Principles and Practice of Islamic Finance Systems

Dr. Julius B. Bertillo

Adjunct Professor, College of Business Administration Arab Open University Bahrain Branch Email: jbbertillo@yahoo.com.ph

Dr. Josefina B. Salando, CPA

Managing Partner, Salando & Associates (CPAs & Underwriters) Lecturer, Department of Administrative & Financial Sciences Oman College of Management and Technology Email: johsalando27@yahoo.com

ABSTRACT This paper aims to highlight the Islamic finance systems in the Arab world. Specifically, it answered the following: a) principles and prohibitions, b) traditions and practices; and c) global challenges and opportunities. The Islamic Finance was embraced by the Muslims in the Arab world for the purpose of lending money to others for their start-up capital or for other personal needs. The general concept of Islamic Finance it is based on Sharia Law prohibits imputing a fixed rate of interest; acceptance of fees or charges on loans is called Riba or usury. The practice of usury or charging of interest on loans is contrary to the Islamic principles of the Muslims called haraam or forbidden. This ideology was adopted by the Islamic banking, financial institutions, and non-profit organizations within the Muslim community. It is an Islam dogma forbidding lending out money with an interest rate. The Islamic rules on transactions are provided for in the Fiqh al-Muamalat. Monies lent out earn benefits through profit and loss sharing of Islamic financing which is commonly called as Mudharabah in Arabic. Wadiah is the Islamic term for safekeeping. Musharakah is a joint venture of any particular business in the Arab countries. Murabahah refers to cost plus contract, and ljar for finance lease. The financial systems in the Arab countries operate under the provisions of the Shariah Law. Therefore, Shariah Law in the legal point of view is more focused on the banking industry micro financing, entrepreneurship, politics, economics, as well as religions as the bottom line of this Islamic law, and considers the guiding principle of the Muslims in the real life situation (Silva, 2006). Hence, this article is based on qualitativequantitative research approach of investigation.

Keywords: Islamic Financial Systems, Islamic Finance, Shariah Law, Islam

2 1. Introduction Islamic finance was based on Shariah, which is commonly called Islamic law. The term Shariah for Muslim people, these include religion, law, politics, business, economics and banking guidelines (Silva, 2006).1 The Islamic financial system is usually the set of rules and laws in Shariah. These include the religion, social, economic, political and cultural aspects in the Islamic organizations or societies in the Arab countries. The Shariah comes from the rules written by the Prophet Muhammad in the Qurn (central religious text of Islam) and its practices of the Muslims, an Arabic term is called the Sunnah (Iqbal, 1997).2 However, Ilias (2010) believed that the principles of Islamic finance of Shariah, or Islamic law. He further explained the principles of financial system of Shariah specifically on (a) ban on interest, (b) ban on contractual uncertainty, (c) adherence to risk-sharing and profit-sharing, (d) promotion of ethical investments that enhance society, and lastly, (e) asset-backing (Ilias, 2010). The Islamic finance is popular in the Gulf Cooperation Council (GCC) countries, such as: Kingdom of Bahrain, Kuwait, Sultanate of Oman, Qatar, Kingdom of Saudia Arabia, and United Arab Emirates. The challenges and opportunities were also expanded globally in GCC countries or in the gulf region. With this, scenario, the theory and practice of the Islamic Investments of the European and other countries, they are after of the reform of their tax and legal structures to attract investors more particularly the United States which they also consider a growing market for Islamic finance (Ilias, 2010).3 It is known publicly that Islamic banking will embellish in the Middle East countries as well as the conventional Western banking in our society. The growth of the Islamic banking globally including Australia, the Islamic banking is considered riba-free from the Muslim society in general, they promote equity in the society. The Islamic financial institution performs effectively and operates Islamic and non-Islamic economies globally. This can be verified in the Australian context, this is currently observed in Islamic banking. There were 50 countries adopted the Islamic banking in Western and Muslim countries. The Kingdom of Bahrain, Bangladesh, Brunei, Iran, Malaysia, Pakistan, Saudi Arabia, and Sudan follow the Sharia Islamiiah. According to Mirza and Halabi, (2003)4 determine the Islamic societies on the relationship between religion and banking, finance and insurance practices which he considers proper Islamic financial and business practice. Molyneux and Iqbal (2005) highlighted that the financial systems are bank-based. He explained that the capital markets are somewhat relatively underdeveloped. The banking and financial sector has a major role in the society. This means these countries experienced financial reforms to strengthen their financial systems. The findings revealed that the commercial banks dominate GCC financial and banking systems. In 1990, Gulf banking systems their asset quality, capital adequacy and profitability are relatively favorable (Molyneux, et al., 2005).5 The findings further revealed that Islamic finance in the Arab world is approximately more than two hundred (200) Islamic financial institutions (banks, mutual funds, mortgage companies, insurance companies). He also revealed that the industry growth has an average range from 10% to 15% per year. While, the conventional banks (Citibank and HSBC) have opened Islamic windows; the industry's market share is 10 percent. (Useem, 2002).6

