Islamic Banking System: The Theoretical Framework PDF

Empirical Banking The Islamic Banking System THE THEORETICAL FRAMEWORK Stefano Caiazza 2024-2025  Ancient Laws Lending money with interest charged for its use is ancient. This activity was called lending to usury. However,...

Empirical Banking The Islamic Banking System THE THEORETICAL FRAMEWORK Stefano Caiazza 2024-2025  Ancient Laws Lending money with interest charged for its use is ancient. This activity was called lending to usury. However, ancient laws forbade the payment of interest. The reason was also practical: the debtor often ended up being sold as a slave. Hammurabi’s code of laws (1754 BC), Hammurabi king of Babylon, displayed on monumental stelae (memorial stones) in temples throughout Mesopotamia, formed of 282 laws that covered property, family, trade, and business practices. Babylonian law required that a creditor who lent with "excessive" interest be deprived of his claim. Solon, an Athenian legislator who lived in Athens between the seventh and sixth centuries BC, abolished the slavery that arose from debts contracted, obliging each creditor to forgive existing debts, and proposed a state system based on the census so that charges were proportionate to the financial capacity of citizens. Even in ancient Rome, there were numerous laws regarding the limitation of interest.  Eye for an eye If a man put out the eye of another man, his eye shall be put out. If a builder builds a house for someone and does not construct it properly, and the house he built falls in and kills its owner, then that builder shall be put to death. If it kills the owner’s son, that builder’s son shall be put to death. https://avalon.law.yale.edu/ancient/hamframe.asp  Philosophical point of view Plato (V/IV century BC), particularly in the book: Πολιτεία (The Republic), believes that the accumulation of money is, for the polis, a "terrible scourge" that gives rise to war. Aristotle (V/IV century BC) did not think producing “money from money” was right. He spoke out against the loan with interest because, the Stagirity said, "hatred is produced quite reasonably" and represents the worst form of accumulation of resources (chrematistics, χρήματα) since one derives gain from the money itself and not from the purpose for which it was invented. It is an unjust and shameful form of accumulation, unworthy of free and balanced men. Aristotle, Politics (Book I): Consequently some people suppose that it is the function of household management [οἰκονομία, economy] to increase property, and they are continually under the idea that it is their duty to be either safeguarding their substance in money or increasing it to an unlimited amount. The cause of this state of mind is that their interests are set upon life but not upon the good life; as therefore the desire for life is unlimited, they also desire without limit the means productive of life (1252a). https://www.perseus.tufts.edu/hopper/text?doc=Perseus%3Atext%3A1999.01.0058%3Abook%3D1 Aristotle, Nicomachean Ethics (Book I, 5): The life of money-making is a constrained kind of life, and clearly wealth is not the Good we are in search of, for it is only good as being useful, a means to something else (1096a). https://www.perseus.tufts.edu/hopper/text?doc=Perseus%3Atext%3A1999.01.0054%3Abekker+page%3D1096a  Religions The Jewish religion excluded the possibility of claiming interest on loans granted to compatriots but authorized it for foreigners. Leviticus (35, 35-37): If your brother becomes impoverished and cannot support himself in the community, you will assist him as you would a stranger or guest so that he can go on living with you. Do not charge him interest on a loan, but fear your God, and let your brother live with you. You will not lend him money on interest or give him food to make a profit out of it. Deuteronomy (23, 20-21): You must not lend on interest to your brother, whether the loan be of money, of food, or of anything else that may earn interest. You may demand interest on a loan to a foreigner, but you must not demand interest from your brother; so that Adonai your God may bless you in all your labors, in the country which you are about to enter and make your own. Psalm 15: Adonai, who can find a home in your tent, who can dwell on your holy mountain? […] Who asks no interest on loans, who takes no bribe to harm the innocent. No one who so acts can ever be shaken. Nehemiah 5, 7-8 Amos 8, 4-6  Religions Even the Christian religion prohibits loans with interest. Saint Luke (6, 35-37): Instead, love your enemies and do good to them, and lend without any hope of return. You will have a great reward, and you will be children of the Most High, for he himself is kind to the ungrateful and the wicked. Saint Thomas Aquinas: Summa Theologiae, Question LXXVIII, Secunda Secundæ Partis, Article 1 https://www3.nd.edu/~afreddos/summa-translation/TOC.htm In particular, usury was seen as a sin against Justice because, unlike the traditional view according to which it was a "shameful profit" (turpe lucrum), it was believed that it was a theft, according to an identification proposed by Saint Anselm (11th century) and taken up by Ugo di San Vittore (12th century). First is theft of time, which belongs only to God because it charges the time elapsed between granting the loan and its repayment. Usury, therefore, gives birth to a new time, the time of the usurer. But also a theft against the right price and the right salary.  