The main source of guidance is received from our Respected MA’AM NEHA ZAIB, It might seems quite trivial here in this set of words or it might seems like a set of words of praising towards a TEACHER, but it’s nothing like that, To be very honest with everyone, If we hadn’t got proper guidance from Ma’am Neha zaib, we could’ve never been able to complete this whole project, and even if we had completed it, it would’ve been never gotten over such a robust and inevitable level. We believe that we have tried our utmost to make it the best there is and now we will also try our very best to present each and every thing, we will try our very best just not to deliver the phenomenal information, but also deliever each, and everything there could be delivered to brainstorm the minds, and to give them a positive view, and also to explain the product, the working, the processes, and much more that could be explained.

EXECUTIVE SUMMARY

A Bank is an economic institution whose main aim is to earn profit through exchange of money & credit instruments. It is a service oriented as well as profits oriented organization.

The motto of Islamic banking is profit sharing and loss bearing. The main objective of Islamic banking is as same as conventional banking system which is profit making. To follow the shariah system Islamic banks actually follow certain terms which is known as Mudharabah, Wadiah, Musharakah, Murabahah, Ijar.

The difference between the conventional and non-conventional banks

· Time value is the basis for charging interest on capital.

· Profit on trade of goods or charging on providing service is the basis for earning profit.

Conventional Banking:

A commercial bank (or business bank) is a type of retail bank that provides services, such as accepting deposits, giving business loans and basic investment products.

A financial institution that provides services, such as accepting deposits, giving business loans and auto loans, mortgage lending, and basic investment products like savings accounts and certificates of deposit. The traditional commercial bank is a brick and mortar institution with tellers, safe deposit boxes, vaults and ATMs. However, some commercial banks do not have any physical branches and require consumers to complete all transactions by phone or Internet. In exchange, they generally pay higher interest rates on investments and deposits, and charge lower fees.

Categories of commercial banks in Pakistan:

Commercial banks operating in Pakistan can be divided into four categories:

§ Nationalized Commercial Banks (NCBs),

§ Privatized Banks

§ Foreign Banks.

Nonconventional banking (Islamic Banking):

A banking system that is based on the principles of Islamic law (also known Shariah) and guided by Islamic economics. Two basic principles behind Islamic banking are the sharing of profit and loss and, significantly, the prohibition of the collection and payment of interest. Collecting interest is not permitted under Islamic law.

Fundamental of Islamic Banking:

§ Shariah laws are the tenets of Islamic Banking. As such, the comparison with that of the conventional are not exactly like-to-like.

§ Conventional banking was build upon the fundamentals of debtor-creditor relationship with interest being the price of credit and reflecting the opportunity cost of money. Hence, money is a commodity somewhat.

§ Financial relationship in Islam is generally participatory in nature. E.g. the principles of Musharakah and Mudharabah, or contractual transaction. In addition, risk and reward relationship is guided by the socio-economic principles.

Islamic Bank in Pakistan:

§ Bank Islami Pakistan Limited

§ Burj Bank

§ Dubai Islamic Bank Pakistan Limited

§ Meezan Bank Limited

§ Al Baraka Bank (Pakistan) Limited

§ Emirates Global Islamic Bank Basic

Products of Islamic Banks:

· Sukuk:

Islamic Finance also has a bond like conventional financial system has bonds as a medium of investment. The word Sakk refers to a single bond and its plural is Sukuk, which is a famous word in the world of Islamic Finance. Sukuk are Islamic bonds that are structured in a way to generate returns to the investors, without any transaction involving riba (usury)

· Murabahah

Murabahah is another product based on the Islamic Sharee’ah; it refers to the sale of goods at a price which includes a profit margin, i.e. cost plus. This product is predominantly offered by Islamic banks in asset financing, property, microfinance and commodity import and export. A Murabahah contract has an honest declaration of cost and the expenses incurred on the product, along with the profit mark up being taken by the seller, which is the bank in this case

· Musharakah

Musharakah is a partnership-based contract or an investment product with a partnership structure for sharing profits and losses, which is based on the Islamic Sharee’ah. It involves investment from all the partners and an agreement to share profits in a predetermined ratio and to share losses in the ratio of contribution. Parties to the contract of Musharakah are referred as “musharik” which literally means partner