3 In the international platforms, the United States and United Kingdom economic and euro zone sovereign debt crisis, it shows that they are in dire need of reform. A potential Islamic economic financial solution was denounced because of double standard at work: Islamic finance at home, but riba finance at the international level. However, the World Bank recognized Islamic finance and it is a priority area for its financial sector program according to Noor Islamic Bank Social Media (2011).7 According to Imam and Kpodar (2010)8 of the International Monetary Fund (IMF), the Islamic banking system is a complement to conventional banks, rather than a substitute. These are the five (5) Shariah principles applicable to finance which is absolutely different from the conventional finance. Shayerah Ilias, an expert analyst of the International Trade and Finance (ITF), discussed the five (5) major principles of Shariah, these are the following: (1) Ban on interest (riba).9 This refers to conventional forms of finance that differentiate between acceptable interest and usurious interest such as excessive rates of interest (Ilias, 2010). Literally, the term interest it means usurious and is prohibited in Islamic law. (2) Ban on uncertainty. This refers to uncertainty in contractual terms and conditions are prohibited, unless the terms and conditions on risk factors are clearly understood by both parties in a financial transaction; (3) Risk-sharing and Profit-sharing. This refers to all parties involved in a financial transaction which is shared both the associated risks and profits. This means the earnings of profits or returns from assets are acceptable with the condition that the business risks are shared with the lender and the borrower (Jobst, 2007)10; (4) Ethical investments. This refers to investment in industries which are prohibited by the Qurn, like for instance: alcohol, pornography, gambling, and other pork based products; and (5) Asset-backing. This refers to a financial transaction on tangible, identifiable underlying asset, like, real estate or commodities. In Shariah principle, the money is not considered an asset class because this is not tangible and may not earn a return (NBAR-IFO, 2008). These principles of Shariah mentioned above are very much important to all employees working in Islamic banking, financial institutions, non-profit organizations, business professionals, educators of the Islamic Finance System, students, general public (Muslim community), and future researchers. (Y-Sing and Richter, (2008)11 the standardization of Islamic financial systems across the globe must be continuously and strictly implemented based on Islamic tradition or practices. However, it can be assumed that Shariah can be interpreted in many ways and some Islamic scholars are not completely agreed that constitutes ShariahCompliant Financing (SCF). On the other hand, standardization is very challenging since the maturity of Islamic finance markets varies across the countries in global markets is wellestablished.

4 2. Literature Review This section presents the discussion of the related literature and studies relevant to the present undertaking. It also provides the discussion on the synthesis of the art for clearer understanding of the Islamic Financial Systems in the Arab world. Ali and Syed (2010) investigate on the perceptions of the Islamic finance industry and impacts on the industry which focused on mainstream media. The results of the investigation relative to the Islamic finance industry professionals and Islamic finance media professionals, this further revealed that there are a few related articles on Islamic finance with terrorism, and twelve percent was maintained a negative tone. This further revealed that Islamic finance professionals in this study, there was an increased misconception; however, this led to growth and awareness. On the other hand, the majority of Islamic finance media professionals perceived a negative impact, while seventy percent of them are critical of how the industry handled media attention. Hence, the study revealed that despite some negative media coverage of Islamic finance, the development of the industry was not significantly impacted, and the outlook for future development is overwhelmingly positive.12 Hanif and Iqbal (2010) evaluated the suitability of the existing business environment in Pakistan for application of Sharia based financing. The results of the study revealed that Islamic financial instruments are categorized objectively as Sharia compliant and Sharia based. In this study, Sharia compliant instruments are used by Islamic Financial Institutions (IFIs). The findings also revealed that the share of Sharia based financial instruments is less than three percent as investment portfolios of IFIs works in Pakistan according to finance professionals, Islamic bankers, entrepreneurs and academicians that served as respondents of the study. It could be noted that there are a number of hurdles such as: 1) the dominance of conventional banking, 2) earnings manipulation by firms, 3) higher taxes, 4) weaker auditing, 5) lack of trust and confidence in the abilities of Musharaka partners, 6) riskiness of Musharaka, and 7) inability of conventional financial reporting framework to ensure transparency. However, from the findings suggests that the increased awareness, new product development, capacity building of IFIs, reforms in the financial reporting framework and strengthening the audit institution, may help in the implementation of Musharaka financing.13 Zaki and Sattar (2011) studied the risk mitigation in Islamic finance through policies and regulatory model- a way to long-term stability. It could be noted that the risks in Islamic finance have gained more importance in recent era because of the financial crisis faced by conventional finance. He believed that Islamic finance is turning to be an alternative to the orthodox economic system but, the nature and risks faced by Islamic financial institutions have alarming concerns for Islamic finance and it is functioning. However, the findings revealed that the policies and procedures are highlighted as the variables of the study. These include, a) policies for prudent financing, b) investing and lending activities, c) separation of Shariah advisory board of management for the mitigation of Shariah non-compliance, and d) effective information system, policies for mitigating risks. Hence, this research study, it leads to purported results which provide bases for stability and effective risk mitigation of Islamic banks according to the researchers.14

