Banking principle lecture

Introduction to Islamic Banking and Finance:
Principles and Practice
M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni
Chapter 1
Introduction to Islamic
Banking and Finance

Subject Aims:
The key aim of this subject is to assist students in
understanding the theory and practice of Islamic banking,
based on the contemporary situations. At the end of the
course, students will be able to:
1. Understand the theory of Islamic banking,
2. Understand the operation of Islamic banking,
3. Identify the products offered by Islamic banks,
4. Evaluate the performance of Islamic banks, and
5. Analyse current issues and problems faced by Islamic banks.

Introduction
• Islam is a way of life. A verse from the Quran states, “This
day I have perfected your religion for you, completed My
favour upon you, and have chosen Islam as your way of
life” (Qur’an 5:3). The lexical meaning of the word Islam is
‘submission’
• Actions in Islam can be categorized into two broad
categories, namely ‘Ibadaat and Mu’amalaat.

Introduction (cont)
• ‘Ibadaat – Acts of Worship
Ibadaat are based on the individual’s direct relationship with
God. This entails that specific acts of worship must be directed
solely for Allah (God) alone with sincerity. This includes one’s
Prayers, Fasting, Pilgrimage etc.
• Mu’amalaat – Interactions with People
This refers to the conduct one has with fellow human beings.
This can refer to law, work, marriage, inheritance, business
transactions, partnerships, buying, selling etc. Islamic finance
and banking falls under this category. One must ensure their
conduct is in conformity with Shari’ah principles.
• Objective of human life is to please GOD – Almighty Allah via
Ibadaat and Mu`amalaat.

Introduction (cont)
• Shari’ah –Islamic Law
Shari’ah is the set of rules which includes and clarifies
obligations, prohibitions, recommended duties, detested (yet
not blameworthy) actions, what is lawful and unlawful etc.
Therefore it includes ethics, manners, laws, public life, social
life, economic life, politics etc.
• Sources of the Shari’ah
The two Primary sources of the Shari’ah are the Qur’an and
the Sunnah. Other sources include Ijma’ (consensus) and
Ijtihad (juristic decision)

Basis of Islamic Banking and Finance
Figure 1.1: Shari’ah as the Basis of Islamic Banking and
Finance

The Qur’an
• The Qur’an is believed by Muslims to be the word of God
revealed to the Prophet Muhammad – peace be upon him
(PBUH). It is the final revealed scripture and remains intact in
the Arabic language. The Prophet Muhammad was instructed
with the Message of Islam when he was at the age of forty in
the year 610 CE. From then onwards, his Prophethood lasted
twenty-three years until the Message was complete and the
Prophet passed away.
• The Qur’an was therefore revealed over a period of twenty-
three years in stages and intervals. The Qur’an can be studied
closer by looking into the Sunnah, the teachings of the
Companions (who learned directly from the Prophet and were
preserved when verses were revealed concerning specific
circumstances), studies from scholars and experts in the
Arabic language.

Basis of Islamic Banking and Finance
The Qur’an
• The first source of the Shari’ah
• General and specific rules on religious, commercial, political,
economic, legal and social norms
• Emphasis on mutual consent and consensus among
consenting parties
• Prohibits exploitative measures:
– Excessive risk or uncertaintly (gharar)
– Usary or interest (riba)
• Prohibits cheating and corrupt practices in the management
of funds
• Does not allow dealings in prohibited products
Learning Objective 1.1
Describe the conceptual
basis of the modern
practice of Islamic banking
and finance.

The Sunnah
• The Sunnah refers to the authentic statements, actions and
approvals of the Prophet Muhammad. Sunnah literally means
way and therefore refers to the way of the Prophet. Another
word sometimes interchangeably used with Sunnah is Hadith
(speech, statement or saying). Therefore, books of Hadith are
referred to as the Sunnah as they are collections of the
statements, actions and approvals of the Prophet Muhammad
- PBUH.
• The Sunnah is collected in many volumes of Hadith books.
Hadith can be used to help explain and elaborate on the
Qur’an. Likewise, the Sunnah contains rulings and guidance
on all kinds of issues and circumstances. There are over forty
verses in the Qur’an which command adherence to the way of
the Prophet (his Sunnah).

Other sources for Shari’ah are Ijma’ (consensus)
and Ijtihad (juristic decision).
• Ijma’ (Consensus) – This refers to teachings in Islam that have
been agreed upon by the early generations of Muslims or
Muslim scholars. These are matters that are established and
leave no room for disagreement in the Shari’ah.
• Ijtihad (Juristic decision) – Ijtihad is applied by the Mujtahid
(Muslim Jurist/Scholar) who does not find the answer clear cut
from the Qur’an or Sunnah. Therefore, they explore into the
Primary sources to find the answer based on their skills of
judgment -maintaining the aims of the Shari’ah- and trying
their best to interpret the intent of the Law Maker.
• Sometimes the word Qiyas (analogy) is used to refer to ijtihad.
Qiyas is used to figure out rulings based on similar existing
rulings by way of analogy.

Origins and Historical Overview of
Islamic Banking and Finance
• Islamic finance is both a new and old phenomenon. The
history of Islamic finance is divided into two general
aspects:
• The early days transactions (The guiding principles of Islamic
Finance originate from the early days of Islam).
• The modern-day experiments (Experiments in Islamic finance in
Egypt, Malaysia, and Pakistan: the basis of modern Islamic banking and
finance) .
Explain the historical
development and
conceptual arguments of
Islamic banking and
finance

The early days transactions
• The Era of the Prophet
• The Period of Orthodox Caliphate (632 – 661 C.E.)
• Period of the Noble Companions and the Succeeding
Generations
• The Umayyad and Abbasid Eras
development and
Islamic banking and
finance

The Era of the Prophet
The prevailing modes of transactions during this era include:
• Shirkah (partnership) based on profit-and-loss sharing (PLS)
• Al qard Al hasan (benevolent loan)
• Salam (Forward) contract
• Sarf (exchange of money), i.e. gold for gold and silver for
silver at the same sitting
• Ijarah (leasing)
• Trans-regional trade involved trade caravans from Mecca to
Syria and vice versa
development and
Islamic banking and
finance

Timeline of Modern-day Experiments of
Islamic Banking and Finance from 1962 to 1975
• Initial Reforms in the Banking Industry in Pakistan in 1962
• Mit Ghamr Local Savings Bank in Egypt of 1963 (“the first modern-day trial
of Islamic baking”)
• The Malaysian Pilgrims Savings
Board, Tabung Haji of 1969
(managing savings of prospective
pilgrims by investing in Sharī’ah-
compliant investments)
• The new birth of modern Islamic finance took place in Dubai in 1975
through Dubai Islamic Bank as the first Islamic commercial bank in the
world. At the same time, IDB established and started Islamic Finance.
development and
Islamic banking and
finance

The functions of the IDB are:
• To participate in equity capital and to grant loans
• To provide financial assistance to member countries
• To establish and operate special funds for specific purposes
• To accept deposits and to mobilize financial resources
through Sharī’ah compatible modes
• To promote foreign trade, especially in capital goods, among
member countries
development and
Islamic banking and
finance

Dubai Islamic Bank (DIB)
The first fully-fledged Islamic world commercial bank in 1975.
Operates five main business groups:
• Retail banking
• Corporate banking
• Real estate
• Investment banking
• Proprietary trading investments
development and
Islamic banking and
finance

What is Islamic Banking?
Definition:
“an Islamic bank is a financial institution whose statutes, rules
and procedures expressly state its commitment to the principle
of Shariah and to the banning of the receipt and payment of
interest on any of its operation…” (OIC)
Moreover, the Malaysian Islamic Banking Act 1983, defines an
Islamic bank as
“… a company which carries on Islamic business. Islamic
business means banking business whose aims and operations
do not involve any element which is not approved by the
religion of Islam…”
Thus, Islamic banking is banking that complies with Shari’ah or
Islamic law.

The Banking Business
1. Bank is an authorized deposit-taking institution (ADI)
2. Facilitates intermediation between savers and investors.
3. Transfer funds from surplus units to deficit units.
4. It manages payments and clearing systems (EFTPOS, Cards,
BPAY, Cheques,…)
Islamic and conventional banking (1 to 4 above + …)
• The prohibition of riba (interest, usury), gharar (excessive
uncertainty) and haram (impermissible) activities.
• The implementation of profit and loss sharing (PLS) principle.
• The emphasis on productivity and real economic activity
(rather than credit worthiness).

The Banking Business: Flow of money

The Banking Business: Flow of profits

Key 6 principles of Islamic banking
1. Prohibition of predetermined loan repayments as interest
(riba)
2. Profit and loss sharing, which is at the heart of the Islamic
finance system
3. Making money out of money as being unacceptable, with all
financial transactions needing to be asset-backed
4. Prohibition of speculative behavior
5. Only Shariah approved contracts being acceptable
6. The sanctity of contracts
In the News: The Vatican says Islamic Finance May Help Western Banks in Crisis
“The ethical principles on which Islamic finance is based may
bring banks closer to their clients and to the true spirit which
should mark every financial service,” (the Vatican’s official newspaper
Osservatore Romano)*
• *A Lorenzo Totaro 2009 'Vatican Says Islamic Finance May Help Western Banks in Crisis, Bloomberg.com, viewed on 17 February 2010
http://www.bloomberg.com/apps/news?pid=20601092&sid=aOsOLE8uiNOg&refer=italy

And many mo
Islamic Banking and Finance around the world

"The LM Australian Alif Fund has been awarded 'Best New Product
2009' at the world's leading Islamic Banking and Finance awards in
Dubai for its innovative approach to Shariah-compliant investment,
beating a shortlist of prominent international Islamic institutions'‘
http://www.lmaustralia.com
Islamic Banking and Finance in
Australia

The Banking Business: Flow of money
Bank
(Financial
Intermediary
)
Surplus
Units
(savers)
Deficit
Units
(borrower
s)
Mobiliza
tion
of funds
Allocati
on
of
funds
Deposits mechanism:
Mobilizes funds from savers
according to return and
liquidity (withdrawal)
requirements. Efficiency in
mobilization of funds is
improved with increase in
the range of financial assets
Real Economic
activity
(assets,
projects,
service…)
Fund providers Funds users

The Banking Business: Flow of profits
Distrib
ution
of
profits
Alloca
tion
of
profits
Unique risk/return needs
and expectations by savers
and investors are matched
through the creation of a
range of financial products
and services.
Real Economic
activity
(assets,
projects,
service…)
Bank
(Financial
Intermedia
ry)
Surplu
s
Units
(savers
)
Deficit
Units
(borrow
ers)
Fund providers Funds users

Why so much interest in “No Interest” banking?