· Mudarabah

Mudarabah is an equity-based contract offered by Islamic banks, which is based on the Islamic Shari’ah. It is a special kind of partnership, where one partner provides money to another and the latter manages the money by investing it in commercial projects in order to earn profit which is shared among the two in a predetermined ratio. The first partner who provides the money to the second is called “rabb al maal (capital provider)” while the second partner is known as “mudarib (manager)”

Islamic Modes of Financing

Participatory Modes

1. Mudarabah

2. Musharakah

Sale Modes

1. Murabaha

2. Salam and parallel salam

3. Istisna and parallel Istisna

Rent based Modes

1. Ijarah

2. Ijarah wa Iqtina

Difference between conventional banks and non-conventional banks

Conventional Banking

Non-Conventional Banking

Money is a commodity besides medium of exchange and store of value. Therefore it can be sold at a price higher than its face value it can also be rented out.	Money is not a commodity it is used as a medium of exchange and store of value; therefore it cannot be sold at a price higher than its face value rented out.
Time value is basis for charging interest on capital.	Profit on trade of goods or charging on providing service is the basis for earning profit.
Interest is always charged if your organization or business in loss and some kind of suffering and it is not based on profit and loss sharing.	Non-conventional banks operates on the basis of profit and loss, the bank will share these losses based on the mode of finance used.
There is no exchange of goods and services are made.	The execution of agreements for the exchange of goods and services is a must under murabaha salam and istisna contracts.
Conventional bank use money as a commodity which leads to inflation.	These banks tend to create link with the real sector of the economic system by using trade related activities.
The functions and operations modes of conventional banks are full manmade principles.	The functions and operating modes of Islamic banks are based on the principles of Islamic shariah.
The investor is guaranteed of predetermined rate of interest or returns.	It promotes risk sharing between provider of capital and the user.
It does not deal with zakat.	This bank is deal in zaqat. It also work as a zakat collector.
Non conventional banks have no provision to charge any extra money from the defaulter except for compensation.	It can charge additional money in case of defaulters.
For interest based commercial banks borrowing from the money market is relatively strictly private and confidential easier.	For the Islamic banks, It must be base on a shariah approved underlying transaction.
Greater emphasis on the viability of the projects.	Emphasis equals to commodity pricing.
The relation is often defined as those creditor-debtors.	The status of Islamic bank in relation to its clients that of partners investors and trader buyers and seller.
A conventional has to guarantee all its deposits.	The Islamic bank can only guarantee deposits for deposit account.
Aiming for profit without religious moral boundaries.	Aiming for profit that adheres to Islamic discipline that is limited to that which benefits society.
The retail loan product applies the system of giving out loans with multiplied interest.	Its retail products utilize the trading or renting of an assets and not the loan contract.
Charging a compounding penalty on a loan if there is late payment.	Charges compensation for any late payment.
Earn revenue from fixed interest charged to the customers.	Profit according to the concept of sharing profit and loss.

The Two Basic Sides of Banking Transactions

The financial transactions of a bank are generally divided in two sides;

1. The Asset side - This side of a bank's transactions refers to the financing facilities that the banks provide to their clients. For instance, a conventional bank provides financing to its clients by giving them interest based loans where as an Islamic bank provides financing to its client based on profit based financing such as Murabaha, Ijarah, Salam, Istisna etc.

2. The Liability side - This side of a bank's transactions refers to the deposit and investment facilities that the bank provides to its clients. A conventional bank accepts deposits from its client and forwards them on interest to other clients who require financing. The interest that accrues on such a transaction is distributed amongst the depositors and the bank. On the other hand, an Islamic bank receives deposits on the basis of Musharakah or Mudarabah and invests these funds in a Shariah compliant manner. The profit that is earned on such a transaction is thereafter shared amongst the bank and the depositors based on a pre-agreed profit sharing ratio.

Comparison between conventional and Islamic banking transactions on the asset side

A conventional bank's transactions on the asset side include financing on interest. It is clear that the underline transaction of all such financing is an interest based loan no matter what purpose the client may have taken this facility for. An Islamic bank, on the other hand, provides financing facilities based on different transactions depending on the requirements of its clients. The following are the three common types of transactions used to provide financing facilities:

1. Murabaha

2. Ijarah

3. Diminishing Musharakah

In addition to the above, sometimes Salam and Istisna are also used to provide financing facilities.

