The management of finacial operations in islamic banking

RIGA TECHNICAL UNIVERSITY
THE MANAGEMENT OF FINACIAL OPERATIONS
IN ISLAMIC BANKING
Sardorbek Mirzaev
Riga
5/27/2014
Abstract
The globalization of finance has allowed Islamic finance to thrive and there has been in
recent years a fusion of sorts between Islamic and conventional banking. My task includes to
provide the apprehensible and intelligible description for Islamic financial terms, specifications
and peculiarities of financial transactions; to explain the non-interest system in Islamic banks
and the substitutions and alternatives of them. At last but not least, to analyze the interactions of
Islamic and conventional banks in modern society, pertaining to corporate finance; to
distinguish the advantages and cons in financial operations; elicit the competitive prevailing
advantages of techniques and methods of allocation of assets and liquids both in Islamic and
conventional banking system. Primarily, to proper analysis of the issue in details I have divided
my paper into two main parts: Analytical (Theoretical) Part and Practical Part. In analytical
part I have covered main theories and definitions related to Islamic banking and Islamic
financial operations, transactions. Also it covers existing methods and techniques of Islamic
financial operating system and gives information about results and success of the management of
financial operations in Islamic banking system in early stages, before and after the world crisis,
interaction between Islamic banks and conventional ones, their current status quo in
contemporary economic and financial world, respectively. The second main part is about Islamic
banks and financial institutions operating throughout the world, their annual financial reports
and statistical data. To investigate their efficacious performance and amelioration of their
reputation in the financial market I’ve researched apposite data from a few Islamic financial
institutions. In addition to it, I’ve exampled a typical leasing situation in both Islamic and
conventional banks. Prioritizing the benefit from client-costumer side, I have proved the possible
outcomes depending on client’s decision on which of the financial institutions are suitably meets
his expectations. The examples create pictures of the ordinary banks’ credit-borrowing
transparent procedures and distinct conditions in Islamic banking and conventional financial
institutions, respectively.This paper includes 7 formulas, 16 figures and 7 tables. The total
volume of it is 65 pages.

1
CONTENT
INTRODUCTION……………………..………………………………………………….2
1. ANALITICAL PART…………………………………………….…………………4
1.1. Uzbekistan banking overview……………………………………………….4
1.2. The Principles and Characteristics of an Islamic Economy………..……....10
1.2.1. Principles of Islamic Economy………………………………...………..10
1.2.2. The Elements and Superstructure of Islamic Financial System………...12
1.2.3. The Role of Islamic Banking and Finance: a Global View and Trend…16
1.3. The Role Non-interest Philosophy of Islamic Finance……...……..………19
1.4. Islam, Economics and Finance…………………………..…………………20
1.4.1. Historical and Religious Background…….…………………………….20
1.4.2. Islamic Economics……………………………...………………………22
1.4.3. Reconciling Islam and Finance..………………………………………..23
1.5. The Ethical Framework of Islam …………………………………………..24
1.5.1. Riba and Gharar……………………………………………………….24
1.5.2. The Moral Economy of Islam…………………………………………25
1.6. Financial Products and Instruments in Islamic Banking and Their
Conformity with Conventional Banks………………………………………27
1.6.1. Murabaha………………………………………………………………27
1.6.2. Leasing ………………………………………………………………...30
1.6.3. Profit and loss Sharing………………………………..............................31
1.6.4. Sukuk – Islamic Bonds………………………………………………...33
1.6.5. Islamic Mutual Funds…….……………………………………………36
1.6.6. Mircro-lending or Mirco-finance………………………………………37
1.7. The management and Control, the Islamic Moral Hazard………………….37
2. PRACTICAL PART……………………………………………………………….40
2.1. Uzbekistani Leasing Market……………………………………………..…40
2.2. Leasing Procedures in Conventional Banks………………………………44
2.3. The Leasing in Islamic Banks………………………………………………49
2.4. The Comparison of the Systems: Leasing and Ijarah in Conventional and
Islamic Banks Respectively…………………………………………………52
CONCLUSION………………………………………………………………………….…55
BIBLIOGRAGHY….…………………………………………………………………...…57

2
INTRODUCTION
Nowadays, due to the various types of financial crises and mistrust to modern banking
system it is quite popular and well-known such terms as “Islamic economy”, “Islamic banking
system”. But, what is it? What it has been built on? What does it underlie? Certainly, it would be
impossible to explicate in a brief description, since Islamic economy is the whole science based
on Islamic jurisprudence. Therefore, I try to reveal this curtain of fundamentally different
system, touching with expository theory such aspects as: principles of Islamic economic theory,
its ethical principles, prohibited trade deals and reasons for these forbiddances and et al. Islamic
banking services.
Islamic finance and banking system have been growing rapidly in recent years. Motivated
by a heightened interest in financial instruments that emphasize risk sharing, it has been
attracting greater attention in the wake of the recent financial crisis. Today, as a consequence of
broad changes in the political-economic environment, a new generation of Islamic financial
institutions, more diverse and innovative, is emerging as the doctrine is undergoing a new –
aggiornamento-update. Perhaps the most important development has been the growing
integration of Islamic finance into global economy.
The Islamic banking industry is based on the prohibition of interests, and it promotes just
distribution of wealth whereby all levels of the society would benefit. The Western World, in
particular the Europe has been using and developing the conventional banking system which has
brought a lot of economic instability for many people living there. The conventional banking
system which basically operates on the basis of interest has created social problems because it is
simply not sustainable. Many have written about the conventional banking system which
produced capitalistic society and the financial crisis. Therefore, the existing conventional
banking system is definitely not suitable and the sound of alternative should be sought. Islamic
banking system could be that alternative everywhere in the world because it is an ethical
financing which promotes welfare for everyone [21].
In my thesis I’ve tried to reach the objective of presenting the core principles of Islam
finance, that place great emphasis on social justice, inclusion, and sharing of resources between
the haves and the have-nots. Islamic finance addresses the issue of financial inclusion from two
directions: one by promoting risk-sharing contracts that provide a viable alternative to
conventional debt-based financing; and the other through specific instruments of redistribution of
wealth in society; to improve understanding of the perspective of Islamic finance on economic
development, social and economic justice, human welfare, and economic growth.
The author has analyzed the structural difference in management of financial instruments
between Islamic finance and conventional financial institutions. The purpose of the paper is to

3
identify and analyze the affinity for financial operations and tools in two banking financial
institutions, disparate from one another. There have been a great number of discussions
pertaining Islamic finance and its possible future prospective. For this reason I’ve decided to
analyze that differences, fluctuations and performances of both financial institutes as my subject
in my work.
In consideration of these prospects and objectives, this research tends to accomplish the
following tasks:
 Discuss the banking sector in Uzbekistan, especially it for Islamic finance in the nearest
future
 Analyze the theoretical background of Islamic banking and finance instruments
 Describe the positioning of Islamic banking in global financial market and its role
 Study the elements of Islamic financial products and the possible corresponding products
in conventional banking sectors
 Explain the problematic issues concerning expansion of Islamic banking in Europe
 Overview the implications of regulatory standards on bank capital adequacy, stress
testing and market liquidity risk, and related Islamic baking indices
 Define pros and cons of leasing in Islamic and conventional banking sectors.
The paper itself is divided into two major parts. Analytical part reviews the Uzbekistan’s
banking sector in brief, including an analysis of them. Moreover, in the first part the reader can
discover the origin and foundation of Islamic financial system, its technics, products, and
regulations. The second part is about the calculations and practical analysis; opportunities for
leasing operation are analyzed in conventional banks of Uzbekistan, also, in Islamic banks in
example of Turkish participation bank “BankAsya”.
The author used in his work the methods of grouping, processing statistical data related to
the theme of the thesis. The author confined by analyzing leasing operation procedures in
Uzbekistan as well its alternative transaction in participation bank “BankAsya” based on Islamic
non-interest principle. The author does not consider the features and problems of value added tax
(VAT) describing formulas and solutions in his calculations. In design of this work, the writer
uses internship experience gained in “BankAsya”, Istanbul, Turkey in 2013. The paper ends
with brief concluding remarks and appendix after the second part.

4
1. ANALYTICAL PART
1.1. Uzbekistan banking system overview
Uzbekistan has traditional two level banking systems, headed by the Central Bank of the
Republic of Uzbekistan (CB). Main functions and objectives of the Central Bank are defined in
the Law on Central Bank, issued in December 1995. At present, the CB is fulfilling functions of
central monetary-lending institution. Main goal of the Bank is to maintain stability of the
national currency. The priority objectives of the Bank are as follows:
 development / maintaining monetary-lending, credit and currency policy of the
country;
 introduction of efficient payment system in Uzbekistan;
 licensing and regulation of banking and financial activity;
 management of cash flow of the state budget and performance of commercial
activities on behalf of the Government (together with the Ministry of Finance);
 Management of state reserves of the Republic of Uzbekistan (currencies,
precious metals and etc.).
Aggregate capital of commercial banks of Uzbekistan in 2010 increased by 44% versus
2009 and reached 4.1 trillion Soums (about US 18 billion) by the 1 January.
The domestic financial sector was not directly affected due to the isolated and
underdeveloped nature of the financial system. The banking sector and capital market in
Uzbekistan is not yet well developed. The government has taken a gradual approach in economic
reform. Similarly, reforms in the banking sector and capital market are slowly undertaken. The
deposit base and penetration (ratio of loans and assets to GDP) are one of the lowest in CIS
countries. Credit to economy/GDP and broad money /GDP are quite low. Credit to economy was
about 38% of GDP in 2001, however, it declined to around 14% in 2007, which was low
compared to other CIS countries. The state-owned banks are predominant in the banking system .
Over half of the assets, capital, and loan portfolio in the Uzbek banking are possessed by state
banks. The banking system is concentrated in Uzbekistan since the five largest banks own 70%
of assets. Government guaranteed loans are still significant, albeit they are declining every year
22].
Uzbekistan’s state-dominated banking sector has promoted industrial development by
channeling public investment to strategic industries and increasing total bank lending, while
keeping banks sound. At the end of 2013, the sector’s capital adequacy ratio reached 24.3%.
Aggregate capital in the banking sector rose by 25%, helping expand total credit by 31%.
In August 2013, Moody’s Investors Service issued a stable outlook for the country’s banking

