WHAT IS PARTICIPATORYBANKING?

Concept, Instruments and Issues

AUSAF AHMAD

International Conference on Participatory BankingNew Delhi

Sept 01, 2007

In the name of Allah, the most Beneficent, the Most Merciful.

This presentation includes:

• What is Participatory banking?• Basic function: Financial

Intermediation • An Introduction to Participatory

financing techniques.• Observations on some common

misconceptions.

Clarification on Nomenclature• Participatory Banking is known by

several names:• Interest free banking (Iran)• PLS Banking (Pakistan)• Islamic Banking (Gulf)• Special Finance Houses (Turkey)• All expressions are used

interchangeably.

COMMON PARAMETERS BETWEEN PARTICIPATORY AND COMMERCIAL BANKS

• Same purpose: Financial intermediation.

• Same Objective: Profit• Successful Operation of

Participatory banks has shown that financial intermediation is possible even without interest.

FINANCIAL INTERMEDIATION

SURPLUS HOUSEHOLDS

DEFICIT HOUSEHOLDS[Firms}

FINANCIAL INTERMEDIATION

FINANCIAL INTERMEDIARIES

Financial Flow

Financial Flow

THE FIRM

FINANCIAL MARKET

FINANCIALINTERMEDIARIES

INDIVIDUALS

DIRECT FINANCING

HouseholdsBusinesses

Flow of Real goods

Financial Flow

Indirect Financing

Business

Financial Institutions

Households

Financial Resources

Financial Resources

Return on Investment

Return on Investment

STRUCTURE OF FINANCIAL MARKETS

Supervisory Bodies

Direct Finance Indirect Finance

Bonds Equities

PrimaryMarkets

SecondaryMarkets

InvestmentBanks

Dealers andBrokers

StockExchanges

Over-the-CounterExchange

DepositoryInstitutions

ContractualSavings

Institutions

InvestmentIntermediaries

CommercialBanks

Saving & LoanAssociations

Cooperatives

InsuranceCompanies

Mutual Funds

PensionFunds

FinanceCompanies

Social and Moral Norms

• Gharar Should not indulge in Riba

• Should not involve in • Should not indulge in

fraudulent behavior• Should not coerce• Should assure

fairness to all parties.

• No coercion.

• No financing of socially undesirable goods such as alcohol, drugs, pornography.

• Should not resort to morally reprehensible practices such as cheating, bribing, fraudulent practices.

The View on Bank Interest

• No distinction is made between usury and interest.• No distinction is made between consumption loans

and productive loans.• No distinction between constant and variable

interest rates.• No distinction is made between individual and

institutional rate of interest.

AVOIDANCE OF GHARAR

• Definition of Gharar• Uncertainty / Ambiguity• Ambiguity of Quantity [Gharar fil

Miqdar]• Ambiguity of Attributes [Gharar fis

sifah] such as• Ambiguity in time or place of delivery• Ambiguity in price etc.

DEBT FINANCE Vs.

PARTICIPATORY FINANCE • Participatory finance, in

comparison, to debt finance is:• More just• More equitable• More efficient• More growth oriented.

PRESENT SCENE

• Participatory Banks in the Government Sector• Pakistan, Sudan, Iran

• Participatory Banks in the Mixed Sector• - Malaysia

• Participatory Banks in the Private Sector• Gulf

• Non Banking Financial Institutions• Al Ameen [ Bangalore, India]

• Participatory Financing by standard Commercial Banks in the Domestic Sector• Saudi British, NCB, Saudi American, Misr Bank• Participatory financing by Commercial banks in the foreign sector.

• Islamic Banks established by multinational BanksCitibank, HSBC Amanah Bank,

A TYPICAL BALANCE SHEET

Sources of Funds

Current AccountSaving AccountsInvestment AccSpecial Invest. Acc

Uses of Funds

MurabahaMusharakahMudarabahIjarahQard Hasan

Business Practices in Sources of Funds

• Current Accounts• Saving Accounts• Investment Accounts

• General Investment accounts• Limited Period Investment accounts• Specified Investment accounts

Current Deposits [sources of funds]• Very Similar to standard commercial banks• No return paid back to depositors• Checking facilities• Are Current deposits a loan to the bank from

depositors ? • Are Current deposits a trust by depositors to

banks ?

• Use of Current deposits by the banks on their

own risk.

Saving Deposits[Sources of Funds]

• Saving deposits without authorization to invest

• Saving deposits with authorization to invest• Return to depositors who provide authorization

to invest.• Saving deposits as a part of trust accounts.• Saving deposit as Notice account

Investment Deposits[Sources of Funds]

• Islamic Banking counterpart of Fixed Deposits.• Withdrawal allowed only in special cases• Investment deposits as Mudarabah Accounts.• Depositor: Rabbal Mal; Bank: Aamil• Share profit on agreed basis, bear full loss. • Investment pool• Distribution of profits on pro rata basis.

