An Overview of Social Investment Bank Limited
Introduction
Social Invest Bank Ltd was established on November 22,1995 with an authorized capital of taka.1000 million and Paid up Capital of Taka 260 Million by a group of originally successful entrepreneurs from various field of economic activities. It is a fully licensed scheduled entrepreneur from various fields of economic activities. ;t is a fully licensed scheduled commercial Bank set up in the private sector in line With the Government to liberalize Banking& Financial services.
The founder Chairman of the Bank was Prof. Dr. M.A Mannan. He is a world wide renowned Islamic Economist. The ~irst managing director was Mr. M. azizul Haq. .Highly professional people having wide experience in domestic and international Banking are managing the Bank.
The present Chairman is Mr.Ahmed Akber Sobhan who is also the Chairman of 3ashundhara Group and,a renowned Industrialist of the country. The present managing Director is Mr.Golam Mustafa has long experience in domestic: relational Banking. The Bank has made significant process with in a very short – ie due to its very competent Board of Directors, dynamic management and ; education of various customers friendly deposit and loan products. SiBL is cerating three-sector Banking such as Forma!, Non -formal and Voluntary Sector. SIBL is beginning a new era of Islamic banking having social, ethical and =ral dimension in each of its activities ranging from credit to construction, trading transport, forming to fising, manufacturing to mining and so on. Some renowned personalities and institutions are sponsors and directors of this bank.
Investment Position of SIBL:
| Total Operating Income of the Bank as on 31st December 2004 stood at Tk. 670.30 million against Tk. 694.89 million of the preceding year. The Bank made an operating profit of Tk. 414.99 million in 2004 against Tk. 500.54 million of 2003. | ||||||||||||||||||||||||||||||||||||||||
| A summery of operating result of the Bank as on 31st December 2004 vis-a-vis the position as on 31.12.2003 is shown below: | ||||||||||||||||||||||||||||||||||||||||
| (Taka in millions) | ||||||||||||||||||||||||||||||||||||||||
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Investment policy & the different modes used by SIBL
Islami Banking:
An Islamic bank is a financial institution which operates with the objective to implement and materialise the economic and financial principles of Islam in the arena of banking.
“An Islamic Bank is a financial institution whose status, rules and procedures expressly state its commitment to the principle of Islamic Shariah and to the banning of the receipt of interest on any of its operations”-OIC.
The Organisation of (Ali & Shaskar 1995, pp-20-25) Islamic bank is a “company which carries on Islamic banking business …. Islamic banking business means banking business whose aims and operations do not involve any element which is not approved by the religion Islam” (Act No 4.276).
Dr. Ziauddin Ahmed says, “Islamic banking is essentially a nomative concept and could be defined as conduct of banking in consonance with the ethos of the value system of Islam” (lbid).
Investment policy of SIBL:
The special feature of the investment policy of the bank is to invest on the basis of profit loss sharing system in accordance with the tents and principles of Islamic Shariah. Earning profit is not the only motive and objective of the Banks investment policy rather emphasis is given in attaining social good and in creating employment opportunities for the desiring peoples of Bangladesh.
Accordingly the plan envisages composition of the investment profit-folio with for agriculture and rural investment, 16% for industrial term investment, 14% for industrial working capital, 6% for housing and real estate, 6% for transport and communication, 2% for electricity, gas, water and sanitation services, 2% for storage’s 40% for import, export and local trade and trade related activities and % for other productive purposes by the end of the plan period, i.e. the year 2004.
Further, in order to diversify investment profit-folio, the bank engaged itself in investment operations through special schemes introduced during the years. The Bank is planning to introduce new investment schemes in addition to welfare oriented investment schemes such as Rural Development scheme. Its new investment schemes are Transport investment schemes, car investment scheme, small business investment schemes, Doctors investment scheme, Household Durables investment scheme, Housing investment scheme and agricultural implements investment scheme etc. Besides the bank is financing various economic groups in different sectors in both urban and rural areas for upliftment of their economic condition.
Investment operation of a Bank is very important as the greatest share of total revenue is generated from it, maximum risk is cantered in it and the very existence of a Bank mostly depends on prudent management of its Investment Port-folio.
For efficient deployment of mobilized resources in profitable, safe and liquid sector a sound, well-defined and appropriate Investment Policy is necessary.
The important feature of the investment policy of the Bank is to invest on the basis of profit-loss sharing system in accordance with the tenets and principles of Islami Shariah. Earning of profit is not the only motive and objective of the Bank’s investment policy rather emphasis is given in attaining social good and in creating employment opportunities.
A sound well defined, well planned and appropriate investment policy frame work is a pre-requisite for achieving the goal of the Bank i.e. implementation and materialization of the economic and financial principles of Islam in the Banking area and justice in trade, commerce and industry and to build socio-economic infrastructure, create opportunity for income and sustained economic growth of the country.
Objective and Principles of investment operations of SIBL:
- The objectives and principles of investment operations of the Banks are:
- The investment fund strictly in accordance with the principles of Islamic Shariah.
- To diversifies its portfolio by size of investment, by sectors (public and private), by economic purpose, by securities and by geographical area including industrial, commercial and agricultural.
- To ensure mutual benefit both for the Bank and the investment client by professional appraisal of investment proposals, judicious sanction of investment, close and constant supervision and monitoring therefore.
- To make investment keeping the socio-economic requirement of the country in view.