"The LM Australian Alif Fund has been awarded 'Best New
Product 2009' at the world's leading Islamic Banking and
Finance awards in Dubai for its innovative approach to
Shariah-compliant investment, beating a shortlist of
prominent international Islamic institutions'‘
Australia

Video: Why Islamic Finance?
Play
• Any other questions?

ISLAMIC BANKING - FIN5BNK
Topic 2: Ethics & Prohibitions in Mu’amalat
Ethics in Islamic Finance and Banking - Main prohibitions in
Mu’amalat: Riba - Gharar - Impermissible (Haram) activities
Sanctity of Contracts
FACULTY OF LAW AND MANAGEMENT
SCHOOL OF ECONOMICS AND FINANCE

Ethics in Islamic Finance and Banking
"Assist one another in righteousness and piety. And do not assist
one another in sin and transgression…" (Qur’an 5:2)
• One objective of Islamic finance and banking is to assist in the
spread of economic prosperity. The other objective is to do
this in accordance with Shari’ah principles.
• Among the norms concerning Islamic finance are a free
market, where prices are determined by demand and supply,
freedom from manipulation, prevention of hoarding, profit
and loss sharing in partnerships, information efficiency etc.

Among the norms in Islamic finance that we want to
elaborate on here are the following three topics:
• 1. The Prohibition of Riba (Interest or Usury) – Money is not
to be exchanged for money with profit. As a result of this
prohibition, alternative solutions are given which encourage
trade and equity participation.
• 2. The Prohibition of Gharar (Uncertainty) – This demands
transparency in contracts as well as in buying and selling.
Prices should be specified, there should be clarity of the
delivery details, quality of goods, quantity of goods etc. The
information should be available to all parties involved and the
outcomes of a contract should be free from ambiguity etc.
• 3. Sanctity of Contract – Contracts should be fair and agreed
upon by both parties. Therefore, the contract should be free
from the elements of Gharar and reach Shari’ah approval in
their content.

1. The Prohibition of Riba (Interest or Usury)
• Definition of Riba: ‫الربا‬
• Riba in the Arabic language literally means increase. However,
according to the specific Shari’ah definition, it means unlawful
increase ‫المحرمة‬ ‫الزيادة‬. Under today’s literature and
terminologies, riba commonly refers to interest and usury.
• The Islamic Fiqh Academy which was initiated through the OIC
(Organization of the Islamic Conference), was established to
bring scholars from around the world in order to address
current issues and concerns. During the 2000 meeting, the OIC
reaffirmed the consensus of the historical prohibition of
interest. Riba is one of the core concerns in Islamic finance. In
order to avoid riba, many financial alternatives have been
adopted over the centuries. Although scholars describe
rationales as to why riba may be prohibited, the sole reason
for sincere Muslims to refrain from riba is to conform to what
the Law Maker has legislated.

Interest in Judaism and Christianity
The prohibition of interest is not something exclusive to Islam. Jews
and Christians were likewise given instructions in their scriptures
which forbade them to deal with interest or usury. Although
other faiths may have had aversion to interest or usury, only
Judaism and Christianity are singled out here due to the common
historical link between the three faiths. Below are some passages
from the present day Bible.
Old Testament
• If you lend money to one of my people among you who is needy,
do not be like a money lender; charge him no interest (Exodus
22:25).
• Do not take interest of any kind from him, but fear your God, so
that your countryman may continue to live among you (Leviticus
25:36).
• Do not charge your brother interest, whether on money or food
or anything else that may earn interest (Deuteronomy 23:19).
• Hath given forth upon interest, and hath taken increase: shall he

New Testament
• But love ye your enemies, and do well, and lend, hoping for
nothing again; and your reward shall be great, and ye shall be
the children of the Highest: for he is kind unto the unthankful
and to the evil (Luke, 6:35).
In Judaism and Christianity, lending money in order to receive a
profit was strongly condemned. In the Talmud, Ezekiel
condemned interest as an abomination. He also likened
usurers to people who shed blood. In Judaism, the distinction
was made between Jews and gentiles. They tolerated charging
interest to gentiles, yet, were forbidden to practice it with
their own fellow brethren (Deuteronomy 23:20).
Pope Alexander III (12th Century) excommunicated usurers,
which in that period was seen as an extremely harsh
punishment. In 1317 the Council of Vienna took a strong
stance and issued a law that usurers were to be
excommunicated. However, by the fifteenth century in
Europe, usury practices gradually gained ground and
acceptance.

Riba ‫الربا‬ (Interest or Usury)
• Riba is strongly prohibited in Islam. The many verses of the
Qur’an leave no question in this regard: “Allah has permitted
trade and forbidden riba.” (Qur’an: Surah Al-Baqarah 2:275).
The verses prohibiting riba are located in four Surahs of the
Qur’an; Surah Al-Baqarah 2:275-276, 278-280; Surah Aal
Imran 3:130; Surah An-Nisaa 4:161 and; Surah Ar-Room 30:39.
• Riba is further elaborated on in the Prophet’s Sunnah.
Numerous hadiths explain the details surrounding riba. In a
hadith narrated by the Prophet’s companion Jaabir: “Allah’s
Messenger cursed the one who accepts riba, the one who
gives it, the one who records it and the two witnesses to it,
saying, ‘They are all the same.’” (Collected By Muslim).

Types of Riba:
• There are two major categories of riba.
• The first category is known as Riba An-Nasee’ah which relates
to riba in debt. It increases with time (e.g. interest on
borrowed money). This is the most common type of riba today
and it relates to return of money on money at any rate (fixed
or floating, compounded or simple interest).
• The other category is Riba Al-Fadl which refers to riba in
exchange. This type of riba refers to the six commodities (e.g.
Gold) mentioned in the hadith.
It increases with the transaction.

Riba An-Nasee’ah - Riba in Debt
• This form of riba was well known in jahiliyah (pre-Islamic era
of ignorance). When the date of maturity neared for one’s
debt, it would be said to him, “pay up, or pay riba (increase)”.
Due to deferment in repaying the debt, the debt would
increase. It would continue to accumulate as compounded
interest until it doubles and so on.
• Another practice from the jahiliyah period included the
loaning of money with a fixed increase in the return. For
example, one would borrow, 10 gold coins (Dinars) with the
condition of returning 12 gold coins at a future date.
• From the above description, we see how riba an-nasee’ah is
equivalent to interest. For example, it includes the use of
credit cards and “interest free” periods, as the date of
maturity passes, interest is incurred. Likewise it is typical of
bonds, or loans from conventional banks today which lend
money with the condition to be paid back with an increase of a
certain percentage in the future, at a variable or fixed interest
rate.

Riba Al-Fadl - Riba in Exchange
• Although gold and silver were the real currency at the time,
the Prophet described certain commodities that relate to riba.
These commodities are prohibited to exchange, same for
same, unless they are of equal amount, without increase. One
hadith states, “Gold with gold, silver with silver, wheat with
wheat, barley with barley, dates with dates, and salt with
salt; same quantity for same quantity, equal for equal;
transaction being made hand to hand (i.e. on the spot
payment)” (Muslim).
• Some scholars have stated that these commodities are only
limited to the six mentioned. Other scholars, by making Qiyas
(analogy), have stated that it can also include other
commodities that can be weighed, or other food, or specific
food which can be stored similar in nature to the six.

Riba Al-Fadl - Riba in Exchange (cont)
• However, gold and silver are the universal tenders like cash
money today. The remaining four commodities may have been
used in a similar fashion to currency.
• Another hadith mentions, “Do not sell gold for gold unless it is
the same amount for the same amount, and do not make one
amount greater than the other. Do not sell silver for silver
unless it is the same amount and do not make one greater
than the other.” (Bukhari and Muslim).

• The following narration sheds light on this form of riba with the
exchange of these types of commodities. A hadith mentions,
“Once Bilal brought Barni (a kind of dates) to the Prophet and
the Prophet asked him, ‘From where have you brought these?’
Bilal replied, ‘I had some inferior type of dates and exchanged
two Sa’s (approximately 6 kilograms) of it for one Sa’
(approximately 3 kilograms) of Barni dates in order to give it to
the Prophet to eat.’ Thereupon the Prophet said, Beware!
Beware! This is definitely Riba! Don’t do so, but if you want to
buy (a superior kind of dates), sell the inferior dates for money
and then buy the superior kind of dates with the money”
(Bukhari).
• This hadith shows the prohibition of exchanging the same
commodity of a different measurement, yet it also displays the
alternative solution. That is to sell the dates, and buy the other
dates with the money.
Riba Al-Fadl - Riba in Exchange (cont)

Riba rules - summary
• The commentator of Sahih Muslim, Imam Nawavi has
summarized these rules in the following way:
• When the underlying ‘Illah of the two goods being exchanged
is different, shortfall/excess and delay both are permissible,
e.g. the exchange of gold for wheat or dollars for a car.
• When the commodities of exchange are similar, excess and
delay both are prohibited, e.g. gold for gold or wheat for
wheat, dollars for dollars, etc.
• When the commodities of exchange are heterogeneous but the
‘Illah is the same, as in the case of exchanging gold for silver or
US Dollars for Japanese Yen (medium of exchange) or wheat
for rice (the ‘Illah being edibility), then xcess/deficiency is
allowed, but delay in exchange is not allowed. (Ayub 2007,
p.52)

Wisdom behind the prohibition of riba as put
forward by some scholars.
• It goes against mutual cooperation, generosity,
and spirit of partnership.
• Acquisition of property by wrongful means and
harm to the needy.
• Removal of the possibility for injustice and
exploitation.
• Drives the capital-owner away from enterprise
and real economic activities that contribute to the
welfare of society (e.g. commerce, manufacturing,
construction and so on)
• Money is meant to be a medium of exchange and
standard of value for other goods. Riba violates

2. The Prohibition of Gharar (Uncertainty)
• Gharar has a broad scope and is not limited to one simple
definition. For our purposes here, it relates to excessive
uncertainty or ignorance by way of a contract, or the goods
involved in a sale, the price, ownership, possession of goods,
deliverability, dates of exchange etc. A hadith collected by
Muslim narrated by Abu Hurairah states, “The Prophet
forbade selling by way of tossing stones to settle a sale (Al-
Haasah), and the sale of Gharar.”

