TABLE OF CONTENTS

1. INTRODUCTION

1. 1 An Introduction to financial system

1.1.1 Importance of financial system
2.1 Islamic financial system
2.1.1 Need for Islamic banking

2. ISLAMIC FINANC

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 AN INTRODUCTION TO FINANCIAL SYSTEM

A financial system is a system that allows transfer of money between savers and borrowers.
It normally comprises of a set of closely interconnected financial institutions, markets,
instruments, savers, practices, transactions etc. Financial system in the modern day serve as
a channel through which household savings are distributed to corporate sector for productive
utilization for the ultimate good, consequently, of the economy at large. It allocates
investment funds among firms, and allows inter temporal smoothing consumption by
household and expenditure by firms. In effect, an efficient financial system is a tool of
running the economy smoothly, ensuring stability and growth

Importance of financial system

Provides framework for carrying out economic transactions and monetary policies

Helps efficiently channel savings to investments

Sound financial system is essential for promoting economic growth.

Sound financial system can be considered as the back bone of prospering economy. A
defective one could reduce effectiveness of monetary policy and deepen or prolong economic
downturn. It creates a capital flight ( or large fiscal costs related to rescuing troubled
institution)on a large scale. To add to it, in the modern liberal world scenario, weakness of
one country can rapidly spill over across national borders and result in a global economic
slump as weve seen in the recent past. That is to say, a sound financial system is essential for
the domestic as well as the countries those that have trade or financial linkages with the
country concerned.

Thinkers of the recent and ancient past have devised several forms of financial system to
keep large economies on its heels. The most popular of them are capitalistic and communist
system of finance, both of which in the present scenario have proven to fail on account the
unprecedented economic crisis that the planet plunged into. This situation calls out for a
need for alternative financial system for a healthy and sustainable global economy. Islamic
finance is an answer to that quest.

Islamic banking is essentially banking in consonance with the ethos and value system of Islam
and governed in addition to the conventional good governance and risk management rules,
by principles laid down by Islamic law, Shariah. It is, however, not confined to interest free
banking, which is a narrow concept. In addition to non-acceptance of interest-based
transactions, the fundamental tenet is that of fairness. It envisages ethical practices,
contributions towards a more equitable distribution of income and wealth and active
participation in achieving the goals and objectives of an Islamic economy.

The history of non-interest banking in its present day incarnation is of recent origin. In the
second half of the 20th century, efforts were made to adopt Islamic finance in Egypt. It slowly
spread to Middle East and then to other parts of the world. Today approximately 700
registered Islamic finance institutions are said to exist covering 51 countries. The annual

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growth rate of Shariah compliant assets is more than 15% on year-to-year basis. At this rate,
it is the worlds fastest growing financial sector and is becoming an increasingly important
component of the international financial system.

Need for Islamic Banking

The collapse of major Wall Street institutions, notably Lehman Brothers, and the subsequent
global financial crisis and economic recession, Islamic banking is seriously being considered
and has emerged as a possible alternative to the conventional banking because of the
following reasons:

It is based on Ethical and Socially Responsible Investments (SRI)

It aims at Equity and Justice and leads to poverty alleviation
It acts to new dimension to assets and actual projects aiming to support real economic
growth instead of financial engineering
It provides services to under banked populations ignored by conventional banks

CHAPTER 1: Islamic finance

Section1 . Principles of Islamic Banking:

Islamic banking has its own unique principles that clearly distinguish it from the rest of the
financial system. Principles of Islamic banking and finance are largely value based and as per
the guidelines prescribed by the sharia law. These principles form the basis for the tools and
Techniques of Islamic financing. Prohibition against the payment and receipt of a fixed or
predetermined rate of interest.

The essential feature of Islamic banking is that it is interest free. Islam prohibits Muslims
from taking or giving interest regardless of the purpose for which such loans are made and
regardless of the rates at which interest is charged. However, the Islamic ban on interest
does not mean that capital is costless in an Islamic system. Islam recognizes capital as a
factor of production, but does not allow the factor to make a prior or predetermined claim
on the productive surplus in the form of interest. Islam allows the owners of capital a share
in the surplus, which is uncertain. Profit sharing permissible in Islam, while interest is not, as
in the case of the former, it is only the profit sharing ratio, not the rate of return itself that is
pre-determined.

Profit- making is acceptable in Islamic society as long as these profits are not unrestricted or
driven by the activities of a monopoly or cartel. 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. Profit making addresses the Islamic ideals of social justice because
both the entrepreneur and the lender bear the risk of investment. Because both the
entrepreneur and the lender bear the risk of investment.

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Thus the interest is replaced by profit and loss sharing arrangements, where the rate of
return on financial assets held in banks is not known and not fixed prior to the undertaking
of the transaction. The actual rate of return can be determined only ex-post, on the basis of
actual profits accrued from real sector activities that are made possible through productive
use of financial assets.

1.1 Sharing risks and rewards:

The prohibition of a risk free return and permission of trading makes the financial activities
in an Islamic set-up real asset-backed with ability to cause 'value addition'. Islamic banking
system is based on risk sharing, owning and handling of physical goods, involvement in. the
process of trading, leasing and construction contracts using various Islamic modes of finance.

