Interest Benchmarking in Islamic Banking

Introduction

This article presents first of all the basics about Islamic banking and finance. The Islamic concept of banking and sources from where it is originated is explained. Describes system of Islamic finance in contrast to conventional banking system and how religious needs of Muslims affect their choice of banking system. Islamic banking structure paramount the real sector and help in societal development. In addition Riba, Gharar and Maysir are described in the reference of Quran and Sunnah. Unlawful contracts according to majority and Hanafi jurists are explained separately. Short comparison of Waad (unilateral promise) and Aqd (bi-lateral contract) are also given. Then main focus of the article is on benchmarking and using interest as benchmark in Islamic transactions. Describes the practice of interest benchmarking in Islamic banking i.e. where and how it is implemented, for instance we take two transactions Murabahah (cost plus profit sale) and Ijarah (to give an asset on lease). And conflicts rose due to the interest benchmarking are also discussed, how jurists gave objections for this issue and create an argument that how scholars defend against these objections. Finally we concluded that whether Islamic banking is interest free or not even after the usage of interest as benchmark.

Advance Research Methods

Page 1

Interest Benchmarking in Islamic Banking

1. Islamic banking and financial system:

Islamic system of finance has a rapid growth in Islamic and non-Islamic countries since 1970s, the era of its officially launching (Dudley, 2001)1. The Islam is not limited only to the mosques but is the proper guideline for the humanity. Islam guides human in all aspects of life, so it is impossible that Islam leave the humanity alone in the race of financial culture. The system of Islamic banking is governed by the set of rules determined by the Islamic shariah.

1.1.

Origin and source of Islamic banking and finance

In last century Islamic banking became a prominent part in society otherwise the Islamic concept for financial systems existed since the birth of Islam (De Jounge 1996)2. The origin of Islamic financial system is the QURAN and SUNNAH of HAZRAT MUHAMMAD (SAWW). As written in holly QURAN, (Surah BAKARAH verse 278) O you who believe! Be afraid of Allah and give up what remains (due to you) from Riba (usury) (from now onward), if you are (really) believers. Quran and Sunnah are considered to be the primary source of Islamic concept of finance and banking. The secondary source consists of: Ijmah: Collective decision of several jurists. Ijtehad: Independent opinion or reasoning qualified Ullamah (jurists). Qiyas: Comparing the issues not directly covered in shariah with the parallel issues shariah has provided.

Advance Research Methods

Page 2

Interest Benchmarking in Islamic Banking

1.2.

Principles of Islamic finance as opposed to conventional finance

The religious factors, forcing the Muslims towards Islamic banking and finance, are the inbetween line of Islamic and the conventional banking methodologies. The Islamic banking system in the era of conventional banking seems to be important when study shows that conventional system is practicing operations which are purely prohibited in the Islamic shariah. The major of those practices are:

Riba (Interest): The excess of anything due to the delay in payments, like interest on the loans
or debt payments taken frequently in the conventional practices.

Gharar (Uncertainty): Any element attached with the contract whose presence creates any sort
of uncertainty, like maysir gambling (playing chances) and derivatives (the future dated contracts based on an event to be fulfilled).

Money as Commodity: Money cant be used as commodity in Islamic banking while it is

treated as commodity in the conventional system. (Ahmed and Shabir, SBP)3

PLS(Profit Loss Sharing): In Islamic concept of finance the loss is being shared to all the
parties in the case of any loss to the organization , but conventional system pays the interest even in situations of bearing loss. (Mabid and Munawar)4. Beside all these studies some researchers claims, that the real practice of the Islamic banking going on now a days are not much different from the conventional system (Chong and liu, 2007)5.

Advance Research Methods

Page 3

Interest Benchmarking in Islamic Banking

1.3. How real sector-equity based economy is paramount in Islamic finance

Financing backed by the assts are considered to be the most important practice in the Islamic mode of financing. (Usmani, 1998)7. The prohibition of interest in the Islamic finance prohibits the loan system and forces that the business activities must be backed by the real equity. (Zarqa, 2009)6.

The transactions of Islamic banking are based on the real or tangible assets. (Ahmed and Shabir, SBP)3 Equity based economy influence the stability of the economy in the positive way and the interest based economy takes the economy to the stages of instability. (Zarqa, 2009)6. The Islamic bank uses depositors funds in the tangible asset generating business and helping in the development of societys real assets, because these tools are not used for money to money transaction they are baked by some real sales, purchases, business or investment in the real sector.

Advance Research Methods

Page 4

Interest Benchmarking in Islamic Banking

2. Concepts of Riba, Gharar and Maysir:

2.1. Meaning of Riba:
Literal meaning of riba is to the increase, expansion, addition or growth. (Chapra, 1985)9. In Islam the term Riba is used for the unequal exchange of the things, commodity or money (Inayat, 1993)8.

