commodity in cash. In case a sale deed is required (e.g. in case of car or house) the registration is in the name of the bank. Once the ownership of the commodity is transferred to the bank, it sells the commodity to the client on the basis of diferred payment basis against an agreed price.
The new price at which the bank sells the commodity to the client includes the original price (which is cost to the bank) plus the mark-up the bank is charging (which is the profit margin). The client pays this price either in instalment or in lump sump at an agreed later date.
There are certain requirement for the muraba- ha contract to be valid. It is necessary that profit margin (or the mark-up) the bank is charging must be determined by mutual agreement between the parties concerned. Similarly, the good in question should be in the physical possession of the bank before it is sold to the client. Then transaction between the bank and the seller should be separate from the transaction between the bank and the purchaser. There should be two distinct transactions. That is why certain Islamic banks effect a muraba- ha transaction in two stages using two separate contract forms. The first form is a request to the bank through which the client informs the bank of his intention to carry out the murabaha. In this contract, the client promises to buy the good from the bank. It should also be noted that a promise is not legally enforceable. Hence, the client has a right to change his mind and the bank runs the risk of losing the money it has invested in this particular murabaha. The second contract deals with the sale of good by the bank to the client on deferred payment basis, the terms and conditions of which are clearly spelled out in the contract form.
The murabaha form of financing is being widely used by the Islamic banks to satisfy various kinds of financing requirements. It is used to provide finance in various and diverse sectors, e.g. in consumer finance for purchase of consumer durables like cars and household appliances, in real estate to provide housing finance, in the production sector to finance the purchase of machinery, equipments, raw material, etc. However, probably the most common use of murabaha techniques is in financing short-term trade. Murabaha contracts are also used to issue letter of credit and to finance import trade.
Musharakah is another technique of financing used by Islamic banks. In this form, two or more financiers provide the finance for a project. All partners are entitled to a share in total profits of the project according to a ratio which is mutually agreed upon. However, the losses are to be shared exactly in proportion to capital proportion. All partners have a right to participate in the management of the project. However, they also have the right to waive this right in favour of any specific partner.
There are two main types: permanent musharakah and diminishing musharakah. In the first case, the bank participates in equity and relieves an annual share of profit on a pro rata basis. The period of termination of the contract is not specified, so it can continue as long as the parties concerned wish it to continue. The technique of diminishing partnership is getting quite popular with Islamic banks because of its potentialities. In permanent musharakah, funds may be committed for a long period, but it is not so in case of diminishing musharakah.
Diminishing musharakah allows equity participation in the first place and share of profit on pro rata basis. However, the contract also provides a further payment of a sum of money over and above the bank’s share in profits as a payment of the part of the equity held by the bank. In this way, the equity held by the bank keeps on getting reduced progressively with time. After a certain lime, bank will have zero equity and shall cease to be a partner. Islamic banks have found it quite suitable to finance commercial buildings in this way.
Islamic banks in Sudan, particularly Sudanese Islamic Bank (SIB), have evolved yet another application of musharakh which has tremendous potential for rural and agricultural development in the Islamic countries. SIB has been experimenting in providing finance to farmers under musharakah arrangements.
It works in the following manner: the SIB and the farmer enter into a musharakah contract under which the bank provides the farmer with the fixed assets such as ploughs, tractors, irrigation pumps, sprayers, etc. and working capital such as fuel, oil, seeds, pesticides, fertilisers, etc. Farmer’s equity is confined to provide land, labour and management. Since it is a partnership contract, there is no need of collaterals or guarantees other than personal guarantees. First, the farmer is paid 30 percent of the net profit as a compensation for his management. Rest of the net profit is shared between the bank and the farmer on a pro rata basis for each side’s respective share in the equity.
Musharakah technique of financing is also used to finance domestic trade, imports and to issue letters of credit.
Several theorists of Islamic banking have postulated mudarba to be a dominant mode of financing under the scheme of Islamic banking. However, this technique, for various conceptual, practical and legal hindrances, has not been able to find wide application by the Islamic banks. The Jordan Islamic Bank (JIB) is one among the few banks which use mudarba as a financing technique. The law of the JIB mentions two kinds of mudarba: individual and joint.
In case of' individual mudarba, the JIB provides finance to a commercial venture run by a person or by a company on the basis of profit-sharing. The joint mudarba may be between the investors and the bank on a continuous basis. The investors keep their money in a special fund operated by the bank in continuous joint financing. The investors receive a proportionate share of the net profit realised even without the liquidation of those financing operations which have not reached the stage of final settlement.
I Jar All (Leasing)
Leasing is also one of the approved method of earning income according to Islamic law. In this method, a real asset such as a machine, a car, a ship, a house, etc. can be leased by the lessor to the lessee for a specified period against a specified price. The benefit and cost of each party should be clearly spelled out in the contract to avoid any element of uncertainty (gharar) with respect to the responsibility of each party.
Leasing is emerging as a popular technique of financing among the Islamic banks. Some of the important Islamic banks which use leasing as a technique of financing include Islamic Development Bank, Bank Islam Malaysia and commercial banks in Pakistan.
Under this scheme of financing, the bank purchases a real asset (the bank may even purchase the asset as per the specifications provided by the prospective client) and leases it to the client. The period of lease may be determined by mutual agreement according to the nature of assets. In general, it may be anywhere between three months to five years or more. During the period of lease, the asset remains in the ownership of the bank but physical possession of the asset and its right of use are transferred to the lessee. After the expiry of the lease agreement, these also revert back to the original owner.
At present, Islamic banks are experimenting with various forms of leasing, one of which is lease purchase agreement. In this scheme, the lessee can purchase the equipment at the end of the lease period at an agreed price. In certain eases, the rental paid during the period of the lease may constitute part of the price.
Loans with Service Charge
Some Islamic banks give loans with service charge. The Council of the Islamic Fiqh Academy, established by the OIC, in its third session held in Amman on Safar 8-13, 1407 H (October 11-16, 1986), in a response to a query from the Islamic Development Bank resolved that it is permitted to charge a fee for loan-related services offered by the bank. However, this fee should be within actual expenses and any fee in addition to the actual service-related expenses is forbidden because it is considered to be usurious.
Hence, the amount of the service charge should be carefully calculated. According to this ruling, it may be calculated in the following manner:
Actual administrative expenditure
Service charge^ x 100
Average assets during the period
A 1 + A 2
Average assets =
A1 = Total assets at the beginning of the period.
A2 = Total assets at the end of the period.
Service charge in this manner may be calculated only after the end of the period because it is only then that actual expenditure on administration will be known. Under the circumstances, it is possible to levy an approximate service charge on the clients, then reimburse or reclaim the difference at the end of the period when actual expenses on administration are known.
Qard-E-Hasan (Interest-Free Loans)
Most of the Islamic banks also provide interest-free loans to their customers. Practices, however, differ. Some banks provide the privilege of interest-free loans to the holders of investment accounts at the bank. Some other banks have the provision to provide interest free loans to needy students and other economically weaker sections of the society. Yet some other banks provide interest-free loans to small producers, farmers, entrepreneurs who are not qualified to get financing from other sources. The purpose of these loans is to help them start independent life or to raise their income and standard of living.
In Pakistan, a distinction is made between ordinary loans which are granted with a service charge and qard-e-hasan loans which are granted without any service charge.
Source: Elimination of Riba, Khurshid Ahmad, Khalid Rahman and Zahed A. Valie. Republished with permission.