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.

1.2 Permissible forms of businesses:

The forms of businesses allowed under Islamic banking include joint ventures based on
sharing of risks 8 profits and provision of services through trading, both cash and credit, and
leasing activities.
Though the apparent similarity between trade profit in credit sale and Riba in loaning is not
denied in literature, trade has been permitted and Riba is prohibited. 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. Besides trading, Islam allows leasing of assets and getting rentals
against the usufruct taken by the lessee. All such things/assets corpus of which is not
consumed with their use can be leased out against fixed rentals. The ownership in leased
assets remains with the lessor who assumes risks and gets rewards of his ownership.

1.3 Making money from money is not acceptable:

Money is only a medium of exchange, a way of defining the value of a thing; it has no value
in itself, and therefore should not be allowed to give rise to more money, via fixed interest
payments, simply by being put in a bank or lent to someone else. The human effort,
initiative, and risk involved in a productive venture are more important than the money used
to finance it.
Muslim jurists consider money as potential capital rather than capital, meaning that money
becomes capital only when it is invested in business. Accordingly, money advanced to a
business as a loan is regarded as a debt of the business and not capital and, as such, it is not
entitled to any return (i.e. interest). Muslims are encouraged to purchase and are

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discouraged from keeping money idle so that, for instance, hoarding money is regarded as
being unacceptable. In Islam, money represents purchasing power which is considered to be
the only proper use of money. This purchasing power (money) cannot be used to make more
purchasing power (money) without undergoing the intermediate step of conversion into
kind; i.e. by acquisition of goods and services.

Section 2: TOOLS AND TECHNIQES OF ISLAMIC FINANCING

In order to cater to the needs of the modern world, Islamic financing puts forwards a wider
range of tools and techniques of financing. These while ensuring to meet the needs of the
financial world, also takes care to adhere to rules of sharia, which is primarily staying off
interest system.
As per the rules of sharia, any addition to the principal amount which adds up without
creation of real wealth amounts to riba. That is to say, the amount earned without sharing of
risks or losses would in effect amount to riba.
Engineers of Islamic financing tools have been careful enough to meet up the requirements
of its tenets and basic principles. In effect, what they put forward to us is a wide range of
new techniques of financing which are complex in its very own nature and application. At
the same time, theres ease and simplicity at the side of the customer of the banker.
Islamic financial tools function basically on:

1. Profit sharing (mudaraba)

2. Buy and sell back (murabaha)
3. Venture Capital (musharaka)

Many tools might resemble the conventional tools of financing as they might look, but might
differ in it simply because it dont cater to riba.
A wide range of tools and techniques of Islamic financing has been listed in the upcoming
chapters.

MURABAHA
(Cost plus Finance)

Murabaha is a form of cost plus or mark up financing where an asset id acquired by the bank
and sold to the customer. No money is loaned to the client. Rather, the financing party
purchases the goods himself, based on the requirement of the client. This ensured that
financing is always asset based. In effect, this type of financing creates real assets and
inventories.
It is understood that most of the financing operations in Islamic banking are based on
Murabaha.

Steps in Murabaha:

1. The client indicates an interest in purchasing a particular asset from the bank for a certain
price (a combination of cost price plus profit) at a certain time (the utilization date).

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2. The client identifies the vendor, selects the goods and advises its particulars, including the
vendor's name and its cost price to the bank in writing. Often the bank will appoint the client
as its wakil (agent) to acquire the asset on the bank's behalf.
3. The bank acquires the asset and offers to sell it to the client. The vendor will typically
make delivery of the asset to the client (as the bank's agent). Delivery need not be physical;
it can also be constructive (i.e. evidenced by delivery of documents of title).
4. The agency contract comes to an end. The client accepts the offer and the bank
immediately sells the asset to the client through a valid sale contract, with payment due on
the agreed date in the future.

Fig 1: Working of Murabaha

Subject of Murabaha
The assets (mal), which are the subject of the sale, must fulfill the following requirements:
The subject of sale must exist and be in the ownership (physical or constructive) of the
bank at the time of sale. In other words, the second contract must "follow" the first contract.
This risk- bearing by the bank - even if for a short or fleeting time period legitimizes banks'
profits under Shari'ah as distinct from prohibited riba.
They must be something of value that is classified as property in fiqh (Islamic
jurisprudence) and must not be forbidden commodities, such as alcohol, pork etc.
Specification of price
The sale price and payment terms must be known. The price is fixed at the time of
contracting, as is the mode of payment, e.g. frequency and quantum of installment
payments. This is to avoid any gharar or uncertainty. Where the sale price includes a known
profit or mark-up, the profit rate can be determined or expressed in relation to the market
interest rate such as LIBOR. The price may not always be specified in the main murabaha
documentation but can often be the subject of side letters/agreements between the parties.