Come; let us now discuss the transactions of Islamic banks in some detail.

Murabaha

Murabaha is a type of sale in which the seller informs the buyer about the cost at which he would acquire the goods and the amount of profit that he would sell the goods at to the buyer.

In other words, together with all the other conditions of a valid sale, the seller is obliged to fulfill one more condition which is to disclose his cost and the amount of profit he would make on the transaction.

Murabaha transactions, that are concluded in Islamic banks comprise of the following stages.

1. Signing a Facility Agreement

In the first stage, the client and the bank arrive at a mutual understanding of the transactions that would commence and sign a general agreement or facility agreement. The limit of the amount at which the client will purchase goods from the bank, the profit that the bank will make on these goods, the method of payment of these goods etc. are amongst those aspects that are agreed upon in this agreement. (It should be noted that this is not the Murabaha transaction. It is merely a memorandum of understanding or a general framework for the transaction that would follow.)

2. Purchasing the desired goods

Thereafter the bank purchases the goods from the market that it would later sell to the customer.

At this point, the Islamic bank either purchases the desired goods from the market itself or appoints an agent other than the client to purchase these goods; however, in case of Difference between Islamic And Conventional Banking necessity the client himself may be appointed as an agent of the bank to purchase the goods from the market on behalf of the bank.

From this we understand that it is not necessary for the client to be appointed as the bank's agent and neither does the Islamic bank stipulates that it would only sell goods to the client if the client agrees to become its agent. In fact, if circumstances do not allow the bank or an agent of the bank other than client to purchase the goods, only then can the Islamic bank appoint its client as an agent to purchase the goods. However, currently Islamic banks generally appoint their clients as their agents to purchase goods on their behalf. The client also prefers to purchase the goods themselves as the bank or a third party client may not be aware of their exact requirements. In fact, there is a strong possibility that the required goods purchased by the bank or the third party client may not fulfill the requirements of the client and the client may reject the goods. In such a situation, if the supplier refuses to take the goods back, the Islamic bank would suffer a heavy monetary loss. Therefore, with the mutual agreement of both parties, the client can be appointed as an agent to purchase the goods on behalf of the bank.

3. Taking possession of the purchased goods and informing the Islamic bank

If the client himself is appointed as the agent of the bank to purchase on its behalf then, he is supposed to take possession of the goods after purchasing the required goods and inform the bank accordingly. According to the Shariah, the possession taken by an agent is considered as possession taken by the principal. Hence, these goods are now in possession of the principal, which is the bank and all the rules pertaining to possession would take effect immediately. At this point if these goods are destroyed without any negligence on part of the client, then the bank would have to bear this loss. The client cannot be held responsible for such a loss. Similarly if the goods are being imported from a foreign country, the risk of the goods being destroyed lies with the Islamic bank until the goods reach the country of import, and are sold to the client. In case of destruction the bank would have to bear the loss.

4. Execution of Murabaha

After purchasing the required goods as a bank's agent the client offers to purchase these goods from the bank at a certain price which clearly states the cost of the bank and its profit. The client agrees to pay for the goods either immediately or according to a particular schedule. When the bank accepts this offer, the Murabaha transaction is concluded and the client becomes responsible to pay the amount agreed upon to the bank. The bank acquires some collateral from the client as a guarantee for the payment of this amount.

This is the gist of the transaction that has been named Murabaha in Islamic banks. The different stages of Murabaha mentioned above are not against the Shariah or they are impermissible. However, it's the responsibility of the Islamic banks to execute Murabaha with the above mentioned details conditions.

The Difference between Murabaha and an Interest Based Loan.

The above explanation clarifies the fact that there is a world of difference between the Murabaha transaction and the conventional interest based loan.

A conventional bank advances cash on the basis of a loan against which it earns an interest. As these funds are advanced on the basis of a loan the bank does not hear any risk of loss on these funds. On the other hand, an Islamic bank first purchases an item and by taking its possession, assumes the risk of that item. Thereafter, the bank sells it at a specified profit. This transaction is same as that of a shopkeeper who purchases goods and sells them in his shop at a specific markup.

The only difference is that a normal shopkeeper does not generally discloses the cost and profit to his customer (this sale is called Mussawamah), whereas an Islamic bank discloses its cost and markup in Murabaha.

