Misconceptions about Islamic modes of financing

Most-talked-about issue in the global financial arena is the emergence of Islamic banking. Global Islamic banking assets attained a compounded annual growth rate (CAGR) of around 17% over the last five years which is much higher than their conventional counterparts. Assets base of more than 500 Islamic financial institutions around the globe amounted to two trillion US dollars which has been projected to 5 trillion US dollars in the next five years. In Bangladesh, Islamic banking contributes around one-fourth of the total banking system. Despite having commendable growth, Islamic Banking concept is yet to be familiar and still many misconceptions prevail among the banking community as well mass people.    
It has been alleged that Shari'ah based investments in Islamic banks are very insignificant on the ground that Islamic banks have very little contribution in investments under 'Mudaraba' and 'Musharaka' mode. While other modes of financing ('Bai-Murabaha', 'Bai-Muajjal', 'Bai-Salam', 'Ijara', 'HPSM' etc.) are also equally permitted by Shari'ah, misconceptions still prevail due to lack of understating of different modes of financing. In this article an attempt has been made to clarify the issue and to remove the misconceptions.
First of all, it is to make clear that opting for an investment mode in an Islamic bank is a matter of choice between the bank and the client as long as the mode of investment is supported/permitted by Shari'ah principles and regulatory guidelines and directives in the jurisdiction. Shari'ah does not give any optimum mix among different modes of investment nor does it mean that investment other than 'Mudaraba' and 'Musharaka' do not qualify for Shari'ah principle.  
The underlining principle of conventional banking system is interest ('riba-al-nasia' in Arabic) which is derived from the core principle of finance, the 'time value of money'. The basic assumption of 'time value of money' is that every transaction is measured by time; and money itself is used as commodity. However, Islamic Shari'ah does not permit to take or give additional amount of money or goods in exchange for time as it considers money merely as a 'medium of exchange'. So if somebody wants to establish that an Islami banking product is not supported by Shari'ah, he/she will primarily have to prove that there is an interest element on it. For better understanding, the modes of financing of Islamic banks need to be described.   
Islamic banks deploy their funds under different modes of financing as permitted by Shari'ah which mainly include Trade Mechanism (Bai in Arabic), Partnership Mechanism (Shirkat in Arabic), and Leasing Mechanism (Ijara in Arabic). Majority of investments of Islamic banks, not only in Bangladesh but also around the globe, are made under Bai/trade mechanism which can mainly be taken place in three ways:
Bai-Murabaha: Bai-Murabaha means sale on agreed upon profit where the bank sells certain specific goods permissible under Islamic Shari'ah and law of the land to the buyer/client at a price determined by charging agreed profit or mark up over cost price. In this case, the buyer/client either makes cash payment or is allowed to make payments by instalments/lump sum on a fixed future date. Unlike conventional mode of financing, under Bai-Murabaha mode of investment, there is no scope to increase the price once it is fixed. As the bank, being the buyer of the good/commodity for selling the same to the clients, takes the title of the goods, it has to bear all risks until the goods are actually delivered to the clients. Since the mode of financing is made completely under trade mechanism which has clearly been permitted in the Holy Quaran ["Allah hath permitted trade and forbidden usury/interest" (Sura Bakara: Aya: 275)], the question of Shari'ah non-compliance does not arise at all.
Bai-Muajjal: Bai-Muajjal means 'deferred payment sale' or 'sale on credit' where the bank agrees to sell certain specific goods, as per order and specification of the client, at an agreed price payable at a certain fixed future date in lump sum or within a fixed period by fixed instalments. In this mode also, money is first converted into goods and goods are sold to the clients although it is not obligatory to disclose the cost price and mark up separately to the client. Thus, this mode does not have any interest element and qualifies for the Shari'ah principles.  
Bai-Salam: Salam means advance purchase. It is a mode of business under which the buyer pays the price of goods in advance on the condition that the goods would be supplied/delivered at a particular future date. The seller supplies the goods within fixed time.
It may be mentioned that around 55% to 60% investments of Islamic banks in Bangladesh as well as other prominent Islamic banks around the globe are made under trade/Bai mechanism. It has been reported that slight over 60% investments of Islamic banks are made under this mechanism which is in line with local and global Islamic banking practices.   