Portrayal of the Dantesque Inferno squanderers usures They are seated, with a bag hanging around the neck on which there is the family crest, unrecognizable, burned by the rain of fire, with the hands constantly in motion (to put out the flames).  Evolution of Christian thought on usurers The desire of the usurers to be considered good Christians and the will of the Church to save even the worst sinners. The theological reflection of the XIII century: Lenders assume a risk (resicum)."Uncertainty and risk cannot erase the nature of profit, namely usury, but where there is true uncertainty and no calculation, the value of risk can fall within the fairness of justice" (Gilberto di Lessines, De usuris, 13th century). The usurer renounces to benefit from the money during the term of the loan (loss of profit). Interest was the reward for the work of which money was the consequence. Rehabilitation was connected with the ideal of Justice: the definition of a reasonable interest rate (20%).  Usury rates in Italy Law 108/96 Usury rate: the interests disproportionate to the performance, if the person who promised them is in economic or financial difficulty (art. 1). Law establishes a limit for the usury rate, referred to the Average Global Effective Rate. Legislative Decree 70/2011 modifies Law 108/96 Every quarter the Bank of Italy publishes the Average Global Effective Rate for the various financing operations. Each average rate, increased by a quarter and to which another four percentage points are added, determines the threshold rate, i.e. the rate beyond which the crime of usury is triggered. The difference between the threshold rate and the average rate cannot exceed 8 percentage points. Advice Of Average Global Real Interest Rates As Per The Usury Law Reference period: 01 October – 31 December 2020 Application from 01 April until 30 June 2021 10,48+(10,48*1/4)+4=17.1000  The Koran The Koran is the holy book of Islam. It contains the foundations of Muslim belief and worship revealed directly by Allah (God) to the Prophet Muhammad, through the Archangel Gabriel, from 610 to 632 AD. The Koran is divided into 114 Suras (chapters), each consisting of a variable number of verses, arranged in order of decreasing length (except the first Sura) in an inverse sequence to the chronological one: the last Suras are the oldest.  Homo Islamicus The sacred text of Islam imparts detailed prescriptions about some aspects of economic life: The value of natural resources and their exploitation The importance of work and private property Income distribution and the fight against poverty Trade and finance Competition and monopoly The role of the State and taxation  Homo Islamicus Natural resources belong to Allah, who gives them to humanity to contribute to its development. They can be duly used but must be respected and preserved. Therefore economic growth and nature protection must be adequately combined. Despite being guaranteed and considered an inviolable right by many scholars, private property has many limitations. The first is linked to the fact that all goods are given by Allah, the only One who can claim absolute ownership. A second limitation is related to respect for nature and neighbor: Each member of the community must never be deprived of the goods necessary to be able to live in dignity. Of particular importance is the fair distribution of wealth. Allah created everything in the correct quantity to satisfy human needs. The scarcity of resources is, however, the result of human behavior, greed, and the desire for accumulation. It follows that: Islam explicitly prohibits monopoly because it brings about inequality while competition is encouraged However, trust in the market is not unconditional: every freedom must pass through the Islamic filter The Muslim businessman must be not only motivated by profit but also by the desire to serve his community Cheating, lying, and dishonesty are strictly prohibited Employees must be remunerated fairly, and discrimination of any kind is not allowed  Homo Islamicus: Financial Issues Islamic banking and financial institutions are based on Shariah guidelines (right way): these are wide- ranging ethical and moral principles, which for the faithful Muslim are perfect and immutable. Shariah