2.1.1. Riba in the Quran:

There are several places in Holy Quran where ALLAH had described clearly, the place of riba in Islam. Several times ALLAH had given the warnings to the wrong doers and some time clearly sentenced the punishments for them. The few of the references from Quran are as follows:

(Surah Al-Bakarah: 278-279) O you who believe! Fear Allah, and give up what remains of your demand for usury, if you are Indeed believers. If you do not, take notice of war from Allah and His Messenger: but if you turn back, ye shall have your capital sums; Deal not unjustly, and ye shall not be dealt with unjustly.
(Surah Al-e-Imran: 130) O you who believe! Devour not usury (riba), doubled and multiplied; but fear Allah; that you may prosper. (Surah An-Nisa: 161) That they took usury, though they were forbidden; and that they devoured men's substance wrongfully; We have prepared a grievous punishment for those among them who reject Faith.

2.1.2. Types of Riba: (Ayub, 2002)17.

Most commonly riba is divided into two parts:

Riba-al-Fadal: Transecting the high quality goods to the low quality of goods of the same
nature, like rice in the exchange of rice etc.

Riba-al-Nasiah: Irrational and exploited structure of loaning charging excess amount from the
principle amount, like a common practice in the conventional banking.

Advance Research Methods

Page 5

Interest Benchmarking in Islamic Banking

2.2. Gharar:
Prophet Muhammad SAWW describes gharar as Selling fruit before it has begun to ripen is an uncertain transaction.(Malik, Book 31, Hadith 31.8.12) Gharar means the uncertainty or risk and in Islamic contracts Gharar is not permitted For
example the contract of a fish which is not yet caught, this type of sale is prohibited in Islam (Chong Beng Soon, Liu Ming-Hua 2007)5. The ambiguous elements attached with the main information of a contract like price, partys obligations, properties of a subject matter etc is known as Gharar. (Ayub, 2002)17.

2.3. Maysir:
The meaning of the Maysir is Gambling (a chanced game) and it is the prohibited in Islam and its elements cannot be including in the Shariah contracts. (Kwan Kin Sum, Tan Ai Chin, p .1)10. Ideal Islamic economy is created when it is free from the Maysir. For the Islamic moral economy the Maysir is eliminate from the foundational basis. In modern Islamic system the Maysir is replaced by true profit and loss sharing models. (Shafiel, A.Karim, 2010) 13.

Advance Research Methods

Page 6

Interest Benchmarking in Islamic Banking

3. Identification of Unlawful Contracts (Hurriyah, 2008)11:

Here we describe the unlawful contracts. In Islam there are the different opinions of the majority jurists and the Hanafi jurists. From the majority point of view the contract may be valid or invalid Valid: The contact in which all the elements of the contract are fulfilled. Invalid: The contract in which one of the necessary element of contract is missing Basic elements of contract are:. y y y Mutual consent of the parties. The position of parties to obligate the contract. Finally the subject matter of transaction must be, existing at the time of the contract, deliverable and hallal according to shariah

While the Hanafis point of view the contract may be Sahih, Bathil and fasid. Sahih (valid): The basics and properties of a contract according to shariah. Bathil (void): Contract breaching one or more of the basics of contract in shariah. Fasid (irregular): The basics are according to shariah but the nested obligations are not. .

4. Concept of Waad vs. Aqd

Waad had a literal meaning of Promise. It means a unilateral willingness of someone on a certain subject matter. While Aqd had a literal meaning of Contract, where there is a bilateral consensus of two or more than two individuals or groups. (Razali, 2008)12.

Advance Research Methods

Page 7

Interest Benchmarking in Islamic Banking

5. Benchmarking:
Evaluating the processes, services and working of organizations continuously under the comparison of best practices carried out in the world (Spendolini, 1992)14. In general view the benchmarking is to make a slandered for reducing the uncertainty and for the ease of defining a path.

5.1. Practice of Benchmarking in Islamic banking:

Islamic banking is developed in last 3 decades they are facing a great competition from the conventional banking system. So where the conventional banks are providing the interest rates according to the Interest rates published by the central banks of the relative country, to compete to these banks Islamic banks also take interest as a benchmark. (M. EhsaanUllah, 2010)15. The purpose of interest benchmarking is to satisfy the customer in the age of competition. The Islamic banks use interest as a benchmark in certain mode of Islamic financing for instance we take these two transactions of Islamic system Murabaha (cost plus profit sale) and Ijarah (to give an asset on rent).

5.1.1. Usage in Murabahah

Murabaha is the sale where the seller tells the cost of acquiring the subject matter and the profit is then adjusted on the consensus of both the parties (seller and buyer). When there is the matter of adjusting the profit ratio, they may decide the profit of the seller according to the prevailing interest rate on the consensus of both parties. (Usmani, 1998)7.