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 MUDARABA
(Trustee Finance Contract)

Mudaraba is essentially an agreement between a financier and an entrepreneur the

principals. It is a contract whereby one side the investor or Rabb ul Mal contributes money
and the other side work, being the manager or Mudarib. The Rabb ul Mal bears all losses,
and the Mudarib earns a profit share. Mudaraba is a concept to provide capital to somebody
undertaking the work. It could be understood as being similar to the function of an asset
manager or employed manager of a company. Participatory Financing The central idea in the
concept of mudaraba is that two parties, one with capital and the other with know- how, get
together to carry out a project.

The financier provides the capital and plays no further part in the project; specifically, he
does not interfere in its execution, which is the exclusive province of the entrepreneur. If the
project ends in profit they share the profit in a pre-arranged proportion. If it results in loss
the entire loss is borne by the financier, and the entrepreneur gains no benefit out of his
effort, which was his part of the investment. However, in cases of proven negligence or
mismanagement by the entrepreneurs, they may be held responsible for the financial loss
incurred.
Mudaraba is usually translated as profit-and-loss-sharing but, as far as the financier is
concerned, it is in fact profit-sharing-and-loss-absorbing.
Preconditions of Mudaraba contract
1. The financial risk is entirely and exclusively born by the banker, and as such theres no
scope for reducing credit risk by requesting collateral security.
2. The rate of profit should be determined strictly as a percentage and not as a lumpsum.
3. The entrepreneur has absolute freedom to manage the business. Restricted and
Unrestricted Mudaraba Where the capital is provided as being unrestricted for any purpose
the manager deems fitting is called Unrestricted Mudaraba or al-mudaraba al-mutlaqah.
The banker may also grant it upon conditions what has to be made with it which would then
constitute what is called Restricted Mudaraba (Mudaraba al Muqayyadah), e.g. all
investment funds.
Two -Tier Mudaraba
The structure of Mudaraba transactions is such that the banker is involved in two different
mudaraba transactions, and hence the name two-tier mudaraba. The first Mudaraba is
between the bank and the client with surplus capital (depositors) and the second one is
between the bank and the clients who require financing.

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The first tier Mudaraba between depositors and the Islamic has those depositors acting as
Rabb ul Mal and the bank acting as the Mudarib. The depositors place their funds with the
bank with no guarantee of principal and a return based on the profitability of the
investments made by the bank on their behalf. As with other Mudaraba, the depositors bear
any losses and share profits with the Islamic bank according to a pre-agreed ratio.
The second tier Mudaraba between the Islamic bank and those receiving financing has the
bank acting as Rabb ul Mal and the customers acting as Mudarib. The bank bears all losses
except in cases of fraud by the Mudarib and share profits with the customer according to a
pre-agreed ratio.

Table No. 1
Investment options of capital- holders

Table No. 2
Financing options for entrepreneurs

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Termination of Mudaraba The contract of Mudaraba can be terminated at any time by either
of the parties. The only condition is to give a notice to the other party. If at the time of
termination, assets of the mudaraba are not in cash form, the mudarib shall be given an
opportunity to liquidate them so as to determine the amount of profit, which shall then be
divided as per the agreed ratio.

MUSHARAKA
(Joint Venture)
Musharaka is a contract whereby the bank and a customer agree to combine their financial
resources for the establishment or running of a business or project, or for undertaking any
type of business activities. The two parties agree to manage the project in accordance with
the terms of the contract.
The profit or loss will be apportioned between the parties, according to a mutually agreed
proportion, which need not coincide with the ratio of amount of capital invested. Losses are
shared by all parties in proportion to their investment. Banks have a legal authority to
participate in the management of the project, including representation on the Board of
Directors.
Different types of Musharka:
There are two basic types of Musharaka;
1. Shirkat-ul-milk (Partnership based on joint ownership) This a voluntary Musharaka,
which come into existence at the option of the participants.
2. Shirkat-ul-aqd (Partnership based on contractual relationship) This partnership is based
on contractual relationship. They are further divided into 5;
1. Shirkat-ul-Mufawadah (full authority and obligation) This is a limited partnership with
equal capital contributions, responsibility, full authority on behalf of others, along with
responsibility for liabilities incurred through the normal course of business.
2. Shirkat-ul-Inan (restricted authority and obligation) This too is a limited form of
partnership, but with unequal capital contributions. They do not share equal responsibility,
and this reflects their share of profits.
3. Shirkat-ul-Wujuh (goodwill/ credit worthiness) This is a kind of partnership entered into
with companies based on reputations of one of both parties, typically small scale business.
4. Shirkat-ul-Abdan (labour, skill and management) Partnership with a company based on
the contribution of human efforts with no capital contributions. These are again typically
small scale business.
5. Shirkat-ul-Mudaraba This is a partnership for a Mudaraba contract.

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Diminishing Musharakah
This is a derived form of Musharakah and was developed in the near past.
According to this concept, the financier-and the client participate either in the joint
ownership of a property or an equipment, or in a joint commercial enterprise, on a
diminishing share basis. The share of the financier would be divided into a number of units
and the contract is on a condition that the client purchases the units of the share of the
banker one by one periodically, thus increasing his own share till all the units of the financier
are purchased by him so as to make him the sole owner of the property, or the commercial
enterprise, as the case may be. At the same time, the share of ownership of the financier in
the property keeps diminishing and hence the name Diminishing Musharaka.