5
Source: based on information from[33]
2009 2010 2011 2012 2013
GDP 8.1 8.5 8.3 8.2 7.4
Inflation (%) 7.8 7.2 7.3 7 7.2
Investment FDI(%) 2.5 4.2 3.6 1.7 1.7
Labor remittances (%) of GDP 3.9 4.5 6 6.8 6.5
Debt (%)of GDP 15 14.8 13.4 13 13
0
2
4
6
8
10
12
14
16
18
Uzbekistan Key Economic Indicators
sector, citing healthy bank profits, improvements in asset quality, stable liquidity, limited
reliance on wholesale funding, and few problem loans, averaging less than 10% of total lending.
The government reported a budget surplus of 0.3% of GDP in 2013, though the surplus in the
augmented budget, which includes the FRD, is estimated to have narrowed to 1.8% of GDP from
the 4.7% recorded in 2012 Budget revenues (including the FRD’s estimated revenues) are
estimated to have declined slightly, from 38.6% of GDP in 2012 to 35.8% in 2013, in line with
declining international prices for key export commodities (Figure 1.1). Rising government
spending, particularly for health and education, helped slightly raise budget expenditures
(including the FRD’s estimated expenditures) from 33.9% of GDP in 2012 to 34.0% in 2013.
The government adopted a new budget code in 2013, streamlining legislation on public finance
management and strengthening the enforcement framework [3].
The government raised public sector wages and pensions by 21% in 2013 and
maintained large-scale public investment in industry and housing. State investment spending
grew by 11.0% to $11.3 billion, enabling gross fixed capital formation to rise by 19.8%,
following 11.1% growth in 2012. An increasing share of investment is financed by the Fund for
Reconstruction and Development (FRD), a sovereign wealth fund with assets exceeding $15
billion [33].
Figure 1.1 Key economic indicators of Uzbekistan
There are following banking system and insurance market in Uzbekistan:
I. Commercial banks - 30:
 3 state-owned banks
 13 joint stock banks

6
NBU
31%
Asaka Bank
12%
AgroBank
7%
UzPSB
8%
Ipotekaban
k
4%
Microcredit
bank
7%
People'sBan
k
6%
Others
25%
Capital
NBU
32%
Asaka
Bank
11%Agrobank
10%
UzPSB
11%
IpotekBa
nk
5%
Microcre
ditbank
3%
People's
Bank
6%
Others
22%
Assets
 5 banks with foreign capital
 9 private banks
Over 4600 branches and retail offices all over the country
II. Nonbank financial Institutions:
 110 Credit Unions
 82 Microfinance Entities
III. Fund for Reconstruction and Development
Since the Uzbek government saw the banking sector’s role as an important instrument in
the implementation of the country’s import substitution policies, the sector was dominated by
state- 9 owned and state-controlled banks. The assets of the three banks that are directly owned
by the government comprised 65 to 80 per cent of the assets of the banking sector over the period
1996 to 2005. Among these three, the National Bank of Uzbekistan stands out. Since 1996, this
giant bank has controlled over 50 per cent of assets of the banking system. Thus, since 2004 the
National Bank has shown positive dynamics of development and strengthened its position in the
Republican financial market. The consolidated balance of the National Bank in terms of US
dollars comprised 2,929 million. However, nowadays the tendency of private banks, for instance,
Hamkorbank, Trastbank, et al. have shown escalating progress in financial operations in both
medium and large scales of banking economic sector of Uzbekistan.
Figure 1.2 Assets and capital of Uzbekistan banking system according to Fund for
Reconstruction and Development of Uzbekistan
The following Figure 1.2 illustrates the distribution of assets and capital of Uzbekistan
banking system among national and commercial banks [5710].
Source: based on information from [10]

7
1386
4904
1181
934
0
1000
2000
3000
4000
5000
6000
7000
2005 2011
Domistic sources External Debt
Stable banking and financial system are in strict compliance with the Basel Core
principles of banking supervision sustaining the stability of banking system in Uzbekistan. The
one of the fundamental rations as bank capital adequacy ratio is over 23%, which indicates the
positive efficiency of banks and being almost 3 times higher than international standards. The
banks’ total assets of banks are more than 2 times higher than the total balance of the population
and legal entities deposits, insuring complete protection and guarantee of timely payments.
For the last 10 years domestic sources channeled to financing the real sector of the
economy )increased by 25 times Total current liquidity of the banking system is 10 times higher
than external payments due (Figure 1.3).
Figure 1.3 Credit portfolio of commercial banks (USD mln)
The Islamic Development Bank (IDB) is an international financial institution established
in pursuance of the Declaration of Intent issued by the Conference of Finance Ministers of
Muslim Countries held in Jeddah in Dhul Q'adah1
1393H, corresponding to December 1973. The
Inaugural Meeting of the Board of Governors took place in Rajab 1395H, corresponding to July
1975, and the Bank was formally opened on 15 Shawwal 1395H corresponding to 20 October of
1975.
The purpose of the Bank is to foster the economic development and social progress of
member countries and Muslim communities individually as well as jointly in accordance with
the principles of Shariah i.e., Islamic Law.
1
Dhu al-Qi'dah is the eleventh month in the Islamic calendar. It is one of the four sacred months in Islam
during which warfare is prohibited, hence the name ‘Master of Truce’.
Source: The authors idea based on information from[10].

8
Uzbekistan became an IDB member in 2003; an exemplary step in this direction is the
recent IDB’s US$37 million 14-year ﬁnancing that will be used to purchase medical equipment
for the modernization of oncological institutions in the country. The project, whose total amount
is US$83 million, is one of the 15 projects currently jointly implemented by the Uzbek
government and the IDB in the ﬁelds of health, education, agriculture, energy and transport, with
a total value exceeding US$400 million.
In the past three years, IDB has sponsored several important projects and signed many
significant treaties:
• US$30 million in loan financing, co-financed with the Asian Development
Bank, to improve water supply to major cities around the country, including Bukhara and
Samarkand.
• US$54 million grant: Of this amount US$15 million will go the National Bank
for Foreign Economic Activity to finance small business projects; US$12.5 million will
be spent on modernizing an asphalt factory, constructing roads and buying equipment for
these purposes; US$25 million will be spent on the construction of an electricity line
from two existing power stations; and US$143,000 will be spent on preparing a project
on setting up an investment company.
• In 2005, the Islamic Corporation for the Development of the Private Sector, a
member of the IDB Group, and the National Bank of Uzbekistan signed an agreement of
cooperation to further develop the Uzbek private sector.
In the three years following Uzbekistan’s induction into the IDB, the IDB has already
established a strong presence within the country providing the Uzbek government with
considerable financing and sponsorship of numerous projects. This trend will likely continue in
the future.
In just over a decade, Uzbekistan has proven to be prime candidates for the establishment
of Islamic banking and finance. Although primarily landlocked, the countries of this region for
the first time are being linked to a greater network of commerce and trade throughout the Muslim
world with the help of not only the IDB but also the just-flourishing Islamic banks . Not only
has an organization like the IDB effectively demonstrated its support for socio-economic
development, but it has also provided the six Muslim republics of this study with a means to
remain Islamic-compliant when running various banking and finance projects that promote
national development. [11].
On the other side, the private-owned bank – Hamkor Bank – is gearing up to provide
Islamic banking services across the country leveraging on the bank’s wide network.Hamkor
Bank is open joint-stock commercial bank, was established in 1991. Since its inception, Hamkor

9
Bank is focused on private and corporate customers. The bank's customers are companies who
are attracted to sound banking philosophy, which allows ensuring the stability, efficiency and
security of financial transactions.
Hamkor Bank, being a universal financial organization provides services to customers
regardless of their activity and size of business. Current customers are representatives of large
and small businesses, leading manufacturers of consumer goods and construction companies,
telecommunication and transportation companies, trading organizations and representative
offices. In previous years, Hamkor Bank was looking to collaborate with selected international
organizations to become the first entity to provide Islamic banking solutions to the country’s 29
million Muslims to develop its human capital base to ensure that its Islamic banking initiatives
and, to a greater extent, Uzbekistan’s Islamic banking and finance aspirations, can be kick-
started with "sound foundations". He added that the bank, which focuses mainly on SMEs, is the
only bank in Uzbekistan which is looking to collaborate with international financial institutions,
such as the World Bank, Islamic Development Bank and Asian Bank for this purpose.
In May 2010 the International Finance Corporation (IFC) acquired a 14.5% stake in
Hamkor Bank, at US$0.09 cents per share, for US$3 million. The stake was then diluted to
12.59% in 2012 when the bank issued additional equity worth US$3.4 million.
In February 2013 the Chief Executive Officer of Al Huda Centre of Islamic Banking and
Economics – Muhammad Zubair Mughal – recently has met with Ikram Ibragimov, the chairman
of supervisory board of Hamkor Bank in Uzbekistan's capital, Tashkent. There was a detailed
discussion on affairs of their mutual interest for the advancement of Islamic banking in
Uzbekistan. Unfortunately, Hamkor Bank is the only bank is Uzbekistan which is working in
collaboration with international organization e.g. World Bank, Islamic Development Bank, Asian
Development Bank, European Bank, KFW, Triple Jump and others Hamkor Bank will cooperate
and be supervised by Al Huda CIBE Pakistan, especially advising and consulting in Islamic
Banking; Shariah advisory; and Human Capital Development in this field. Consequently, Islamic
banking can be initiated in Uzbekistan with sound foundations. Furthermore, Hamkor Bank,
though not as big as leading banks in Uzbekistan, has a wide network in the country through
which they wish to render the services of Islamic Banking.
Shariah compliance and Islamic human capital development will be privileged so
that Islamic banking can be initiated in Uzbekistan with sound foundations [15]. Uzbekistan is
not the only country in the region to have realized the opportunities offered by Islamic ﬁnance
and competition is rife between countries to conquer the Islamic ﬁnance pole position in central
and north Asia [2].

