Islamic Banking: A New Vehicle In

Fostering Entrepreneurship
Journal Of Islamic Banking And
Finance,Vol: 13, 3, July-Sept. 1996, 28-
39
- By Sudin Haron

Abstract  The last twenty years have

witnessed the emergence of a number of
Islamic financial institutions. The
concepts of justice and equity are the
foundation of Islamic banking and their
operations are free from any element" of
interest. To avoid interest, Islamic banks
have developed profit-sharing schemes in
tapping and mobilising their resources.
Both Islamic bank's leading policy and
lending principles are excellent tools for
creating and developing entrepreneurs. In
relation to entrepreneurs, the status of the
Islamic bank is either of partner or
investor, whereas, for conventional banks
the relationship is more of creditor-
debtor. Entrepreneurs need not worry
about the repayment of loan since
Islamic banks will only get their share if
and when the business is profitable.
Entrepreneurs who maintain a
relationship with the Islamic banks are
expected to be more ethical and not be
involved in businesses that are prohibited
by the Islamic laws.
 
The emergence of interest-free
institutions or better known as Islamic
banks especially in the Middle-East in
the late 1970s and early 1980s has
received considerable attention from
many scholars around the world. Muslim
scholars especially, awakened by the
"back to religion spirit" started to focus
their intellectual ability to studying this
new system and its applicability in the
modern business world. Western
scholars, however, puzzled by this new
system, are also paying considerable
attention in understanding this new
dimension in the economy. Scarcity of
literatures, especially in English is
hampering these scholars' efforts in
understanding this new concept of
banking.
Pioneered by Mit Ghamr Local Saving
Banks, which were established in 1963 in
a provincial rural centre in the Nile
Delta, Egypt, there are currently more
than 100 interest-free institutions all over
the world (Abbasi and Hollman, 1990),
providing services that are compatible to
those services offered by the interest-
based institutions or conventional banks.
These Islamic banks not only serve the
needs of Muslim customers but have also
extended their operations to service non-
Muslims. Bank Islam Malaysia Berhad,
for example, as at the end of August
1993, had 350,000 customers of whom
17,000 were non-Muslims. Islamic banks
have also extended their wings to the
Western world. Islamic Banking System
International Holding, for example, was
established in Luxembourg in 1978,
becoming the first Islamic institution on
Western soil, followed by Dar al-Mal al-
Islami, in Switzerland (1981), and
Islamic Bank International in Denmark
(1983). The collapse of the Soviet Union
was an opening for a new frontier for the
Islamic banks. Al-Baraka group now has
its own bank in Kazakhstan by the name
of Al-Baraka Kazakhstan Bank and this
group is aiming for a new joint-venture
in Uzbekistan. Arab Islamic Bank is also
setting-up an investment bank with an
authorised capital of US$100 million on
a joint-venture basis in Albania
(Rudnick, 1992).
Although Islamic banks have been in
existence for more than three decades,
Muslim scholars are still continually
debating, discussing and searching the
details of every aspect of Islamic banking
practices that are permissible under the
Shariah (Islamic), law. The continuing
discussions do not mean that the Shariah
law is incomplete. This is because Islam
provides avenues for its jurists to discuss
and search the practicality and suitability
of Shariah law with the existing
environment.
Basically, there are four sources of
Shariah law (All 1950, Klien 1985). The
first source of Shariah law is the Islamic
Holy Book called Al-Quran. The Holy
Quran is the original and eternal source
of Shariah law. It constitutes messages
that Allah inspired the Prophet (peace be
upon him) for the guidance of the
mankind. These messages are universal,
eternal, and fundamental. The Sunnah,
the second foundation of Shariah, is next
in importance to the Quran. The Sunnah
signifies the custom, habit, usage of the
Prophet (peace be upon him). It
designates his behaviour, mode of action,
his sayings and declaration under a
variety of circumstances in life. It is also
called Hadith, a piece of information,
account, narrative, story and record of
actions, doings and saying of the Prophet
(peace be upon him), as recorded and
handed down by tradition and which
have become the rule of faith and
practice of Muslims. The third source of
Shariah is the Ijma. Ijma means a
consensus of opinion of the Mujtahids
(the learned doctors of Islam), or an
agreement of the Muslim jurists of a
particular age on a question of law. The
fourth or last source of Shariah law is the
Qiyas which means literally 'measuring
by' or 'comparing with'. Qiyas is the
process of reasoning by analogy of the
Mujtahids with regard to certain difficult
and doubtful questions of doctrine or
practice, by comparing them with similar
cases already settled by the authority of
the Quran, Sunnah or Ijma and thus
arriving at the solution of undecided
questions. Within these four frameworks,
Sharia law is "able to deal with the
complexity of today's dynamic world and
capable of handling various conflicting
problems of modern life.