Management of the Musharaka

Every partner has a right to take part in the management and to work for it. However, the
partners may agree upon a condition that the management shall be carried out by one of the
and not by other partners. In that case, the sleeping partner should be entitled to the profit
only to the extent of his investment, and the ratio of the profit allocated to him should not
exceed the ratio of his investment.
Termination of Musharaka
Every partner has a right to terminate the Musharaka at anytime after giving his partner a
notice to this effect, whereby the Musharaka with come to an end. Termination of one
partner need not terminate the whole agreement and others may purchase the terminating
partners share and continue the business.

IJARA
(ISLAMIC LEASE)
Ijara is an agreement wherein the Bank leases movable and immovable assets to its
customers, with the option that the customer may or may not own the leased asset at the
end of the term of the lease as per the agreement singed between the two parties. Ijara
means lease, rent or wage.

Basic rules governing Leasing

1. Contract should be for an agreed period, at an agreed consideration; determined at the
time of contract.
2. The consideration should in monetary form.

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3. The object being leased must have a valuable use; and it should not be perishable.
4. The leased asset should remain in the ownership of the lesser; only its usage is transferred
to the lessee
5. All the liabilities arising out of the ownership shall be borne by the lesser, but the liabilities
arising from the use of the property shall be borne by the lessee.
6. The lessee cannot use the leased asset for any other purpose than specified in the
agreement.
7. Damages to the asset owing to misuse or negligence shall be borne by the lessee asset
caused by any misuse or negligence on the part of the lessee; whereas that which is beyond
the control of lessee shall be borne by the lesser.
8. A property under joint ownership can be leased out and the lease amount distributed
between the owners In proportion to their shares in the property.
9. The leased asset should be fully identified by all the parties.
10. If variable rentals are fixed different phases, the particulars should be agreed upon at the
time of the lease; else the agreement would not be valid.
11. The lease period commences on the delivery of the asset.
12. If the leased asset loses the function for it was leased, provided it cant be repaired and it
didnt occur due to negligence on part of the lessee, the lease is terminated.

Types of Ijara
(Hire Purchase)

These are variations on a theme of purchase and lease back transactions. There are two
contracts involved in this concept. The first contract, an Ijarah contract (leasing/renting), and
the second contract, a Bai contract (purchase) are undertaken one after the other. For
example, in a car financing facility, a customer enters into the first contract and leases the
car from the owner (bank) at an agreed rental over a specific period.
When the lease period expires, the second contract comes into effect, which enables the
customer to purchase the car at an agreed price. In effect, the bank sells the product to the
debtor, at an above market-price profit margin, in return for agreeing to receive the
payment over a period of time; the profit margin on the lease is equivalent to interest
earned at a fixed rate of return.
Ijara- Wal- Iqtina
A contract under which an Islamic bank provides equipment, building or other assets to the
client against an agreed rental together with a unilateral undertaking by the bank or the

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client that at the end of the lease period, the ownership in the asset would be transferred to
the lessee. The undertaking or the promise does not become an integral part of the lease
contract to make it conditional. The rentals as well as the purchase price are fixed in such
manner that the bank gets back its principal sum along with profit over the period of lease.
QARD HASSAN
(Benevolent Loan)

Islam allows loan as a form of social service among the rich to help thepoor and those who
are in need of financial assistance. Loan in Islam may be obtained in two ways: (i) Loan with
condition of repayment, and (ii) gratuitous loan without any compensation or gift. However,
Islam does not recognize any loan with interest for the benefit of the debtor. It only
recognizes gratuitous loan or better known as al-qard al-hasan. M. Umer Chapra has given
the definition of qard al hasan as: "Qard alhasan is a loan which is returned at the end of the
agreed period without any interest or share in the profit or loss of the business." Therefore,
qard al- hasan is a kind of gratuitous loan given to the needy people for a fixed period
without requiring the payment of interest or profit. The receiver of qard al-hasan is only
required to repay the original amount of the loan.

Objectives of Qard Hassan

1. To help the needy fellow people.
2. To establish better relationship among poor and the rich.
3. The mobilization of wealth among all people in the society.
4. To strengthen the national economy.
5. To facilitate the poor to create new jobs market and business ventures by using their
merits, skills and expertise.
6. To establish a caring society.
7. It can remove social and economical discrimination from the society.
8. To eradicate unemployment problem from the society.

TAKAFUL
(Islamic Insurance)
Takaful is an Arabic word which means guaranteeing each other or joint guarantee as
against guarantee or mutual security. Takaful or Islamic Insurance is basically based on the
concept of mutual or cooperative insurance and it takes care of all the Shariah related
concerns including ensuring investment to be made in Shariah compliant instruments.