10
It should be noted that Hamkor Bank is a part of a large financial group of Uzbekistan.
The group comprises of a bank, insurance company, 4 leasing companies and other institutions.
1.2. The principles and characteristics of an Islamic economy
1.2.1. Principles of Islamic economy
The Islamic economy is an economic, social and political model based on the theological
doctrines and values promoted by the Quran and Sunnah1
. In other words, as “Islamic economy is
an approach to, and progress of, interpreting and solving the economic problems of human
beings based on the values, norms, and institutions found in, and derived from sources of
islam”.2
While the Quran is considered prescriptive, the Sunnah and hadith literature is
considered descriptive. These two textual sources serve as the foundation of Islamic law.
There are no compete economic or financial systems described in Islam. If to locate
economics and finance in Islam, one could visualize the connection as seen in Figure 1.4.
Figure 1.4 Economics and Finance in Islam
Another useful definition is following: Islamic financial institutions are those that are
based, in their objectives and operations, on Koranic Principles [Ibrahim Wade, Edinburgh
University Press, 2001]. They are thus set apart from ‘conventional’ institutions, which have no
much preoccupation. This definition goes beyond simply equating Islamic finance with ‘interest-
Islam
Faith and Belief Practices and Activities Morality and Ethics
Worship to God Social Interaction
Political
Activities
Economic Activities Social Activities
Banking and Financial Activities Other Activities
Source: Designed based on the ideas of the author

11
free’ banking. It allows to take into account operations that may or may not be interest-free, but
are nonetheless imbued with certain Islamic principles: the avoidance of riba (in the board sense
of unjustified increase) and gharar (uncertainty, risk, speculation); the focus on halal (religiously
permissible) activities; and more generally the quest for justice, and other ethical and religious
goals. Two aspects of Islamic finance must be signed out. Fist is risky-sharing philosophy: the
lender must share in the borrower’s risk. Since fixed, predetermined interest rates guarantee a
return to the lender and fall disproportionately on the borrower, they are seen as exploitative,
socially unproductive and economically wasteful. They preferred mode of financing is profit-
and-loss sharing (PLS). Second is the promotion of economic and social development through
specific business practices and through zakat (almsgiving).
Figure 1.5 Islamic Concepts of a Market Economy between Economics and Law
Source: Designed based on information from[25].
.
Most but not all Islamic institutions have a Shariah board- a committee of religious
advisers whose opinion is sought on the acceptability of new instruments, and which conduct a
religious audit of the bank’s activities – as well as other features reflecting their religious status.
In sum, the defining difference is that while ‘conventional’ finance usually seeks profit-
maximization within a given regulatory framework, Islamic finance is also guided by other,
religiously-inspired goals.
Secular Economics
Koran Sunna
Fiqh (jurisprudence)Islamic Economics
Shariah
(Islamic law)
Concept of market Economy
Principles Rules
Systems
Design
IslamicSystemSecularLaw

12
Islamic banking also involves more than banking more than banking. It includes mutual
funds, securities firms, insurance companies and other non-banks. Where once - in the mid-
seventies – Islamic banks were few numbers and easily identifiable, the phenomenon has become
quite amorphous with the proliferation of Islamic institutions and the blurring of the lines
between traditional banking and other forms of finance (Figure 1.5). Another complicating factor
is that growing number of conventional institutions, inside and outside the Islamic world, have in
recent years created Islamic subsidiaries or have been offering Islamic ‘windows’ or products in
addition to conventional ones.
For the outside observe, the inevitable question is: how can a financial system operate
without interest rate? The answer is that it can through the development of profit-and-loss
sharing mechanisms, or through alternatives such as imposing fixed service charges or acting as
young agents for clients.
1.2.2. Elements and Superstructure of Islamic system
Over the past decade, public duties (both of society and the state) have broadened to
include safeguarding sustainable economic activity and protecting the environment. Finally, the
state should create favorable framework conditions for a private economy consistent with the
requirements of Islam, something which can have particular implications [25].
Essentially, this list contains all the elements that constitute a social market economy,
which have been summarized in the Konrad-Adenauer-Stiftung’s publication entitled
“Guidelines for Prosperity, Social Justice and Sustainable Economic Activity”. The prevalent
doctrine of Islamic economics today can be summarized as follows:
 Islam conveys a positive outlook on this life in general and provides a supportive value
system for economic activities in particular
 Islamic economic ethics exhibits considerable overlap with Western-Christian
perceptions in the field of individual ethics. Great importance is ascribed to personal
achievement.
 Individuals are expected to earn their living through their own work. A person’s own
achievement (physical and intellectual work) is the most important basis for legitimately
obtaining material goods and wealth. Neither individual human skills nor natural
resources should lie idle unnecessarily, and it is forbidden to waste or wantonly abuse
resources.
 Legitimately acquired wealth should not be used to maximize the pursuit of a person’s
own wants (in this life): luxury is frowned upon; Islam preaches moderation; and the use
of surpluses for social aims is meritorious.

13
 The needy have their own claim to solidarity from the community, which is
institutionally protected and based on the Quran: Muslims are required to pay zakat, i.e. a
two and a half percent levy on assets or a five or ten percent levy on agricultural produce,
which is used for specific (social) purposes. This is an obligation for the individual, and
the claims of the needy should be satisfied by the community or the society (and only
then by the state); this is very similar to the principle of subsidiarity.
 The needy have their own claim to solidarity from the community, which is
institutionally protected and based on the Quran: Muslims are required to pay zakat, i.e. a
two and a half percent levy on assets or a five or ten percent levy on agricultural produce,
which is used for specific (social) purposes. This is an obligation for the individual, and
the claims of the needy should be satisfied by the community or the society (and only
then by the state); this is very similar to the principle of subsidiarity.
 Since Allah has made the goods of this world available to all human beings, inequalities
in the distribution of income and wealth must not be allowed to become too great. If
needs be, the state must intervene with corrective measures to fight poverty.
 Humans, as God’s custodians of the earth, only have the right to use creation. They must
not inflict lasting damage on it and must consider the legitimate claims of future
generations in what they do. This principle gives rise, among other things, to a collective
ownership of non- renewable resources (natural resources, but also water) and, more
recently, a duty to protect the environment.
 Islamic law recognizes private ownership of the means of production. Nationalization and
state control of the economy are only permissible in exceptional circumstances.
Land and capital become productive only as factors of production when combined with
labor. Therefore, income may not be derived from merely owning land or capital. Financing,
lease, and other contracts, which allocate returns and risks to the owners of factors of production,
must meet particular criteria of justice. [4].
For the outside observe, the inevitable question is: how can a financial system operate
without interest rate? The answer is that it can through the development of profit-and-loss
sharing mechanisms, or through alternatives such as imposing fixed service charges or acting as
young agents for clients. By this means of information, a following chart can be structured to
properly understand the Islamic economic system (Figure 1.6.).
Legal framework
Law and the rule of law are important: linking government action to a superior law –
Shariah (which only contains some directly applicable economic content) and Shariah compliant
secular law (the formulation of which gives great creative leeway). Concepts of an Islamic

14
Source: Designed based on information from [25]
economic system are compatible with different forms of government (democracy, monarchy,
etc.).
Figure 1.6. Elements and Superstructure of an Islamic Economic System
Competition as a basis
Justice is important: price fairness; state protection of competition against
monopolization; occasional state intervention in the case of “sensitive” prices.
Solidarity and social security
Poverty reduction is as a primary economic objective. Zakat at the core of a social
security system that is independent of the family (claim of the needy in respect of society – state
is subsidiary).
Sustainability
Allah is the ultimate owner, human beings are merely custodians, and duty extends to
future generations (idea of sustainability).
Open markets
Science Ideology Religion
Prescriptiveness Mobilization
Open and Competitive Markets, Competition Policy
Financial and Monetary Economy
 Prohibition of riba
 Stable money ( gold, 100%,…)
Individual social Security
 Zakat (social security contributions)
 Takaful (mutual insurance)
State and the Public Sector Economy
 Legal Framework
 Infrastructure, environment
Legitimacy
Functionality

15
In principle, for all open goods, services, and labor markets, but reservations with capital
markets (issue of interest, speculative transactions).
Therefore, the special regulations in Islamic economy lead to sustain development of the
social market and life of the nations. For that reason there were the formal restrictions, which
stem from the requirements for Shariah-conformity, do not prevent the construction of a
sophisticated and efficient financial system and capital market – without which the social market
economy could not function. In view of the current global financial crisis, such a strong link
between the financial sector and the real economy, and a limit to the development and
application of synthetic financial products for speculative and high-risk purposes is, perhaps,
more beneficial than detrimental for a social market economy. Against the backdrop of
replications of problematic, conventional techniques and products that conform to Shariah law,
the calls by Islamic economists – which perhaps go a little too far – for every financial
transaction to be based on a real economy transaction, can also be understood in some respects as
self-criticism, or at least a warning to Islamic financial engineers.
The Islamic economic systems are indeed compatible with the concept of the social
market economy, and that Islamic economics can act as an advocate of such a concept transfer.
Nevertheless, this alone would not bring much benefit as the political effectiveness and the
practical relevance of Islamic economics as an academic discipline is relatively weak at a
systems level, and this influence has tended to wane rather than wax over the past twenty years.
It is an obvious fact that the social market economy is a concept that was created for
highly developed and structurally differentiated economies only in the twentieth century in the
Western world, where it has proved itself. In Islamic countries, most of which only gained their
independence in the middle of the twentieth century, this concept was rather unknown.
In the light of the lasting development problems of many countries of the Muslim world
– stretching from North Africa, across the Middle East to Southeast Asia – these states have by
no means ruled out the search for economic concepts that promote development. Not least as a
result of disappointment with the results of the capitalist and socialist economic systems, since
the mid-1970s people have been progressively formulating ideas about an Islamic economic
system, propagating them as an alternative to the unsatisfactory status quo. Against this
backdrop, therefore, it is worth investigating the general principles of the social market economy
and their compatibility with such economic systems in order to share the experiences of our own
economic system as part of the dialog surrounding development policy.