According to a verse of the Holy Quran, sale is permissible whereas interest is prohibited:

As Murabaha is also a type of sale and the Holy Quran has permitted sale transactions (buying and selling), Murabaha transactions are also permitted, provided that the required conditions are adhered to.

The logical reasoning for the permissibility of Murabaha is that the Islamic bank assumes the risk of the subject matter of the sale and it is a law of the Shariah that the one who assumes the risk of an item is eligible to earn a profit from that item.

It should be kept in mind that "risk" refers to the risk associated with the subject matter of the sale and not the risk of default by a client. The risk of default by the client is found in every transaction but no expert of Shariah has permitted any transaction based on this risk to date. However if by assuming a risk, the risk of default of the client is considered to be meant, then there would be no transaction in the world that would be impermissible whereas there are many transactions that are impermissible in the light of the clear rulings of the Quran and the Hadith.

Ijarah

Ijarah in the terminology of Shariah is called to hire a specific thing or a person for a permissible purpose against specific remuneration.

Ijarah is basically of two types.

1. Ijarah of an Asset

To rent out something which is called leasing in English and in the terminology of Fiqh it is called “Ijaratul Ayaan”

2. Ijarah of a person

To hire ones services for a specific remuneration, it is usually referred in English as employment, while in the terminology of Fiqh it is called as “Ijaratul Ashkhas”

Ijarah of an asset or lease is further of two types:

1. Financial lease

2. Operating lease

Operating Lease

Operating lease is the Ijarah done commonly in which a person or an institution leases its specific asset for a specific period against a specific rent, and after the expiry of the period the asset is returned back to the owner. For example renting out a house or a shop or any item of daily usage like tent, speaker system etc. This type of Ijarah is in practice since long.

Financial lease

The type of Ijarah which is used in the banks is the finance lease. This type of lease was adopted as a form of capital investment and Ijarah was used as a tool of financing. The asset is leased out for a specific period like 3-5 years in which the lessor receives the principal with the profit of the asset in the shape of rent and after the lease period the ownership is transferred to the client or lessee.

Defects in Conventional lease

The finance lease in practice in the conventional banks has the following Shariah defects.

1) The agreement comprises of sale and lease contracts since the installments paid by the client are initially considered as rent, while at the end of the lease period they are supposed to be the price of the asset and the ownership is automatically transferred from the institution to client without any further contract. If such transaction is analyzed in the light of Shariah it will be considered that the client asks the institution in such a manner that "I will take this car on rent with the condition that at the end of lease period I will be the owner of the car against the rental paid. "Islamic jurisprudence will consider this transaction „Suf‟qataan Fisa‟afqa‟ or two contracts tied in a contract which is not permissible. Such a transaction is clearly prohibited in the Hadith (see 398/, Nasai 4629, Tabrani alAwsat 1633)

2) All the liabilities of the leased asset are borne by the lessee, where as the Shariah only imposes the liabilities on lessee which are regarding to the usage of the asset. For example in a car the lessee's liability is to make service, change the oil, etc, while the liabilities regarding the ownership are the responsibility of the lessor, like paying ownership taxes and the maintenance of asset if it is defected/destroyed without the negligence of the lessee.

3) Rentals are charged from the lessee even before the asset is delivered to the lessee while Shariah does not allow charging any rental unless the asset in working condition is handed over to the lessee.

How are these defects being eliminated in Islamic banks?

These defects have been eliminated in the Ijarah product, designed for the Islamic banks in the following manner.

1) During the lease period only rental contract is signed between the client and. the bank. Hence the asset remains in the ownership of the bank from beginning to the end of Ijarah. At the end of Ijarah after handing over the asset back to the owner, the client is given an option that he might purchase the car through a separate sale contract.

2) It is clearly mentioned in the Ijarah contract that the liabilities regarding "Minor Maintenance" will be borne by the lessee while the ownership expenses like tax, takaful, defects in case of accident will be borne by the bank. This is what Shariah requires.

3) The bank does not charge any rent unless the asset is handed over to lessee.

The above detail clears the difference between the procedure of Islamic banks and the conventional banks, and also clears the argument made by some people that there is no difference between them, as some Islamic banks also take rentals from the very first day.