- To increase the number of potential investors by making participatory and productive investment.
- To finance various developments schemes for poverty alleviation, income and employment generation with a view to accelerating sustainable socio-economic growth and upliftment of the society.
- To invest in the form of goods and commodities rather than give out cash money to the investment clients.
- To encourage social upliftment enterprises.
- To shun even highly profitable investment in fields forbidden under Islamic Shariah and is harmful for the society.
- The Bank extends investments under the principles of Bai-Marabaha, Bai-Muazzal Hire purchase under Shairkatul Meilk and Musharaka. The Bank is making sincere efforts to go for investment under Mudaraba principle in near future.
Salient Features of Investment
· Observance of the legal investment limit of the bank.
· Observance of the legal investment limit of the client.
· Optimum utilization of investable fund.
· Profitability of the investments.
· Safety and security of the investments.
· Investment at minimum possible risk.
· Liquidity of investments.
· Conform to central bank’s investment restrictions.
· Preference to short term investments.
· Preference to the investments for small size.
· Satisfactory return on investments.
Investment Modes of SIBL:
Investment is the action of deploying funds with the intention and expectation that they will earn a positive return for the owner. An Islamic bank makes a direct investment in short, medium & long-term projects in commercial, industrial, agricultural, real estates and housing, transport & other services. A profit-loss sharing bank, particularly the SIBL anges in may types of financing arrangements.
There are three Investment Modes which are:
o Partnership Mode (Share Mechanisms)
1. Mudaraba
2. Musharakah
o Trading Mode(Bai Mechanism)
1. Bai Murabaha
2. Bai Muajjal
3. Bai Salam
4. Bai Istishna’a
o Leasing Mode (Ijara Mechanism)
1. Hire purchase (Ijarah)
2. Hire purchase under Shirkatul Malk
description of Three Investment Modes
Partnership mode (Share Mechanism):
a) Mudarabah:
It is a form of partnership where one party provides the funds while the other provides the expertise and management. The first party is called the Sahib-Al-Maal and the latter is referred to as the Mudarib. Any profits accrued are shared between the two parties on a pre-agreed basis, while capital loss is exclusively borne by the partner providing the capital.
b) Musharaka:
An Islamic financial technique that adopts “equity sharing” as a means of financing projects. Thus, it embraces different types of profit and loss sharing partnership. The partners (entrepreneurs, bankers) etc.) Share both capital and management of a project so that profits will be distributed among them as per rations, where loss is shared according to ratios of their equity participation.
3.5.2. Trading ModeS (BAI MECHANISM)
a) Bai Murabaha:
Bai-Mudarabaha may be defined as a contract between a buyer and a seller under which the seller sells certain specific goods (permissible under Islamic Shariah and the Law of the land), to the buyer at a cost plus agreed profit payable in cash or on any fixed future date in lump-sum or by installments. The profit marked-up may be fixed in lump-sum or in percentage of the cost price of the goods.
b) Bai – Muajjal:
Bai-Muajjal may be defined as a contract between a buyer and a seller under which the seller sells certain specific goods (permissible under Islamic Shariah and the Law of the Country), to the buyer at a cost plus agreed profit payable in cash or on any fixed future date in lump-sum or by installments. The seller may also sell the goods purchased by him as per order and specification of the Buyer.
c) Bai Salam:
Under this mode Bank will executive purchase contract with the client and make payment against purchase of product, which is under process of production. Bai-Salam contract will be executed after making any investment showing price, quality, quantity, time, place and mode of delivery. The profit to be negotiated. It this mode the payment as the price of the goods is made at the time of Agreement and the delivery of the goods is deferred.
d) Isteshna’a:
Isteshna’a is a contract between a manufacturer/seller and a buyer under which the manufacturer/seller sells specific product(s) after having manufactured, permissible under Islamic Shariah and Law of the Country after haying manufactured at an agreed price payable in advance or by installments within a fixed period or on/within a fixed future date on the basis of the order placed by the buyer.
Leasing Mode (Ijara Mechanism):
a) Hire Purchase /Ijarah:
The term Ijarah has been derived from the Arabic works Ajr and Ujrat which means consideration, return, wages or rent. This is really the exchange value or consideration, return, wages, rent of service of an Asset. Ijarah has been defined as a contract between two parties, the Hiree and Hirer where the Hirer enjoys or reaps a specific service on benefit against a specified consideration or rent from the asset owned by the Hiree. It is a hire agreement under which a certain asset is hired out by the Hiree to a Hirer against fixed rent or rentals for a specified period.
b) Hire Purchase Under shirkatul Melk:
Hire purchase under shirkatul Melk is a special type of contract which has been developed through practice. Actually, It is a synthesis of three contracts: Shirkat, Izara and sale. Shirkat means partnership. sharikatul Melk means share an ownership. When two or more persons supply equity, purchase an asset, own the same jointly, and share the benefit as per agreement and bear the loss in proportion to their respective equity, the contract is called Shirkatul contract.
Stages of Hire Purchase Under Shirkatul Melk:
Thus Hire Purchase under Shirkatul Melk Agreement has got three stages:
· Purchase under joint ownership.
· Hire and
· Sale and /or transfer of ownership to the other partner Hirer.