is based on the Koran (1), its interpretation by the Prophet Muhammad (known as the Sunnah) (2) and Islamic jurisprudence (3). In fact, principles alone are not enough to show the right way, as they very often do not cover specific cases. Jurists translate principles into written laws. The set of rules and laws governing the Islamic financial system – that abolish interest and other prohibited activities that link with transactions such as: Gambling (maisir) Speculations Excessive uncertainty (gharar): prohibition on the sale of items whose existence or characteristics are not sure and which are ambiguous upon contractual terms; Derivatives Illegitimate transactions related to pornography, tobacco, short-selling, producing and selling alcoholic beverages, processing and selling pork, casino, nightclubs, and other activities are considered detrimental to society. However, financial transactions are more complex and challenging than conventional transactions and are mostly asset-based rather than debt-based. All transactions must be backed by a real economic transaction involving a tangible asset.  Brief History of the Islamic Banking System The history of Islamic banking practices began in 1963 with Egypt’s Mit Ghamr local savings bank. At about the same time, another Islamic investment company was established in Malaysia, Lembaga Tabung Hajj (Pilgrim Fund Board) received deposits and provided services for pilgrimages. Other Islamic banks emerged in the 1970s, particularly in Egypt, Saudi Arabia, the United Arab Emirates, Sudan, Bahrain, the Philippines, and Jordan. In the 1980s, countries such as Pakistan, Sudan, and Iran declared their intention to transform their financial system to accommodate the Islamic financial system. Even though recently Islamic banks have grown considerably, nowadays, they still represent a tiny share compared with the entire banking system of the planet. Spread of Islam  Islamic school of law in the Muslim World The numerous legal and theological schools are the source of a plurality of interpretations of the same rule (with the exception of dogmatic aspects). There is no single 'authentic' interpretation of the lawfulness of financial instruments.  Riba A crucial prescription is the “prohibition of the payment or receipt of any predetermined, guaranteed rate of return” (Riba, Sura II, 278). The meanings of Riba are: money increase, an increase of anything, or an increment of anything from its original amount. Literally, Riba means prohibition of excess In a nutshell, Riba is the predetermined return on the use of money. In the past, there has been a dispute about whether Riba refers to interest or usury. Still, there is no consensus among Muslim scholars that the term covers all forms of interest, not only "excessive" interest. However, not all increases are considered Riba in Islam. Money may increase in business activities as well, and this is not Riba. Instead of being prohibited (Haram), this typology of increase is approved (Halal) in Islam. Islam prohibits only those charged on loans with a prefixed rate.  Types of Riba The term Riba is used in Shariah in two senses. The first is Riba al-nasi'ah. The term means to postpone, defer, or wait and refers to the time allowed for the borrower to repay the loan in return for the 'addition'. The prohibition essentially implies that Shariah does not permit the fixing in advance of a positive return on a loan as a reward for waiting. It makes no difference whether the return is a fixed or a variable percent of the principal, an absolute amount to be paid in advance or on maturity, or a gift or service to be received as a condition for the loan. The point in question is the predetermined positive return. Islamic jurists have always considered money as a medium of exchange and a unit of account, rejecting its function as a store of value. Lending at interest is therefore prohibited since it is considered unfair and unequal: money would generate wealth in itself and not as used in a production process or a transaction.  Types of Riba The second sense in which Riba has been used is Riba al-fadl. It is encountered in the hand-to-hand purchase and sales of commodities. It covers all spot transactions involving cash payment on the one hand and immediate delivery of the item on the other (cash and carries transactions). The question of Riba al-fadl arises because of a saying of the Prophet requiring that if gold, silver, wheat, barley, dates, and salt are exchanged against themselves, they should be exchanged spot and be equal and alike. It may be mentioned that the above six items did the function of money at that time. This prohibition states that nothing is owed more than the value of the goods in exchange and that it is not allowed to set the price and conditions for future exchange today as this may not be fair for the parties involved. This principle is the basis of the prohibition of derivative instruments.  