Minor and major Gharar
Minor Gharar
• Gharar has been categorized into two categories, namely
major and minor. It is expected that minor (or trivial) accounts
of gharar will exist and for that reason it is tolerated and not
given concern. Such is the case of catching a taxi, there is an
element of uncertainty in the price as it rises with the mileage,
yet this is a minor form of uncertainty and is permissible.
Another example is buying fruit without peeling the skin to see
inside.
Major Gharar
• Causes for alarm are the major or substantial forms of gharar
which are clearly condemned from a Shari’ah perspective.
Major Gharar will be simply referred to as gharar in the rest of
the lecture notes.

• Gharar can generally refer to the following:
• Lack of Transparency -The Shari’ah stipulates that
transparency must exist in order for contracts to be legitimate.
For example, the terms of the contract must be clear to both
parties involved in order to be just and fair. Under such
measures, individuals are protected from fraud, deceit and
exploitation.
• Deception - Gharar can also imply deceit.
Once Prophet Mohammad came upon a heap of grain in the
market of Madinah and thrust his hand onto it. His fingers felt
dampness. On being asked, the trader replied that rain had
fallen upon it. The Prophet observed, "Why did you not then
keep (the wet portion of) it above the dry grain, so that
people may see it? He who deceives, has nothing to do with
me” (Muslim). Therefore, relevant information cannot be
withheld.

• Selling what you do not have
Part of Gharar is selling what is not in one’s possession. The
common example of this is the selling of the fish in the ocean
which has not been caught yet, or selling vegetables that the
seller is yet to purchase (i.e. they are not in possession or
ownership). This can lead to settlement risk and is therefore a
form of gharar. One should therefore catch the fish and then
sell it, or buy the vegetables from a wholesaler, and then sell
them to avoid the risk of uncertainty.
An exception to this rule is a salam contract (Bai’ As-Salam)
which relates to farm produce which has not been harvested
yet. Such a contract is paid up-front and an agreed upon
amount of goods (e.g. one ton) must be delivered at a later
date when the produce is harvested.

• Ignorance - The buyer should have relevant information
about the goods they intend to buy or the contract they intend
to sign. This is why it is important to inspect the goods one is
about to buy. With regards to what the buyer is buying, the
buyer should know (for example) the quantity, the attributes,
species etc. Or in the case of a contract, both parties should
have a sufficient understanding of the details and outcome of
the contract in order to remove any doubt.
• Unspecified Price - The price of the sale should be stipulated.
This is important if the goods are purchased on credit, in order
to avoid disagreement at a later date.
• Unspecified dates - As for the delivery of goods, the price can
be delayed or the goods can be delayed in delivery, yet this
should be by mutual consent of the buyer and seller.

• Akin to gambling
Maisir (game of chance) is regarded as gambling because the
outcome is unknown and clearly involves gharar. The practice of
Maisir is declared forbidden in Qur’an (2: 219). Therefore,
according to the Shari’ah, such games of chance are to be
avoided. An example of this is speculation in short selling,
conventional methods of forwards, futures, options and other
derivative transactions where future delivery of underlying assets
is uncertain (and usually settled in cash) as being forms of maisir.
• Although excessive gharar is condemned by the Shari’ah, this
does not rule out levels of risk by way of entrepreneurial risk and
risk associated with calamities (such as natural disasters).
Systematic risk and unsystematic risk will be covered in more
detail in the following weeks.
• Complexity in Contracts
Undue complexity in contracts or interdependent contracts
where two sales are combined in one are not permitted. (e.g. I
will sell you A as such a price, if you sell me B at such a price.)

3. Sanctity of Contract
Sanctity of Contract
• As excessive gharar is impermissible in Islam, the Shari’ah
emphasizes that contracts must include transparency and
honesty. Prices should be specified, there should be clarity of
the delivery details, quality of goods, quantity of goods etc.
The information should be available to all parties involved and
the outcomes of a contract should be free of ambiguity.
• When full disclosure is present, both parties eliminate or
reduce financial speculation and undue complexity in
contracts (due to gharar). This will include discloser of the risk
involved by providing as much information as possible for
buyers or investors.

3. Sanctity of Contract (cont)
• If two or more parties come together for a partnership (e.g.
musharakah), all parties should be aware of their profit-
sharing ratio, underlying assets involved, and other conditions
of the contract.
• The parties involved must mutually agree on the sale or
contract, albeit orally or preferably in written form, without
coercion.
• Contracts must be in accordance with Shari’ah principles.
Therefore, investments considered unethical, unlawful
(haram), unjust etc, would not be considered. Although riba
and gharar may not be involved, one must make sure that
other unlawful practices are not present. For example, it is
prohibited to finance a casino or deal with alcohol etc.

Case study: Riba & Gharar today
Identify role of Riba & Gharar in:
I. Global Financial Crisis (GFC)
II. European debt crisis (EDC)
III. Other examples?

Topic 3: Equity Based Financing (PLS mode)
Equity Based Financing:
Musharaka (Sharing, Equity/Business partnership, Joint Venture)
Mudaraba (Trustee/Limited/Investment Partnership)
FACULTY OF LAW AND
MANAGEMENT
SCHOOL OF ECONOMICS AND

Introduction
• The bank generally acts as a financial intermediary between
lenders and borrowers. By connecting savers to borrowers via
various financial products, banks mobilise funds that impact
on economic activities. However, Islamic financial Institutions
are less straightforward because the Shariah prohibits certain
transactions.
• Islam prohibits making money by money and thus all
transactions must not involve any interest (riba). The Qur'anic
verse "Allah has permitted trade and has forbidden interest
(usury)" [2:275] is the main reason why Islamic banking
derives its profit from real economic activities by means of
trading or investment. Given that the Shari’ah equally
prohibits charging and paying interest, opportunities for the
Australian financial sector lie in establishing Shari’ah compliant
financing instruments.

Equity based financing
• Under Islamic Banking there are two main fields of financing.
One is Equity Based Financing and the second is Debt Based
Financing. These modes of financing primarily differ from
conventional financing due to their voidance of interest.
• Equity Based Financing - profit-and-loss sharing (PLS)
• Musharaka (Sharing, Equity/Business partnership, Joint
Venture)
• Mudaraba (Trustee/Limited/Investment Partnership)

Musharaka (Sharing, Equity/Business
partnership, Joint Venture)
• Two or more parties come together and contribute funds in a
partnership. Partners share in the profit or loss of a joint
venture.
• The profit-ratio is determined according to the agreement of
the partners and not necessarily according to their capital
contribution. This could depend on how much each partner
contributes to the partnership beyond their capital share.
However, the losses must be determined according to the
percentage of one’s share in the investment. Scholars agree
(Ijma’) on the equal division of loss in accordance with the
ratio of each investor.
• The profit returned to each partner should reflect the actual
profits made by the enterprise as opposed to a set income.
Partners may contribute cash or assets towards the
partnership. Their contribution ratio should be determined
according to the value of the assets.

75%
25%
$7.5mil Profit
$2.5mil Profit
$10mil (25%)
Musharaka (Equity partnership, Joint Venture)
Investor
A
Investor
B
Business
Venture
$30mil (75%)
Profit
10mil

Musharaka - example
Investor Contribution Outcome
1
Profit 200
Outcome
2
Loss 100
A 100 (10%) 20 (10%) -10 (10%)
B 300 (30%) 60 (30%) - 30 (30%)
C 600 (60%) 120 (60%) - 60 (60%)
Profit arrangement ratio is pre-agreed at the start (10/30/60 or
it could be eg. 15/30/55) based on investors involvement in the
business management and other relevant factors (eg. experience,
skills and so on). However, loss must be shared in proportion to
contributed capital (in this case 10/30/60) and can not be
changed.

Home purchase
• Diminishing Musharaka – This method can be used in
purchasing property or assets such as machinery for a factory.
For example, under a diminishing Musharakah contract, the
bank (or financier) and the client become partners.
• The client must provide a significant amount of funds e.g. 20%
to purchase the house with the bank. The bank in this case
owns the other 80% which the client will pay over time in
installments. Since the client will be living in the house, they
will pay (on top of the installments) a certain percentage (e.g.
8%) in rent (ijarah) to the bank for the share the bank owns.
• Over time, the client will own more equity in the house until it
is completely bought, while the rent will decrease as the
bank’s share diminishes.

Payment for piece of
property (eg. 10%)
Transfer of ownership
Rent %
Rent %
Price 80% Price 20%
Diminishing Musharaka (Musharaka Mutanaqisa)
Customer
Bank
Home Purchase
Ownership %
Bank Customer
80%↓ 20%↑
70%↓ 30%↑
60%↓ 40%↑
50%↓ 50%↑
40%↓ 60%↑
30%↓ 70%↑
20%↓ 80%↑
10%↓ 90%↑
0%↓ 100%↑
Bank’s participation diminishes over
time until customer becomes sole
owner of the property.

Mudaraba (Trustee or Investment
Partnership)
• Such a contract requires one partner with the funds, known as
Rabb-ul-Mal (Owner of Wealth), and one partner is the
Mudarib (Entrepreneur, Fund Manager). There can be more
than one Mudarib to work together as partners with the Rabb-
ul-Mal.
• If the business or project is a success, the profit is shared
according to a pre-agreed ratio. Typically, the Rabb-ul-Mal
bears the risk of losing money, while the Mudarib loses time and
effort if the project does not bear fruit.
• The Rabb-ul-Mal may specify where they want the Mudarib to
invest their money (Al-Mudaraba Al-Muqayyada – specific or
restricted Mudaraba, eg. Specific type of business of place).
Otherwise, the Mudarib is free to invest where they best see fit
(Al-Mudaraba Al-Mutlaqa – unrestricted or general investment
(Mudaraba), unrestricted by time, place, activity and so on).