3.5.4. There are two other modes of investment which have limited
impact in our country:
a) Quard:
The word “Quard” is an Arabic word” which means loan or credit on advance. The literal meaning of Quard is giving “Fungible goods” for use without any extra value returning those goods. It must follow the principle of equal for equal return with homogenious goods. Fungible goods may be rice, oil, salt, money etc. In banking sector, money is used as quard. Quard is Halal by Islam for not to pay any extra or interest in return.
b) Quard-E-Hasana:
Quard-E-Hasana is also one kind of Quard which is given with the expectation of return or not.
3.5.5. Special Schemes Under Investment Modes:
a) Small Business Investment Scheme:
Bangladesh a third-wood developing country is rich in natural and human resources. Inspite of vast possibilities, the majority people of the country live in hardship-below poverty tapped, explored and exploited. Physical labour is their only means of earning. A large segment of this populace is active youth force. Many of them are efficient, intelligent and energetic with initiative & drive and have courage to tale risks. But they can not uplift their socio-economic condition due to poverty, lack of financial support and other required facilities. Lack of capital compelled many small traders to leave their profession. As a result in our country not only unemployment problem increased but also the young generation is involved in anti-social activities; thus creating threat to the social life
b) Real Estate Investment Program:
Professionals, Service-holders, Businessmen, Real Estate Developer and other categories of people who are not entitled for availing investment facilities under Housing Investment Scheme, shall be eligible under this programme Investment is to be extended to build new houses and for extension/ completion of the house already constructed, commercial building, shopping complex, flat apartment etc.
c) Transport Investment Program:
Under this scheme, investment in being allowed to the existing successful businessmen and potential entrepreneurs in this sector for all types of road and water transport with simple and easy terms and conditions. The bank is also extending investment facilities to multinational companies, established, business houses and well to do officials and professionals for acquisition of private cars, microbus and jeeps.
d) Rural Development Scheme:
Islami Bank Bangladesh limited (SIBL) envisages an economic system based on equity and justice. Taking into consideration that majority of the population below poverty line lives in rual Bangladesh, the Bank has devised a Rural Development Scheme (RDS) with a view to creating employment opportunity for them and alleviates their poverty through income generation activities.
The SIBL through its RDS project has been implementing integrated programs for the landless poor, eage labourers and marginal farmers aimed at meeting their basic needs and promoting their comprehensive development. Consciousness among the poor needs to be enhanced so that they can firm up their position in the socio-economic structure of the country. In order to consolidate their economic base, invested money should be used in income generating activities so the poorer section of the population can become self-reliant. RSD works for the realization of that objective.
e) Micro Industries Investment Scheme:
Bangladesh as a developing country has been trying for its overall economic growth. One of the major problems confronting its growth is lack of development of enterprises and potential entrepreneurs who can create more job opportunities by establishing new enterprises in the industrial sector. There are a number of educated unemployed youths and also skilled & semi skilled unemployed persons in the country. Besides, every year quite a good number of youths are coming out of the general/technical educational institutions to add to this already crisis ridden employment market.
Development programmes and efforts will bring no meaningful result unless and until income generating employment opportunities can be created for the growing number of unemployed people including the educated unemployed youths. Establishment and expansion of micro industries can play a vital role in creating more employment opportunities as well as in the overall socio-economic development of the country.
Social Investment Bank Limited has been appreciably participating in this direction by financing industrial sector. With a view to creating wider base for industries, the Bank has decided to launch “Micro Industries Investment Scheme” through its Branches. This scheme has been devised to career to the investment needs of those persons who intend to set-up new micro industrial ventures or to restructure their old units by way of BMRE involving a total cost of Tk. 5.00 lac.
This is intended mainly to create new jobs for the educated, skilled & semi unemployed and also to encourage those who remain outside the purview of investment due to shortage of funds and insufficient collateral. The scheme has been prepared with easy terms and conditions to encourage the small entrepreneurs, educated unemployed youths and skilled/ semi skilled persons to come forward for establishment of micro industries commensurate with the local demand.
f) Special Schemes:
Cash Waqf provides a unique opportunity for making investment in different religious, educational and social services. Savings made from earning by the well off and the rich people of the society can be utilized in our organized manner. Income earned from these funds will be spent for different purposes like the purposes of the waqf properties itself.
MODES OF ADVANCE & LOAN USED BY THE CONVENTIONAL BANKING
The development of commercial banking institutions has been taken place in different countries according to their economic, political, social and geographical conditions. Primary function of commercial bank is a) accepting of deposits & b) lending of money. Deposits are an important source of a bank’s funds. A major portion of the deposits received by a bank is lent by it. Commercial Banks follows fixed interest rate in it’s functioning.
Conventional banks engage in the following types of financing arrangements:
Advances:
Granting advances is the primary function of a bank. A major portion of is funds is used for this purpose and this is also the major sources of bank’s income. However, lending money is not without risk and therefore, a banker must take proper precaution in this process.
Forms of Advance:
a) Cash credits:
A Cash Credit is an arrangement by which a banker allows his customer to borrow money upto a certain limit. Cash credit is a popular mode of borrowing by traders, industrialists and agriculturalists. It is a separate account by itself and does not require having any other account with the bank. It resembles the use of overdrafts on a checking account. It is an arrangement whereby the borrower may withdraw funds as needed for day-to-day operations without the delay associated with making a loan. The borrower may not exceed a predetermined limit and must deposit cash back into the account as funds become available from daily operations. Interest is charged on the daily balance in the account.