Sura II Those who (in charity) spend of their goods by night and by day, in secret and in public, have their reward with their Lord: on them shall be no fear, nor shall they grieve. Those who devour Riba will not stand except as stands one whom the Evil hath driven to madness by his touch. That is because they say: "Trade is like usury," but Allah had permitted trade and forbidden usury. Those who after receiving direction 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 loveth not creatures ungrateful and wicked. O you who believe! Observe your duty to Allah, and give up what remains (due to you) from Riba, if you are (in truth) believers. And if you do not, then be warned of war (against you) from Allah and His Messenger. And if you repent, then you have your principal (without Riba). Wrong not, and you shall not be wronged. If the debtor is in a difficulty, grant him time till it is easy for him to repay. But if ye remit it by way of charity, that is best for you if ye only knew.  Pros …. The economic rationale for eliminating Riba (interest) is based on values of justice, efficiency, and stability. The arguments for distributive justice are: The industrial and commercial risk is shared more equitably between the entrepreneur and the capital owner Replacing a fixed return with a proportionate share in actual profits would ensure equitable returns to capital regardless of whether profits are high or low and whether prices are inflationary, stable, or deflationary Wealth would generate more wealth for owners only when its use in economic activities leads to the creation of value-added The arguments for efficient allocation of capital are: In contrast to the provision of risk capital, loan finance tends to serve the most creditworthy borrowers and not necessarily the most productive and profitable projects Profit-sharing arrangements harmonize the interests of lenders and borrowers (of capital), resulting in a joint focus on productivity Eliminating interest also provides for social cohesion between different classes, the motivations of which are often conflicting and opposed in the conventional system The arguments for stability are: An interest-based economy has a built-in tendency toward inflation because the creation of money is not related to productive investments, either at the level of the Central Banks or at the level of commercial banks  … and contras The Western financial systems are based on the existence and use of debt instruments. The underdevelopment of debt instruments in Islamic finance, affected by orthodox Koranic prescriptions, eliminates a degree of freedom and a crucial source of external finance. Even though it is known that debt may create conflicts between creditors and shareholders, with the former being more risk-averse than the latter, it is nonetheless a crucial instrument to prevent cash flow waste from managers (Jensen-Meckling, 1976; Jensen, 1986; Grossman-Hart, 1982). Moreover, with the impossibility or the difficulty of signing debt contracts, firms are unable to signal their strength to lenders in a framework of asymmetric information (Ross, 1977; Leland- Pyle, 1977)  Deposit Accounts at an Islamic Bank The Islamic bank collects deposits, in the form of current accounts or investment accounts, and uses these sums not to offer interest-bearing loans but transactions that also include direct participation in business projects, risking some of the paid-up capital. This exposes the Islamic bank to risk profiles on assets and liabilities, that differ from those of a Western bank. Current accounts allow the depositor to acquire a share in the bank's capital, participating in the earnings and risks of the bank's business. Such accounts allow the customer to withdraw the deposit at any time. The depositor in investment accounts can invest in assets permitted by Shariah. The depositor finances the bank, which, in turn, grants a loan according to the agreement with the depositor (first possibility) or on its own initiative (second possibility). Such accounts cannot be withdrawn before the maturity of the investment and may: i) be exposed to the risk of failure of the project and share in the bank's earnings; ii) or be guaranteed, but without receiving any remuneration.  