It is not our intention to elaborate the
ways and means of the formulation
process of the Sharia law in adapting to
the current dynamic business world, nor
to explain in detail the modus-operandi
of the Islamic banking operations. The
purpose of this paper is to highlight some
of the distinct features of Islamic banking
concepts that we believe have both direct
and indirect implications in fostering
entrepreneurship
Islamic Banking in Brief
Islamic banking is defined as a banking
system whose operations are governed by
the Sharia law that prohibit usury and
interest. In Shariah, both usury and
interest fall into the same category that is
called Riba. Therefore, financial
institutions such as commercial banks,
investment banks, merchant banks,
finance companies, discount houses,
insurance companies that choose to offer
products or services without the interest
element can be considered as performing
business using Islamic banking products.
Unlike the conventional banking
institutions that charge interest on loans
granted to their customers or pay interest
on the money deposited by their
customers, no interest is paid or charged
by the Islamic banks.
The prohibition of taking or paying
interest came from various sources of
law. There are few verses in the Quran
that clearly mention the prohibition of
interest. For example, Verse 2: 275
reveals that 'Those who devour usury will
not stand except as stands one whom the
evil one by his touch has driven to
madness. That is because they say
"Trade is like usury." But Allah
permitted trade and forbidden usury'. In
order to make this matter more clear, in
Verse 2: 278-280, Allah says that 'O
believers, fear God, and give up the
usury that remain outstanding if you are
believers. If you do not do so, then be
sure of being at war with God and His
Messenger. But, if you repent, you can
have your principal. Neither should you
commit injustice nor should you be
subjected to it. If the debtor is in
difficulty, let him have respite until it is
easier, but if you forego out of charity, it
is better for you if you realise.' In another
Verse 3: 130, Allah says, "Devour not
usury, double or multiple; but fear Allah
that you may really prosper'. Prophet
Muhammad (peace be upon him) also
had reminded Muslims not to be
involved in any dealing which involved
interest. He forbade exchange of one
commodity for the same commodity,
unless they were of equal quantity. In
one Hadith, Prophet (peace be upon him)
is reported to have said that 'Gold for
gold, silver for silver, wheat for wheat,
barley for barley, date for date, salt for
salt and like for like in hand to hand
(transaction): whoso gives more or takes
more, than the taker and the giver are
equal in taking interest in it.'
Like any other conventional bank,
Islamic banks are also playing a very
important role in resource mobilisation,
resource allocation and utilisation. This
means Islamic banks are also providing
saving facilities to depositors and
extending financing facilities to the
needy. Normal deposits facilities such as
savings account, current (checking)
account, fixed or investment deposits are
available to customers. Islamic banks
also provide assistance to business
customers in overcoming their working
or fixed capital problems. This assistance
may be for the short or long term. Islamic
banks are also involved in facilitating
international trade for their customers.
Services, such as letters or guarantee,
money market, foreign exchange, and
remittance services are available at
Islamic banks.
Advisory services are also available at
Islamic banks in many countries. These
services include project planning,
property management, preparation of
feasibility studies, project evaluation,
trustee services and training and
education in Islamic finance and
economics. Unlike conventional banks
whose objective is profit maximisation,
Islamic banks are playing more of a
social role. These services may be
classified into three main areas namely,
benevolent loans, collection and
distribution of zakat (alms or wealth tax)
funds, donation and activities that will
enhance Islamic values and ways of life.
Basically all Islamic bank products and
services fall into three categories that are
permissible by Shariah. The first
category is services for which a fee,
commission or fixed rate is charged. A
second category is services that are based
on partnership (profit-sharing), and the
last category is services rendered free of
charge. Some of the Shariah principles
which are applicable to the above three
categories of services are Mudaraba,
Musharaka, Murabaha, Bai Mua'zzall, of
Ijara-wa-Iktina, Qard-e Hassan,
Wakalah, Kafalah, Mozara'ah, Masqat,
and Jo'alah.
