Chapter 2

Literature Review

2.1 Introduction:

The purpose of this chapter is to review past studies in order to help answering the research
question. In Pakistan, Islamic Banks have brought the major changes in banking system and this
dissertation aimed to investigate these changes. In this chapter the author had related the
published material and inter relate the research questions. It is important to have clear concepts
about Islamic banking and Conventional banking before going into further details of the
dissertation. The following are the differences and kinds of Islamic banking according to
Rahman (2009):

2.1.1 Dependence on Sharia

Islamic Banking system is entirely different from conventional banking system because in
Islamic banking all laws, rules and regulations are in accordance with Sharia or Islamic
teachings. It is based on teachings of Religion (Islam). Under the Islamic Banking System
individuals are not allowed to have any business practice that creates pornographic acts nor have
drugs involvement, (Rahman, 2009).

2.1.2 Prohibition of Riba

Riba means excess or increase and this increase can be over any loan transaction, (Rahman,
2009).

Any activity which can lead to Riba or its any forms are strictly prohibitive in Islamic Banking
system and the prohibition of Riba is mentioned in four different verses in the Holy Qur’an.
These are Surah al-Rum (verse 39); Surah al-Nisa (verse 161); Surah al- Imran (verses 130–
32); Surah al-Baqarah (verses 275–81).

Islam does not permit its followers to get involved in some kind of business where interest is the
central part of any payment and in the Holy Quran it is clearly stated the ban of such practices of
Riba. All rules and regulations of Islamic Banks are in accordance to Holy Quran and Mezan
Bank also follows the same pattern that is described in Shariah. One of the reasons why Islamic
Banking could not capture the market of the banking industry in Pakistan is due to Riba
(interest). In following Surah’s it is clear that Islam favors trade but forbids Riba and Muslims
are not allowed to be part of such harmful practices. Mezan Bank is not involved in any type of
passive money making procedures and they have the vision of no profit in returns of any sale
(whether house or car sale). According to Thomas (2006), Riba comprises of two main types and
they are Credit Riba and Surplus Riba.

Credit Riba

Credit Riba is the most dangerous type of Riba because those who are involved in credit riba will
be put in fire at the day of judgment and this is the riba where exchange of one kind of goods
against other or if anyone not able to pay his payments, he has to give excess amount of goods
with that delay payment (Thomas, 2006).

Surplus Riba

According to Thomas (2006), excess amount of goods or money over the payments and this is
with no delay payments and this is the purest form of Riba. This is prohibitive in the Sunnah.

Four Stages of Riba

According to Holy Quran there are four stages of Riba. Each stage has special characteristics
which distinguishes them from each other:

First stage of prohibition of Riba

“That which you give in usury for increase through the property Of (other) people, will have No
increase with Allah: But that which you give For charity, seeking The Countenance of Allah”
(Surah al-Rum, 30:39)

Second stage of prohibition

“That they took usury, though they were forbidden: And that they devoured Men’s wealth
wrongfully; – We have prepared for those among them who reject Faith A grievous
chastisement” (Surah al-Nisa, 4:161)

Third stage of prohibition

“Ye who believe! Devour not Usury, Doubled and multiplied; But fear Allah; that Ye may
(really) prosper” (Surah al-Imran, 3:130)

Fourth and final stage of prohibition

“Those who devour usury will not stand except as stands one whom The Satan by his touch Hath
driven to madness. That is because they say: ‘Trade is like usury,’
“But Allah hath permitted trade and forbidden usury. Those who after receiving Admonition
from their Lord, Desist, shall be pardoned For the past; their case Is for Allah (to judge); But
those who repeat(The offence) are Companions Of the Fire: they will Abide therein (for ever)”

“Allah will deprive Usury of all blessing, but will give increase for deeds of charity: For He
loved not Any ungrateful Sinner”

“Ye who believe! Fear Allah, and give up what remains of your demand for usury, if ye are
Indeed believers” (Surah al-Baqarah, 2:275–8)

Prohibition of Riba in the Sunnah

Reported by Jabir bin Abdullah that the Prophet (P.B.U.H) said: "Cursed is the receiver and the
payer of interest, the one who records it and the two witnesses to the transaction". And he said:
"They are all alike". (Muslim)

2.1.3 Sources of Increase of Money and Prohibition of Gharar

Islamic banking does not permit any effort which is targeted to increase the money from the
money and there is no space of charity or any other praiseful act. However, in some exceptional
situations it is allowed where permanent disability or illness is reported, (Sinke, 2007).