5 Ismail and Tohirin (2010) presented a paper which describe the link between finance and economic growth in the present of Islamic contracts. The types of contract of partnership, buy-sale contract, to a contract of usufructs; and the nature of Islamic contract is to avoid riba (i.e. interest system). It is unjust and prohibited, under conventional system, they rely on the interest system. The distinctive character of Islamic contracts applied by Islamic banking and finance relies mostly on the profit and loss sharing mechanism which contains the cooperative spirit, in the contracts which is called mudharabah (profit-sharing), musharakah (partnership). On the development of equity partnership instruments in the financial system necessitates a different set of regulation and institutions in order to achieve Islamic goals through economic/financial activities. This further suggests that a new framework for financial institutions is necessary in order to accomplish the maqasid-al-Shariah, by implementing the true spirit of cooperative through various Islamic contracts.15 Mouawad (2009) conducted a case study on the development of Islamic finance in Egypt. He analyzed the political and economic dilemma that Islamic finance (IF) poses on some Muslim Governments of either encouraging or restraining this global phenomenon; in spite of their awareness of the developmental role that IF plays. Egypt, in this concern represents a peculiar example where government's policies have apparently determined the performance of Islamic financial institutions. This further analyzes the policies of the Egyptian Government towards Islamic financial institutions since its inception in 1963 until 2007, with a specific focus on Islamic banks and Islamic companies. The findings revealed that the shares of Islamic finance in the Egyptian economy are modest at local, regional and global levels. Such backward position could be justified in the light of the governmental policies and their manipulation over the legal, economic and religious institutions in a way that restrain the performance of Islamic financial institutions.16 Ahmed (2010) discussed the global financial crisis and the Islamic finance model which is competent of playing down the severity and frequency of financial crises, by introducing the financial system based on sharing in the risk. It links credit expansion to the growth of the real economy by allowing credit primarily for the purchase of real goods and services which the seller owns and possesses, and the buyer wishes to take delivery. It also requires the creditor to bear the risk of default by prohibiting the sale of debt, thereby ensuring that he evaluates the risk more carefully. He further explained that it is important for everyone's future to study the current crisis in order to develop sustainable financial practices and in quest of a new business model based on sharing the profit and loss. Ahmed (2010) mentioned that the divergence approach is used for exploring possibilities and constraints of inherited situations by applying critical thinking and analysis through the published literature in Islamic finance. This is to create new understandings of international finance and using new banking business model towards better design solutions to the current global financial crisis and preventing more collapse in the future. The findings further revealed that a new business model for the banking system based on noninterest-based transactions but profit and loss sharing should be in practice at the financial system. Accordingly, the financial institutions should encourage business and trade activities that generate fair and legitimate profit. Islamic finance, there is always a close link between financial flow and productivity. Hence, this intrinsic property of Islamic finance contributes towards insulating it from the potential risks resulting from excess leverage and speculative financial activities which are part of the root cause of the current financial crisis.17