Cash Credit arrangements are usually made against the security of commodities hypothecated or pledged with the bank.
Hypothecation- In case of hypothecation, possession of goods is not given to the bank. The goods remain at the disposal and in the go downs of the borrower. The bank is given access to goods whenever it so desires. The borrower furnishes periodical return of stock with him to the bank. Such an advance is granted by the bank to a person in whose integrity it has full confidence.
Pledge- In cases of pledge, the goods are placed in custody of the bank with its name on the go down where they are stored. The borrower has no right to deal with them.
Advantages of Cash Credit:
Flexibility- in case of a cash credit system, the customer need not borrow at once whole of the amount he is likely to require but draw such amounts as and when required. He can put back any surplus amount, which he may find with him for the time being. Interest has to be paid by the customer on the amount actually drawn at any time and not on the full amount of the credit allowed.
Convenience- banks have to maintain only one account for all transactions on the customer and hence repetitive documentation cab be avoided. Thus, the system is quite convenient to operate.
b) Overdrafts:
When a current account holder is permitted by the banker to draw more than what stands to his credit, such an advance is called an overdraft. The banker may take some collateral security or may grant such advance on the personal security of the borrower. The customer is permitted to withdraw the amount as and when he needs it and to repay it by means of deposit in his account as and when it is feasible for him.
- Interest is charged on the exact amount overdrawn by the customer and for the period of its actual utilization.
- Generally, a bank on the basis of a written application and a promissory note signed by the customer gives on overdraft facility (normally for 30 days).
Loans:
Under loan system, credit is given for a define purpose and for a predetermined period. The most obvious form of financing by a conventional bank is the loan arrangement. Normally, these loans are repayable in installments. Funds are required for single non-repetitive transaction and are withdrawn only once. If the borrower needs funds again or wants renewal of an existing loan, a fresh request is made to the bank. Thus a borrower is required to negotiate every time he is taking a new loan or renewing and existing loan.
Advantages of loan system:
- Financial discipline on the borrower- as the time of repayment of the loan or its instalments is fixed in advance, this system ensures a greater degree of self-discipline on the borrower.
- Periodic review of loan account- whenever any loan is granted or its renewal is sanctioned; the banker gets an opportunity of automatically reviewing the loan account.
- Profitability- the system is comparatively simple. Interest accrues to the bank on the entire amount lent to a customer.
Types of loans:
a) Short Term Loans:
Short term loans are granted to meet the working capital need of the borrowers. These loans are granted against the security of tangible assets mainly the movable assets like goods and commodities, shares, debentures etc.
Bridge loans- Bridge loans are essentially short term loans which are granted to industrial undertakings to meet their urgent and essential needs during the period when formalities for availing of the term loans sanctioned by financial institutions are being fulfilled or necessary steps are being taken to raise the funds from the capital market. These loans are granted by banks or by financial institutions themselves and are automatically repaid out of amount of the term loan or the funds raised in the capital market.
b) Term loans:
Medium and long term are usually called Term Loans. These loans are granted for more than a year and are meant for purchase of capital assets for the establishment of new units and for expansion or diversification of and existing unit. Such loans constitute a part of the ‘project finance’ which industrial enterprises are required to raise from different sources. These loans usually secured by the tangible assets like land, buildings, plant and machinery etc.
This type of loan is advanced to industries and agriculture for fixed capital requirements. These loans are also granted to traders for purchase of fixed assets, to transport operators for purchase of vehicles, and to self-employed persons for purchase of equipment. These loans are usually extended for a term of 3 to 7 years and in special cases up to 10 years and are generally repayable by instalments. Since it will take a year or two to derive the full benefits of expansion or renovation, instalments for repayment may commence after one or two years of the disbursement of the loan. Interest is charged on annual basis.
c) Consumption loans:
Though normally banks provide loans for productive purposes only but as an exception loans are also granted on a limited scale to meet the medical needs or the educational expenses or expenses relating t o marriage and other social ceremonies etc. of the needy persons, such loans are called consumption loans.
d) Hire-purchase advances:
Under this arrangement, conventional banks grant advances to its clients engaged in hire-purchase business relating to transports, refrigerators, and televisions, for example. This type of financing is usually repaid with instalments including principal and interest. The bank generally requires immovable property as collateral against this type of financing.
e) Bills purchased/discounted:
Export-Import businesses are performed through opening of L/Cs with Bank. The client, while opening the L/C, comes to an agreement with the bank that the latter will repay the bill received on the farmer’s behalf on a certain date onward in exchange for a specific rate of interest determined at the time of agreement. If the bill happens to reach well ahead of the date mentioned, the bank may purchase the bill, if requested, with a discount. In this case, the bank makes the return twice: first, by charging interest and then by discounting the bill.
In conventional banking loans and advances are generally extend as a Project Loan, Working Capital Loan, Trade Finance (Domestic & International), House Building Finance (Commercial & Residential), Contractors Financing, Receivable Financing, Cash Credit, Over Draft, Packing Credit, Trust Receipt, Guarantee, Letters Of Credit, Personal loan, Loan against TR (LTR), Payment against Documents (PAD), Loan against Import & merchandise.