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The concept of Takaful as such is not new in Islamic Commercial Law.
Islam accepts the principle of reciprocal compensation and joint responsibility. The system of
Takaful insurance tends to achieve selfreliance through a self-sustaining insurance system
based on community pooling, solidarity and joint guarantee for the well being of community
and individuals in need, the entire system and operation being based on Islamic principle.
Principles of Takaful:
Policyholders cooperate among themselves for their common good.
Every policyholder pays his subscription to help those that need assistance.
Losses are divided and liabilities spread according to the community pooling system.
Uncertainty is eliminated in respect of subscription and compensation.
It does not derive advantage at the cost of others.
Modules under Takaful
1. Mudaraba - By this principle, the entrepreneur or al-Mudharib (takaful operator) will
accept payment of the takaful installments or takaful contributions (premium) termed as
Ra's-ul-Mal from investors or providers of capital or fund (takaful participants) acting as
Sahib-ul-Mal. The contract specifies how the profit (surplus) from the operations of takaful
managed by the takaful operator is to be shared, in accordance with the principle of al
Mudharabah, between the participants as the providers of capital and the takaful operator
as the entrepreneur.
2. Wakala - Here the Takaful provider act as an agent for the participants and manages the
Takaful/Retakaful (Reinsurance) fund for a fee. This model is generally used in middle-east
region.
3. A combination of both Mudaraba and Wakala

SUKUK
(Islamic Bonds)
Sukuk in general may be understood as a shariah compliant Bond. In its simplest form
sukuk represents ownership of an asset or its usufruct. The claim embodied in sukuk is not
simply a claim to cash flow but an ownership claim. This also differentiates sukuk from
conventional bonds as the latter proceed over interest bearing securities, whereas sukuk are
basically investment certificates consisting of ownership claims in a pool of assets. Sukuk
(plural of word sak) were extensively used by Muslims in the Middle Ages as papers
representing financial obligations originating from trade and other commercial activities.
However, the present structure of sukuk are different from the sukuk originally used and are
akin to the conventional concept of securitization, a process in which ownership of the

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underlying assets is transferred to a large number of investors through certificates
representing proportionate value of the relevant assets.
Distinction between Sukuk and conventional Bond:
A bond is a contractual debt obligation whereby the issuer is contractually obliged to pay
to bondholders, on certain specified dates, interest and principal, whereas, the sukuk
holders claims an undivided beneficial ownership in the underlying assets.
Consequently, sukuk holders are entitled to share in the revenues generated by the sukuk
assets as well as being entitled to share in the proceeds of the realization of the sukuk
assets.
A distinguishing feature of a sukuk is that in instances where the certificate represents a
debt to the holder, the certificate will not be tradable on the secondary market and instead
is held until maturity or sold at par.
Features of Sukuk
Tradable shariah-compliant capital market product providing medium to long-term fixed or
variable rates of return. Assessed and rated by international rating agencies, which investors
use as a guideline to assess risk/return parameters of a sukuk issue.
Regular periodic income streams during the investment period with easy and efficient
settlement and a possibility of capital appreciation of the sukuk.
Liquid instruments, tradable in secondary market.
Uses of Sukuk Funds
The most common uses of sukuk can be named as project specific, assetspecific, and balance
sheet specific.
1. Project-specific Sukuk
Under this category money is raised through sukuk for specific project.
2. Assets-specific Sukuk
Under this arrangement, the resources are mobilized by selling the beneficiary right of the
assets to the investors
3. Balance Sheet-specific Sukuk
This is an arrangement wherein the Islamic bank mobilizes funds by issuing sukuk and these
funds are used to finance various projects of the member countries.
Types of Sukuk:
Sukuk takes several innovative Shariah compliant forms that combine various particles of
Islamic forms of finance together.

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1. Ijarah Sukuk
Ijarah Sukuk are related to leased properties and assets, they carry equal values, and are
issued by the owner of the leased property or his agent.
The aim of the transaction at the end is to sell the leased property through issuing Sukuk,
accordingly, the holders of the certificates or Ijarah Sukuk own the asset and its charges
during the rental period, each in proportion to the certificates of Sukuk held in the leased
asset.
2. Usufructs of Existing Assets:
Usufructs of existing assets' Sukuk certificates carry equal values and are issued by the
owner for an existing asset or by sublease at the consent of the owner or by both. The
certificates represent the rights on the service or usufruct of an asset that could either be
directly or indirectly hired to a second or a third party. A house could either be rented by its
owner or agent to a second party or sub rented by the second party to a third party.
In both cases the lessee owns the right to enjoy the service of the asset during the lease
period while not owning the asset itself.
3. Usufructs of Future Assets:
The usufruct could also be futuristic for a specified period of time for a specified asset which
would not be ready at the time of issuing the Sukuk certificates but, it could be under
construction or contracted for construction and delivery at a future time. This is analogous
to the Salam contract.
4. Contractor's Sukuk:
A contractor's or a supplier's Sukuk can be issued by a contactor or a supplier of a good or a
service. The Sukuk could be for existing commodities or those, which would be offered
during a contracted time in future. These sukuk carries equal values issued by a covenanter
to provide or sell services described in the security, such services are to be sold in a form of
sukuk, so that the holders of the same shall to be the owners of such services and shall gain
the proceeds from selling the same in the markets.
5. Potential Services Sukuk:
These Sukuk carries equal values issued by a contractor (or a supplier) or an agent having a
saleable services to Sukuk holders and such holders shall have the right to sell the same in
the stock market.
6. Salam Sukuk
Sukuk or certificates of Salam carry equal values for mobilizing the capital necessary to
produce some specified commodities contracted for deliverance at specified periods of time
in future while their value prices are fully paid in advance. A separate parallel Salam contract
could be signed by the Salam item buyer with a third party, without linking it to the first