16
1.2.3. The Role of Islamic Banking and Finance: a Global View and Trend
Over the last three decades, the concepts of Islamic Finance and Islamic economics have
captured the attention of researches. The growing market for transactions compatible with
Islamic law (Shari’ah) is further evidence of growing interest in this mode of finance. Although
Islamic finance is one of the fastest growing segments of emerging global financial markets, it is
often stated that the market is far below its true potential. At the same time, the concept of
Islamic finance are not fully explained and exploited – especially in the areas of economic
development, inclusion, access to finance, and public policy. Over the last two decades, by some
estimates, the total volume of Islamic financial assets has grown by 15-20 percent a year and
now exceeds $1.3 trillion [7].
 There are more 267 Islamic financial institutions (IFI) worldwide with capitalization in
excess of $13 billion. This includes banks, mutual funds, mortgage companies & Takaful
 Shariah-compliant financial products estimated to exceed $250 billion with annual
growth rate of 23.5%over the past 5 years
 There is approx. $1.5 trillion of GCC funds held in investment assets worldwide
(Treasuries/corporate bonds/equities/funds etc). Of this $1.5 trillion, $250 billion
constitutes of High Net Worth Individuals
 The potential is huge. By 2020, there will be 2.5 billion of Muslim population worldwide
from the current 1.5 billion level
 Islamic banks are expected to manage 40%-50% of total savings of Muslim
 Population in 8 to 10 years. Therefore, potential for Islamic financial services is
estimated at $4 trillion by 2020
It is crucial these huge amounts of funds are channeled towards productive use –into
GCC infrastructure/economic sectors and other emerging economies.
Following on from the significant developments that have occurred in what we view as
the core area for this market – the predominantly Muslim countries – we are now witnessing the
globalization if Islamic finance. In recent years, significant interest in Islamic finance has
merged in the world’s leading financial centers, including London, New York, and Hong Kong,
and Western investors are increasingly considering investment in Islamic financial products. The
growth of this market has been driven by the high demand for Shari’ah-compliant products, as
well as increasing liquidity of Gulf States. The table 1.1 shows the growth trend in Islamic
finance for banking sectors by different regions, with estimates of total Islamic banking assets
reaching $1.8 trillion by the end of 2013 [7].

17
19
9
34
20
25
42
22.5
8
5
18
13
15
31
14
0
10
20
30
40
Malaysia Indonesia Turkey Saudi Arabia United Arab
Emirates
Qatar Median
Islamic banking Conventional Banking
Table 1.1.
Total Islamic Banking Assets (in $ billion)
Global Islamic banking assets 1.334
Growth estimates by the region through 2013
Southeast Asia 89
Gulf Cooperation council (GCC) countries 131
Rest of the world 257
Global Islamic Banking assets (2013, est.) 1.811
In the following figure 1.7 we can see trends promoting the growth of the Islamic
financial sector in the 2006-2010 periods surpassed the growth of the conventional financial
sector in all segments of the market, ranging from commercial banking, investment banking, and
fund management to insurance in several Muslim-majority countries [6].
Islamic banking continues to be an exciting growth story characterized by robust macro
outlook of core Islamic finance markets and increasing share of system assets. It is increasingly
gaining acceptance, especially in high-growth emerging markets, as an effective means to build
an inclusive financial system and replace the shadow economy. Figure 1.8 illustrates the global
distribution of Islamic assets in world’s financial market.
One of the recent developments in Islamic finance is the introduction of Islamic bonds, or
sukuk, which are structured as a securitized product. The key feature of sukuk is that they are
structured following principle of linking the financial return to the real sector activity. We will
Figure 1.7 Growth of Islamic Banking and Conventional Banking Assets in Selected
Countries (in percent)
Source: based on information from [3,33]

18
Saudia Arabia
16%
Malaysia
8%
UAE
5%
Kuwait
4%Qatar
3% Turkey
2%
Indonesia
1%
Bahrain
1%
Rest of the world(inc.
Iran)
60%
50 50
100
180
300
370
420
685
831
794
825
0
100
200
300
400
500
600
700
800
900
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Volume ($ billion) Number of issues
describe more explanatory about this special financial product later on, however there is a room
to mention about important value of the introduction of sukuk escalated the financial stability of
Islamic liquidityin world market. Figure 1.9 shows the total number of sukuk and their volume
over the last ten years, which is testimony to the rapid growth of this market, and its quick
recovery during global downturn. The sukuk market has been used by both the public sector and
corporate sector to mobilize finance [21].
Figure 1.8 The Global Distribution of Islamic Assets
Source: based on information from[3,33]
Figure 1.9 Total Sukuk Issuance 2002-2012

19
1.3. The Role non-interest philosophy of is Islamic Finance
Most definitions reduce Islamic banking to ‘interest-free’ banking. Islam prohibits
interest but it does not means, that it prohibits all gains on capital. The only increase stipulated or
sought over the principle loan or debt is prohibited in Islamic shariah law. Islamic principles
simply require that performance of capital should also be considered while rewarding the capital.
The prohibition of a risk free return and permission of trading, as enshrined in the Holy Quran,
makes the financial activities in an Islamic set-up real asset-backed with ability to cause ‘value
addition’.
Islam deems profit, rather than interest, to be closer to its sense of morality and equity
because earning profits inherently involves sharing risks and rewards. Islam encourages shearing
of risk among lender and borrower, Islamic financing system is based on this principle, it has
also another character of owing and handing of real assets, its involvement in trading,
construction and leasing using Islamic mode of financing. As such, Islamic banks deal with asset
management for the purpose of income generation. They will have to prudently handle the
unique risks involved in management of assets by adherence to best practices of corporate
governance. Once the banks have stable stream of Halal income, depositors will also receive
stable and Halal income. Profit has been recognized as ‘reward’ for (use of) capital and Islam
permits gainful deployment of surplus resources for enhancement of their value. However, along
with the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no
other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to
be permissible, should be associated with goods, services or benefits. At macro level, this feature
of Islamic finance can be helpful in creating better discipline in conductive of fiscal and
monetary policies [30].
The most important prohibition is riba (usury/ interest). The subject of riba is a difficult
for many scholars. There is huge number of literature discussing the topic of riba in accordance
to Islamic teachings.
Islam, however, strongly and precisely prohibits interest, but permits trade. Doing interest
business is viewed equal to rebel against God and His prophets. In Koran2
it states: “Those who
take riba (increased amount, i.e. usury / interest) will not stand but as stands the one whom the
devil has driven to madness. That is because they say: ‘Trade is like usury’, but Allah has
permitted trade and forbidden riba. Those who after receiving direction from their Lord, desist
(from indulging riba), shall be pardoned for the past; their case for Allah to judge; but those who
repeat (the offence) are companions of the Fire: They will abide therein (forever)” [17]. “Allah
2
Koran (Quran) is the scripture, the holly book of Muslims and was verbally revealed from God to his
prophet Muhammad.

20
will deprive usury of all blessing, but will give increase for deeds of charity: for He loves not
creatures impious and sinning”.[17]. “O you, who believe, do not eat up the amounts acquired
through Riba, doubled and multiplied. Observe your duty to Allah, that you may be
successful”.[17].
At the same time, there is a notable number of hadith explicitly pointing of the
prohibition of interest, e.g. the Prophet Muhammad (BPH) cursed “the one who accepted
interest, the one who paid it and the one who recorded it and the one who witnessed it, and said
that they are all alike (i.e. they are equal partners to the sins)”.[5].
Trade on the other hand is permitted, furthermore, encouraged. It says as follows in
relevant verses: “There is no sin on you that you seek the grace of your Lord (by trading)” [17].
Despite numerous proofs and easily accessible information presented, the question of
whether interest is prohibited in Islam seems to be the most frequently asked question in regard
to Islamic finance. The main reason Islam has delivered such a harsh rulings against interest that
it is set to establish economic system in which all forms of exploitation are eliminated, and
particularly the injustice in the form of financier being assured of a positive return without doing
any work or sharing risk, while entrepreneur, in spite of his management and hard work, is not
assured such a positive return. In this regard, Islam wishes to establish justice between the
financier and the entrepreneur. The difficulty to understand the prohibition comes from lack
appreciation of the whole complex of Islamic values, and particularly its emphasis on socio-
economic justice and equal distribution of income and wealth. [20].
1.4. Islam, Economics and Finance
1.4.1. Historical and Religious Background
Any successful belief system, whether religious or secular, has seemingly contradictory
characteristics: it is malleable enough to adopt to a variety of geographical settings and survive
the test of the time, yet it must be able to maintain its specificity, or else it would disappear or
become fused with competing belief systems; it is idealistic, sometimes even utopian, yet
capable of adjusting to human imperfection and making the kinds of compromises that are
endemic to political and economic life. With this in mind we can better understand hoe a system
rooted in the Middle Ages could survive, and thrive, in the global economy [14].
Following, a board of overview of the parallel evolution of religion and history we can
now deepen into the mechanisms by which Islam adapted to changing circumstances, and
explains how Islam could accommodate itself with modern economic and finance.
The tenets of the Islamic religion can be conceived as a pyramid. At the top stands Koran,
considered by Muslims to be God’s word as conveyed to the Prophet Mohammed. Below it are