Principles of Shariah in Islamic
Banking
Mudaraba:
This is basically an agreement between at
least two parties that is a lender 'or
sometimes known as an investor (rabb at-
mal) and an entrepreneur also known as
an agent-manager (mudrib). In the
agreement the investor agrees to finance
or entrusts money to the entrepreneur
who is to trade with it in the agreed
manner and then return to the investor
the principal and pre-agreed share of
profits and keep for himself the
remaining balance. The distribution of
profit between two parties must
necessarily be on a proportional basis
and cannot be a lump sum or a
guaranteed return. In the case of loss and
this loss is as a result of circumstances
beyond the control of mudrib, the
investor will bear all financial risk and
the mudrib loses the time and his effort
only. The majority of the Muslim
scholars believe that this principle is
suitable for businesses that involve
trading such as buying and selling and
that the recipient of the funds should not
mix the mudaraba's funds with his own
funds.
Musharaka:
Musharaka is normally translated in
English as 'partnership'. In the context of
Islamic banking, however, musharaka
means 'participating financing'. Literally,
Musharaka means a joint-venture
agreement between two parties to engage
in a specific business activity with an aim
of making profit. The termination of
agreement may be based on time or after
fulfilment of a certain condition. In this
principle, both parties will provide the
capital and the investor or lender may
also participate in the management. As in
the case of Mudaraba, all parties agree
through negotiation on the ratio of
distribution of profits generated from the
business activity which need not coincide
with the ratio of participation in the
financing of the activity. However, in the
event of a loss, all parties bear the loss in
proportion to their share in the financing.
Murabaha:
This is basically the sale of goods at a
price covering the purchase price plus
profit margin agreed upon by both parties
concerned, which transforms a traditional
lending activity into a sale and purchase
agreement, under which the lender buys
goods wanted by the borrower for resale
to the borrower at a higher price agreed
upon by both parties. In this principle,
Islamic banks are no longer to share
profits or losses, but assume the role as a
normal business entity.
Bai Mua'zzal:
This is a variant concept of Murabaha,
whereby the borrower is allowed to defer
settlement of the payment for goods
purchased within the period, and in the
manner, determined and agreed upon by
both parties.
Ijara:
This is the Shariah's concept of leasing
finance, whereby the bank purchases the
asset required by the customer, and then
leases, the asset to the customer for a
given period, the lease rental and other
terms and conditions having been agreed
upon by both parties.
Ijara-wa-Iktina:
This is a variant concept of Ijara. The
lessee will be given an option for the
acquisition of the leased asset.
Qard-e- Hassan:
This is a benevolent loan that obliges a
borrower to repay the lender the principal
sum borrowed on maturity of the loan.
The borrower, however, has the
discretion to reward the lender for his
loan by paying any sum over the above
amount of the principal.
Wakalah:
This is an agreement between a customer
and the bank whereby the bank will issue
a letter of guarantee to the third party and
guarantee that the customer will fulfil
his/her obligation and in case of default
the bank will make payment as specified
in the guarantee letter.
Wadiah:
This is an agreement to deposit an asset,
excluding immovable fixed assets in a
custody of another party. The owner will
give his/her consent to the custodian to
make use of their funds as long as these
funds remain in the custodian's hands.
Mozara'ah:
This is a contract between the owner of
land (Mozare) who turns over a specified
plot of land for a specified period of time
to another party (Amel) for the purpose
of farming. In return, both Mozare and
Amel will share the harvest according to
the earlier agreeable ratio.
Mosaqat:
This is a contract between the owner of
trees and the like with another party in
return for a specified common share of
the produce. The produce can be fruits,
leaves, flowers, etc.
Jo'alah:
This is the undertaking of one party
(Ja'el or employer) to pay a specified
amount of money or wage to another
party (Jo'al) in return for rendering a
specified service in accordance with the
terms of the contract. The party rendering
the service is called amel or contractor.
Source of Funds
Like conventional commercial banks,
besides their own capital or equity,
Islamic banks are dependent on the
depositors' money as a major source of
funds. Under the Islamic scheme of
banking, there may be two types of
deposits namely, transaction deposit and
investment deposit. The first type of
deposit can be regarded as equivalent to
demand deposit or checking account in a
conventional banking system. Depositors
may be allowed to withdraw their funds
at any time without any notice. This type
of deposit is for security and convenience
purposes. In most cases, Islamic banks
would guarantee the nominal value of the
deposits and pay no return on this type of
deposit. Islamic banks, instead may
impose service charges and recover zakat
(alms or wealth tax) from this deposit.