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contract. Ethically, the contractors should be committed towards their contract parties, and
should not transfer their own responsibilities in a contract to their parties in another one.
7. Istisna Sukuk
Sukuk or certificates of Istisna carry equal values for mobilizing capital necessary to produce
some specified commodities. Such commodities could be sold with partial advance
payments according to Istisna contracts in order to be delivered at a specified period of time
in future.
Istisna is applicable on building and establishing ships, airplanes, bridges, roads, power
generation stations, water supply stations and the alike according to a specific specifications
stipulated in the contract and according to a pre-stated delivery date and value. It is possible
to synthesize another formula with the same to respond to the requisites of the process and
finance. This type is amongst the most active instruments in world of Sukuk.
A separate parallel Istisna contract could be signed by the Istisna item buyer, with a third
party, without linking it to the first contract, as it is the case with the parallel Salam
contracts. Wherein the supplier enters into a contract with an entity to manufacture a
specified merchandise for them, then the supplier enters into a contract with a third party to
manufacture the product to deliver the same for the demanding party on the stipulated
time.
8. Murabaha Sukuk
These Sukuk carry equal values and are issued by the merchant or his agent in order to
finance the purchasing a commodity then to sell the same at a known Murabaha as for
equipments required within an Istisnaa contract weher the equipments shall be purchased
on a known Murabaha and the holders of Sukuk will be the owners of such equipments and
of the sales income from the same.
9. Musharakah Sukuk
These Sukuk carry equal values and are issued by the supplier (entrepreneur or a
covenanter) or his agent, to finance a project or projects where the holders of Sukuk will be
the owners of such projects, this is far similar to partnership companies although they might
differ if the Sukuk issuer is authorized to select the projects which are transferred and
constructed.
10. Mudarabah Sukuk
This type of Sukuk, carry equal values issued by the contractor to provide the
entrepreneurship and to manage the proposed project, for the purpose of financing such
project or a combination of projects which are specified or those in which he is authorized to
act upon. Thereby, the Sukuk holders shall be the owners of the capital of the project and
the project shall remain a partnership between them and between the entrepreneur at an
agreed portion of the profits and shall bear the expected losses in capital.

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CHAPTER2: The importance of Islamic banks on the financing
of the economy
The goal of Islamic banking and finance is to bring greater justice and strive to achieve socio-
economic development. Islamic financial system can serve as a tool to foster economic
growth and human well-being. Promoting risk-sharing instead of debt-financing, reduces
poverty and inequalities which are the necessary objectives of that need to be addressed by
economic development policy makers. Islamic banks handle fund from sever to investors
through Islamic modes of finance.

Section1: Functioning of islamic banks.

It can be seen that in any banking business, there exist two aspects - at the one end is the
deposit aspect and at the other end is the lending or investment aspect. At the deposit end
of the scale, Islamic banks normally operate three broad categories of accounts, namely,
current, savings, and investment accounts.
1. Current accounts
Current accounts are based on the principle of al-wadiah, whereby the depositors are
guaranteed repayment of their funds. At the same time, the depositor does not receive
remuneration for depositing funds in a current account, because the guaranteed funds will
not be used for PLS ventures. Rather, the funds accumulating in these accounts. can only be
used to balance the liquidity needs of the bank and for shortterm transactions on the bank's
responsibility.
2. Savings accounts
Savings accounts also operate under the al-wadiah principle. Savings accounts differ from
current deposits in that they earn the depositors income: depending upon financial results,
the Islamic bank may decide to pay a premium, riba, at its discretion, to the holders of
savings accounts.
3. Investment accounts
An investment account operates under the mudaraba-al-mutlaqa principle, in which the
mudarib (active partner) must have absolute freedom in the management of the investment
of the subscribed capital. The conditions of this account differ from those of the savings
accounts by virtue of:
a) a higher fixed minimum amount,
b) a longer duration of deposits, and c) the depositor may lose some of or all his funds in the
event of the bank making losses; ie, the principal or the rate of return on the deposits is not
guaranteed. The only contractual agreement between investment depositors and banks is
the proportion according to which profits or losses are to be distributed between the parties
of the deposit contract.
The amounts so pooled are invested in a business acceptable to Shariah.