Special Investment Deposits [Sources of Funds]

• Concept of Wakalah• The bank acts as a wakeel. Implement\s the

instruction of the Mawakkil.• Special purpose investment, Specify, purpose,

sector, industry, or even project.• The bank gets a fee for the services rendered. • Full profit or loss goes to the depositor. The

bank will share in loss only in case of proven neglect.

USES OF FUNDS

• MUDARABAH• MUSHARAKAH• MURABAHAH• IJARAH (Leasing)• IJARAH WA IQTINA (Lease Purchase)• MUSHARAKAH MUTANAQISAH• LOAN ON SERVICE CHARGE• INTEREST FREE LOANS.

TYPES OF CONTRCTS

Contracts

Muawadat Contracts against Payment

Musharakat Contracts of Partnerships

TabarruatContracts of Charity

TYPES OF CONTRCTS

• Contracts of Sale / Lease are Muawadat. Gharar is not allowed in such contracts.

• Mudarabah and Musharakah are contracts of Partnerships. Some amount of gharar may be tolerated in such contracts.

• Sadaqat and Hadaya are Tabarruat. No objection to Gharar in these type of contracts.

Financing Techniques

• These techniques were devised in the classical period for the commodity trade

• Their application to financial sector is an innovation of the modern era.

• The application of these techniques requires new documentation which was not required in the early period.

MURABAHAH [USES OF FUNDS] - I• The word MURABAHA is derived from the word

Ribh, meaning profit in Arabic.• Sale with a profit.• Cost-plus financing. • Examples of Murabahah.• Two contracts: A contact of intent to conduct a

Murabaha Sale and another contact to buy the good ordered in previous contract.

• Promise is not a legal binding. It introduces an element of risk in the transaction.

• The element of risk justifies the profit in Murabaha sale : Fiqhi principle : Al Kharaj bi Daman.

MURABAHAH [USES OF FUNDS] - II• Applications of Muraqbaha:

• In domestic trade• In foreign trade• In financing consumer durables• In financing real estaes

• ABUSES OF MURABAHA• MURABAH AND BAY EINA.

MURABAHAH [USES OF FUNDS] - II• Applications of Muraqbaha:

• In domestic trade• In foreign trade• In financing consumer durables• In financing real estaes

• ABUSES OF MURABAHA• MURABAH AND BAY EINA.

MUSHARAKAH [USESOF FUNDS] • Musharakah is from the word Sharikah.• More than one partners: Partnership in capital

proportion and project supervision.• A partner may waive his right of supervision or delegate

it to another partner.• Arrangements: Sharing of Profit and loss in accordance

with capital proportion agreed proportion.• Variant: Share of profit in agreed proportion, share of

loss in capital proportion.• Applications of Musharakah: • i. in Import trade• Ii. In Agriculture

MUDARABAH [USES OF FUNDS]• Mudarabah existing from pre-Islamic times.• Permitted on the Cannon of Necessicity.• Profit and loss sharing is a wrong translation.• Arrangement: Profit is shared on an agreed

basis, loss is borne by the Rabbal Mal.• Bank: Rabbal Mal, Entrepreneur : Aamil• Double tier Mudarabah. • Requirements for a successful Mudarabah

Other Financing Techniques• Loans on Service Charge• Qard Hasan [interest free loans]• Service Charge is to be equal to actual

administrative expenditure• Qard Hasan is limited to social purposes

only.

IJARAH [USES OF FUNDS]

• Ijarah is emerging as a popular technique of financing amongst the Islamic banks

• Elements of a lease contact: Lessor, Lessee, instrument and period of lease,

• The asset remains in the ownership of the lessor. Maintenance is the responsibility of the owner.

• Ijarah muntahi bit tamlik

Other Financing Techniques

• Diminishing Musharakah• Loan of Service Charges. Only

administrative expenses can be charged.

• Interest free loans are provided as a social service

Latest Trends in Participatory Financial Markets

• Derivatives and secondary market• Evolution of Financial Instruments

and Financial Papers• Securitization• Musharakah bonds• Ijarah bonds

SOME MISCONCEPTIONS

• PARTICIPATORY BANKING IS RELIGION BASED.

• PARTICIPATORY BANKING IS FOR A SPECIFIC COMMUNITY

• PARICIPATORY BANKING REPLOACES INTEREST RATE WITH PROFIT AND THAT IS ALL.