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A brief study

Submitted to: Ustad Zaid Alavi Hudawi M.phil.

By: Muhammed Thufail Pk Ad no: 1245


Islamic banking emerged as a practical reality and started functioning in 1970s. Since then it has been growing continuously all over the world. Presently, Islamic banking industry has reached US$1.0 trillion US dollars by the end of 2008. International Rating Agency, Standard & Poor estimates that Islamic financial industry has potential to grow to US$4.0 trillion over medium term. It is surprising to note that global conventional banks like HSBS, Standard Chartered Bank, Deutsche Bank, Citibank, etc, have also set up separate Windows/Divisions to structure Islamic financial products and are offering Islamic banking services to their Muslim clients and even to those non-Muslim clients who are interested in profit and loss sharing (PLS) financial instruments. UK, France, China, Singapore and many other countries have developed special regulatory to facilitate the working of Islamic banking.


Before the dawn of Islam, the Makka, the Holy city of Arabian Peninsula, was the centre of world trade and regarded as a safe haven for investors and business people. Traders caravans used to make two trips-north and south- to and from Makka during the summer and winter. Amid this relative security and local prosperity in trade and business, it was obvious that primitive system deposits and the utilization of money shall appear in preIslamic Makka society. Mostly goods are exchanged on bartered basis while payments also made in Dinar and Dirham coins. Dinar coins were in gold while Dirham coins were in silver. The business of money changing was common. Similarly, lending money on interest (Riba) was also common in Arabian Peninsula. The Jews of Medina, Banu Nadir, monopolized local business. They lend money to local people and charge high rate of interest. It was their main source of income. They were in majority and wealthy community as compared to other communities while the Quresh tribe of Makka was the men of trade and commerce. They pooled financial resources for carrying out large business ventures and share profit according to proportion of their contribution. However, when Holy prophet (MPBUH) along with his companions migrated to Medina the concentration of business activities were also shifted from Mecca to Medina. The Holy Prophet and his companions were experienced and honest traders and the residents of Medina took full advantage of their presence. Medina was an agrarian city and most of its residents were engaged in agriculture activities. But after the arrival of the Holy Prophet the

entity of that city was changed and it was emerged as one of the main business cities of Arab region. (K.Ali, Study of Islamic History, p.59). The tiny Muslim state was emerged from the city of Medina and was transformed into the big empire of the world due to introduction of pro-poor, equitable and welfare-oriented financial system. The next four to six centuries saw a continuous expansion of Muslim empire and high living standard of its citizens. The Muslims love for trade is expressed by Goitein (1967: 55) in these words: Merchants, craftsmen, and scholars alike would be combine journeys undertaken in their personal interests with pilgrimages to holy places. The Muslim pilgrimage, of course, far outstripped in importance those of the other two religious. In the first place, pilgrimage was one of the main religious duties of a Muslim, whereas in Christianity and Judaism it was only a meritorious deed. Secondly, from its very inception, the pilgrimage to Mecca was connected with the great transcontinental trade and remained so throughout the Middle Ages. The standing wish for a Muslim pilgrim was: May your Hajj be accepted, your sin be forgiven and your merchandise not remain unsold.


The people having savings or valuable articles, used to keep them under the custody of trusted persons who were known for their trustworthiness and having capability to discharge their obligations promptly whenever demanded. The underlying objective was to keep small savings in the shape of deposits with trusted persons for safekeeping and not for earning profit. This was the early shape of deposit-taking which is one of the functions of modern banking. Similarly, the wealthy people supplied funds to honest and experienced traders to finance their trade ventures and earn profit. The traders used to purchase commodities from the areas where they were abundant and sold where they were scarce and whatever the profit they earned they handed over to the owner of capital after charging their fee and traveling expenses. This was the early model of financing which is the core business of modern banking. This kind of financing is known in Islamic financial literature as Modarba transaction. Pactical examples from the history of Islam to illustrate early Islamic banking model (a) The people of Makka used to deposit their money and valuables with the Holy Prophet (PBUH) because he was the most honest and commonly known as Amin (trustworthy) even before the declaration of his prophethood. These deposits and valuables remained under his custody until his emigration from Makka to Medina. Before, his departure, the Holy

Prophet handed over these deposits and valuables to his cousin and son-in-law, Hazrat Ali for their onward return to their owners. (b) Hazrat Usman b.Affan, who later became Khalifa, was a wealthy and generous person. He generously supported the Muslims after embracing Islam and provided financial help to every one. He also lent money to Yaqub, a Jewish merchant of Medina, to carry on business with his money during the period of Hazrat Umar b.Khitab, Second Muslim Caliph. (Imamuddin, (1991:178).