The second type of deposit that is
available for customers is investment
deposit and this deposit is governed by
the principle of Mudaraba. Within this
context, Islamic banks will act as the
agent-manager or Mudarib and the
depositor as investor or Rabb al-mal.
There are a few alternatives available
within this type of deposits. The bank
would provide no guarantee, nor fixed
return on the amount deposited. The
customers who hold their funds in this
investment deposit will be treated as if
they were shareholders of the bank and
be entitled to a share of the profits or
losses made by the bank. The agreement
on how the profit or loss will be
distributed between the bank and the
depositor is made at the beginning of the
deposit period and cannot be amended
during the tenure of the deposits, except
by consent of both parties. The
distribution of profit for the depositors
may be on a quarterly, half-yearly, or
yearly basis and advance notice is
required for those who wish to withdraw
the funds before maturity date.
Islamic banks are also allowed to raise
funds by way of issuing an investment
certificate that carries no fixed return and
the tenure of the certificate would vary
from one to five years or even more. The
return is normally in the form of a
dividend that will be announced and
distributed on a yearly basis.
There is no standard Sharia principle
used by the Islamic banks in the deposits'
facilities. In Malaysia for example; the
principle of wadiah is used for the
current and saving accounts facilities,
whereas, in Iran, similar facilities are
also available but the principle is based
on Qard-e-hassan. The principle of
Mudaraba, however, is used by Islamic
banks all over the world for their
investment deposit facility.
Uses of Funds
Unlike conventional banks that have a
relatively simple financing mechanism,
Islamic banks are facing a complicated
task in allocating their resources. There
are many factors that differentiate
Islamic banks and conventional banks.
First, Islamic banks are not guided by a
profit hunting motive. Their utmost
objective is for the betterment of the
Ummah (whole community) and its over
all business philosophy is based on
justice and equity. Second, the status of
Islamic banks in relation to their
customers is that of partner, investor, and
trader, whereas, for conventional banks
the relationship is more of creditor-
debtor. Third, for many conventional
banks, their lending policy normally is
that the loan wanted to a customer is for
the additional capital and not as initial
capital (with the exception of venture
capital institutions). Islamic banks
however will participate in both new or
existing projects as long as the proposed
venture is viable and profitable. Another
factor that makes Islamic banks differ
from the conventional banks is in terms
of their lending criteria. Normally,
conventional banks will use the interest
rate as a cut-off point in making loan
decisions. No loan will be approved if
the rate of return of the borrower's
business is below the interest rate on
loan. Contrary to this practice, Islamic
banks will participate m any project as
long as the selected project generates
profit.
Non-commodity trading is strictly
prohibited by Shariah. Since Shariah
considers money as a non-commodity
item (Siddiqi 1986) granting loans to
customers for profit is therefore,
unlawful. In most cases the funds will be
used through equity participation or
partnership. Principles of Mudaraba,
Musharaka, and Murabaha are commonly
used by the Islamic banks in helping their
commercial customers. Principe of lira
and principle of Ijara-wa-Iktina are for
the leasing facility, Whereas, principles
of Bai Mua'zzal and Qard-e-Hassan are
for ordinary customers who need
financial assistance in buying houses
durable goods, and other personal needs.
Other banking services such as letters of
guarantee, letters of credit, remittance
services, travellers' cheques, and safe-
deposit boxes are considered as fee-base
services Principle of Wakalah and
principle of Kafalah are normally used
by the Islamic banks when rendering
these services.
Relations with Entrepreneurs
To many entrepreneurs, the conventional
bank is just a friend who will give you an
umbrella during the sunny days and will
take it back during the rainy days.
Similarly when a business is prospering,
without invitation on bankers will knock
on entrepreneurs' doors and offer them
all sorts of banking facilities. Once the
business is on the downturn, they tend to
withdraw the facilities granted and
demand for full repayment. On failing to
make full repayment, entrepreneurs will
be charged with various kinds of legal
proceedings until the banker is
completely satisfied that nothing
valuable can be claimed from the
entrepreneurs. Islamic banks however,
due to the principle of justice and equity
are playing a different role towards
entrepreneurs. As mentioned earlier,
there are many actors that make Islamic
banks differ from an ordinary bank.
Islamic banks, nevertheless, are expected
to be more receptive and proactive in the
process of creating, moulding and
developing entrepreneurs.