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The investment funds so created may be invested in varied forms:
a. Equity Fund
In an equity fund the amounts are invested in the shares of joint stock companies. The
profits are mainly derived through the capital gains and dividends earned on the equity
shares.
Dealing in shares or acquisition of shares of companies can be acceptable under Shariah,
subject to the following conditions:
The main business of the company is not violative of Shari'ah.
If the main business of the companies is ha/al, like automobiles, textile, etc. but they
deposit their surplus amounts in an interestbearing account or borrow money on interest,
the shareholder must express his disapproval against such dealings, preferably by raising his
voice against such activities in the annual general meeting of the company.
If some income from interest-bearing accounts is included in the income of the company,
the proportion of such income in the dividend paid to the shareholder must be given in
charity, and must not be retained by him.
The shares of a company are negotiable only if the company owns some illiquid assets.
The subscribers to the fund will be treated in Shari'ah as partners interest. All the
subscription amounts will form a joint pool and will be invested in purchasing the shares of
different companies. The profits can accrue either through dividend distributed by the
relevant companies or through the appreciation in the prices of the shares. In the first case
i.e. where the profits are earned through dividends, a certain proportion of the dividend,
which corresponds to the proportion of interest earned by the company, must be given in
charity.
The contemporary Islamic Funds have termed this process as 'purification'.
The management of the fund may be carried out in two alternative ways.
The managers of the Fund may act as mudaribs for the subscribers. In this case a certain
percentage of the annual profit accrued to the fund may be determined as the reward of the
management. The second option for the management is to act as an agent for the
subscribers. In this case, the management may be given a pre-agreed fee for its services. This
fee may be fixed in a lump sum or as a monthly or annual remuneration.
According to the contemporary Shari'ah scholars, the fee can also be based on a percentage
of the net asset value of the fund.
b. Ijarah Fund
In this fund the subscription amounts are used to purchase assets like real estate, motor
vehicles or other equipments for the purpose of leasing them out to their ultimate users.
The ownership of these assets remains with the Fund and the rentals are charged from the
users. These rentals are the source of income for the fund which is distributed pro rata to

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the subscribers. Each subscriber is given a certificate to evidence his proportionate
ownership in the leased assets and to ensure his entitlement to the pro rata share in income.
These certificates may preferably be called 'sukuk' -a term recognized in the traditional
Islamic jurisprudence.
Since these sukuk represent the pro rata ownership of their holders in the tangible assets of
the fund, and not the liquid amounts or debts, they are fully negotiable and can be sold and
purchased in the secondary market.
Anyone who purchases these sukuk replaces the sellers in the pro rata ownership of the
relevant assets and all the rights and obligations of the original subscriber are passed on to
him. The price of these sukuk will be determined on the basis of market forces, and are
normally based on their profitability.
c. Commodity Fund
Another possible type of Islamic Funds may be a commodity fund. In the fund of this type
the subscription amounts are used in purchasing different commodities for the purpose of
their resale.
d. Murabaha Fund
If a fund is created to undertake Murabaha, it should be a closed-end fund and its units
cannot be negotiable in a secondary market. The reason is that in the case of murabaha, as
undertaken by the present financial institutions, the commodities are sold to the clients
immediately after their purchase from the original supplier, while the price being on
deferred payment basis becomes a debt payment payable by the client. Therefore, the
portfolio of murabaha does not own any tangible assets. It comprises either cash or the
receivable debts, therefore, the units of the fund represent either the money or the received
debts are not negotiable. If they are exchanged for money, it must be at par value.
e. Mixed Fund
Another type of Islamic Fund may be of a nature where the subscription amounts are
employed in different types of investments, like equities, leasing, commodities, etc. This may
be called a Mixed Islamic Fund. In this case if the tangible assets of the Fund are more than
51% while the liquidity and debts are less than 50%, the, units of the fund may be
negotiable. However, if the proportion of liquid assets and debts exceeds 50%, its units
cannot be traded according to the majority of the contemporary scholars. In this case the
Fund must be a closed-end fund.
Section2: Rise and scope of Islamic Banks.
Since the early 1980s, Islamic banking has developed into a multi-billion dollar business. The
Western world is realizing that, even in its own cities, it is no longer a fringe business.
2-1: History of Islamic Banking
The creation of the Islamic Development Bank (IDB) in Jeddah in 1975 was a landmark for
Islamic banking. The IDB was the first development institution dedicated to the financial