Gamal (2006), reviews add value to the prohibition of Gharar and in Islamic banking system all
types of contracts need to be free from Gharar and he further explains the meaning of Gharar in
his article, this is the uncertainty and this is forbidden in terms of justice and equity.

2.1.4 Risk sharing

Islamic banking system deals with its customers in a very different manner from the
conventional banking system because in Islamic banking there is no possibility of unbroken
profit or loss and it is not just for the same person to always be winning or losing and keep
rotating the capital (Chase, 2000). According to Chase (2000) the liquidity risk comprises of both
types of risks; funding risk and liquidating assets risks. Risk of liquidating assets means being
not able to stand at right time with the affordable prices in a prescribed time and the other is the
risk that is unable to feed their assets at proper rates and maturities. These concepts were helpful
for the researcher in order to develop the analysis of the research question where interest free
banking system acceptance was discussed.

This chapter presents a literature review of following basic key concepts:

 Modes of Islamic Finance

 Trading Modes
 Participatory Modes
 Insurance Modes
 Mudarba
 The keys for the success of change in Islamic banking
 Resistance to change

The author has tried to widen the topic in order to answer the research questions related to the
Islamic banking system.

2.2 Modes of Islamic Finance

It is recommended that before going into the modes of Islamic Finance, it is advised to discuss
the background which gave rise to such modes. First of all was the absence of Shariah rules in
the financing institutes in Pakistan. The second reason was the lack of research in the Islamic
finance department and third consists of ineffective code of conduct for professionals (Fakhani &
Hassan, 2005). These reasons were the failure of previous efforts and gave birth to modes of
Islamic finance which comprises of trading modes, participatory modes and insurance modes.

2.2.1 Trading Modes

1. Ijarah

‘Leasing’ or Ijarah is the term where contracts are signed and the term and conditions are defined
by the bank and it is the form of contract where the bank buys and then leases an item. In Ijarah
the hiring of assets instead of rent and the wage is replaced by hiring of persons. Today this
practice is gaining momentum and Islamic banks leasing of cars is one of the best examples of
Ijarah. Rahman (2009) discuss the Shariah basis of Islamic banking products and in an Islamic
economic system where the form of capitalism has been up rooted and the concept of interest
based investments are common practices in non Islamic societies today. For example Rahman
(2009), discusses the approach of data integrity and the study reveals the basis of more closed
relation with customers at local level mainly in Muslim states.

2. Musawamah

It is the kind of sale in which the seller is not obliged to disclose the cost for the goods and
services (Inayat, 1993). Musawamah is done where the price of the goods consists of a pool of
products (Inayat, 1993). There are certain conditions regarding the musawamah that the asset
must possess the value and it is usable for another condition product. The sale which is done
from such products must be at spot and the future date sales are not allowed in the sharia and it is
considered as void (Inayat, 1993). Musawamah form of trading sale is mostly seen in the Islamic
industry. Pakistan is not an economically strong country and Inayat (1993) explains about the
ground realities of Islamic banking in Pakistan in a very impressive manner. The author has also
discussed the process of Islamization of banking in Pakistan, Riba, Islamic modes of financing
and their implementation by banks at the local level.

3. Salam

A study by Inayat (1993) covers Salam which is an exceptional sale allowed in the sharia in
which advance payment is made on the spot for the future delivery of the goods. For example it
can be understood in a way that a farmer needs money for the growing purpose of the crop and
made a Salam contract with the bank or some other entity. For that purpose the bank will provide
the money to the farmer and make the agreement that on that future date the farmer will provide
the crop to the bank or the person with whom the contract is made (Rahman 2009).

In a Salam contract it is mandatory that the quality, quantity and all the related matters are
clearly disclosed by the parties. It is not allowed that the payment of the Salam is made available
to the person in tranches. According to Fakhani & Hassan (2005), the contract of Salam will be
considered halal (which is allowed in religion) when the payments are in advance for the
delivery of goods. It is important to maintain the quality of the goods and commodity must not
leave any ambiguity which can be resulted in any dispute.
In Salam the object of sale must not be gold, silver or currencies since the Salam of these objects
are prohibited in sharia. Islam has the right to have any private property of an individual but it
does not support the idea to create any sort of disorder on earth (Inayat, 1993).