5.1.2. Usage in Ijarah

Ijarah is the contract of hiring a person on wage basis in general, and also for the contract of leasing. The later is used by Islamic mode of financing to rent out an asset i.e. to transfer the using rights of any asset to someone in exchange of money in the form of rent. (Usmani, 1998) 6.
Whenever the Ijarah contract is for the long term period then to receive a constant amount of rent even the inflation is going on for the whole term of lease is un ethical and not justice, so often the practice is used that after a certain time from the commencement of contract the rate of interest will be increased by a certain percentage and for that, often interest rate is benchmarked.

Advance Research Methods

Page 8

Interest Benchmarking in Islamic Banking

5.2. Jurists objections and counter arguments:

5.2.1. Using of prohibited element as a benchmark.
As discussed above in the beginning that riba is purely not allowed in Islam or in any sort of financing in the light of Islam, many jurists take it as a base that, Riba itself is prohibited in Islam so combining Islamic transactions with it makes the whole practice dirty. (Usmani, 1998)7.

Counter argument:
Jurists over come to this objection in a way that interest is not directly involved in the transaction but is only being used as a benchmark (Usmani, 1998) 7.
In conventional system the lessee is responsible for any risk attached to the leased asset while the Islamic finance states that the leaser will remain the responsible person for any loss or risk attached to the leased asset. In this way the Islamic system works on the risk sharing mechanism and just the profit ratio equal to the interest rate does not changes the permissible subject matter to prohibited one.(Ashraf Usmani, 2002)16.

one person Mr. A carried out the business of Alcohol and charged 10% over its cost on single bottle. His neighbor Mr. B started the business of Filter Water he benchmarked Mr. As rate of profit to be charged for his product. Due to this benchmarking his Filtered water cant be narrated as prohibited in shariah.

5.2.2. Interest rate creates an uncertainty

Secondly many jurists gave the objection that the interest rate is not constant i.e. having a frequent changes which are out of control and offered a great risk to, lesser when minimized to an unexpected rate and vice versa. (Usmani, 1998) 7.

Counter arguments:
The jurists defend against this argument in a way that, we can apply the ceiling to the rates of interest, so that no un-structural ups and downs of rates can effect transaction i.e. the rates of interest fluctuation will affect the contract within the limits like up to 10% increase or decrease.
(Usmani, 1998) 7.

Advance Research Methods

Page 9

Interest Benchmarking in Islamic Banking

6. Conclusion
We concluded under the opinions of scholar arguments that there is no harm to use interest as benchmark in Islamic banking, as interest is not used directly, but only for the benchmarking. Gharar attached with the usage of interest can also be eliminated by using the limiters for interest ups and downs of rate. But the Islamic community must find the way out of it as the Islamic banks in this era are in standalone position they have to create their own position as strong, so that they can create their own benchmark and compete with the conventional banking sector.

Advance Research Methods

Page 10

Interest Benchmarking in Islamic Banking

References:
1. Dudley, N. (2001). Islamic Banks, tap A Rich New Business. 2. De Jounge, A. (1996). Islamic Law and the Finance of International Trade. Melbourne:

Monash University. 3. Ahmed, Imran and Shabir, Ghulam, N.D., FAQs, Islamic Banking Department, State Bank of Pakistan. 4. Mabid Ali Al-Jarhi and Munawar Iqbal, N.D., AIMS-UK Islamic Banking & Finance
5. Chong, Beng-Soon and Liu, Ming-Hua, 2007, Islamic Banking: Interest-Free or Interest6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17.

Based. Zarqa, M. Anas, global financial crises, 2009, p.228 Usmani, Mufti M. Taqi.1998 Introduction to the Islamic Finance. Inayat, Nadeem, 1993, theory and practice of Islamic banking in Pakistan, Chapra, M.umer, 1985, Towards a just monetary system the Islamic foundation. Kin sum Kwan and Ai chin tan, N.D., top ten things to know about Islamic finance. El Islamy, Dr. Hurriyah, 2008, Business on the Interest; Islamic perspective and its comparison with common law & the law as applicable in Malaysia. Dr. Razali, Citi Salwani, 2008, The concept of waad in Islamic financial contract. Shafiel, A. Karim, 2010, The Islamic Moral Economy, Brown Walker press, Boca Raton, Florida, USA. Spendolini, J.M., 1992, The Benchmarking Book, American management association, New York. M. EhsaanUllah, 2010, Personal Interview, Financial Analyst & Personal Financial Advisor, Lecturer of Economics & Finance, Ashraf Usmani, Dr. M. Imran, 2002. Meezan banks guide to Islamic banking. Ayub, M. , 2002, Islamic banking and finance theory and practice. SBP.

Advance Research Methods

Page 11