21
the Hadith and the Sunna. Often interchangeably, the first actually refers to the words and deeds.
In other words, the Hadith, in the form of a large and ill-defined number of short texts, relates
stories about and sayings (specific pronouncements, deeds, or approvals of other people’s
actions) of the Prophet, whereas the Sunna consists of the practices and rulings deduced from
such narratives.
In order to examine the impact of Islamic banking it is important to understand the
historical origins of the banking system in predominantly Muslim countries and the evolving
divergences from conventional banks. The modern conventional banking system in Islamic
countries is a product of colonizers using the support of financial institutions for mining,
agriculture, and manufacturing. The initial banks were predominantly used for the funds of
foreigners and as a means to increase foreign-owned industries that spread through imperial rule.
These institutions were used to finance the expansion of the public sector in the Middle East and
North Africa, huge portions of the population made up of devout Muslims [23].
Throughout its golden age (roughly the seventh to tenth centuries in the Middle East, and
the eleventh to fourteenth centuries in North Africa and Spain), the Islamic world did not fit the
imagine of a narrow-minded theocracy. Great libraries and translation centers were established
where great works of philosophy, literature, medicine and science from East and West were
collected and translated. Such knowledge was improved upon and formed a necessary link to
later advances in the West.
So where does the persistent image of an Islam incapable of separating mosque and state
– indeed incapable of dealing with the modernity and change – come from? The answer lies in
the parallel evolutions of Islam and the West, starting with the end of the golden age.
However, due to the industrial revolution in the West countries in the late nineteenth
centuries, most countries followed a path of Westernization and secularization that led to adopt,
under foreign tutelage, Western models in politics, economics, law, and education. Muslims
were divided. While some did not see a necessary contradiction between Islam and
Westernization, a number of political and religious movements emerged throughout the Islamic
world, calling for a return to Islamic values and traditions. There was no clear consensus, insofar
as some wanted a return to the past while others called for an update of Islamic doctrine. Islamic
modernists shared with traditional Islamist groups the belief that the ills of the society were
caused by the betrayal of Islamic ideals. While they shared with secularists the embrace of the
reason, science and progress, what set Islamic modernists apart their belief that political
liberalization and intellectual reawakening could be, indeed had to be, rooted in a return to Islam
[14].

22
In sum, modernity – undertaking a radical reinterpretation of Islam to suit modern
conditions – is not easy to dissociate from a quest for authenticity. And traditional
fundamentalism – if defined as the effort to return to the fundamentals of the religion – is not
necessarily the same as literalism.
1.4.2. Islamic Economics
The commerce is central to the Islamic tradition. The Prophet Mohammed was himself a
merchant. In his day, the economic system was quite simple. Mecca, at the time wealthiest
Arabian city, depended heavily on trade. The continuous spread of Islam soon brought the
region’s lucrative trade routes, previously controlled by Byzantium and Sassanid Persia, under
Islamic control. As the expansion of trade in Islamic world, the economy became increasingly
complex institutional innovation occurred, for example with the creation of hisbah, an office in
charge of supervising markets, providing municipal services, and settling petty disputes.
By the time passed, Muslims in the liberal era who had studied Western-style economics
tried to transpose that knowledge to the Islamic world. With decolonization and the nascent tend
toward a return to Islam, religious scholars attempted to rethink economics and the social
sciences in the light of their religious training, with the goal of creating an ‘authentic’ or at least
indigenous brand of economics. It is usually agreed that the most original work in Islamic
economy is that of Mohammed Baqer as-Sadr, whose book Iktisaduna (‘our economy’) is an
attempt to develop an Islamic approach to economics.
With the newfound wealth of oil-producing countries and the rise of Islamic militancy,
the need to promote further thinking on economic matters gained new urgency. A number of
fiqh3
academies sprouted throughout the Islamic World, have settled a majority based decision
making processes. Gathering in convocations, scholars deliberate collectively and decide
questions by the majority vote.
First time the Islamic economics conference was held in 1976, in Mecca, where the
conference dealt exclusively with economic matters. King Abdul Aziz University established
the International Center for Research in Islamic Economics in 1979. Starting with Pakistan in
1977, a growing number of countries sought to Islamicize their economic systems. Islam would
typically be presented as offering a ‘third way’ between capitalism and socialism that would be
not only different, but also superior to, and no less efficient than, the two others.
In Islam, strict definitions have typically prevailed. But as its economy grew more
complex, the Islamic world was able to find proper substitutes, justifications, or subterfuges.
3
Fiqh is Islamic jurisprudence, based on the expansion and interpretation of Shariahh; deals with the
observance of rituals, morals and social legislation in Islam

23
1.4.3. Reconciling Islam and Finance
Muslims’ Holy book – Koran states that despite superficial resemblance, profits from
commerce are fundamentally different from profits from money-lending [Surah Al-Baqarah,
275]. Muslims, unlike other nations, have traditionally looked favorably at commerce, while
being suspicious towards finance. While the reconciling between other religious representatives
and finance was long-drawn and fraught with theological and philosophical disputes, in Islam
however, riba would occasionally be interpreted not as interest [14], but the usury or excessive
interest, severe and accurate descriptions have, in common, as a rule dominated. The early years
of Islam, jurists devised an impressive array of contracts designed to circumvent interest-riba, the
most important ones being profit-and loss contracts (mudarraba or qirad).
Modern finance entered the Islamic world alongside wit Western colonial expansion.
Foreign banks financed trade and development, and in due course Islamic governments, strapped
for cash, had become debtors, therefore paying interest to foreign creditors. For example, the
Ottoman Empire in the middles of 19 century had been issuing interest-bearing treasury bonds
[28]. In Egypt foreign banks played a crucial role: in 1920 Banque Misr was established, the first
ever to be formed exclusively with local capital. Egypt’s thriving stock-market made it a favorite
among early twentieth-century ‘emerging markets’, which promoted to be a third largest stock
market in the world after World War 2. Perhaps most importantly, it is in Egypt that interest was
legitimated by religious authorities in 1904.
The riba controversy was temporarily ignored but not to rest. Many legal codes adopted
by Islamic countries observed an ‘eloquent silence’ – on the issue of interest-bearing loans.
The world finance took a new tern with the end of colonialism: newly independent states
established national monetary authorities and central banks, issuing local currencies.
Thus, until resent attempts at ‘Islamicizing’ economic systems, all countries regardless of
ideological learnings, learned to live with interest and with modern finance. With the advent of
Islamic finance, prevailing consensus among Islamic scholars was that dealing with conventional
banks was acceptable if Islamic institutions were not accessible to them. The transformation of
modern finance that has taken place since 1980s has also reopened the debate about the
acceptability of new financial instruments. But rather than a wholesale rejection, the trend has
been towards a now ijtihad designed to separate those products that are acceptable from those
that are not, and to create financial instruments adapted to the need of Islamic societies [9].

24
1.5. The Ethical Framework of Islam
1.5.1. Riba and Gharar
Most definitions reduce Islamic banking to ‘interest-free’ banking. While the injunctions
against riba are indeed the cornerstone of Islamic finance, debates persist as to the exact
significance of the word. Since the early days of Islam, the majority of scholars have adopted a
restrictive definition: any form of interest constitutes riba. The debate is nonetheless still keeps
actual topicality in modern world. The most common way of financing throughout recorded
history is where the owner of money loans it to someone in need and receives the principal plus
an agreed upon amount of interest after an agreed upon time.
The riba debate has been approached from many angles. One set of discussions contrasts
‘interest’, a moderate economically justified remuneration of capital, with ‘usury’, an excessive,
sometimes extraordinary rate. A few scholars have argued that only latter constitutes rib,
however the majority of Islamic scholars still consider that any increase in the amount of money
returned by a borrower constitutes riba and is therefore prohibited.
Another angle is the requirements of modern economy. As one of the Islamic modernist –
Fazlur Rahman says: “As long as our society has not been reconstructed on the Islamic pattern, it
would be suicidal for the economic welfare of the society and the financial system of the country
and would also be contrary to the spirit and intentions of the Koran and Sunna to abolish bank-
interest [16]. Despite argues and long debates; in 1986 the Fiqh (jurisprudence) Academy of
Islamic Conference supported the restrictive interpretation of early jurists, condemning all
interest-bearing transactions as void. But in 1989, while an economic and rhetorical debate
between Islamic financial institutions and conventional banks was raging, the mufti (religious
scholar) of Egypt A. Tan2tawi, issued what he considers fatwa (code), one legitimizing
‘capitalization certificates’, which are interest-bearing government bonds underwritten by
Egyptian banks. There is little difference between Western-style bans which offer fixed interest
rates, and Islamic banks in which depositors share the risk of investing projects, for Islam
simply requires financial transactions to be market by clarity and justice.[29]. On the other hand,
the Egyptian fatwas had paradoxical impact on Islamic finance, insofar as they added the
legitimacy to more pragmatic approaches, but the intellectual debate on riba is still raging. It is
all the more inconclusive that unassailable, factual elements about the origin of riba are scarce.
Islamic scholars have insisted that the prohibition of the riba is not an isolated religious
injunction but ‘an integral part of Islamic economic order with its overall ethos, goals and values.
Based on the definitions it comes out the riba is not necessarily about interest rates as
such and it certainly is not exclusively about interest rates. It really refers to any unlawful gain

25
derived from the quantitative inequity of the counter values. Interest or usury would then be only
one from riba.
The meaning of the word ‘Gharar’, however is not mentioned as riba in Koran,
etymologically relates to the words deception or delusion. The principals are the same as
prohibition of riba: unequivocal though the concept itself is somewhat vague. The Gharar in
addition to deception and delusion also connotes peril, risk and hazard. In more financial terms it
can be interpreted as ‘uncertainty, risk or speculation’. Any gain that may result from chance,
from undetermined causes, is here prohibited.
There are some examples to clear up with this definition. It would be wrong to get a
worker to ski an animal by promising to give him half the skin as the reward, or to get him to
grind some grain by promising him the bran separated out by the grinding process. It is
impossible to know for certain whether the skin may not be damaged and lose its value in the
course of the work, or to know how much bran will be produced.
More accurately, Gharar refers to aleatory transactions, that is, transactions conditioned
on uncertain event. Gharar should not be used interchangeably with the broad concept of risk.
Gharar is prohibited yet it would be nonsensical to prohibit risk.
There are Hadith goes much further, extending the concept of commercial transactions
involving uncertainty. The meanings of most significant of them are following:
 Do not buy fish in the sea, for it is Gharar.
 To sell grapes until they become black, and sale grain until it is strong.
 Do not sale what in wombs, contents of the udders, pebble.
1.5.2. The Moral Economy of Islam
The three pre-requisites for an economic system as being a set of rules, an ideology to
justify them, and a conscience in the individual which makes him strive to carry them out [ 27].
The Ethical dimension is not all too often forgotten, though it exists, as well in any society.
Hard work and participation in economically creative activity is obligatory for every
Muslims [17]. Economic activity is not to be confined to earning or producing enough to meet
one’s personal needs only. Muslims are expected to produce more because they cannot
participate in the process of purification through providing security to others (zakat or alms tax)
unless they produce more than what themselves consume. The most recommended use of fairly
earned wealth is to apply it to procuring of all means to fulfill a Muslim’s covenant with Allah
[18].
The broad ethical/economic system emphasizes fairness and productivity, honesty in
trade and fair competition, the prohibition of hoarding wealth and worshipping it, and protection