4. Istisna'a

Many people consider Salam and Istisna as a one, but there is a difference between both selling
contracts. Inayat (1993) explains that Istisna is a contract in which manufacturing of something
is involved. For instance, the Istisna can be applied in the making of jackets and in any other
manufacturing of goods.

In Istisna it is allowed that payment be made at spot, tranches or at the maturity of the contract.
The facility of the istisna contract can be provided to construction companies for building
houses, bridges and highways (Rahman 2009).

2.2.2 Participatory Modes

1. Murabaha

Murabaha is the cost plus sale contract where it is necessary to disclose the cost and profit to the
buyer. In Murabaha the bank charges a certain profit which is usually related to the inter bank
rate. It is a contract wherein the institution, upon request by the customer, purchases an asset
from the third party usually a supplier/vendor and resells the same to the customer either against
immediate payment or on a deferred payment basis (Usmani, 2002). The recovery of the
Murabaha financing could be agreed on the installments or the balloon payment. In Sharia, the
amount of installment or price of the asset cannot be increased or decreased in case of default or
early payment. In order to create pressure on the client for prompt payment a penalty is imposed
upon the customer as agreed in the Murabaha contract. The amount of penalty for default in
prompt payment recovered cannot be included in the income and must be spent for charity
(Usmani, 2002). Murabaha financing differs from a conventional financing, as it involves the
financing of physical assets. The bank shares in the risk of ownership. Rather than simply
advancing money to a client, the bank itself buys the goods from a third party on request of a
customer (Inayat, 1993).
 2.2.3 Stages and processes of Murabaha

According to Usmani (2002), there are various documents involved in the Murabaha
financing transaction. The most important documents which will be discussed later in the
chapter are the following

• Master Murabaha financing agreement

• Agency agreement
• Order form
• Declaration
• Purchase evidence
• Demand promissory note
• Payment schedule (Usmani, 2002)

2. Musharakah

Shah & Niazi (2009), explains the financial products of the local bank in Pakistan and the
concepts of Mudarba, Mudarib, Musharakah and Islamic finance are discussed in depth.
Musharakah is a contract which is made by the mutual consent of the parties, and many
parties are involved who share the losses and profits. According to Shah & Niazi (2009),
Musharakah is the partnership between two parties and both of them are sharing risk and
reward factor with each other. All the participants are not required to participate in the
management. The profit is shared in the pre agreed ratio but in the case of loss it is shared
according to the participation of the capital (Shah & Niazi, 2009).

3. Diminishing Musharaka

In the diminishing Musharaka the contract is done in a way that the bank buys the house
on the request of the client and afterwards client pays the bank rentals and with the time
the ownership is transferred to the client. Shah & Niazi (2009) explains that in this
contract the tenure is decided in the beginning of the contract that how long this would be
valid because according to that contract rentals are divided. Simply it can also be
understood as that the whole amount of the contract is divided into the units and the client
 against the rent purchased the unit periodically. The ownership is gradually transferred
from the bank to the client.

4. Sukuk

Sukuks are the Islamic bonds or certificates which are according to the rules of the Sharia
and trading of Sukuks are allowed in the Sharia (Rahman, 2009).

2.2.4 Insurance Modes

1. Takaful

Research conducted by Siddiqi (1985) discussed Takaful elements which are forbidden
by Islam. Takaful is a substitute for an insurance contract in the conventional terms. Takaful is
used to mitigate the risks of the different types (Siddiqi, 1985). According to Siddiqi (1985), the
principles of the Takaful are as following:

 All the policy holder cooperate among themselves for the common goods

 All the losses are divided according to the pooling system

 Uncertainty is mitigated by the compensation

 Takaful does not derive the advantage at the value of the others (Siddiqi, 1985).

According to Siddiqi (1985), there are three models of the Takaful companies upon which
they work and they are

 Mudarabah model
 Wakalah model
 Combination of both

2.3 Reference of Takaful in Holy Quran

The Takaful is mentioned in the Holy Quran in the following sentence:

“Cooperate with one another in matters of righteousness and piety.” (Surah Maida: Aayat No.2).
Therefore it is expected from the follower of Islam that they should cooperate among each other
and in Islamic banking mutual cooperation and solidarity are the pillars in times of any
misfortunes and difficulties.

2.4 Mudarba

Mudarba is a partnership between two partners in which one provides the capital and other
provides the expertise and management (Shah & Niazi,2009). In Mudarba each commercial
partner gets the agreed profits but in the case of loss it would be bear by the investor; but there
are certain conditions in case of loss which will be discussed later in this chapter.