The modern interest based banking system was emerged in Italy in eighteenth century. This interest based false system made a mushroom growth all over world. As far as this system based on the non- Islamic ideologies it was unacceptable to Muslims. So it was the necessity of time to have a modern financial system based completely on Quran and Hadith.


The earliest references to the reorganisation of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties, followed by a more elaborate exposition by Mawdudi in 1950. The writings of Muhammad Hamidullah 1944, 1955, 1957 and 1962 should be included in this category. They have all recognised the need for commercial banks and their perceived "necessary evil," have proposed a banking system based on the concept of Mudarabha profit and loss sharing. In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors.

The early 1970s saw institutional involvement. The Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, the First International Conference on Islamic Economics in Mecca in 1976, and the International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process.


The first instance of Islamic banking came into the picture in Egypt in 1963. The pioneering efforts by Ahmad El Najjar brought this bank into existence, whose key principle was profit sharing (non-interest based philosophy of Shariah). By the end of 1976 there were 9 such banks in the country. These banks neither charged nor paid interest but their activities were mostly limited to trade and industries where these banks invested directly or as partners of depositors. Hence, functionally these banks were working more as financial institutions rather commercial banks. In 1971, Nazir Social Banks is known to be the first commercial bank in Egypt, though its charter never made references to Shariah. The first bank explicitly based on Shariah principles was established by the Organization of Islamic countries (OIC) in 1974, called Islamic Development Bank (IDB). This bank was primarily engaged in intergovernmental activities for providing funds for development projects running into member countries. Its business model involved fees for financial services and profit sharing financial assistance for projects. With time, during the 1970s several Islamic banks came into existence, including the Dubai Islamic Bank (first Islamic private commercial bank, 1975), the Faisal Islamic bank of Sudan (1977) and the Bahrain Islamic bank (1979). Others from the Asia Pacific region include the Philippine Amanah Bank (PAB), formulated under presidential decree. Pakistan also had an established Islamic banking system at the time which unfortunately didnt survive. Within a decade of the first private bank coming into existence in Dubai, the global industry had more than 50 such banks in the same country. Most banks were a result of private initiatives, whereas the first concrete government initiative was taken by the Iranian government, when in 1985 no bank was permitted to give or take interest. Interests was replaced with service charges of 4-8% and guaranteed minimum profits. The true phase of development of Islamic financial institutions actually occurred in the 1980s. Earlier initiatives were more inclined towards interest free Islamic banking, but the emergence of financial systems has evolved in the 80s. However, non payment of interest

still remains the pivotal part of Islamic banking, whereas principles of Islamic finance such as property rights, sanctity of contracts and the rules of sharing risk are also supported. In 1985, the High Council of OIC (Organization of Islamic Conference) declared takaful /Islamic insurance as Shariah compliant. The new, wider spectrum of Islamic finance covers not only banking activities but also capital markets, capital formation and other financial instruments and intermediaries. In most countries the establishment of interest-free banking had been by private initiative and were confined to that bank. In Iran and Pakistan, however, it was by government initiative and covered all banks in the country. The governments in both these countries took steps in 1981 to introduce interest-free banking. In Pakistan, effective 1 January 1981 all domestic commercial banks were permitted to accept deposits on the basis of profit-andloss sharing (PLS). New steps were introduced on 1 January 1985 to formally transform the banking system over the next six months to one based on no interest. From 1 July 1985 no banks could accept any interest bearing deposits, and all existing deposits became subject to PLS rules. Yet some operations were still allowed to continue on the old basis. In Iran, certain administrative steps were taken in February 1981 to eliminate interest from banking operations. Interest on all assets was replaced by a 4 percent maximum service charge and by a 4 to 8 percent profit rate depending on the type of economic activity. Interest on deposits was also converted into a guaranteed minimum profit. In August 1983 the Usuryfree Banking Law was introduced and a fourteen-month change over period began in January 1984. The whole system was converted to an interest-free one in March 1985.11 The biggest change in terms of adaptability came in 1991 when the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was established to advise on Islamic finance standards all over the world. Later, the development of uniform standards was supported by other organizations such as Islamic Financial Services Board (IFSB) in Malaysia in 2002. Since then, Islamic finance is spreading all over the world at a tremendous pace from virtual anonymity to becoming a powerful competitive force in the world today

In this modern age the Islamic banking considered as an alternative for interest based, not real economy stricken conventional banking. Economists state that the future of banking is devoted for Islamic ideologies and it will show the growth of more than 100% every year in spite of the downward growth of conventional banking system.

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