26
of human beings from their own folly and extravagance. Such a system, although rooted in
ancient tradition, is not, at least in its broad outlines, far moved from many contemporary
approaches to ethical business practices.
As for the ethical/economic justification for the prohibition of riba, it is three-pronged:
riba is unfair, it is exploitative, and it is unproductive. Due to this relation the lender and
borrower are in equalized balance of economic chain. Islam prefers the risks of loss be shared
equitably between the two both lender and borrower. In other words, rather than collecting a
‘fixed, predetermined’ compensation in the form if interest, leaders should be entitled to a share
from any profits from a venture they have helped to finance. The broader argument is that any
point should be morally and economically justified. As in other religions riba was also seen as
exploitative, since it tended to favour the rich, who are were guaranteed a return, at the expense
of the vulnerable who assumed the risk.
A number of economists and philosophers disagreed with the idea of marking capital gain
without any effort and living off other people’s work unethical. The prominent ancient-Greek
philosopher Plato (424-347 BC) pointed out immortality of interest and argued that in an ideal
society interest should be forbidden as it leads to inequity, egoism and egotistical conflicts
among people. Another Greek philosopher Aristotle (384-322 BC) like his teacher did not agree
the idea of exploiting money interest. According to him there was a ‘natural’ and ‘unnatural’ way
of income. Shepherding, fishing, farming, hunting and alike were natural ways. Unnatural ways
on the other hand were those done with the sole purpose of making profit. The worst way of
gaining wealth through unnatural ways was interest. In this regard he recorded: “Very much
disliked also is the practice of charging interest: and the dislike is fully justified for interest is a
yield arising out of money itself, not a product of that for which money was provided. Money
was intended to be a means of exchange; interest represents an increase in the money itself.
Hence of all ways of getting wealth, the most contrary is to nature.” [32].In the early times of
Roman Empire there were laws forbidding interest. Even later under the ‘Law of the Twelve
Tables’ interest rates was fixed, and loan sharking was illegal.
Significantly, the issue of fairness is related to the issue of productivity and efficiency.
Earning a profit is legitimate when one is engaged in an economic venture and thereby
contributes to the economy. By certain accounts, Meccan merchants in the days of the Prophet
routinely engaged (usually in-between arrivals and departures of caravans) in interest-based
lending, speculation and aleatory transactions [13]. This would account for the sharp distinction
drawn in the Koran between profit from trade and profit from riba. While the former benefited
the community and enhanced welfare, the latter diverted resources towards non-productive uses
and contributed to illiquidity and scarcity. The modern-day economy equivalent of that debate

27
contrasts the real, productive economy with the financial, speculative one. Some Islamic
economists have also argued that an interest-based economy was inherently inflationary and
caused unemployment and poverty because of money was not linked to productive investment.
1.6. Financial Products in Islamic Banking and Their Conformity with
Conventional Banks
Most Islamic financial institutions engage in a variety of financial operations. Besides
their range of equity, trade financing and lending operations, Islamic banks worldwide also offer
a wide array of wholesale and retail products including loans, partnership investments, foreign
exchange transactions, fund transfers, letters of credit, securities safe-keeping, investment
management and advice, and other conventional banking services. Many are also in active
derivatives, fund management and insurance. There are favourable investment climate on
liability side in Islamic banks for depositors as well. Current accounts are operated on the
principles of al-wadia (safekeeping) and are not remunerated. In this term, depositors are
provided with the cheque-books and can withdraw their funds at any time without any
restrictions or conditions, unlike in conventional banks. Investment in profit-and-loss (PLS)
deposits linked to bank mudaraba investments are in the theory though not in practice the
principal instruments offered to depositors. Banks usually offer a variety of accounts – PLS
deposit accounts, PLS special notice deposit accounts, etc. (Figure 1.10).
Yet in classical Islamic tradition, the only acceptable loan was the ‘qadr hasan’ (meaning-
good loan) or interest-free loan in the only common form of deposit was ‘al-wadia’
(safekeeping). By creating new products that pose no religion objections, or by invoking custom,
or overriding the general interest to justify the creation of somewhat controversial instruments,
Islamic bankers have been able to devise new products and instruments by updating or
combining contracts that go back to classical Islam. In Appendix, the reader can find more
information about differences of products and techniques in Islamic and conventional banks.
1.6.1. Murabaha
The best-known Islamic banking instrument is murabaha a cost-plus contract in which a
client wishing to purchase the equipment or goods requests the financial provider to purchase the
items and sell them to him at cost plus a declared profit. It is thus a financing-cum-sale the items
and sells them to him at cost plus a declared profit. It is thus a financing-cum-sale: the bank
purchases the required goods directly and sells them on the basis of fixed mark-up profit,
agreeing to defer the receipt of the value of the goods. While the interest-based bank would lend
the money on interest to client, and he would go and purchase the required commodity from the

28
Shariah Sources
Koran
Sunna
Ijtima jurists’consensus)
Qiyas (Analogy)
Ijtihad (Reasoning)
Shariahh
Filter
islamic
products
transations
Islamic Trade/ Financial
Contracts
Musharaka ( partnership)
Murabaha (purchase-sale)
Ijarahh (lease)
Takaful (insurance)
Salam( forward sale)
market, in Islamic bank, as it does not operates on interest basis, the bank therefore, purchases
the commodity in cash and sells it to the client on an agreed mark up. Thus, the client gets the
commodity on credit for which financing required and the Islamic bank makes profit on the
amount it has spent in acquiring the commodity and selling it to the client on installments. There
are a number of requirements for a murabaha transaction to be a legit transaction and meet
Islamic standards of a legal sale. The whole murabaha transaction is completed in two stages. In
the first stage, the client requests the bank to undertake a murabaha transaction and promises to
buy the specified commodity from the bank. A promise under Shariah, however, is not legally
binding. Which means, if the client goes back on the promise to purchase, the bank risks the loss
of the full or part of amount it has spent to acquire the goods. To eliminate such situations,
Islamic banks sign legally binding agreements with their clients beforehand, which also can
Figure 1.10 Islamic Finance in Ethical and Religious Framework
Banking and financial needs
Asset-backed
transactions with
investments in real
durable assets
Islamic Banking and finance
Prohibition of certain
investments:
- Sectors: (e.g.: alcohol,
armaments, tobacco
pork pornography )
- Instruments(e.g. no
forward transactions,
no derivatives, short
selling
Credit debt
products are not
encouraged

29
Supplier
Financial Institution
Costumer
Sell asset at purchase
price Make upfront payment
Deferred payment
Sell asset at purchase price +
markup
be understood as a promise between the two parties. In the second stage, the client purchases the
good acquired by the bank on a deferred payments basis and agrees to a payment schedule.
Another important requirement of a murabaha sale is that it consists of two sales contracts, and
through which the bank acquires the commodity for the client, and the other through which it
sells the acquired commodity to the client. The two contracts should be separate and real
transactions (Figure 1.11).
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
such as consumer finance – for the purchase of consumer durables, for example, cars and
household appliances, the real estate – to provide housing finance, the production sector – to
finance the purchase of machinery, equipment and raw materials. Murabaha contracts are also
used to issue letters of credit and to provide financing to import trade at Islamic banks.
A Murabaha transaction has the following characteristics:
 The cost price of the asset is known to both the buyer and seller
 The buyer pays the seller at a fixed agreed time after receipt of the asset for an agreed
mark-up
 The mark-up may be a lump sum or a certain percentage of the purchase price
 The mark-up can, and often does, relate to the prevailing LIBOR (or equivalent) rate
 Payment default will require the buyer to cover the seller's stated cost of capital for this
period
A Murabaha transaction is a debt based transaction and is therefore not tradable (as
Figure 1.11 Murabaha transaction structure

30
Shariah forbids trading in debt) but can be transferred at par value.
Generalizing the incidental closeness between profit shares and interest rates, which
appear in some periods, and thereby reaching some conclusions will not give correct results. A
conventional bank determines the interest rate it will pay clients at the time of depositing money.
A Islamic banks on the other hand utilizes the money through applicable profit margins, and
shares the money it earns. Event in case that the distributed profit shares are close to the interest
rates of conventional banks, this does not mean that the work done is the same. Important here is
not the rate of interest and profit sharing, but the source of each. While interest steams from a
source forbidden by all theistic religions and condemned by many prominent philosophers and
economics, profit sharing at participation banks is a result from permissible economic activity.
In order for earning yield to be interest, it is necessary that income is known beforehand,
and that money earned in return for lending out money. For instance, a conventional banks
collect money from the depositors in return for a certain interest, and yet again present it in terms
of cash loans to those in need for financing, subject to current interest rates. But on the other
hand, there is neither a promise made for income nor a guarantee for principal capital of the
people under profit sharing.
1.6.2. Leasing
Ijarah4
or leasing is probably the fastest growing activity in Islamic financial institutions.
The principle is well knows and virtually identical to conventional leasing: the bank leases as
asset to a third party in exchange for specified rent[1]. The amounts of payments are knows in
advance and the asset remains the property of the lessor. Only in a few respects do Islamic
contracts differ. A variation of basic principle is ijarah wa iktina, a lease- purchase agreement
whereby at the expiration of the lease, the lessee becomes the owner of the asset (Figure 1.12).
From the standpoint if classical Islamic fiqh, ijarah is understood as the sale of usufruct
(manfaa) and, as such, its rules closely follow those of ordinary sales. In order to avoid the
elements of riba and gharar, there are minor differences between ijarah and commercial leasing.
The law views some benefits and burdens of the property as belonging naturally and
unchangeably to the lessee, others to the lessor. For example, law provides that the duty to repair
the goods always fall on the lessor since the repair benefits him as the owner. Also, the usufruct
is not something existent and tangible, but a stream of the use extending into the future, which is
risky and unstable. Islamic law thus gives broad scope to the lessee to cancel the lease if the
4
“Ijarah” or in various literature “ijara”, which are identical in definition.