Share of profits
capital
management
Share of profits
Mudaraba (Investment Partnership)
Investor
Mudarib
(entrepreneur)
Business
Venture
Profit
Profit can not be a fixed amount (for PLS financing) but must be determined
by a pre-agreed ratio. In case of loss, the investor loses capital and the
mudarib loses time and effort. In the case of proven negligence by the
mudarib, the mudarib may be liable for capital as well.

Topic 4: Debt-Based Financing (non-PLS Modes)
Murabaha (Cost Plus Sale) - Bai’ bithaman ajil (BBA, deferred payment) - Ijarah (Leasing)
- Bai’ As-Salam (Deferred Delivery Sale) - Bai’ Al-Istisna’ (Manufacturing Sale) - Bai’
Al-Istijrar (Suply Sale) - Qard Hasan
Contentious Instruments: Bai’ Al-Einah (Back to back repurchase) - At-Tawarruq
(Tripartate Sale) - Bai’ Al-Dayn (Sale of Debt, Bill discounting)
FACULTY OF LAW AND
MANAGEMENT

Debt-Based Financing or non-PLS Modes.
• The following instruments are the most commonly used within
IBF. They are the Shari’ah compliant alternatives to interest
based modes of financing.
Murabaha (Cost Plus Sale)
Implies a mark-up in price. The merchandise is purchased, the
buyer marks up the price and sells it to the customer and thus
benefits from the profit.
Bai’ bithaman ajil (BBA)- Murabaha (deferred payment) In the
case of financing, Murabaha is the useful alternative to
conventional loans when it is combined with Bai’ bithaman ajil
(BBA). Bai’ bithaman ajil (BBA) means sale with deferred
payment and can also be known as Bai’ Al-Mu’ajjal, which
carries the same meaning.

• BBA and Murabaha are similar concepts and are often used
interchangeably, where Murabaha is used for short term and
BBA represents long term credit sale.
• When a customer seeks to purchase a product and is unable to
pay up-front, the customer may require the bank (or financier)
to purchase the product. Thereafter, the bank (or financier)
sells the product to the customer who will pay at a later date,
in full or by installments (BBA), with a mark-up in price. The
profit is a fixed amount agreed upon at the commencement of
the contract. Under a Murabaha contract, both parties are
aware of the original price as well as the mark up price. This is
different from a typical everyday sale (Musawama) where
costs and profit are not disclosed (like buying from the shop).

$130,000
(deferred
payment,
including profit
mark up)
$100,000
(spot payment)
Goods
(immediate
delivery)
Murabaha
Customer
Bank
Goods
Supplier
Bank must own
the asset before
selling it.
Goods
(immediate
delivery)
Financing asset purchase
Debt Based Financing:
Why it is called debt

Ijarah (Leasing)
• Leasing entails that ownership remains that of the lessor and is
to be transferred to the lessee by way of usufruct (i.e. the right
to use it). The lessee pays the lessor for the duration of the
contract at an agreed amount.
Upon the close of an ijarah contract:
• The lessee may return the assets to the owner.
• The lessee may sign another contract to continue leasing.
• The lessor may offer to sell the assets to the lessee under
another contract. This is known as Al-Ijarah Thumma Al-Bai’
(AITAB).
• The lessor may give the asset as a gift to the lessee. This is
referred to as Al-Ijarah Muntahia Bittamleek (a contract of
leasing ending with ownership).
Ijarah cannot be applied to money, or perishables (food), or
other things that can be consumed (such as fuel).
Ijarah can also be used in reference to the services given by a

Bai’ As-Salam (Deferred Delivery Sale, pre-paid sale)
• When the Prophet came to Madina, the inhabitants use to pay
in advance for dates to be delivered a year or two later. The
Prophet told the people, “Whoever pays in advance for dates
(to be delivered later) should pay it for a known specified
weight and measure (of the dates).” Another hadith mentions,
“…for a specific period”(Collected by Bukhari). The other items
that were sold in the lifetime of the Prophet under a Salam
sale included wheat, barley and raisons.
• Selling agricultural produce in advance is permissible providing
certain conditions are fulfilled. Some may refer to a Salam
contract as a forward contract, however, a forward contract
involves a deferred payment as well as deferred delivery.
Among the conditions of a Salam contract is the up-front spot
payment. This may help the farmer with the means of
sustenance or for the finance needed to harvest the crops. As
the hadiths above mention, the Salam contract must stipulate
a specified measure for a specific time period.

• Bai’ Al-Istisna’ (Manufacturing Sale) – This sale requires the
manufacture, assembly, construction etc of a specified item or
items. This could be used for the production of electrical
goods, machinery, a construction of a house, plane etc. Unlike
a Salam sale, an Istisna’ sale may consist of a deferred
payment, lump sum or installments, depending on the
agreement.
• Bai’ Al-Istijrar (Suply Sale) – This involves the delivery of
certain goods periodically over time. Likewise the price can be
paid periodically according to the agreement of both parties.
• Qard Hasan (Benevolent Loan) – This is a loan that involves no
interest. The principle is paid at a later date without any
increase. If one borrows $1000, they will repay $1000 at a
later date.

Contentious Instruments.
• The following products are used in some countries, yet, have
received the most criticism from various scholars.
Bai’ Al-Einah (Back to back repurchase)
• One contract that comes under scrutiny is Bai’ Al-Einah. When
someone requires money, they sell a product to the bank in
receipt of cash. The seller then agrees to buy back the product
from the bank at a higher price to be paid in the future,
commonly through installments (BBA). Therefore, it includes a
spot sale and a credit sale. Most scholars criticize this sale as a
form of ‘riba through the back door’. The sale is artificial in
order to receive cash. Likewise the bank buys the goods
momentarily for which it has no use. Likewise, Al-Einah
involves two sales in one contract. The Prophet forbade “two
sales in one” (Ahmad, An-Nasaa’i, Al-Tirmithi).

Repurchase
of goods
$100
(spot
payment)
$110
(deferred
payment)
Bai-al-Einah (Repurchase)
Customer
Bank
Goods
In Bai-al-Einah, identity
of the customer &
supplier is the same.
Customer ends up with
$100 (cash) and
deferred debt of $110
is created.
Profit in this case is not
result of a genuine sale
and is therefore
indistinguishable from
riba.
This mechanism is used
in some countries for

At-Tawarruq (Tripartate Sale)
• Tawarruq has been criticized as being related to Al-Eenah in
the sense that it is seen as a means to by-pass Riba. Others
may see it as a legitimate sale, some scholars do not. Those
who tolerate this sale may do so based on the individual’s
need for instant cash, providing certain conditions are met.
Unlike Al-Eenah which involves only two parties, three parties
are involved in Tawarruq. For example, the customer seeking
cash approaches the bank. The bank buys a product from a
vendor, then sells it to the customer BBA-Murabaha (Mark-up
sale with deferred payments). The customer agrees and then
requires the bank (now as an agent) to sell it to a vendor on
their behalf in order to receive cash. The customer gains
liquidity, yet now they have a higher debt to pay at a later
date.

Spot
sale
for
$100,000
$130,000
(deferred
payment)
$100,000
(spot payment)
Goods
(immediate
delivery)
Tawarruq (Tripartate Sale)
Customer
A
Bank
Goods
Supplier
Goods
(immediate
delivery)
Customer
B
In Bai-al-Einah identity of the customer A &
supplier is the same, while in Tawarruq it is not.
Customer A ends up with cash that is result of a
genuine sale to customer B.
This mechanism is used in some countries for
credit card arrangements. However, organised
tawarruk where goods supplier and customer B
have same identity may resemble Bai-al-Einah

Bai’ Al-Dayn (Sale of Debt, Bill discounting)
• The Shariah promotes investment in tangible assets
as opposed to investment in debts. The only
exception put forward (by the Shafi’ee School) for the
sale of debt is when the debt is sold off (or passed
on) at par value without any discount. This condition
is necessary in order to prevent any form of riba
(interest).
• In the following weeks we will look at how some of
these mechanisms have been applied in the Islamic
banking industry.

Transfer of debt
$115
$110
Bill of exchange
*Representing
deferred
payment of
money.
Eg $115.
Sale
Bai’ Ad-Dayn (Sale of Debt, Bill discounting)
A
Note:
Selling more money (later) for
less money (now).
Transfer of debt only allowed at
par value in order to prevent
creation of riba (interest).
B C

Topic 5: Deposit products
Main Deposit accounts: Current (Wadiah/Qard) account -
Savings (Wadiah/Mudaraba) account - Investment (Mudaraba)
account - Debit and Charge cards
FACULTY OF LAW AND
MANAGEMENT

Deposit products
• In order to facilitate intermediation between savers and
investor, the bank mobilizes funds via a range of deposit
products with different risk/return characteristics.
• Main Deposit accounts:
1. Current (Wadiah/Qard) account
2. Savings (Wadiah/Mudaraba) account
3. Investment (Mudaraba) account
Bank
(Financial
Intermedia
Deposit
accounts:
1.
Current
account
Deposits
Financi
ng
Produc
ts
Equity-
Based
(PLS)
Debt-
Based
(Non-PLS)

Deposit products (cont)
• Deposit accounts play a key role, not just for banks, but for the
economy in general. Much of the wealth kept within the trust
of a bank is utilized in investments, financing businesses etc.
This in turn helps the workforce and stimulates productivity
via a number of PLS and debt-based modes of financing.
Islamic banks therefore, with deposits from customers, utilize
these modes of financing to provide a sustainable service to
the community.
• While mobilizing in a Shari’ah compliant manner, other issues
such as risk, return, liquidity, maturity, safety, and stability are
considered before offering the right deposit account that
would satisfy customers’ needs.