The two investment modes that are only claimed to be Shari'ah based investments are Mudaraba and Musharaka. These two modes actually fall under partnership/share mechanism. Under Mudaraba mode of financing, the bank (here called Sahib-al-maal) provides fund while client (here called Mudarib) provides his expertise and management support for the enterprise. Any profit accrued is shared between the two parties on pre-agreed ratios while capital loss (without negligence on the part of the client) is fully borne by the bank. On the other hand, under Musharaka mode of financing, both the bank and the client invest capital in a venture and share profit/loss at a pre-agreed ratio. In practice, these modes of investment contribute a very small portion of investment mix. In the present context of Bangladesh, most of the clients do not want to enter into such agreements because in most cases profit under these modes is high; which the clients do not want to share with the bank. Moreover, as the bank takes control over the business of the client, clients are less interested to participate in this sort of agreement in anticipation of disclosure of their 'trade secret'.   
However, Islamic banks in the industry provide considerable amount of finance (around one-fourth) in Hire Purchase under Shirkatal Melk (popularly known as HPSM) which is a derivative product of leasing and a synthesis of three contracts: Shirkat, Ijara and Sale. Under the mechanism, the bank and the client jointly provide capital (on pre-agreed ratio) to buy an asset and determines rent and selling price. The instalment payment includes rent (for the part of the bank) and principal by the client and gradually ownership is transferred from the bank to the client with the ratio of release of principal amount. If we analyze the inherent features of this mode of finance, we will see that this mode represents partnership and almost akin to 'Diminishing Musharaka' provided in different Islamic banks in some neighbouring countries.  
Islamic banks, being scheduled commercial banks, are being operated under the regulations and guidelines of Bangladesh Bank (BB). Banking Regulation and Policy Department of BB has given the detailed guidelines for Islamic banking. In section-V of the said guidelines, Bangladesh Bank has clearly articulated the investment principles and investment products which include Mudaraba, Musharaka, Bai-Murabaha, Bai-Muajjal, Salam and Parallel Salam, Istisna and Parallel Istisna, Ijara, Hire Purchase, Hire Purchase Musharaka Mutanaqasa (HPMM) etc. In addition all the said modes of financing are explained by Islamic Development Bank (IDB) as well as Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). Thus, it is misleading to conclude that only 'Mudaraba' and 'Musharaka' modes qualify for Shari'ah based investment.
It is also claimed that Islami banks deduct loss from the principal amount of depositors and the bank does not bear any loss on its part. This is also not true. Unlike conventional banking system, Mudaraba depositors (Sahib-al-maal in Arabic) keep their fund in the bank (Mudarib in Arabic term) in the form deposits and earn share of profit along with the principal. The investment income, which is earned through deployment of the fund of Mudaraba depositors, is distributed at a pre-agreed ratio between them and the bank (Say 65:35 ratio). While calculating investable Mudaraba deposits, a certain percentage is deducted (as Cash Reserve Requirement) as per the provision of the Banking Companies Act 1991. Total investable fund of the bank consists of equity, Mudaraba deposits and other deposits and fund. Mudaraba deposits get priority over other funds at the time of investment. Since gross investment income (before charging any operating expense, provision for investment and taxes) is distributed between the Mudaraba depositors and the bank at the pre-agreed ratio, usually there is no room for loss to the Mudaraba depositors on an aggregate level.
Islamic banking and finance is rapidly growing not only in Bangladesh but also around the globe. This is not because of religious emotion but because of its superiority in terms of 'mechanism and 'makasad' (objective). Islamic banking system has been proved to be resilient during the global financial crisis due to its non-involvement in the toxic assets in the banking system and adherence to real assets in lending which is directly linked with economic development and prosperity of the country. By its inherent nature and objectives, Islamic banking system focuses on ethical aspects of financing. Rapid growth of Islamic banking even in many non-Muslim countries in an environment of overwhelmingly dominated conventional finance reveals the superiority and wide acceptability of Islamic banking.

The author is an Assistant Vice President at Islami Bank Bangladesh Ltd. The views expressed in the article are the author's own and not necessarily the organization he represents. The author may be contacted at [email protected]