Islamic Banking differ with Conventional Banking
Islamic Banking Vs Conventional Banking:
Islamic Banking is a special nature of financial intermediary, which does not involve in any way with interest. On the other hand, conventional banking is a banking system based on interest transactions. Therefore, the nature and modes of dealing the banking activities under Islamic framework obviously will be un-identical from the conventional one. The following features of Islamic financial transactions may be helpful to identify the differences between an Islamic bank and a conventional bank in different areas:
A. Theoretical aspects:
01. Islamic Banking is an integral part of Islamic Economics and thereby an Islamic way of life. As Islam prescribes the complete codes of life of a human being, therefore, the transactions should be tagged and conformed to the basic teachings of Islam. The traditional banking approach /model is not derived from such beliefs and understanding.
02. Under Islamic frame work, prohibition of riba (interest/usury) from all sorts of financial activities is the primary motto of transactions. In 1978, at its annual conference for Foreign Ministers in Senegal, Organization of Islamic Conference (OIC) resolved the following concrete definition of Islami Bank–
“Islami Bank is a financial institution whose statutes, rules and procedures expressly state its commitment to the principles of Islamic Shariah and to the banning of the receipt and payment of interest on any of its operations.”
03. Banning of interest is not the only scope of Islami banking rather deployment of fund should also be restricted to the sharia permissible (Halal) businesses.
04. Ethics i.e. what is just/right and what is unjust/wrong is the integral part of Islamic banking. Adal and Ehsan are the beauties of Islamic Muamelat. In conventional banking such ideology is not exercised.
05. All sorts of exploitation in any nature is prohibited in Islam. In banking, exploitation may occur depriving the majority people from their legal share of earnings generated by a bank. Conventional bank pays pre fixed interest to its depositors which may not tally with the earnings of the bank. In Islamic banking the mechanism stipulated under Mudaraba modes ensure the depositors to earn as per agreed ratio.
06. “Bankers deal with documents not with goods” – the statement may not necessarily be applicable at all times in Islamic banking. Islami bank buy and sale goods to the client as per its requirement. The buying-selling is ensured by adopting the mechanisms of Bai modes that include Murabaha, Muajjal and Salam. Concept of buying and selling is absolutely absent in conventional banking.
07. A banking that makes its human resources accountable for their activities in here and here after. Accountability should be ensured through practices. Paper banking without shariah can be confirmed in many ways but result will make the entire income doubtful.
08. Profit is not the only objective of Islamic banking system. Balanced welfare/development/growth of the entire economy (development of the people of all sphere of life) is to be taken into account by a banking system run under Islamic framework as Allah (SWT) asked to mobilize the resources not only to the haves. On the other hand, conventional banking is designed to earn more and more profit by any means.
09. Practices of Islamic Banking derived from Quran and Sunnah. Practices include contract among the parties, writings, evidence etc.
10. Conventional banking is based on the basis of debtor – creditor relationship. Banking under the Islamic framework is participatory between the client and the bank. Participation is ensured through the relationship of buyer and seller of goods and as partner of business in case of shirkat modes.
11. In traditional banking interest is the price of credit lent by bank. Concept of credit/loans/ advances is absent in Islamic banking. Islamic bank makes funding under different investment tools and profit/loss is the result of investment. Further conventional economists argue that interest is the reward of savings while Islamic economists disapprove the same arguing that money must be transformed into capital to be productive and money may be identified as a potential to capital as money can do nothing independently.
12. Without taking risk, financial transactions are not allowed in Islam. Under Islamic frame work, depositors are taking risk as Shahib al Mal. Therefore, the earnings of depositor are uncertain while conventional banks offer prefixed interest.
13. Under Islamic banking, access of everybody as depositor/ entrepreneur is ensured to share the resource mobilization. It contributes to build more national savings resulting in more investment, more employment, more income and more savings. As conventional banks impose different barriers against small savers/micro entrepreneurs therefore national growth is hampered for unutilized resources.
B. Operational / Functional aspects :
Deposit mobilization :
01. Mudaraba Principle:
A contract between Mudarib (Bank) and Sahib al Mal (Depositor). Sahib al Mal provides the fund while Mudarib provide the management. Earned profit is distributed as per agreed ratio. Financial loss is borne by Sahib al Mal and management /skill /time / efficiency / goodwill loss is borne by Mudarib.
In traditional banking there is no existence of such contract as it collects deposit on fixed interest basis.
02. Al wadeeah Principle
Use of public fund with their consent. Under traditional banking, it is implied. Islam doesn’t allow to utilize others resources without their permission.
Investment :
01. Under Trading modes :
Buying and selling should be confirmed in Islamic banking. Three components should be ensured–existence of goods, having the possession/ownership/title and transfer of ownership. As per clients order bank will procure the goods and then sell to the client with adding profit. Quotation, cash memo and other papers (if any) should be in favor of bank to ensure procurement of goods. Goods once sold can not be resold i.e. in case of payment failure bank can not charge on the goods al ready sold. In practice, bank charge compensation to control willful default which is not realized as income in bank’s books of accounts. Customary trading modes are Bai Muajjal, Bai Murabaha and Bai Salam.
In conventional banking, due to basic difference in principle, no type of loans and advances can be compared with trading modes. However, there is an apparent similarity at operational level of the trading mechanism with the Cash Credit (hypothecation and pledge) of conventional banks. But the concept of buying and selling between Bank and client is absolutely absent. Compound interest is charged and accounted for in case of failure/delay of payment.