The principle of Mudaraba, for example,
is impetus for creating new
entrepreneurs. Those who possess
business skills and ideas but without any
capital can turn to Islamic banks for
financing. This mode of financing will
encourage existing entrepreneurs to
undertake projects that involve high risk
but are highly profitable and productive.
Entrepreneurs who are enjoying the
Mudaraba mode of financing will benefit
in two ways. First, they need not worry
about repayment. The Islamic banks will
only get their share from the ex-post
profit. In case of losses, entrepreneurs
only go unrewarded for their time and
work efforts. The risk of losses will be
completely borne by the banks. Second,
as a partner, the Islamic banks will
extend their full support morally and
financially and make sure that the
targeted profit figure is attainable. As for
the conventional banks, due to the pre-
determined interest factor, they have less
concern in their customer's business. To
them, the borrower must make
repayment as stipulated in the loan
agreement regardless of the position of
the business.
Another important function of Islamic
banks in relation to entrepreneurs is to
act as entrepreneurial moulders. The
Islamic banks are in a good position to
mould their partner toward a religious
and ethical entrepreneur and this can
effectively be done in two ways. First, as
an investor, the Islamic banks are guided
by Sharia and funds can only be invested
in productive and permissible
investments. The Holy Quran declares
the following forms of investment as
unlawful:
1. Trades that promote obscenity
2. Prostitution and adultery
3. Manufacture, sale and transportation
of liquor
4. Making and sale of idols and
services rendered in or to pagan places of
worship
5. Fortune-telling and drawing lots
6. Business that involves usury.
Second, as a trader, Islam has prescribed
some principles concerning trade and
commerce to be followed by its
followers. At any time, transactions must
be conducted with the principle of
honesty, and in a faithful and beneficial
manner. Tirmidzi, reported that the
Prophet (peace be upon him) mentioned
that " The truthful, honest merchant is
with the Prophet and the truthful
martyrs" (Mannan 1986). The Holy
Quran also outlines some of the unlawful
conducts. The following conducts are
prohibited by the Holy Quran:
1. Bribery and misappropriation
2. Embezzlement of public or private
wealth
3. Larceny
4. Unfair use of the property of an
orphan
5. Short weight and measure
6. Gambling
Both Islamic bank's lending policy and
lending principle are excellent tools for
creating and developing entrepreneurs.
Entrepreneurs who wish to seek financial
assistance from Islamic banks need not
worry about the rate of return or the cut-
off level in determining the viability of
any project. Theoretically, Islamic banks,
subject to the availability of funds, will
participate in the venture as long as the
project is profitable. Conventional banks,
however, will not give loans to
entrepreneurs if the profit level is below
the interest rate level. Therefore, in this
case the interest rate will impede the full
exploitation of resources, and
consequently, the avenues of
employment will be smaller thus
distorting the overall economic growth.
Concluding Remarks
Small entrepreneurs, in most cases are
dependent on banks for both short and
long-term financing. Conventional banks,
however, rather than focusing their
efforts towards helping small
entrepreneurs in overcoming their capital
problems, tend to emphasise the
importance of establishing and
maintaining relationships with corporate
customers. This is because corporate
customers are generally customers who
bring more income to the bank and carry
less risk (Turnbull and Gibbs, 1987). On
the contrary, there is no discrimination
among customers from the Islamic banks'
point of view. Islamic banks, therefore,
provide a reliable avenue for the
entrepreneurs in getting initial or
additional capital.
Theoretically, the Islamic banking
system will become an efficient model in
mobilising and allocating resources in the
economy. The elimination of interest and
the profit-sharing concepts are factors
that will benefit both depositors and
entrepreneurs. Entrepreneurs, especially
by associating themselves with Islamic
banks will become more ethical in
conducting their businesses. Funds will
be used properly and the sense of
selfishness is reduced considerably. In
practice, however, there are a few
fundamental issues that need to be
addressed by the Islamic banks. Issues
such as the percentage of profit, priorities
in making investment decisions, the
types and nature of intervention (in
partnered business), and the investment
criteria remain unsolved.
 
Finally, the ability of the Islamic banking
system as an alternative to the
conventional system is beyond question.
Pakistan and Iran for example, for more
than a decade have implemented total
Sharia principles in their economies and
there is no sign that the new system is
causing problems financially or
economically. In other Muslim countries,
however, the contributions of Islamic
banks towards economic and
entrepreneurial development varies from
country to country. Whether Islamic
banks are able to compete with the
conventional banks is an interesting
phenomenon to observe thus providing
an interesting area for future research.
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