Current accounts
• It is attractive for customers to leave their deposits in banks
for safe-keeping and to have easy access to liquidity. These
accounts allow money to be withdrawn by card access to
automated teller machines (ATM). The deposits are held with
the bank as an Amanah (Trust).
• Current account deposit may be structured on various
mechanisms. Two of the most common are:
1. Wadiah-wad-Dhamanah (Guaranteed deposits)
2. Qard (benevolent loan)

Current accounts (cont)
• Wadi’ah (Safekeeping) – Customers deposit money in Islamic
banks under the principle of Wadi’ah wad Damanah. ‫و‬
‫د‬
‫يعة‬
Wadi’ah means Deposit or Trust. ‫ضمانة‬ Damanah means
Guarantee. Wadi’ah is like an Amanah (trust), yet under a
trust there is no total guarantee (due to theft, catastrophe
etc). Therefore the word Damanah is added. Under such an
account the customer is able to safely deposit their money on
the basis of trust, knowing that they can withdraw all or part
of their funds when they desire.
• Since there are no conditions for deposits and withdrawals,
funds kept by the bank as a trust may be utilized at the banks
own risk. Depositors do not share any risk, so, any profit or
loss is passed only to the bank.

Current accounts (cont)
• Qard Hasan (Benevolent Loan) – Another way current
accounts may be described is with the use of Qard Hasan. The
deposit by the customer is seen as an interest free loan given
to the bank. The account bears no profit for the customer.
• As was the case with a Wadiah account, the bank may utilize
the funds at its own risk. Any benefit to the lender under this
mechanism is seen as riba and against the spirit of the qard
account.
• The main motive for a customer to have a current account is
to keep excess liquidity available in demand. The objective to
earn profit is not the priority. These accounts are operated for
the safe custody of deposits, and for the convenience of
customers.

Example:* Islamic Bank of Britain:
Features and Benefits
Interest-free bank account: receive no interest, pay no interest
Deposits may be made by cash, cheque or direct account
transfer
Withdraw funds at our branches through an ATM, or by direct
account transfer to another bank account
Funds deposited will be administered in accordance with Sharia
Principles.
Standing order and Direct Debit facilities
International payments
Access to our foreign currency and travellers cheque services
Automatic access to your account via our automated telephone
banking service 24/7 or online
*http://www.islamic-bank.com

Saving accounts
• Deposit products that are modeled on Wadiah/Mudaraba
mechanisms, are known as savings deposits. Their function is
to safeguard deposits whilst providing a modest return on the
capital. In that sense it is similar to the savings account with a
conventional bank.
• This form of deposits is very popular in South East Asian
countries, as customers have a degree of convenience in using
and accessing their funds. Banks must request the permission
of depositors before utilizing the funds for investment. The
bank however claims ownership over the profits and at times
rewards the customers. Withdrawal facilities are provided by
the banks to the customer, such as passbook, ATM cards and
so on.

• The bank has no obligation to give beyond what is deposited,
however, the bank may give a gift (for wadiah) or profit (for
mudaraba based deposits) to the customers who meet the
minimum required deposit under this account. For Mudaraba
it is mainly related to a minimum balance maintained for
investment during the time period. For Wadi’ah accounts,
Hibah (gift) varies and is not a condition of the contract.
• Jaabir ibn Abdullah said, “The Prophet owed me something
and he paid me back and gave me something extra” (Abu
Dawud). Regarding this hadith, one commentator (Al-
‘Azimabadi) on the hadith collection of Abu Dawud stated, “If,
while paying off his debt, a person gives something extra of his
own accord, it is not riba but just an act of generosity on his
part”. Although the Prophet gave extra in this case, it
definitely was not a condition prior to taking the loan.
Saving accounts (cont)

Investment Accounts
• Investment accounts follow the principle of
Mudaraba (investment partnership). The investor
is the Rabb-ul-Mal who deposits money in the
bank under an investment account. The bank in
this case acts as the Mudarib who will manage the
funds. The bank will find Shari’ah compliant
investments such as projects, sukuk (certificates),
financing transactions, property etc. The profit will
be according to a pre-determined ratio agreed
upon by both parties. As it is based on the
success of investments, the rate of return cannot
be fixed.

Investment Accounts (cont)
• The investor will receive weightages which are profit ratios
according to each investment. Inevitably, the depositor (Rabb-
ul-Mal) risks the loss of funds if the investments fail. Although
bearing loss is not common, this is how a Mudaraba contract
works. However, some banks may guarantee the principle of
the deposit if investments fail.

Types of Investment accounts
• Mudaraba Muthalaqa (General Investment Account) – Under
this account, the depositor does not stipulate where they want
their funds invested. They leave the bank with the flexibility to
manage the funds how it deems fit.
The funds may be placed in a pool of funds from other
investors for a fixed period. Likewise, the funds may be used
for a combination of investments with different maturities.
• Mudaraba Mudayyaqa (Special Investment Account) - This
account allows the depositor to specify what type of
investments they prefer. This may require a certain level of
funds to qualify for this account. The bank therefore only
utilizes the funds to invest in a company, project, venture etc,
where both parties mutually agree.

Example:* Al Rajhi Fixed Term
Investment Account
• The Al Rajhi Fixed Term Investment Account-i is a
flexible, easy and ethical way to get your money
to work harder for you. And the peace of mind
that comes with knowing that all Al Rajhi Bank's
products protect you under the principles
enshrined in the Shariah.
• Enjoy a minimum investment from as low as
RM500
• High profit-sharing ratio up to 80%
• Flexible tenure up to 60 months
• The investment period and the profit-sharing ratio
are agreed upfront. The performance of your
investment funds are calculated on a monthly

Debit and Credit Facilities
Debit Cards
• As offered by conventional banks, the debit card
is a useful alternative to credit cards. The card is
merely a prepaid card and therefore does not
assist users by falling into debt and most
importantly, paying interest. Debit cards fulfill the
same purposes of credit cards like online
purchases (such as airline tickets). The major
difference is that customers must upload their
own money to use the debit card. Likewise, debit
cards also allow cash withdrawals from ATMs
worldwide. Some banks charge a monthly or
annual access fee, while some banks charge no
fees.

In 2010 a ‘Halal-approved MasterCard’ was officially launched in
Canada. It is known as the iFreedom Plus MasterCard.
Although it is only a prepaid card, it was endorsed by a
number of Muslim scholars and likewise it offers a range of
discounts when used (such as 10% discount
with Etihad Airways).
Other Shari’ah Compliant Cards
• Other cards function for the purpose of providing the
customer with the means to purchase, however they incur a
debt that must be repaid. Islamic Charge cards for example,
function according to Al-Eenah or Tawarruq where the bank
makes a profit through the transactions. It is an attempt to
replace the credit card by means of supplying credit for
customers. Yet it bears the hallmarks of a real credit card and
for that reason it finds much criticism.

• Some banks promote Shari’ah compliant credit cards. These
are advertised as bearing no interest and no hidden costs. The
customer pays an annual fixed fee which can be paid monthly.
This fee is seen as ijarah for the services provided (or Ujrah).
There is a grace period like a conventional credit card contract,
thereafter penalties apply for late payments.
• Late Fees
According to Taqi Usmani, to incur a fee for the late payment
resembles Riba An-Nasee’ah (Riba of Debt) where the lender
would say, “pay up or pay riba (increase)”. However, some
scholars may tolerate a fee for overdue payments providing
the fee does not go to the bank, lessor, lender etc. It should be
stipulated that the fee will be given to a charity. This may act
as a deterrent for the debtor to delay payments.

Topic 6: Financial management
Risk and Liquidity management
Systematic risk (Macroeconomic factors)
Unsystematic risk (Unique to a firm or an industry)
Risk Management

Financial management
• The objective of financial management is to
maximize the value of the firm.
• The value of the firm can be measured through its
profitability and risk level.
• In reality one of the key aspects of financial
management is risk management because every
decision or process will have a risk.
• Risk arises when there is a possibility of more than
one outcome and the ultimate outcome is
unknown.

The Elements of risk and Liquidity in
Islamic banks
• Risk is the variability or volatility of unexpected outcome.
• Risk can be divided into two types: systematic risk and
unsystematic risk.
• Systematic risk is a risk that arises from the
macroeconomic factors such as changes in economy, political
and social issues, business environment, interest rates,
inflation, war and international incidents.
• As such it can be hedged, but cannot be diversified completely
away. Systematic risk includes: interest rates risk, foreign
exchanges risk, commodity prices risk and industry
concentration risk.

• Unsystematic risk is a risk
that is unique to a firm or an
industry.
• It is associated with random causes
that can be eliminated through
diversification and it can be
controlled through good
governance. The examples of
unsystematic risk are regulatory
action, mismanagement of a firm,
labour difficulties, consumer
preferences, loss of key accounts
and labour strikes.

Risk Management
• The nature of financial institution operations exposes them to
different types of risks. Both depositary and non-depositary
financial institutions are a risky business. According to
Saunders and Cornett (2006), there are five common risks
faced by financial institutions: credit or default risk, interest
rates risk, liquidity risk, underwriting risk and operating risk.

Risk Management (cont)
• Largest source of serious banking problems
is credit risk, the risk of counter party
default. Credit Risk is defined as a risk that
the value of portfolio may change due to
the unexpected changes in the credit
quality of issuer or trading partner (McNeil,
Frey, & Embrechts, 2005).
• Note:Islamic finance is also vulnerable if
care is not taken - not in terms of its
product structuring, but in relation to non-
performing financing due to its credit
policies.

• Islamic banking is involved in risk taking by its very nature,
with the risk minimized by way of valid risk management tools,
but never totally avoided or eliminated.
• In Islamic banking there has to be real business conducted as a
result of which profit or loss can be incurred and hence Islamic
Banks take on risk. The additional risk that IFI have to face,
compared to conventional finance, is asset risk, market risk,
Shariah non-compliance risk, greater rate of return risk,
greater fiduciary risk, and greater legal risk.

• Asset risk is involved in all modes, particularly in Murabaha
(onward sale to the client with mark-up price), Salam (after
taking delivery from the seller) and Ijarah as all the ownership-
related risk belongs to the bank as long as the asset is in its
ownership.
• If the asset is damaged without any fault on the part of the
lessee and it is not deliverable, the bank’s right to receive rent
will cease.
• Shirkah-based risk (PLS) is borne as per the share in the
ownership market risk.