02. Under Shirkat modes :
Shirkat modes are Mudaraba and Musharaka. Mudaraba principle is the same as mentioned in case of deposit mobilization. Musharaka is the equity participation of both the parties involved. Under Musharaka profit is shared as per agreement and loss is shared as per equity. Musharaka business can be formed with or without participation in management.
Conventional banks do not practice these types of mechanism.
03. Under Hire purchase mode :
In conventional banks, HP is practiced. Two contracts (Purchase and sale) are preformed between bank and client. On payment of the last installment, ownership is transferred to the client. Interest is accounted for at gestation period. On the other hand, Islamic banks are operating a special type of mechanism called HPSM – a mechanism derived through the combination of HP and Musharaka. There are three contracts (Purchase, sale and rent contract) to be performed under the HPSM mode. Ownership is gradually transferred to the client after payment of each installment. Rent is not charged and accounted for in gestation period.
04. Overdrafts, Packing Credits, Demand Loans, Purchase of Demand Drafts:
These are well practiced by conventional banks. In Islamic banking there is no such provision to practice the same due to the involvement of interest. However working capital needs can be met through the mechanism mentioned earlier under Islamic banking.
Comparison of Financial Modes:
For an effective comparison between the modes used by the two systems of banking, the following categorizations common to both may be adopted:
1. Modes related to project financing,
2. Modes related to financing trade and commerce, and
3. Special modes or system specific modes.
In line with the above categorization, medium and long-term loans under conventional banking, and Mudaraba and Musharaka of PLS-banking come under category (a). Under category (b), loans, cash credits, Hire Purchase and bills purchased/discounted of conventional banking and Murabaha, Bai-Salam and Bai-Muajjal of PLS-Banking may be listed. Loans and cash credits of conventional banks may be categorized under (c) to satisfy the working capital needs of the borrower. For Islamic banks, there are no similar modes like its conventional counterpart to meet working capital needs. Though the “Qard Hasan” is customarily grouped under this category, it is not widely practiced by PLS-banks since this mode, by its very nature, does not earn a return. Qard Hasan is benevolent loans, made on an interest free basis.
Keeping in mind the above categorizations, one may analyze the similarities or differences between the modes of conventional and those of the PLS-banking. As far as the first category is concerned, unlike PLS banks, conventional banks advance money in exchange for a predetermined fixed rate of interest. That is, under the conventional banking system, every advance made by a bank is a contract between the bank and the client with the following essential features: (i) a creditor-borrower relationship is established; (ii) the lending or borrowing is time bounded qualifying specific date(s) on which a certain percentage of interest on borrowed capital becomes due for payment along with the principal; and (iii) the income of the bank is known and prefixed and not in any way related to or variable with the income of the borrower generated from the borrowed money.
On the other hand, the financing arrangements under the PLS system of Islamic banks, have the following features: (a) it is a contract between two partners – the bank and the client-providing a partner-partner relationship; (b) the contract is time bounded in the sense that the client has to return the capital on/within specific date(s). However, the return of the bank is not fixed either from the standpoint of time or that of the rate; and (c) bank shares a prefixed ratio of profit expressed in percentage terms. This is not a prefixed rate of return calculated on capital advanced. Thus, income (profit) for a PLS bank, unlike the practice of its conventional counterpart, fluctuates with the profits of the borrower.
Investment decision Conventional Banking:
The bank makes a loan at a fixed rate, which includes a mark-up to cover its cost of capital. The bank is not worried about the rate of return on the project. In other words, in conventional banking, the rate of return to the bank is fixed regardless of the success of the project, which is the opposite of what happens in a PLS banking system.
Under the conventional banking framework, as depicted in Fig-la, the bank charges a fixed rate of interest to finance only those projects which have rates of return greater than or equal to the rate of interest. Thus, the conventional banking system could be termed a Fixed Return System and the investment decision could be stated as:
I = f(r, r)………………. (1) dl dI with–<0; –>0 dr; dr
where, I represents level of investment, r; the rate of interest and r the rate of return from the project
dI
Here — < 0 indicates an inverse relation between interest rate and investment demand, dr;
dI
Whereas — > 0 shows a positive relation between investment, I and rate of return, r. dr
Investment decision Islami Banking:
Under the profit-loss sharing system of investment financing, the bank receives a variable rate of return as it shares a percentage of profits earned by the borrower. Though there is a consensus as to sharing losses in proportion to capital participation, some of the Muslim economists think that the ratio may vary with the application of different types of modes of financing (Hasan 1988, p.47). Thus, the Profit-loss-sharing system of investment financing may be termed a Variable Return System.
Since the Islamic banking system does not charge interest on any financing agreements, the client neither receives nor pays fixed rate of return while financing his investment. Thus, the question arises as to what actually is the allocating device that ensures optimum allocation of scarce financial resources and establishes equilibrium in the money market? Furthermore, how does the financing decision of a bank relate to the investment decision of a firm?