31
usufruct proves less valuable than expected. Finally, the price at which the asset may be sold to
the lessee at the expiration date of the contract cannot be predetermined.
Main characteristics of Ijarah:
 It is necessary that the lessor own the asset and holds valid title to it.
 Operating lease – the asset is returned to the lessor
 Financial lease – the asset is sold to lessee be lessor upon completion of lease term
 Lease rent is fixed by parties updating to market competitiveness
 Lease will terminate upon total loss of asset or damage
A number of reasons account for the repaid growth of leasing : it is an acceptable
instrument in the eyes of the most scholars; it is an efficient means of financial intermediation;
by financing assets, it is useful tool in the promotion of economic development; because it is a
well-established instrument that lends itself to standardized mechanisms and procedures, and
because the similarity to conventional leasing, it is a flexible mode pf financing that lends itself
to securitization and secondary trading and to collaboration with conventional institutions.
1.6.3. Profit-and-Loss Sharing
The basic principle of profit-and-loss is that instead of lending money at a fixes rate of
return, the banker forms a partnership with the borrower, sharing in a venture’s profits and
losses. The partnership can be one or two types: mudarraba (commenda partnership or finance
trusteeship) and musharaka (long term equity-like arrangements). In both cases, the bank
receives a contractual share of the profits generated by business ventures.
The principle is at the core of the Islamic banking philosophy. It is at once the most
‘authentic’ form of Islamic finance since it replicates transactions that were common in the early
days of Islam, the one that is most consistent with the value system and moral economy of Islam,
and the most ‘modern’ one. Indeed, venture capital and merchant banking – both among the
Bank
(Lessor)
Client
(Lessee)
Asset
Purchases Bank leases
Asset to Client
Client pays rent to Bank
Figure 1.12 Ijarah (Leasing) transaction structure

32
fastest growing segments of contemporary finance – would be conventional equivalents of profit-
and-loss sharing arrangements. The bank, being an investor, as opposed to a lender, has a stake
in the long-term success of the venture. The entrepreneur, rather than being concerned with debt-
servicing, can concentrate on a long-term endeavor that in turn would provide economic and
social benefits to the community.
Mudaraba partnership (entrepreneur based partnership) is a type of partnership where one
party supplies the capital and the other the labor. One party who owns capital – rabb al-mal
(beneficial owner or the sleeping partner) – entrusts money to the other party, called the mudarib
(managing trustee), who is to utilize it in an agreed manner. After the operation is concluded, the
rabb al-mal receives the principal and the pre-agreed share of the profit. The mudarib keeps for
himself the remaining profits. The rab al-mall also shares in the losses, and may be in position of
losing all his principal. Among the other rules od mudaraba are the following: the division of the
profits between the two parties must necessarily be on proportional basis and cannot be lump
sum or guaranteed return; rab al-mal is not liable for losses except for the losses beyond the
capital he has contributed; the mudarib does not share in the losses except the loss of his time
and efforts.
Musharaka is similar in its principle to mudaraba, except for the fact that the financier
takes an equity stake in the venture. It is in effect a joint-venture agreement whereby the bank
enters into a partnership with a client in which both share the equity capital, and sometimes the
management, of the project or the deal. Participation in a musharaka can be either in a new
project or in an existing one. Profits are divided on a pre-determined basis, and any losses shared
in proportion to the capital contribution. Under certain circumstances, for example if the mudarib
has engaged in religiously illicit activities (speculation, production of forbidden goods), or of the
bank has imposed a collateral for its investments, the mudaraba or musharaka contracts can be
considered null and void.
Recent variations of mudaraba (mudaraba mutanaqisa) and musharaka (musharaka
mutanaqisa), where the bank’s capital or the bank’s share increase his share in he projects.
Although many scholars consider profit-and-loss sharing as the most authentic and most
promising form of Islamic contracts, there are a few dissenting voices. In addition, profit- and-
loss sharing arrangements create managerial and regulatory problems that have yet to be fully
mastered.
To finance such arrangements, most Islamic banks offer accounts that act like investment
funds. Depositors can reap profits from a venture’s success, but risk losing money if investments
perform poorly. The return paid on investment accounts is determined by the yield obtained from
all financial activities of the bank. After deducting such administration costs as wages, provision,

33
and capital depreciation, the bank pools the yields obtained from all ventures, and the depositors,
as a group, share the net profits with the bank, according to a predetermined ratio that cannot be
modified for the duration of the contract.
Perhaps the greatest strategic challenge of Islamic financial institutions is to increase their
involvement in PLS activities and overcome the institutional and cultural obstacles that have so
far stood in the way [14].
1.6.4. Sukuk – Islamic Bonds
Sukuk market is one of the fastest growing segments of the Islamic capital market
(“direct funding market”) usually translated as Islamic bond is the most active Islamic debt
market instruments (in addition to Islamic equity market). The development of the sukuk market
has accompanied the transformation of the economy that has now become more diversified and
private sector driven. The market, initially dominated by the Government debt securities, now
reflects the growing demand for the long term financing requirements of the private sector. In
this highly competitive environment, the presence of a deep and liquid of sukuk market thus
contributes towards the stability of the financial system.
Nowadays, sukuk or Islamic fixed-income securities that have emerged over the past 15
years become as an increasingly important asset class. Sukuk may be defined as certificates of
equal value that represent an undivided interest (proportional to the investor’s interest) in the
ownership of an underlying asset (both tangible and intangible), usufruct, services or investments
in particular projects or special investment activities. Through this concept, sukuk enjoy the
benefit of being backed by assets, thereby affording the sukuk holder or investor a level of
protection which may not be available from conventional debt securities. Furthermore, unlike
conventional debt securities that mirror debts or loans on which interest is paid, sukuk can be
structured based on innovative applications of Islamic principles and concepts. Sukuk share some
similarities with conventional debt securities, in that they are similarly structured based on assets
that generate revenue. The underlying revenue from these assets represents the source of income
for the payment of profit on the sukuk [19].
Modern sukuk emerged to fill a gap in the global capital market. Islamic investors want
to balance their equity portfolios with bond-like products. Because sukuk are asset-based
securities — not debt instruments — they fit the bill. Each sukuk has a face value (based on the
value of the underlying asset), and the investor may pay that amount or (as with a conventional
bond) buy it at a premium or discount.
With sukuk, the future cash flow from the underlying asset is transferred into present
cash flow. Sukuk may be issued for existing assets or for assets that will exist in the future.

34
Investors who purchase sukuk are rewarded with a share of the profits derived from the asset.
They don’t earn interest payments because doing so would violate Shariah.
As with conventional bonds, sukuk are issued with specific maturity dates. When the
maturity date arrives, the sukuk issuer buys them back. However, with sukuk, the initial
investment isn’t guaranteed; the sukuk holder may or may not get back the entire principal (face
value) amount. That’s because, unlike conventional bond holders, sukuk holders share the risk of
the underlying asset. If the project or business on which sukuk are issued doesn’t perform as well
as expected, the sukuk investor must bear a share of the loss.
Table 1.2.
Most shariah scholars believe that having sukuk managers, partners, or agents promise to
repurchase sukuk for the face value is unlawful. Instead, sukuk are generally repurchased based
on the net value of the underlying assets (each share receiving its portion of that value) or at a
price agreed upon at the time of the sukuk purchase [8].
Distinguishing Sukuk from Conventional Bonds
Conventional Bonds Sukuk
Asset
ownership
Bonds don’t give the investor a share of
ownership in the asset, project, business, or joint
venture they support. They’re a debt obligation
from the issuer to the bond holder.
Sukuk give the investor partial
ownership in the asset on which the
sukuk are based.
Investment
criteria
Generally, bonds can be used to finance
any asset, project, business, or joint venture that
complies with local legislation.
The asset on which sukuk are
based must be shariah-compliant.
Issue unit Each bond represents a share of debt. Each sukuk represents a share of
the underlying asset.
Issue price The face value of a bond price is based on the
issuer’s credit worthiness (including its rating).
The face value of sukuk is based on
the market value of the underlying
asset.
Investment
rewards and
risks
Bond holders receive regularly scheduled (and
often fixed rate) interest payments for the life of
the bond, and their principal is guaranteed to be
returned at the bond’s maturity date.
Sukuk holders receive a share of
profits from the underlying asset
(and accept a share of any loss
incurred).
Effects of
costs
Bond holders generally aren’t affected by costs
related to the asset, project, business, or joint
venture they support. The performance of the
underlying asset doesn’t affect investor rewards.
Sukuk holders are affected by costs
related to the underlying asset.
Higher costs may translate to lower
investor profits and vice versa.