6 Wilson (2009) conducted a study on the development of Islamic finance in the GCC. He mentioned that the modern Islamic banking originated with the establishment of the Dubai Islamic Bank in 1975. The study evaluates the development of Islamic banking in the GCC since then, an industry which now encompasses Islamic Takaful (insurance) and Shariah-compliant asset management, as well as retail and investment banking. He further explained that an examination is made of the extent to which government policy, through both legislation and regulation, has facilitated the development of Islamic finance. Shariah governance systems are appraised, in particular the workings of the devolved form of self-governance of Islamic financial institutions. In this study, the deposit facilities offered by Islamic banks in the GCC are discussed, as well as the financing provided, notably trade finance, consumer credit and mortgages for real estate, which are the dominant types of funding by Islamic banks. Hence, the issuance and trading of Islamic sukuk securities is also considered, as well as the role of the regions financial centers.18 Hasan (2011) studied the current Shariah governance practices with the purpose of promoting greater understanding of some of the crucial issues and to provide relevant information in guiding the future development of the Shariah governance system. The findings further revealed that the state of Shariah governance practices in Malaysia, GCC countries (Kuwait, Bahrain, United Arab Emirates, Qatar and Saudi Arabia) and the UK by highlighting five main elements of good corporate governance that consist of independence, competency, transparency, disclosure and consistency. However, the availability of secondary data on Shariah governance practices is very limited; a detailed survey questionnaire is generated for sourcing primary data from Islamic Financial Institutions (IFIs). The study utilizes a descriptive analysis approach in extracting and analyzing the data and factual input derived from the questionnaire feedback. The survey findings affirm that there are significant differences and diverse Shariah governance practices in the case countries.19 The above cited related literature and studies, the researcher commend that Shariah law or Islamic law, Shariah Complaint and Shariah based, policies and procedures for risk mitigation, the nature of Islamic contract, Shariah Advisory Board (SAB), and the development of Islamic finance in the GCC must be given due consideration in the Islamic finance system in the Arab world. Ali and Syed (2010) investigate the Islamic finance industry and impacts on the industry on mainstream media. However, Mouawad (2009) studied the development of Islamic finance and analyzed the political and economic dilemma. Wilson (2009) focused on the development of Islamic finance. On the other hand, Ismail and Tohirin (2010) discussed the Islamic laws and Hanif and Iqbal (2010) evaluated the suitability of the existing business environment for application of Sharia based financing. However, Hasan (2011) focused on the current Shariah governance practices for future development of the Shariah governance system. Zaki and Sattar (2011) studied the hedging of risks in Islamic finance because of the financial crisis faced by conventional finance. On the other hand, Ahmed (2010) discussed the global financial crisis and the Islamic finance model by introducing the financial system based on sharing in the risk.

7 3. Methodology The researcher decided to use the descriptor type of research method in the conduct of the study. The descriptive research is used to obtain information concerning the current status of the phenomena to describe "what exists" with respect to variables or conditions in a situation. (Key, 1997).20 The descriptive research tools used by the researcher are the online surveys, interviews with practitioners, observation, and documentary analysis. The researcher would make use of observations from their experiences in teaching from the university in the Kingdom of Bahrain in order to come up with a personal description to answer the research problem. The researcher also utilizes the qualitative approach in order to verify the general concept of Islamic finance systems, Shariah law, and Islamic principles applied in the Arab countries. The qualitative research is a form of systematic empirical inquiry into meaning. Systematic refers to planned, ordered and public, following rules agreed upon by members of the qualitative research community. Empirical means to type of inquiry which is grounded in the world of experience. Inquiry means to understand how others make sense of their experience (Shank, 2002).21 However, Denzin and Lincoln (2000) described that qualitative research involves an interpretive and naturalistic approach.22 In this study, the researcher studied things in their natural settings, attempting to make sense of, or to interpret, phenomena in terms of the meanings people brings to them. Therefore, the researcher makes use of existing literature and studies in order to verify their observations and come up with preliminary ideas regarding the research problem. The present study is an exploratory attempt since it would try to gather information regarding the global challenges and opportunities of the Islamic Finance Systems. The data collected through both primary and secondary sources. The primary sources of data collected through online surveys and interviewing professional practitioners and Islamic bankers. The respondents of the study are the employees of the financial institutions, Islamic banking, nonprofit organizations, and commercial establishments in GCC. The interviews were scheduled as formal and informal both for the exploration of the data, and online survey was conducted to answer the research problem. The secondary data were collected from documentary-based secondary data that refer to information collected from previous similar researchers which have also included primary data and have already been analyzed for their original purpose (Saunders et al., 2003).23 However, the secondary data were gathered from various sources such as: books, periodicals, government sources, regional publications, companies annual report, media and commercial sources. (Zikmund, 2003).24 Hence, the major part of the data consisting of secondary sources, were collected through research journals, internet, magazines, books, and other relevant reading materials. The citation and literature discussion have been the prominent approach of this panoramic study. However, in the lights of the literature discussion there were four major areas of concerned in this study, these are: Islamic finance system, principles and prohibitions, traditions and practices, global challenges and opportunities were aimed as the variables of the study. These variables mentioned were analyzed and interpreted based on the data gathered by the researcher.