Regarding the formed question, the rate of interest is replaced by the rate of return in the Islamic banking system. By this replacement there is no strong theoretical reason to support the often-made a priori assertion that investment levels would decline (Haque & Mirakhore 1986, p.iii). Though there is no difference of opinion in regard to the rate of return on equity financing as a tool of efficient allocation of resources in a Zero Interest Rate Economy (ZIRE), some disagreements still persist as to the interpretation of the equilibrium condition. According to Arif, capital will flow into those sectors that offer the highest rate of profits to investors until equilibrium is reached in the all sectors (Arif 1982, pp. 1-23). Kahf, on the other hand, says the equilibrium level of investment can be determined at a point where its cost equals its return (Kahf 1982, pp. 107-23). While Saqr is of the opinion that equilibrium will be reached at a point where the expected rate of profit is just equal to the normal rate of profit. Each industry has its own normal rate, and rates differ according to the size of investment, time maturity, degree of risk and other related factors (Sakr 1982, pp.63-65). Jarhi’s views seem to be more operational and clear. He says that there are two robust rules for static efficiency: First is that marginal rates of return on investment must be equal in all industries. The second rule requires the use of discounting to take proper care of the time dimension of costs and benefits. The process of discounting is entirely acceptable in Islam. This is a rate of return on an alternative real investment (Jahri 1982). Further, Uzair suggests the average rate of profit prevailing in the economy should be used as the measure of opportunity cost that guides project evaluation and resource allocation in the private sector (Uzair 1982, pp.69-70).
The problem still persists as to the definitions of profit and the method of its calculation. The following discussion concentrates upon resolving these issues. The term profit in the capitalist world refers to the reward for enterprise whereas in Islamic context it is a reward that has to be divided between capital and enterprise. In other words, profit in an Islamic system consists of return of capital to the investors and the sharing of the remaining profits from the business operations. But the problem arises with the r being gross rate of return accrued from project, which includes cost of borrowing and 1 and 11 being the ratios going to the financier and the entrepreneur leading to confusion in making a comparison between the first rate and the next two ratios (see Fig-3).
However, the dilemma is not insurmountable. Since we know the rate of return per unit of investment, we may arrive at total profit. The ratios may then be applied to the total profit for the purpose of determining shares of profit going to the financier and the entrepreneur. When we know the ratios and the shares of profits, their respective rate of return against their investment may easily be calculated. When we know the financier’s rate of return at each level of investment, we can derive the financier’s rate of return curve, i.e., r curve.
Under Islamic banking, the financial contract specifies the following returns to the financier (bank) and the investor (borrower), respectively:
r = total rate of return
rf= financier’s rate of return i.e., (1-1)r ………. (2) lr = entrepreneur’s rate of return.
Assuming linearity in the movement of T, the financing and investment decisions under Islamic banking are shown in Fig-lb.
In this figure, the rf curve crosses the horizontal axis at the point marked N’ where r = 0, implying the financier’s interest to finance all those projects which have rates of return greater than or equal to zero. This may not happen since financing always involves some administrative cost. If so, minimum cost of borrowing under Islamic banking will be somewhere (point M) and the zero rate of return (point N’); say, at point M’ as shown above.
We find some additional features of the Fig-3. These are:
i. r; curve is a horizontal line parallel to X-axis.
ii. rf curve is downward sloping and meets with the r curve at its lower level compared to where r; curve meets, and
iii. The equilibrium under Islamic banking takes place at a higher level of investment (ON v)than that of the Conventional banking (ON F).
Stability efficiency and Islamic banking:
Islamic banking has a different cash flow and payment commitment arrangement with the entrepreneurs. Cash flows under Islamic banking are defined as yields generated from regular operation of projects (which essentially mean profits for entrepreneurs). Payment commitments, on the other hand, are promises made to the bank by the entrepreneurs to pay a certain percentage of profits generated by the project along with repayment of principal. In other words, entrepreneurs commit to pay a certain percentage of profits, not a fixed percentage of the loaned amount. Thus, entrepreneurs pay less when profit is lower, and they pay more when it is higher. Moreover, if profit is zero, they pay nothing to the bank and if there is loss entrepreneurs are not obliged to pay any profit, rather the bank shares the loss in proportion to its capital participation. This system of payment, by its very nature, results in the reduction of the spread between profits or cash flow and payment commitments. Now let us show how the payment commitment arrangement under Islamic banking helps reduce cyclical fluctuations. Let us recall the phasediagram (Fig-4). Suppose we are in the Region I. At this stage, both the cash commitments (C) and investment (I) is low. Thus, f > 0; g < 0. The low level of investment can be financed by internal funds. Prospective yields being high, stimulates further investment.
Region II is characterized by a continuous rise in investment. Here, entrepreneurs go on expecting still higher prospective returns. This leads them to increase investment by turning to external financing. In addition they are further encouraged by the financing arrangement that part of the risk will be borne by the financier. On the other hand, financiers will be cautious in financing since they are aware that if there is any loss they will be obligated to share in proportion to their capital contribution.
In region III, the economy enters into the late stage of the boom. High levels of investment, at this stage, dampen forecasts of prospective and actual yields. However, unlike the fixed interest rate case, where cash payments remain the same, payment commitments under the Islamic banking system are adjusted to the decline in cash flows. Therefore, there is not as large a need to refinance existing debts or to take on additional debt in order to meet current payment obligations, like in the conventional banking system. Moreover, the terms of refinancing may not be as stringent as the situation that arises when a borrower is unable to meet his current obligations. Therefore, one can expect that level of investment will not fall as drastically as it does in the conventional banking system.