• The bank might not be able to market the goods purchased on
the basis of salam, Istisna etc at a profitable price.
• Rate of return risk is involved as the price (once fixed) in
Murabaha /Salam cannot be increased.
• Remaining within Shariah principles, Islamic banks are allowed
to take risk mitigation/management measures, but transfer of
risk to anyone else without transferring related rewards is not
permissible.

• In addition to effective management and
supervision, other factors necessary to
ensure the safety of the banking institution
and the stability of the financial system and
the market include; sound and sustainable
macroeconomics policies; well developed
and consistent legal framework; adequate
financial sector infrastructure; effective
market discipline; and a sufficient banking
sector safety net.

• Credit risk is simply defined as the potential that a borrower or
counterparty will fail to meet their obligation in accordance
with the agreed term. It is the risk of failure of the counter
party to honour their commitment and also refer to default
risk.
• This arises from the inability of the counterparty to service
the debt on the agreed term. It can also arise when the
solvency or the credit rating of the counterparty changes
adversely.
• In Islamic banking there is limited availability of credit rating
defined from external agencies.

• The risk of non-compliance with Shariah rules is referred to
as Shariah risk. This can be included in operational risk as
non-compliance can lead to reputational damages which can
trigger an exodus of findings from the Islamic investor, causing
failure and system risk.
• If Islamic financing found a product that does not fully comply
with Shariah rules, then it would be subject to Shariah scrutiny
and thus be considered to be an adaptation based on current
market needs.
• These products pose special risks in terms of being rejected
under the scrutiny of Shariah rules. As interpretation can
differ, the utmost precaution is needed before entering into
any contract, with approval from the Shariah council .

• There are four elements that should be
well defined and considered in financial
risk analysis for Islamic products, which
are:
1. The construction of the financial contract
2. Identification of the markets
3. Identification of the behavior of
counterparties
4. Interaction of the above two within a time
period mapped into the financial contract.

• The role of information in the risk management of the
Islamic financial institution can be more critically
compared to conventional finance, with the nature of
contracts in Islamic banking more integrated with the
activities of the entrepreneur.
• The PLS contract is heavily biased towards the
availability of information for managing risks. In the case
of musharakah and mudarabah contracts, there is a
heavy bias towards the availability of information for
risk management.

• There is special emphasis on transparency in the conduct of
activities, calculation of profit and loss, as well as the nature of
activities. This includes a focus on social responsibilities, with
efficient information management requiring special
dimensions in Islamic finance institutions which are more than
merely statutory .
• Profit has to be earned by sharing risk and reward of
ownership through the pricing of good services.
• Investment both by bank depositors and the financial
institution will be considered only if it is part of real activity,
or is itself a real activity. This is because money has the
potential for growth when joined with entrepreneurship, as in
itself, it is recognized as capital and therefore it cannot earn a
return.

• The business risk involved in shirkah (PLS) based modes where
loss has to be borne by the capital provider, whilst the
manager or entrepreneur loses the labour in the case of joint
business venture.
• For the depositor in Islamic banking, risk stems from the
failure of business and uncertainty in the level of profit to be
shared.
• Depositor should not be burdened on the account of
negligence.
• Mitigation of that risk would require special expertise and
sound knowledge of Shariah rules, lest it may lead to non-
Shariah compliance.

• Risk of default by clients can be mitigated, in some cases, by
putting a penalty clause in the contract to serve as a deterrent,
the amount of penalty would go to a Charity account.
• This is in all modes except Istisna, when the bank can insert a
clause for decrease in the price if asset in case of delay in
delivery.
• The logic behind the provision in the case of Istisna is that
manufacturing/construction of any asset depends, to a large
extent, on personal effort, commitment and hard work by the
Manufacturer who may start work on the contract with other
people. While in the case of Murabahah and Salam one has to
pay the deferred liability that has been defined and stipulated
in the contract.

Liquidity Management
• Liquidity management
means ensuring that the
bank has sufficient liquid
funds available for a smooth
running of its operation in
order to meet short term
financial obligations as and
when due.

Liquidity Management (cont)
• Liquidity can be managed by dealing in the Islamic interbank
fund market. The most useful instrument for the transaction is
the mudaraba ratio that could be negotiated according to
market conditions.
• Liquidity management in Islamic banks can also be done
through securitization of the pool of income generating assets.
If the bank requires liquidity it may sell sukuk in the secondary
market to another bank to generate cash. If it is in surplus, it
can purchase sukuk from the market.

Liquidity Management (cont)
In the case of Mudahrabah ,the following process can be
adopted:
1. A mudarabah relationship will be created
2. Funds received will be allocated to pools
3. Weightages will be assigned periodically, based on different
tier/categories
4. Profit earned will be allocated accordingly to weightages
assigned at the beginning of the period.
5. The bank will charge a pre-agreed Mudarib fee as a
percentage of the realized profit, the bank can pay additionally
from its share
6. The investor will be at a loss unless it arises from misconduct
or negligence of the Mudarib.

The differences in managing risk: IB & CB
• Risk management is a process that protects assets and profit
of an organization by; reducing the potential for loss before it
occurs; mitigating the impact of the loss if it occurs; and
executing a swift recovery after the loss occurs (Coffin, 2009).
• Financial institutions are a business entity owned by their
shareholders and the objective of the business entity is to
maximize the shareholders’ wealth. One way to achieve this
objective is that the management should efficiently diversify
the unsystematic risk and reduce or transfer the systematic
risk. In the financial sector, risk management is an area of high
interest due to the financial crises of the last two decades
(Galindo & Tamayo, 2000).

Basic Concept of Risk Management Process and
System
1. Establishing Appropriate Risk Management
Environment and Sound Policies and Procedures
2. Maintaining an Appropriate Risk Measurement,
Mitigating and Monitoring Process
3. Adequate Internal Control

The differences in managing risk: IB & CB (cont)
• Islamic financial institutions can be riskier than conventional
financial institutions due to several reasons including the
specific nature of risk and the unlimited number of ways to
finance a project using either profit loss sharing or non-profit
loss sharing contracts.
• Scarcity of hedging instruments, undeveloped inter-bank
money markets and a market for government securities which
are Shariah compliant. Therefore, Islamic financial institutions
may be more vulnerable to unfavourable events than
conventional financial institutions.

• Inability to utilize money markets makes Islamic financial
institutions more susceptible to liquidity risk.
• For Islamic financial institutions, liquidity risk can be
considered as one of the most critical risks due to certain
factor such as:
(1)limited liability of Shariah compatible money market and inter-bank
market,
(2) shallow depth of secondary market for Islamic financial instruments and
(3) the problem of the lender as a last resort from central bank.

• The last group of risks faced by Islamic financial
institutions are governance risks. Governance risk
refers to the risk arising from: a failure in governing
the institutions; negligence in conducting a business
and meeting contractual obligations; and from a
weak internal and external institutional environment,
including legal risk, whereby financial institutions are
unable to enforce their contracts.

Topic 7: Introduction to Islamic Capital Markets
FACULTY OF LAW AND
MANAGEMENT
Conventional capital markets
Islamic Capital Market (ICM)
Portfolio choices: Investment in Shares
Conditions for investing and trading with shares
Commodity Murabaha - Islamic Investment Fund
Derivatives in Islamic Finance
Sukuk (Islamic equivalent of bonds)

Capital Markets
In the conventional sense, a capital market is a place where debt
(e.g. bonds) and equity (shares) securities are traded.
It is generally divided into:
• Primary market (issuing and trading new securities, raising
new capital)
• Secondary market (facilitates trading of previously issued
securities).
Why is it called ‘capital’ market?
Why do we need them?
How would conventional be different from Islamic capital

Islamic Capital Market (ICM)
• In the Islamic capital market, all financial intermediation
activities must be Shariah compliant (i.e. free from unethical,
immoral, speculative or prohibited activities such as usury
(riba), gambling (maisir), excessive uncertainty (gharar) and so
on).
• Two main components of an Islamic capital market (ICM)
include:*
A. Debt securities market (Instruments created through
deferred contracts of exchange)
B. Equity securities market (Instruments created through
profit sharing contracts)
*(Kettell, Islamic Capital Markets, 2009, p. 76)

Islamic capital market (ICM)
Main objectives include:
• Efficiency in allocation of financial resources including
transparency in pricing of securities with regards to
risk/return/time preference.
• Transfer of funds from surplus saving to deficit spending units
and equitable distribution of benefits.
• Companies: Raise funds that are used to finance buying
buildings, aeroplanes, factories and other assets and/or
business activities.
• Investor: Yield profitable returns from investment.
• Enhancing liquidity, risk management and portfolio
diversification.

Portfolio choices: Investment in Shares
Shares represent units of ownership interest or a specific part
of the total capital of a company.
By purchasing shares in a company a person becomes a
shareholder or partner in a business. As such, a shareholder is
entitled to receive proportional profits that result from the
company’s economic activities. (Similar to a musharaka
arrangement)
In general there is nothing wrong with buying or selling shares
as part of an investment strategy, as long as Shariah conditions
relative to the main business of the company are followed.

 Qualitative Screens
Industry screening
Business practices
 Quantitative Screens
Debt/Asset Ratio
Interest-related Income
Monetary Assets
 Prohibited Trading Practices
Conditions for investing and trading with
shares

A Qualitative Screens
There are two types of qualitative screens: Industry screening and
business practices.
Industry screening:
The main concern relates to the type of industry the company is
involved in. The general rule is that most business activities are
permitted (halal) unless specifically prohibited by the Shariah. For
that reason, if the main business of the company is halal
(permissible) and Shariah prohibitions are avoided (e.g. Riba),
then shares of such a company are also permissible.
It is not acceptable to buy/sell shares of a company that is
involved with un-Islamic/unlawful (haram) products or services,
such as, gambling, alcohol, pork, tobacco products, interest based
financial institutions like banks and Insurance companies, adult
products and so on.

Business practices
Islamic principles relating to investing and trading stipulate that the
acquisition of shares, from an investor’s point of view, must also be
done in a Shariah compliant way. The following two principles must
be observed while investing:
1. Investible funds must be free from interest based debt:
Financing investment can not be done by borrowing on interest (e.g.
Margin trading (borrowing and leveraging investment) as it is
commonly done by hedge funds).
2. Prohibition of speculation
Entering market as a speculator and thus making short-term
speculative investment decisions is not allowed (This is fundamental
difference between a true investor which is allowed and a
speculator).