35
In practice, some sukuk are issued with repurchase guarantees just as conventional bonds
are. Although not all shariah scholars agree that this arrangement complies with Islamic law, a
product called sukuk ijarah may come with a repurchase guarantee.
The key characteristic of sukuk — the fact that they grant partial ownership in the
underlying asset — is considered shariah-compliant. This ruling means that Islamic investors
have the right to receive a share of profits from the sukuk’s underlying asset.
When you have the basics about how conventional bonds and sukuk work, it’s time to put
them next to each other. Table 1.2 offers a quick look at the key ways in which these investment
products compare. The sukuk bonds can be applied to all other Islamic transactions and
agreements, and therefore, potentially gain the profit of invested capital.
In a mudaraba sukuk, the sukuk holders are the silent partners, who don’t participate in
the management of the underlying asset, business, or project. The working partner is the sukuk
obligator. The sukuk obligator, as the working partner, is generally entitled to a fee and/or share
of the profit, which is spelled out in the initial contract with investors.
With sukuk that are based on the murabaha contract, the SPV (Special Purpose Vehicle)
can use the investors’ capital to purchase an asset and sell it to the obligator on a cost-plus-profit-
margin basis. The obligator (the buyer) makes deferred payments to the investors (the sellers).
This setup is a fixed-income type of sukuk, and the SPV facilitates the transaction between the
sukuk holders and the obligator. The murabaha contract process begins with the obligator (who
needs an asset but can’t pay for it right now) signing an agreement with the SPV to purchase the
asset on a deferred-payment schedule. This agreement describes the cost-plus margin and
deferred payments (Figure 1.13).
The basic idea of ijarah sukuk is that the sukuk holders (investors) are the owners of the
asset and are entitled to receive a return when that asset is leased. The ijarah contract process
begins when a company that needs an asset but can’t afford to purchase it outright contracts with
an SPV, which agrees to purchase the asset and rent it to the company for a fixed period of time.
In this scenario, the SPV receives the sukuk proceeds from the investors; in return, each
investor gets a portion of ownership in the asset to be leased. The SPV buys the title of the asset
from the same company that is going to lease the asset. In turn, the company pays a rental fee to
the SPV.
Istisna is a contract between a buyer and a manufacturer in which the manufacturer
agrees to complete a construction project by a future date. The contract requires a fixed price and
product specifications that both parties agree to. If the end product doesn’t meet contract
specifications, the buyer can withdraw from the contract. Istisna sukuk are based on this type of
contract. The sukuk holders are the buyers of the project, and the obligator is the manufacturer.

36
The obligator agrees to manufacture the project in the future and deliver it to the buyer, who
(based on a separate ijarah contract) will lease the asset to another party for regular payments.
The process of issuing istisna sukuk begins when the obligator (manufacturer or contractor) and
the SPV sign an istisna contract.
Another innovative type of sukuk is hybrid sukuk which has new complicated structures.
Based on various demands of investors, a more diversified kind of hybrid sukuk or mixed sukuk
emerged in the market. The assets can comprise of istisna, murabaha as well as ijarah. Islamic
Development Bank issued the first Hybrid Sukuk for US$400 million. The assets comprised 66%
ijarah sukuk, 31% murabaha and 3% istisna sukuk. The hybrid sukuk structure represents the
potential of new structures and benefits to the investors.
Sukuk has now become the strongest segment in Islamic finance, are involved in the
international market and generate significant cross-border flow of funds as may be achieved
beyond domestic markets. Along with hard work, growth and balanced development agenda, all
countries have the potential to expand the role of Islamic finance is increasing in contributing to
global growth and financial stability. Investment sukuk are the ideal investment for investors
requiring a fixed investment return with low risk and the Shariah Compliant.
1.6.5. Islamic Mutual Funds
Islamic investment funds are similar to socially responsible mutual funds n that they
select their placements bot in bases of profitability alone, but on non-economic criteria – in this
Investor (seller)
SPVAsset or commodity
supplier
Obligator (Buyer)
1. Cash proceeding 2. Sukuk
certificate
issuance
4.Delivery of
asset
3.Purchase of asset
for spot
payment and delivery
5. Differed payments on
installment or lump sum
(cost+profit)
6. Periodic distribution
of deferred payments
Figure 1.13 Murabaha sukuk structure
Source: Designed based on the ideas of the author

37
case, compatibility with Islamic values. Driven by abundant liquidity and the boom in financial
markets, thousands of investments funds were started in recent years. In addition to Islamic
financial institution, virtually every major Western financial institution – such as Merrill Lynch,
Goldman Sachs, Flemings, etc. – now offers Islamic investment funds. In 1990, Dow Jones and
Company has created the Dow Jones Islamic Market Index or DJIM, which track 600 companies
whose products and services do not violate Islamic law.
An Islamic mutual fund is similar to conventional mutual fund in many ways. However,
unlike its conventional counterpart, an Islamic mutual fund must confirm to shariah investment
precepts. The Shariah encourages the use of profit and loss sharing and partnership schemes, and
forbids riba (interest), gambling and gharar (selling something that is not owned or cannot be
described in accurate detail in terms of size, type and amount). Shariah guides and supervises the
several aspects of Islamic mutual funds, including its asset allocation (portfolio screening),
investment and trading practices, and income distribution.
Any Mutual Fund falls roughly into the following two sub-groups:
 Income Funds. The investor receives a regular income (monthly/quarterly) by investing
in securities that provide income (e.g. dividend paying stocks, etc.).
 Growth Funds. The main aim of this type of fund is to grow the capital invested by
appreciation of the underlying securities, and not to provide any annual/quarterly income.
The following Mutual Funds presented below are ones of best prospective funds advertise that
they operate according to Islamic Shariah principle. Most have a Shariah Advisory board that
oversees its compliance with Islamic teachings:
 Azzad Asset Management is a financial services firm specialized in providing ethical
(halal only) financial solutions. The company offers the Azzad Funds as well as an
ethical (halal) separately managed program using asset allocation. Clients can choose
from a variety of retirement, college savings, and managed investment accounts. In
addition, the company assists affluent investors with their estate planning needs.
Businesses and individuals depend on Azzad to help them turn their wealth into their
goals by using only halal investing.
 Amana Mutual Funds. They offer two Mutual Funds (Growth and Income) operating
according to Islamic Principles, with an Islamic Advisory Board.
 Allied Asset Advisors. These are an Islamic Mutual Fund that tracks the Dow Jones
Islamic Markets USA (DJIM-US).
 Wright Islamic Equity Investment. Their objective is to "provide competitive Shariah
compliant investment returns utilizing a globally diversified portfolio of high quality
equity investments rigorously screened for Shariah compliance.

38
1.6.6. Micro-lending or Micro-financing
Most micro-lending or micro-finance institutions (MFI) are not, technically, Islamic
banks. Yet they may be closer to the moral of economy of Islam than many self-styled Islamic
banks, and will no doubt be a source of ideas and concepts for Islamic finance in the future. The
micro-financing idea has gained a number of adherents, in particular among governments and
international organizations in recent years.
Micro-finance purports to provide a market-based solution to one of capitalism’s
thorniest problems: integrating the poor into the economy. This finance scheme focuses on
moving people off the dole and into productive enterprise. Self-helped and self-reliance are at the
center of the system. The scheme turns the conventional banking logic on its head: rather than
looking for creditworthy customers and basing lending decisions on credit history and collateral,
MFIs lend small amounts of money to people – principally women – with no resources, as means
of integrating them in the productive economy.
The best known experience in micro-financing is Muhammed Yunus’s Grameen Bank,
which was initially started in Bangladesh and has since been replicated in more than 50
countries. Although interest-based and devoid of explicit references to Islam, Grameen Bank
concept – not to mention the fact that it was created in an overwhelmingly Islamic country by a
Muslim – is based on a central tenet of the moral economy of Islam.
The MFIs are in the process of destroying several very old myths: the poor are not
creditworthy; they are not reliable borrowers; they are not successful enough to make saving;
they are bad investors and even worse entrepreneurs. Grameen Bank boasts that 98 per cent if its
loans are repaid on time [14].
The main objection of Islamic scholars to micro-lending banks is that they lend at
interest.
1.7. The Management and Control, and ‘Islamic Moral Hazard’
The notion of moral hazard is commonly use in the connection with financial regulation.
It refers to policies that many encourage reckless behavior. For many, it is axiomatic that bank
and their customers are people of virtue, who act at all times in a righteous manner. While it is
undeniable that religious fervor was for many people a reason to work for an Islamic bank, or to
conduct business with it, it was soon discovered that religion could be a double-edged sword. In
the Koran there are numerous references to hypocrisy [17]. Since time immemorial, con artists
have used the cover of religion as a means of rapid enrichment. Even when the overwhelming
majority of people are honest, all it takes is a few bad ‘apples’ – a few dishonest customers or
employees – for banks to incur serious difficulties.

39
There are four factors of special importance in this regard. One is the assumption of
righteous behavior on the part of employees and customers, which sometimes turns certain
institutions into magnet for dubious characters [14]. The second is the use of religion as a shield
against scrutiny. The third is the religious and legal ambiguity that often allows borrowers to
escape their obligations with impunity. The fourth involves conflicts of interest involving the
bank and its clients.
In the early years, Islamic bankers failed to act prudently and exercise the kind of due
diligence expected of bankers, because implicit assumptions about the virtue of their employees,
and customers Internal control has also been a problem for the same reasons. A number of failure
in management of banking was seen in Dubai, the world’s centre of Islamic commercial banks
and regulations in last decade of twentieth century.
A Second type of Islamic moral hazard occurs when financial activities of certain Islamic
institutions or group become immune to scrutiny or criticism, whether for political or religious
reasons. A more subtle but equally pervasive form of Islamic moral hazard is the advantage that
can be taken from ambiguity. Unlike specular systems, the legal system of Islam incorporates
both an economic and religious logic. In the religious law of Islam, equitable considerations of
the individual conscience in matters of profit and loss override the technicalities of commercial
dealings. It is harmonization of these two very different approaches which poses the real
challenge for developing Islamic law today [24].
Islamic banks face serious problems with late payments, not to mention outright defaults,
since some people take advantage of every dilatory legal and religious device. However, it
should be notes that same problems often hurt conventional banks in Islamic countries. In Saudi
Arabia, problems of late payment are endemic, and banks receive little help from juridical
system. In Pakistan, many borrowers took advantage of the ambiguity of a multilayered legal
system to avoid repaying much of their debt.
The last type of Islamic moral hazard is related to the bank’s relation with its depositors.
Islamic banks share their profits with those of their customers who hold investment deposits. For
example, 80 per cent of the net profits may be distributed to the depositors, and 20 per cent to the
shareholders. Empirical surveys have shown that banks often arbitrarily change distribution
ratios.
Perhaps the most vexing managerial issue is the lack of qualified personnel. Bank
officers at once management skills appropriate to conventional institution and religious training.

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