Deposit Accounts at an Islamic Bank The depositor in an Islamic bank is similar to the investor in mutual funds and in terms of risk/return profile is somewhere between the shareholder and the traditional depositor: like the former, he risks the paid-up capital; like the latter, he has no vote in the shareholders' meeting. This ambiguity poses corporate governance problems since the depositor often has no control over the use of the funds paid in and the risk of moral hazard is very high. The Islamic bank should, therefore, be very sensitive to reputational risk in order to avoid a run on the branches. To contain volatility in the remuneration of investment accounts, the Islamic bank provides a reserve in which to set aside part of the profits to be used in the event that the remuneration of deposits is not competitive. Such a policy is essential to gain the approval of depositors and allows the Islamic bank to offer remunerations not dissimilar to those offered by a conventional bank. This is important in those systems where both types of intermediaries coexist.  Deposit Accounts at an Islamic Bank With the spread of people of the Islamic religion in the Western world, the need arose to meet the demand for deposits and investments according to Sharia principles. To this purpose, several Islamic banks have arisen in the West. Often the regulator has allowed 'traditional' banks to open ad hoc offices and branches dedicated to Islamic customers. This is known as an Islamic window, a term that also includes the possibility of offering deposit accounts that do not pay interest but share in the profits. This is the case in the UK where banks such as HSBC, Citibank, Bnp Paribas, Ubs, and others have opened Islamic branches. This poses several problems, e.g. regarding the tax treatment of such accounts.  Exchange contracts Exchange contracts transfer the ownership of an asset from one subject to another. Murabaha is the most important exchange contract.  Murabaha Murabaha provides for a double sale with deferred payment. It is one of the most used contracts by Islamic banks for corporate financing transactions (purchase of raw materials or semi-finished products), consumer credit, and liquidity investments. The Customer wants to acquire a good. He contracts with the Vendor the selling price. Since the Customer does not have the financial resources for the purchase, he turns to an Islamic bank and enters into a Murabaha contract. The customer and the Bank determine the profit margin for the Bank (X). Bank acquires the item by paying (P). Then Bank transfers the item to the Customer at the price of (P+X). Payment may be deferred and/or delayed. The bank has carried out a financing operation for the buyer without lending money at interest but through a double sale whose settlement can take place in installments or at a time after the delivery of the asset. The transfer of ownership of the asset takes place upon payment of the price or the last instalment.  Example A resident of Bahrain intends to buy a car with a price (P) of 25,000 dinars (about 50,000 Euros). The buyer does not have the necessary sum, so he stipulates a Murabaha with his bank. He agrees to pay the bank 27,000 dinars (P + X), where 2,000 dinars is the bank's profit margin (X). The bank buys the car from the vendor for 25,000 dinars. The bank appoints the client’s agent through a parallel agency contract to pick up the vehicle. The property passes to the bank. The Murabaha contract provides that the client pays the sum of 27,000 dinars after three months. Upon payment of this sum, the right of ownership is transferred from the bank to the customer.  Financial Instruments Question 1: What is the difference between the profit margin and the interest paid on a bank loan? Answer 1: Some Islamic lawyers argue that the contract does not include a loan of money but the purchase of an asset in the customer’s interest. The bank is also exposed to the risk associated with the physical possession of the asset, such as theft or damage. Allah permits trading but forbids Riba (II: 275) Answer 2: Not all Islamic jurists, especially those of the Middle East, accept this contractual structure since there is no criterion for participation in profits and losses. This operation has characteristics not dissimilar to an advanced invoice operation widely used in the traditional economy. Question 2: If the payment of the good is immediate, what about the financing? Answer: In such a case, no financing would be included, and the Islamic bank would simply be a middle-man or broker agent. When a customer approaches an Islamic bank to finance a purchase through Murabaha, the price is usually deferred and most commonly paid in installments.  Participation Contracts Participation contracts are loan agreements in which the parties take part in the gains and/or losses by contributing to the project with capital or work. The two main contracts are the Mudaraba (participation in profits) and the Musharaka (participation in profits and losses).  