Quantitative Screens
There are three types of quantitative screens:
1. Debt/Asset Ratio
Question of debt to asset ratio and how much has the company
borrowed? Usually it should not exceed 33%. What if it is
interest based? What if it is not? Is a ratio of 33% acceptable?
2. Interest-related Income
Does the company generate any interest or interest-related
income? (For instance, where earning interest is not their
business, but their surplus funds are placed in investments that
yield interest income). What if it is less than 5%? What if this 5%
of the dividend earnings is given in charity? Difference of
opinions- Why?

Quantitative Screens (cont)
• 3. Monetary Assets
To invest in Shariah compliant companies, one has to be very
careful that non-liquid assets be over 51% (note that this ratio
is the matter of ijtihad). The reason is that money cannot be
traded except at par value.
Why Quantitative screens?
Why the difference of opinions?

Prohibited Trading Practices
i. Day Trading
Buying and selling on short-term price fluctuations (normally
within one day) is closer to gambling and speculation than
actual investing. Should it be prohibited?
ii. Margin Trading:
Margin trading involves interest based borrowing from the
broker in order to buy stocks. It is prohibited because it
involves riba and involves excessive risk.

Prohibited Trading Practices (cont)
iii. Derivatives – Options, Futures & Swaps
The opinion that Futures trading is not permitted due to the
presence of gharar and maisir.
iv. Short Selling:
Short selling (borrowing a stock from the brokerage firm and
selling it in anticipation that the stock price will further go
down) involves huge risk and maisir (gambling) in addition to
selling what one does not possess (borrowed stock).
What are some examples?

Screens for Shari´ah Compliance (Dow Jones Islamic Market )
To determine their eligibility for the Dow Jones Islamic Market
Indexes℠, stocks are screened to ensure that each meets the
standards set out in the published methodology.
<http://www.djindexes.com/islamicmarket/>
Industry Screens
Alcohol, Pork-related products, Conventional financial services,
Entertainment, Tobacco, Weapons and defence.
Financial Ratio Screens
All of the following must be less than 33%:
 Total debt divided by trailing 24-month average market capitalization
 The sum of a company’s cash and interest-bearing securities divided
by trailing 24-month average market capitalization
 Accounts receivables divided by trailing 24-month average market

Wholesale Markets
Commodity Murabaha
• Commodity Murabaha is equal to Tawarruk but the commodity
typically represent metals (excluding gold and silver), that is listed on,
for instance, the London Metal Exchange. It is used for short term
financing.
• Under a basic Murabaha, the customer (who wants to own the
commodity) buys goods from the bank with deferred payment option.
Commodity Murabaha is a sub category of Murabaha, but the client
does not want to own commodity. Rather, the objective is to sell it to
another broker for cash (e.g. To be used as a working capital for
business). Transaction may or may not contain elements of interest,
hence, like in Tawarruq*, it is subject to the same controversy,
conditions and possible misuse.
*Tawarruq (or reverse Murabaha) is when a party in need of cash purchases a
commodity on deferred basis, then sells it on the spot for cash. (seeking

Commodity Murabaha (cont)
• Current practices and reasons for it?
• The transaction does not represent a genuine sale (as practiced
on London Metal Exchange)
• Why? What happens with the goods?
• Do they ever leave the warehouse or are they only used to
generate debt?
• What if it was a genuine sale/trading transaction? How would
it work?
• Would it be possible to trade gold and silver? Which type of
riba is this?
• How to prevent faulty structuring of murabaha?

Islamic Investment Fund (List 5 investment funds)
• Islamic Investment fund works on a partnership basis, where
investors jointly pool surplus money for investment purposes.
The subscribers of the Fund receive certificates or shares.
Modes of Investing:
• Equity fund (investment in the shares of a joint stock
company)
• Ijarah Fund (investment used to purchase assets for the
purpose of leasing)
• Commodity Fund (used for purchasing of different
commodities for the purpose of the resale)
• Murabaha Fund (sale on a cost plus basis, deferred payment
basis)
• Mixed Fund (Tangible assets must be over 51%. If liquidity and

Modes of Investing:
• Equity fund (investment in the shares of a joint stock
company)
• Ijarah Fund (investment used to purchase assets for the
purpose of leasing)
• Commodity Fund (used for purchasing different commodities
for the purpose of the resale)
• Murabaha Fund (sale on a cost plus basis, deferred payment
basis)
• Mixed Fund (Tangible assets must be over 51%. If liquidity and
debt exceed 50%, it can not be traded [it must be a closed-
end Fund])

Derivatives in Islamic finance
• A derivative - financial instrument (security) - is a contract between
two or more parties, whose value is derived from expected future
price movement of the underlying asset (e.g. shares, currency,
commodities, bonds, interest rates and market indexes). An example
of a typical derivative that involves the purchase of debt and liabilities
between two parties (subject of a future outcome of the underlying
asset) are options, swaps and futures.
Main Use: hedging risk and speculative purposes.
Example of hedging in a forward contract:
Farmer - Exposure to price fluctuation of the grain.
Contract Involves parties facing risk in opposite directions (win/lose situation). By
agreeing on a future (deferred) price and delivery, both parties eliminate price
movement risk (like insurance).

Why are derivatives forbidden (haram)?
“They ask thee (O Prophet) about Khamr (intoxicants) and
games of chance (gambling). Say: In both of them there is
great harm although there is some advantage as well in them
for men, but their harm is much greater than their
advantages.” Qur’an 2:219
• While there are some benefits in financial instruments such as
derivatives, the general Islamic principle is that harm which
results from gambling and speculative nature of conventional
derivatives is much greater.

Sukuk (Islamic equivalent of bonds)
• Sukuk – plural of Sakk (legal instrument, deed, check).
Sukuk are Islamic Investment Certificates (Islamic
equivalent/alternative of bonds)
Sukuk are defined by the Accounting and Auditing Organisation
for Islamic Financial Institutions (AAOIFI) as:
‘certificates of equal value representing undivided shares in
the ownership of tangible assets, usufructs and services or (in
the ownership of) the assets of particular projects or special
investment activity.’

Sukuk Structure:
Typical Sukuk Structure:
Partial ownership in a debt (Sukuk Murabaha)
Asset (Sukuk Ijarah)
Project (Sukuk Istisna)
Business (Sukuk Musharaka)
Other mixed structures
Note: Typical Sukuk structure is a combination of several
financial mechanisms such as Murabaha, Ijara, Istisna and so on.

Differences between Sukuk and
conventional bonds
• Prohibition on charging or paying of interest and other Shariah
constraints.
• Some Sukuk (e.g. debt) are not tradable in the secondary
market.
• Sukuk – securitisation & issuance of sukuk (taskeek) –
Transforming an asset’s future cash flow into present cash
flow.

Eg: Sukuk Ijara
*SPV – Special Purpose Vehicle (Issuer)
SPV*
Investor
ABC Ltd
Issue Sukuk
& pay profits
Pay Issue price
Lease (Ijarah)
Rental Payment
Name of Sukuk is derived from underlying principle that
underpins Sukuk structure – in this case ijarah!

Sukuk (cont)
• Ijarah vs Murabaha Sukuk, example:
Q: Who owns asset/debt in each structure and why is that
important? Who should maintain property and how? Can
certificate be traded in secondary markets? Other issues?
• Difference between ijarah and, for instance Murabaha based
Sukuk, is the simple issue of ownership and valuation of share
in the asset. While in Murabaha cash flow simply represents
debt (dayn) resulting certificate can not be traded on
secondary market. This is resolved in ijarah Sukuk where price
of certificate reflect proportional price of underlying asset.
Therefore, since trading with debt at a discount or a premium
is prohibited, ijarah Sukuk represents actual asset and not cash

Example:
GE Sukuk
• GE Capital, the finance
arm of General Electric,
has listed a recently
completed US$500
million Sukuk (Islamic
bond) on NASDAQ Dubai,
the Middle East's
international exchange.

Sukuk (cont)
Structuring Sukuk and Shariah risk
• A recent controversy paralysed Sukuk markets when Sheikh
Taqi Usmani, chair of the AAOIFI Shariah board, announced in
2007 that majority of equity-based Sukuk such as Mudaraba
and Musharaka were not structured in an Islamic acceptable
way.
• For instance, when structuring the question of ownership
must be clearly identified. It is not simply enough that Sukuk
are asset ‘based’ but they must be asset ‘backed’ and
therefore represent real ownership which will provide
sureness for investor in case of the default. It is only in this
situation that performance of the assets will be linked with
profitability of investment and not arbitrary interest rate.

Sukuk (cont)
Contemporary Issues*
• 1. Sukuk should be issued for new commercial and industrial
ventures. If they are issued for established businesses, then the
Sukuk must ensure that Sukuk holders have complete
ownership in real assets.
• 2. The returns of enterprises should be returned to Sukuk
holders regardless of what amounts they reach after costs,
including the manager's fees, or the share of the mudarib in
profits. If there is to be an incentive for a manager, then let it be
based on the profits expected from the enterprise and not on
the basis of an interest rate.
*Read full text:
• Mufti Taqi Usmani, 2007, Sukuk and their Contemporary Applications,

Sukuk (cont)
• 3. It is unlawful for a manager to lend money when actual
profits are less than expected.
• 4. It is unlawful for a manager, whether a mudarib or a partner
or an agent, to commit to repurchase of assets at face value.
Instead, their resale must be undertaken on the basis of the
net value of the assets, or at a price that is agreed upon at the
time of purchase.
• 5. Shariah supervisory boards must abide by the Shariah
Standards issued by the Shariah Council.

Topic 8: Legal and regulatory issues in Australia
FACULTY OF LAW AND
MANAGEMENT
Introduction: Islam and Muslims in Australia
Islamic banking and finance in Australia - Legal and regulatory issues
Awareness & Future opportunities

Islam in Australia
• Muslims came to Australia as early as the 1600s. Fishermen
from Indonesia’s Sulawesi Island began Australia’s first industry.
It involved the gathering of trepang (sea slug) which were
shipped to Indonesian waters to sell to various trade ships.
• With the introduction of camels, the Muslim cameleers brought
new found hope for Australia in the 1860s. Camels were able to
handle the harsh interior of Australia’s outback. This facilitated
inland exploration, the delivery of supplies, food provisions and
other necessities to remote areas. The cameleers mostly came
from what is known today as Pakistan, Afghanistan and India.
Due to their help, many train lines were made as well as the
overland telegraph line. The overland telegraph line stretched
three thousand kilometers across the interior and thus
connected Australia to the outside world through
telecommunication.