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requirements of Muslim countries. The bank's articles of association stipulate that all its
business should be conducted in accordance with Islamic Shari'a law. Its success can be
measured by the Saudi government's decision in 1992 to double the subscribed capital of
the IDB to $5.7bn, making it the largest inter government agency in the Muslim world.
Commercial Islamic banking took off in the 1970s when a number of new institutions were
established in the Gulf, including the Dubai Islamic Bank (1975), the Kuwait Finance House
(1977) and the Bahrain Islamic Bank (1979). However, the most significant developments
took place in Saudi Arabia, aided by its huge economic infrastructure. One of the prime
movers of such developments was Prince Mohammad Al-Faisal, whose ambition was to
create a network of Islamic banks across the Muslim world - a process which saw the
founding of the Faisal Islamic Bank in Egypt in 1977 and the Faisal Islamic Bank in Sudan in
1978. But it was Prince Al Faisal's Geneva-based Dar Al Mal Al Islami, founded in 1981 that
brought Islamic banking to the attention of those Western bankers who, previously, had
little or no knowledge of Islam or Middle Eastern countries. The Geneva office of Dar Al Mal
is now the centre of a network of 43 branches in 20 countries with assets under
management in excess of $3bn. The assets of Islamic banks incorporated in the Middle East
rose from $4.4bn in 1985 to $15.7bn in 1994, although total assets controlled by Islamic
financial institutions, including assets under management and the activities of banks based
outside the Middle East, are estimated to be in the order of $80-$100bn. Compared with
conventional banking this is a relatively small sum, but the overall demand for Islamic
banking products is probably much greater than banks have so far been able to tap.
2-2: Growth of Islamic Banking
In recent times, Islamic banking and financing services have increased phenomenally around
the world. There now exist 150 such banks spread over most countries of the world. Yet, the
same trend in financing with a concentration around murabaha (trade financing) is found to
intensify.
Equity participation and profit sharing have remained distant minimum in the total
allocation of resources. Secondary financial instruments in accordance with Shariah could
not be developed so as to give rise to a viable Islamic capital market. Islamic financial
instruments are therefore traded in conventional stock markets. As a result, neither the
developmental aspects of Islamic banking in favor of realizing an Islamic economy nor the
distributive goals for the poor and marginal enterprises could be attained.
2-3: Reasons for the popularity of Islamic Banking
Some possible reasons of the popularity and acceptability of the Islamic Banking are as
under:
1. Evils of interest based system
Interest based economic and financial system of the world has caused havoc and that Islamic
system has the ability to prevent the recurrence of the global financial crisis and resolve all
related issues. But the world is not ready to do away with the system it is following. The

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truth is that the Islamic system has not been fully and effectively introduced, presented and
popularized in the world to merit any worthwhile attention towards it.
2. Attractive performance of Islamic banking Islamic banking has not yet been fully
implemented anywhere in the world, except as a system complementary to the conventional
interestbased system. However, where this alternative system has been implemented
successfully has proven the unthinkable to the modern financial system. Such attractive
performance has in effect popularized Islamic banking, so much that they accommodate
3. Extended reach of Banking activity
The reach of banking activity in many of the non-Muslim countries like that in the Muslim
countries is very poor and a vast majority of population is not bankable. For example it is
estimated that not more than 15 per cent of Indians have any bank account. In other words
the overwhelming majority of Indians, say 85 per cent, are outside the net of banking
activities they are not bankable. This is a precarious situation for any country because
normally when a person becomes bankable he also brings his savings in the main stream of
economy. As Islamic Banking is genuinely expected to attract savings of Muslims living in
non-Muslim countries it will increase the bankability in a country and will have direct
positive effect on the economy of the countries.
4. Invites Petrodollar
It is said that introduction of Islamic Banking in any country will serve as the drain through
which petrodollar will flow through. As the economy of the members of Gulf Cooperation
Council (GCC) countries in particular and other members of Organisation of Petrol Exporting
Countries (OPEC) in general is rentier based the fund saved in these countries are mostly
invested outside their own respective countries. Till 9/11 a major portion of those savings
were being invested in the USA and other Western countries. But now the situation has
changed and the Arab investors have started looking around for other possible
opportunities. If Islamic banks are opened in non-Muslim countries, including India, such
funds will be attracted and this will ultimately give a boost to economy and a fillip to the
overall welfare of the states.

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 CONCLUSION:

Global finance today dominates the world economy. Western economies are characterized
with financial sectors which generate billions for the economy. Stock Markets,
multinationals, companies raising billions, initial public offerings (IPO) and so on, all
symbolize the apparent success of Capitalism.
Over a period of 300 hundred years the emergence of fiat currencies (i.e. currency without
an intrinsic value), the role of compound interest and the development of limited liability
company structures have shaped western finance.
Such developments have also been the sole reason why the West has come to be
characterized with regular financial crises. This is because the financial sector moved away
from raising finance to fund business startups and projects to speculating on company share
prices and the movement of currencies. In this way trading in the financial sector ceased to
be about purchasing currency or buying shares in the hope of receiving a dividend to
purchasing financial commodities in the hope they could be sold for a higher price.
The financial economy that doesn't produce anything has become so sophisticated that
various products have been created which allow an investment in a paper with no real asset
represented.
The problems that the world economy faced caused hues and cries about an alternative
financial system for smoother and healthier economy. The answer to this human quest was
Islamic Banking and Finance. With its peculiar features of being interest-free primarily,
rationally ensures real economic activities. Its various unique forms of trade, once
unfolded to the world under crisis opened a brand new way of more stable economy. All
tools of it viz., Mudaraba, Murabaha, Musharaka, Ijara etc. all form the discussion of world
economies.
Its basis laid down centuries ago, and practiced for once at the time it was opened to the
world, it was soon forgotten for the greed of money and sheer selfish ends. Now that on the
verge of crisis, some entities practically reminded the world of this wonderful system of
finance, lets hope that the world will receive it a warm welcome, like it apparently does now.
However, introduction of this complex, yet rational system of financing and banking, is still
at the doorstep of our Indian economy. Even after proving its viability and scope, our own
financial conservatism is allowing us to neither shift on to nor to leave little room for this
new system.
For better health and stability of our economy, we do need an alternative, and lets hope that
the Indian government soon resolves the current issues and receive Islamic banking into our
economy.

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