Difference between Ijarah and Conventional Lease

A common argument is also given that Islamic banks in Ijarah say that they bear the risk of the leased asset, but like conventional banks, Islamic banks also insure their leased asset Therefore, whatever loss occurs, it will be the loss of insurance company.

The answer to this argument is that first of all, Islamic banks do not insure their asset from the conventional insurance companies; rather they are bound to have their agreements from Islamic insurance or Takaful. Conventional insurance is not permissible since it consist of Interest, Gambling &Uncertainty while in Islamic Takaful these impermissible elements have been removed.

Secondly although the conventional bank insures its asset, in case of loss if the claim amount is insufficient, the bank does not bear the loss and recovers it from the lessee. On the other hand, in case of loss if the amount of claim from the takaful company is insufficient, the Islamic bank bears this loss by itself and is not recovered from the client rather it hands over the security deposit back to the client.

This difference clears the fact that the conventional bank does not consider itself as the owner of the asset nor it is ready to bear the Liabilities of the leased asset while the procedure adopted by the Islamic banks proves that they consider themselves as the owner and bear the ownership liabilities.

Diminishing Musharakah

The third common product of financing used in the Islamic banks is Diminishing Musharakah. This product is generally used for home financing, therefore, it is also known as' Home Musharakah'

The Procedure of this product consists of three stages.

1) In the first stage the Islamic bank and the client jointly buy a house in which usually the share of the Islamic bank is greater than the clients share. For example a house is jointly bought by the client and the bank in such a manner that the share of the bank is 80% in the property and the share of the client is 20%.

2) Banks share is divided into small units. For instance in the above example, the banks ownership of 80% share will be divided into 80 units and the client will gradually purchase these units, which will result in an increase in the client's ownership and decrease in the bank's ownership.

3) As the client wishes to use the bank's share, a separate rent agreement is executed between the bank and the client, through which the client uses the banks share and pays a certain rent. But as mentioned above, the client gradually purchases the bank's ownership share, the rent amount also gradually decreases until the client becomes the sole owner of the property.

Hence, there are three stages in this procedure.

1) A property bought jointly.

2) A partner (bank) rents out its share to the other (client).

3) Client gradually purchases the share of the bank.

All three stages mentioned above are of course permissible according to Shariah. The question which arises is that, either is it permissible to gather these three stages in a single agreement. The answer to this is that if two to more transactions are linked with each other in such a manner that they are conditional to each other, then it is not permissible.

But if the transactions are not linked to each other in such a manner that if one of them is terminated the other transactions are terminated automatically then it is permissible. In Diminishing Musharakah none of the transactions are conditional to others; rather the client himself promises unilaterally that after partnership he will gradually buy the banks share.

It might be objected that the undertaking of the client to purchase the banks share is similar to make a condition in a sale. This is because, the bank from the first stage knows that the client will purchase the banks share, therefore it should be considered as conditional.

It may be replied that making a transaction conditional for the validity of the other transaction is different from making a unilateral undertaking. Conditional transactions mean that one will be considered complete when the other is fulfilled.

For example Khalid says to Ahmad that I will sell my car with the condition that you will rent your house to me. It means the sale of the car will be completed when Ahmad leases his house to Khalid.

This is prohibited by Shariah as it consist of uncertainty, but if a transaction is not conditional and only undertaking is done then the transactions will not be considered conditional and a transaction will not be dependent on the other. Therefore in the product of house financing of the Islamic banks it cannot be said that the purchase of the house jointly by the bank and the client is dependent on the promise of the client, rather the client in future fulfills his promise or not, the transaction of purchasing the house will take place. Although the client will be enforced to fulfill his promise, if he excuses do so. But because of his breach of promise the transaction executed will not be considered as void automatically. It can be said therefore, that the product of house financing in Islamic banks is not contrary to Shariah principles.

The Difference between Islamic Banks and Conventional Banks on the Liability Side

The previous discussions all relate to that side of the balance sheet which is generally referred to as the asset side. Now we shall briefly analyze the "liability" side of the balance sheet in which the Islamic Banks accept funds from various depositors and make them partner in their profits. The difference between the liability products of a conventional and Islamic Bank can be clearly understood if certain common arguments are explicitly explained.