In Region IV, the final phase of the cycle, there is a drastic reshuffling of portfolios to generate additional cash to meet the payment commitments. This results in a sharp drop in the price of capital assets, which results in chaos in the financing industry. The main reason for this chaos is the ‘spread’ between cash flows and payment commitment. In the Islamic banking system, however, the difference between cash flows and payment commitments is not as drastic as in the conventional banking system. Therefore, there are not as many foreclosures, bankruptcy cases and liquidations of business assets, resulting in a more stable economy during this stage. The flexibility and the built-in stabilizing capacity of the Islamic banking system automatically adjust the spread and keep the capital markets and financing under control. Thus, given this natural stabilizing attribute of the Islamic banking system, it can be stated that it has higher stability efficiency than its counterpart.
Islamic Banking Vis-a-vis Conventional Banking:
Theoretical discussions on Islamic banking and finance have established that a system based on profit sharing is not only viable but also has a number of advantages over the interest-based system. Economists usually evaluate any scheme on the basis of its allocative efficiency, equity, stability and growth implications: In this section we evaluate the Islamic banking model described in the previous section on these criteria.
Equity:
Islam is a religion which emphasizes justice to all parties. A contract based on interest involves injustice to one of the parties, sometimes to the lender and sometimes to the borrower. The riba contract is unjust to the borrower because if somebody takes a loan and uses it in his business, he may earn a profit or he may end up in a loss. Now, in the case of loss, the person using that money, let me call him entrepreneur, loses his labor. In addition to this loss, he has to pay interest and the capital to the lender. The lender, or the financier, in spite of the fact that the business of the enterprise has ended up in a loss, gets his money as well as his interest. Therefore, it is unjust. Now, let us see how sometimes interest contract can be unjust to the lender. Many people do not realize that a riba contract can be unjust to the lender and not always so to the borrower. In most of the underdeveloped countries perhaps it is more unjust to the lender. I will explain how. In most of the under developed countries and even in many developed countries, most of the borrowers today are big capitalist. They pay may be 10% or 15% rate of interest. We know that if the rate of inflation is higher than that, then the real rate of interest becomes negative. The lenders are usually small savers like you and me. Banks collect the savings of all small savers and pass them on to the industrialists who earn a rate of 50%-100% profit but pay back only 10-15% rate of interest which in real sense is not even equivalent to the rate of inflation. Based on that rate of interest and of course minus the administrative expenses of the bank and their own margin, the banks pass on the difference to the lenders. This is why the banks give very small rate of return to the small savers. In an inflationary environment the real rate of interest is even negative. Therefore, had these savings been invested on the basis of profit sharing, they would have got much better return.
On the basis of pure economic reasoning, Islamic banking is superior to an interest based arrangement because it ensures equity between the borrower and the lender. Both parties share the accrued return which the project generates. Let me also mention here that in most of the countries, even in a country like United States, which is the front runner of capitalist model, there are regulations which place upper limits on the rate of interest. One famous regulation of this kind was Regulation ‘Q’ in United States which has now been scrapped but still there are rules in many countries which place an upper limit on the rate of interest that the banks can pay. Now, we know that the rate of inflation in many countries is more than 50%. In the Latin American country, sometimes the rate of inflation has been 1000%. In some Muslim countries also the rate of inflation is quite high. In early 80’s, the rate of inflation in Turkey was more than 50% and never in the history the rate of interest has gone anywhere near this rate.
The rate of interest cannot adjust automatically with the rate of inflation and hence the lenders are at a disadvantage. In profit sharing system, as the prices increase, the rate of return of the projects also increases along with the rate of inflation. Thus the real rate of return does not become negative due to inflation. At the level of an economy the–real rate of return is always positive. There may be a few enterprises which end up in a loss but by and large in a growing economy the rate of return remains positive. Therefore, both the borrowers and the lenders will share that rate of return in an equitable manner.
The distribution of credit in an Islamic banking system is also more equitable than an interest based economy. The reason being that in case of profit sharing the banks are interested in the results of the project. Of course, they are concerned with the safety of the capital itself but in an interest based system the safety of the capital is the sole criteria. Because, rate of interest is fixed, bank’s main concern is that they get their principal as well as the interest -back. In a profit sharing arrangement, the bank as well as the entrepreneurs will try to maximize their profit. So their interests are common. They are working for the same objective, i.e., for getting a better return which they will share. Even if a person’s credibility may be low, if the potential of the project is high, the banks may be willing to finance that project because they will get a better return on their investment. Therefore, small savers, small entrepreneurs who belong to lower and middle class population get an opportunity of getting finance from the banks. In an interest based system most of the funds flows to large industries, Multinational Corporation and big industrialists. Small savers and middle class small entrepreneurs do not’ get sufficient finances even for their very good projects. This is not only a theoretical possibility. It is an empirical fact. The distribution of credit in an interest based system is skewed in favour of the rich and big industrialist whereas in a profit sharing system the distribution of bank finances will be more equitably distributed.
Stability of Banking System:
The third criterion usually we talk about in economics is stability. Form the stability point of view also; the Islamic banking model is more stable than the conventional banking model. (Here, talking about the stability of the banking system and not of the economy.) In an interest based system, there is lack of symmetry in the cash flow of the banks and the cash flow of the enterprise. The entrepreneurs or the businessmen have to give a flexed interest to the banks that has no relationship to the actual return
of the project. Therefore, if the project, i.- not going well in some stage of the project or in the entire life of the project, there develops an asymmetry between the cash inflow and cash outflow of the projects.
That creates instability in the entire business sector. From the other end, th