Financial Instruments Mudaraba: the client brings work and skills, and the bank gets the capital. Mudaraba can take the form of a binding or nonbinding contract. In the first case, the capital is contributed to a specific project In the second case, the client is free to choose the project This contractual structure is widely used for financing transactions and deposit contracts (Investment Accounts). One of the characteristics of the Islamic bank is, in fact, the collection of deposits through Mudaraba contracts in which the remuneration of the depositor is not a fixed interest rate but a participation in the bank's profits. The nominal value of the deposit is not guaranteed, and in the event of losses by the bank, the value of the deposits may be affected.  Mudaraba Project 3. Commission 4. Share in profits or losses 4. Share in profits 2. Capital 2. Work and skills Islamic Client Bank 1. The parties enter into a contract by setting the the share of profit participation 1. The customer wants to develop an entrepreneurial project but lacks the financial resources and turns to the bank. 2. The bank, after verifying that the project respects the Shariah principles, stipulates with the client a Mudaraba in which the client confers the work, the bank the financial resources, specifying the share of the profits, and the amount of the commission paid to the client for the work performed. In the absence of these elements, the contract is void. 3. If the project generates profits, these will be distributed between the bank and the customer. 4. If the project generates losses, these affect the depositor and eventually the bank.  Example of Mudaraba 1. A resident of the United Arab Emirates (subject A) deposits 1,000,000 dirhams (approximately 210,000 Euros) to an Islamic bank (subject B) based on a mudaraba contract: the bank will only be able to use the funds for a project specified in the contract. The investment account is for two years, and the profit sharing is 60% to the depositor and 40% to the bank. Against the deposit, the bank issues certificates. 2. The bank enters into a second mudaraba contract with a Company (subject C): the bank provides the funds, the Company, the work, and its knowledge. The Company will receive a commission for the daily work, which will be deducted from the project’s profits. This second mudaraba provides for 50% profit sharing. 3. After two years, the project is sold for 1,250,000 dirhams: 50,000 dirhams represents the commission due to the company (subject C) for the work performed; the profit of 200,000 is split 50% between the bank (subject B, 100,000 dirham + initial capital) and the firm (subject C, 100,000 dirham). 4. The 100,000 dirhams collected by the bank will then be distributed 60% to the depositor (subject A, 60,000 dirhams + initial capital) and 40% to the bank (Subject B, 40,000 dirhams). 5. If the project is sold at 850,000 dirhams, it generates a loss of 200,000 dirhams (net of the commission received from subject C for the work provided); this loss would be directly transferred to the depositor who would see the initially allocated capital reduced in a corresponding amount.  Example of Musharaka Project 2.Capital + Work 2.Capital + Work Islamic Client Bank 1. The parties enter into a contract by setting the share of profit participation and appointing the Project Manager 1. A Qatari company intends to expand its manufacturing facilities. An Islamic bank has unused land on its balance sheet. The parties decide to form a partnership by concluding a musharaka. 2. The bank grants the land and part of the financial resources for the construction of the plants for a total value of 1,000,000 ryals (equal to approximately 200,000 Euros), while the company grants 3,000,000 ryals (equivalent to about 600,000 Euros). They also established that the profit sharing for the company is 60%, while for the bank, it is 40%. 3. The first year that the plant is fully operational, there are profits of 250,000 ryals, 150,000 for the company, and 100,000 for the bank. 4. In the second year, they record a loss of 100,000 ryals. The loss rate for each partner will be proportional to the paid-up capital: for the bank, equal to 25,000 ryals [100,000 × (1,000,000 / 4,000,000)] while for the company, equal to 75,000 [100,000 × (3,000,000 / 4,000,000 )].  Vendor Ijara (transfer of usufruct) 1. The bank customer and the seller agree on the asset 3. Purchase of the asset 2. The bank client and the Islamic bank enter into an ijara 4. Delivery of the asset Lessor Lessee (Islamic Bank) 5. Rent (client ) 6. Ijara wa iqtinà: transfer of ownership upon expiry 1. A person (lessee) intends to purchase an asset from a seller. 2. Not having the financial resources available, he enters into an ijara with a bank. 3. The Islamic bank acquires asset ownership from the seller under the conditions (price, characteristics, etc.) established with the buyer. 4. The bank (lessor) delivers the asset to the customer, who periodically pays a fee to the bank. 5. Ownership remains with the bank. 6. According to the prevailing interpretation of the main Islamic legal schools, the lessor can redeem the asset at the end of the contract by paying the asset's residual value.