The Current account of Conventional Banks and Islamic Banks are identical to each other

The money that a conventional bank accepts as deposits is regarded as a loan in the Shariah regardless of which account it accepts the deposits for. This is because the conventional banks guarantees that every account holder will definitely receive the full amount of money that he has deposited and any capital whose return is guaranteed is regarded as a loan in Shariah. Now, if the account is a current account then the conventional bank will not give its depositors any extra money above their deposits. Rather, they are only responsible to return the amount deposited. This transaction of the conventional bank does not go against any principle of the Shariah. The current account of an Islamic bank also transacts in exactly the same manner. However, if a depositor wishes to place some funds in a current account then he should deposit his funds with an Islamic bank rather than a conventional bank so that his loan to the bank is used in Shariah compliant forms of financing rather than in financing on the basis of interest based loans.

The difference in the other accounts

Besides the current account, the other accounts such as saving account or fixed deposits etc, the conventional bank takes an interest based loan from its depositors.

It is as though a Conventional Bank takes capital from its depositors and gives them this assurance that their capital is safe and that after specified period they shall receive their deposits along with an extra mark-up.

How will they receive this mark-up? Where will these funds of the depositors be spent? How much will the bank earn from these funds? What will be the share of the depositors from this income? A veil is placed on this question. Whether the bank earns 100% profit from the depositors' funds or does not earn anything, the bank is bound to give its clients the stipulated rate of interest. Hence, it is as though there is no connection between the relationship that the depositor has with the bank and that which the bank has with the clients that acquire finance from it.

Contrary to this, the funds that an Islamic bank accepts in account that generate profits are accepted on the basis of Mudarabah or Musharakah. Also, these funds are held as a trust by the Islamic Bank. In other words, if these funds or a part of them are destroyed due to circumstances not under the control of the bank, then the bank will not be responsible to return these funds.

Secondly, after accepting funds from its depositors, an Islamic Bank: does not put a veil on these funds. Rather, they make their depositors partners in their investment projects in which the "depositors are the Rabbul Maal (investor of capital) or sleeping partners and the Islamic bank is the Mudharib or working partner. The bank gives a proportional share of the profit that it earns from its different forms of financing such as Ijarah, Murabaha and Musharakah etc. to its depositors. This profit sharing ratio is pre determined. For example, it is agreed that whatever profit the bank earns will be distributed between the bank and the depositors on a fifty-fifty basis.

Since, the bank makes the depositors partners of proportionate shares in the profit it earns, a chain is formed amongst the depositors, bank and clients who acquire finance. The result of this chain is that the profit that the bank earns from its clients directly impacts the profit that the depositors receive. Hence, if the Islamic bank provides financing at a higher rate, their depositors will receive a larger profit whereas if they offer financing at a lower rate, their depositors will receive a smaller profit and this is in accordance with the principle of the Shariah.

An Islamic bank cannot fix the profit in advance

It is important to keep in mind that when accepting a deposit, an Islamic bank cannot guarantee its return to the depositors; neither can the Islamic bank tell the depositors with certainty that it will give a specific amount of profit. The fixing of a profit in relation to the capital invested by the depositors is not at all permissible in Shariah. For example, if an Islamic bank tells its depositors that it will give them a profit of 10% on the amount that they have invested, then such a fixture of the profit renders the transactions of Shirkat and Mudarabah void. However, at the end of a particular term, when the bank distributes the proportionate shares of the actual profits earned to its depositors then it is permissible to calculate the profit received in relation to the capital invested and to announce the same.

This could be understood by the following example. The bank (A) accepts a deposit of Rs.100/- from a depositor (B) and earns a profit of Rs.20/- on this investment. The bank keeps 50% of the profit earned and gives the depositor 50%. In this manner the depositor receives Rs.10/- in the form of profit on his investment. This Rs.10 /- is in reality 50% of the profit earned. However, if it is calculated in relation to the capital invested by the depositor then it will be 10% of the capital invested.

Hence, if an Islamic bank announces that it has given its depositors a profit of 10% on their investment, it is allowed. However, at the outset a specific rate cannot be fixed with certainty. This is because, firstly, the transaction of Shirkat and Mudarabah become void and impermissible. Secondly, the Islamic bank does not know in advance how much profit it will earn from this capital. This explains that if an Islamic bank, after distributing profits, announces that this year it has given its depositors 10% profit then this does not go against any principle of the Shariah.

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Saturday 26 August 2017

Conventional and Non conventional banking

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