There are two or more than two persons involved in the Mudarba contract, the investor called the
Rab-ul-maal and the person who manages and provides the expertise called the Mudarib (Shah &
Niazi, 2009). Mudarba is a special contract in the Islamic banking where one party provides 100
percent of the capital and the other provides management expertise (Shah & Niazi,2009).

According to Omar & Haq (1996), there are two types of Mudarba: one called general and the
other called specific. In general Mudarba the investor allows the Mudarib to invest where-ever
he wants to invest but in the halal things and in the other type which is the specific Mudarba, the
investor restricts the Mudarib that he may not invest in the certain business and things. Both
types are halal in the sharia point of view.

2.5 Terms and Conditions

Mudarba is usually for short term basis and it is a fixed price sale (Shah & Niazi, 2009).When
banking as the Mudarib (investment manager) then the bank should know about the contracting
parties and the description of the objects and all the purposes. The next condition is to look how
the contract will be managed and made evident like with the help of certificates. The tenure and
the termination of the contract must be mentioned in the start of the contract. The reference to all
the laws related to the transactions must be mentioned. At the time of the contract the risk about
the currency is mentioned in the contract. Details regarding to the breach of the contract by both
the parties must also be mentioned in the contract (Shah & Niazi, 2009).

In addition to these conditions the bank should ensure that all the procedures and processes are
followed and nothing should remain unambiguous.

2.6 The keys for the success of change in Islamic banking

In recent years, with globalization many important trends have taken place in the financial world
of Islamic banking. According to Inayat (1993), Islamic banks had a 24% increase in their assets
in recent years and the demand is high for establishing Islamic banks not only in Muslim States
but also all over the world. It is observed that when any organization plans change and any
particular form of leadership style is selected by the firm to make that change, arguments are
always part of the process. According to Turnbull and Gibbs (2007), it is necessary that every
organization develop the sense of changing because it is for the betterment of the firm.

For Weick (2010), change is a continuous and never ending process because activities keep on
going in different manners. Upper management in every organization plays a vital role in the
change process. A research conducted by Whitaker (2008), discusses the keys for the success of
change in Islamic banks. According to Weick (2010) communicating change with a sense of
urgency is the backbone of success in any organization. It is important to first plan some good
strategies in the work place about change and then take steps to implement them. In Pakistan the
main reason behind the adoption of a new banking system is inflation. In addition, Islamic Banks
are interest free, which is their main strength to attract customers.

There are first-order changes and second order changes, (Palmer, 2009). Palmer (2009) explains
these two types of changes in his article by giving examples that first order-change consists of
different beliefs and values and it has a strong bond with the structure of the working place.
Whereas, second-order change is not smooth in nature and it brings disharmony and disturbance.
It is observed by the researcher that both types of order changes are present in Islamic banks of
Pakistan and leadership is necessary to build the change. The format of the firm needs to be
changed by planning strategies which can lead the firm to a good change, (McNamara, n,d.).

2.7 Resistance to change

According to Berry & Somerville (2010), change in any organization is only possible when all
employees have good knowledge about the purpose of the change that is going to take place.
Michelman (2007) explains that when change occurs in an organization some amount of
resistance is always expected and in Islamic Banks the situation seems to be the same as in any
other firm.

The author of this dissertation has found the points of resistance to change by Michelman (2007)
very useful in nature in regards to Islamic Banks and in order to manage and control the
resistance at Islamic Banks in Pakistan, it is required to give essential and basic education about
the concepts of change to management including upper level managers of Islamic Banks.

A research by Kegan & Lahey (2001), explains that the leaders of organizations hardly express
their reasons for resistance and negotiation is the vital element which can make the change
successful in Islamic Banks of Pakistan.

2.8 Conclusion:

Chapter 2 presented the literature review and covered the modes of Islamic finance, the keys for
the success of implementation of changes in Islamic banking and resistance to change. Past
studies from various authors were discussed in regards to Islamic Banks and its practices. The
literature seems to indicate that Islamic banking is not a new concept because it can be traced in
history and the Holy Quran has explanation of all terms in it. The literature review has an
essential role in obtaining answers for the research questions because through literature review
the issues and the challenges faced by Islamic banks came in front and it helped the researcher in
obtaining several queries. The published articles by different authors were very much productive
for the researcher as the concept of resistance to change has explained the research questions.
Chapter 3 will discuss the methodology used in this study.