• Today’s Muslim population in Australia is estimated at
400,000. Muslims have migrated to Australia from over 120
countries and are ethnically and linguistically diverse.
• Islamic finance is yet to make significant impact on Australian
soil. However there are signs of facilitation for growth from
the Australian government. During the launch of the booklet
by the Australian Trade Commission (Austrade) titled Islamic
Finance, former Trade Minister Simon Crean said that “Islamic
financing is a crucial plank in the Government's strategy to
make Australia a financial hub in the Asia Pacific region”. In
May 2010 Senator Nick Sherry inaugurated the book launch in
Sydney of Demystifying Islamic Finance: Correcting
Misconceptions, Advancing Value Propositions. He mentioned,
“We are taking a keen interest in ensuring there are no
impediments to the development of Islamic finance in this
country, to allow market forces to operate freely.”

• Senator Nick Sherry also said, “On 26 April, I announced that
the Board of Taxation would undertake a comprehensive
review of Australia's tax laws to ensure that, wherever
possible, they do not inhibit the expansion of Islamic finance,
banking and insurance products.”
Further Readings in PDF Format
Islamic Finance (Austrade Publication)
http://www.austrade.gov.au/ArticleDocuments/2792/Islamic-Finance-
Publication.pdf.aspx
Demystifying Islamic Finance: Correcting Misconceptions,
Advancing Value Propositions (Zaid Ibrahim and Co.
Publication)
https://www.zaidibrahim.com/wp-content/uploads/2010/05/Demystifying-
Islamic-Finance-soft-copy.pdf

Awareness of Islamic banking products
among Muslims: The case of Australia
Query* Yes
(%)
No
(%)
N/A*
(%)
Awareness of halal banking products 55.7 44.1 0.3
Ever having held a halal stylised bank account 19.3 80.1 0.7
Willingness to switch to a halal product given some
quality of conventional banking service (ATM,
online access, phone banking)
92.5 7.4 1.5
Willingness to switch without credit facilities 79.0 20.9 0
Willing to switch to a profit-and-loss agreement
where you might incur losses
60.8 37.9 3.3
Willingness to switch dependant on brand
recognition
60.1 39.7 0.3
*Responses are quoted in
percentage terms with N/A

• Table indicates that, over 90% of Muslims would prefer a
Shariah compliant (halal) account and would consider
switching to another bank if opportunity was presented. What
is even more interesting is that the overwhelming majority of
Muslim customers would switch to halal banking even without
facilities (ATM, online access, phone banking) and despite
possible losses.
• While this study was concentrated mainly on the profit and
loss arrangements, it shows a demand and willingness of the
Muslims to engage proactively in Shariah compliant banking
products.
Awareness of Islamic banking products
among Muslims: The case of Australia

Australia

Introduction
• Islamic banking and finance globally represents one of the
fastest growing financial industries. With its strategic position
and well regulated financial system, Australia is attempting to
create conditions that would facilitate and replicate global
success in the Australian context.
• Australia is, and almost always has been, a capital importing
country. On the road to attract capital, every investment
ultimately needs to pass the test of profitability. Since Shariah
compliant investors have increased the number of global
choices, just offering Shariah compliant products is not enough
to attract key industry players.

Review of the present situation in
Australia
• With an estimated size of $1 trillion, Islamic banking is
predicted to grow at 10% per annum (Austrade, 2010). Major
financial institutions such as Citibank, JP Morgan/Chase,
Goldman Sache, USB, HSBC, ABN Amro, BNP Paribas, Societe
Generale, Deutsche Bank, Nomura Securities and many more
are capitalising on this growth opportunity.
• Since Islamic financial products must be linked with tangible
assets and real economic activities, Australia’s resource
related services and infrastructure creates a superb
opportunity. Moreover, its geographic position and close
proximity to the 972.5 million Muslims in Asia Pacific region
are amongst primary drivers behind the move to position
Australia as a financial centre in the Asia Pacific region
(Austrade 2010).

Australia
• The Australian Financial Centre Forum’s report entitled
“Australia as a Financial Centre - Building on our Strengths” or
as commonly referred as - The Johnson Report - identified the
Middle East as the major global source of offshore capital due
to its booming oil exports.
• The capital intensive nature of Australia’s’ resources related
services and infrastructure (Agribusiness, Mineral resources,
property, Oil and Gas) in addition to Islamic finance which
works mainly with assets, services and projects, creates
prospects for future partnership (Austrade 2010, The Johnson
Report 2009).

The Johnson Report Recommendations 3.6 & 4.8
Issue: Lack of Islamic finance products in Australia is limiting our
access to offshore savings pools.
Recommendation 3.6: Islamic finance products
The Forum recommends that the Treasurer refer to the Board of
Taxation the question of whether any amendments to existing
Commonwealth taxation provisions are necessary in order to
ensure that Islamic finance products have parity of treatment
with conventional products, having regard to their economic
substance.
Recommendation 4.8: Removal of regulatory barriers to
Islamic finance
The Forum recommends the removal of any regulatory barriers
to the development of Islamic financial products in Australia,
guided by the principle that there should be a ‘level playing field’
for such products.

Australia
• However, despite this progress, when compared with other
western nations, Australia is far behind and to see how far, we
only have to look at the IBF situation in the UK with 22 banks
in London (including five that are fully Shariah compliant),
twenty Sukuk issues raising US$11 billion listed on London
Stock Exchange, 20 law firms supplying services in Islamic
finance and a number of institutions offering educational and
training products supporting the IBF industry.
• In the environment that is dominated by the few conventional
banks, ensuring a level playing field will require long overdue
action to remove impediments that relate to taxation, legal
and regulatory obstacles as outlined in the Johnson Report.

Legal and regulatory issues in Australia
• Creating Islamic financial products is a vehicle that allows
Australian assets to be sold to a third party. To make financial
products attractive, beside Shariah compliant issues, it must
be profitable. The key components that determine profitability
typically is the tax treatment and the other regulations.
• For GCC investors - who do not pay taxes and do not have
double tax agreements with Australia - this represents a
particularly important issue. The Johnson report recognises
wholesale investment opportunity and recommends changes
that will attract Islamic investors and make IBF products
more competitive.

Nature of the transaction
• Shariah principle stipulates that in order to sell something one must take
possession and assume all relevant risk associated with the ownership of
the goods. In the murabaha transaction (below) it is required that the bank
must own goods before it can sell it to the third party.

• As apparent from figure A, the bank first obtains the goods
with immediate payment and the delivery. Once the bank
acquires ownership, it is then able to engage with the end
customer and sell with deferred payment and immediate
delivery. The bank in the murabaha transaction makes profit
by charging mark-up that is added to the principle, while on
the other side, the customer benefits from the deferred
payment arrangement.
• From the outset, this transaction is classified as buying and
selling and since the goods change hands twice, it attracts
double Goods and Services Tax (GST). Furthermore, in addition
to double GST, if the product arrangement involves housing
loan that may pose additional burden of double stamp duty.
While this problem was resolved in Victoria, it remains an
impediment on the other jurisdictions, due to the fact that,
property transfer occurs once to the bank and after that to the
customer.

• As a result of a higher cost, Islamic financing translates to less
competitive products that are less attractive to both
customers and investors.
• Finally, since commodities and the other Australian assets can
be packaged with the Islamic financial products, treatment of
the bank’s profit from the customer’s perspective must be
addressed. In general, the tax discount that is applied to
interest payments in conventional banking and profit or mark
up treatment in shariah compliant products, should not
disadvantage customers involved in Islamic financing. In
addition to being taxed twice, which adds to the overall price
of the transaction, profit and mark-up is not tax deductible as
it is the case with interest paid on the conventional loan.
• In order to make Islamic finance competitive and a viable
alternative for a wider customer base, it is necessary to
provide tax neutrality that will accommodate shariah
compliant transactions.

Discussion Paper:
The Board of Taxation (Board) review of
the taxation treatment of Islamic
finance products
The purpose of this discussion paper is to:
• Examines the current approach to
finance taxation in Australia;
• Identifies issues associated with
Australia’s current approach to the
taxation of Islamic finance products;
and
• Examines the tax policy response to the
development of Islamic finance

Example: Discussion paper 2010, Case
study 1
Step 1: A Client agrees to purchase a house from a vendor. The Client
approaches a resident Financier to finance the purchase. A purchase
instruction with promise to purchase is completed by the Client
which is a request that the Financier purchase the asset specified and
an undertaking to purchase that asset from the Financier.
Step 2: If the Financier approves the financing, an Asset Purchase
Agreement will be executed where the Financier purchases the asset
(house) from the vendor on a cash basis for a purchase price of
$360,000. The Financier appoints the Client as its agent to purchase
the asset. The asset is transferred to the Financier at this time.

"The Road Less Traveled“
(now I know why)
Oh! No!
Stamp
duty –
AGAI
N!!!
Wha
t!
Doub
le
GST
???
Ha-ha!
Nice and
easy!
No
uncertain
ty…
After
all this
NO
deducti
ons on
profit


Economic future
• Islamic banking and finance is well positioned to play a major
role in the Australian economic future. While most of the
world suffers from a lack of liquidity, the Johnsons report
identified the Middle East as the major exporter of the capital.
• However, despite its natural advantage and favourable
predisposition, Australia is not utilising opportunities to
connect its capital intensive industry with offshore liquidity.
BOT discussion paper 2010 is designed to highlight changes
that which would ensure level playing filed and the
uncertainty of tax treatment.
• Banks and institutions that embrace introductory steps and
develop shariah compliant products at the retail & wholesale
level will anticipate future opportunities with much more state
of attentiveness. They will have a strong customer base,
knowledge and brand recognition locally and internationally.

Banking principle lecture

Banking principle lecture

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