8 4. Data Analysis and Discussion 4.1 Islamic Finance Systems. The Islamic financial system is based on equity whereas the conventional banking system is loan based. Islam is not against the earning of money. In fact, Islam prohibits earning of money through unfair trading practices and other activities that are socially harmful in one way or another.25 Those who swallow down usury cannot arise except as one whom Shaitan has prostrated by (his) touch does rise. That is because they say, trading is only like usury; and Allah has allowed trading and forbidden usury. To whomsoever then the admonition has come from his Lord, then he desists, he shall have what has already passed, and his affair is in the hands of Allah; and whoever returns (to it) - these are the inmates of the fire; they shall abide in it [Sura 2:275]. According to Hairetdinov, (1998)26 the practice of riba or usury was so deep-rooted in the society and continuance of the practice was so undesirable, that Allah warned the believers that if they did not desist, they should be prepared for a war against Allah and His Apostle. This warning was heeded by the Muslim Ummah and for more than a thousand years the economies of Muslim states were free from riba. With the ascendancy of Western influence and its suzerainty over Muslim states, the position changed and an interest-based economy became acceptable. Efforts in Muslim countries to revert to an interest-free economy was hampered by many obstacles. 4.2 Islamic Finance Systems in the Arab world. The findings revealed that the highest weighted mean was 4.57 or Strongly Agree on the ethical principles on which Islamic finance may bring banks closer to their clients. This means that the ethical rules in Islamic financial banking institutions must be properly observed by the employees with a true spirit which should mark every financial service. The Vatican's official newspaper 'L'Osservatore Romano, reported that the Islamic banking system may help to overcome the global crisis. The Vatican said banks should look at the ethical rules of Islamic finance to restore confidence amongst their clients at a time of global economic crisis. On the profit share is distributed to clients instead of interest earned had a weighted mean of 4.53 or Strongly Agree. This implies that profit share, gained from sukuk, may be an alternative to the interest. The sukuk system could possibly help the industry sectors and support infrastructure projects through investment. Likewise, onIslam prohibits earning of money through unfair trading practices and other activities that are socially harmful in one way or another had a weighted mean of 4.54 or Strongly Agree. The Muslim knows that Ribaa is emphatically forbidden in Islam. Allaah has condemned the one who does that and has declared war on him, and spoken of his bad end on the Day of Resurrection. Alaah says, that those who eat Ribaa will not stand (on the Day of Resurrection) except like the standing of a person beaten by Shaytaan (Satan) leading him to insanity. They say that Trading is only like Ribaa, whereas Allaah has permitted trading and forbidden Ribaa. So whosoever receives an admonition from his Lord and stops eating Ribaa, shall not be punished for the past; his case is for Allaah (to judge); but whoever returns (to Ribaa), such are the dwellers of the Fire they will abide therein.

9 Allaah will destroy Ribaa and will give increase for Sadaqaat (deeds of charity, alms). And Allaah likes not the disbelievers, sinners [al-Baqarah 2:275, 276] O you who believe! Fear Allaah and give up what remains (due to you) from Ribaa (from now onward) if you are (really) believers. And if you do not do it, then take a notice of war from Allaah and His Messenger but if you repent, you shall have your capital sums. Deal not unjustly (by asking more than your capital sums), and you shall not be dealt with unjustly (by receiving less than your capital sums) [al-Baraqah 2:278, 279] The Islamic financial system does not approve of any transaction that includes riba, rather the Shariah forbids certain transactions so as to prevent the means that lead to riba according to Fataawa al-Lajnah al-Daaimah. Moreover, the findings revealed that the Shariah law (a religious code for living), reflects the gradual establishment of a parallel Islamic financial and legal systems had a weighted mean of 4.53 or strongly agree. This implies that by adopting an Islamic Sharia law would help maintain social unity among Muslims in the Arab world. In 2012, the British government will begin offering Muslim workers Sharia-compliant pensions. The launching of the funds, which are said to be structured around a strict code of ethics and based on the Muslim Koran and Islamic Shariah law (a religious code for living), reflects the gradual establishment of a parallel Islamic financial and legal systems in British public life. The Muslim families in Britain can already acquire Sharia-compliant baby bonds under the British government's Child Trust Fund scheme. In 2008, Britain's Financial Services Authority (FSA) authorized the establishment of the country's first Islamic insurance company as well as the country's first Sharia MasterCard, called the Cordoba Gold MasterCard (Kern, 2011).27 This further revealed that the true Islamic financial system is a system that is free of riba, because it is a system that is derived from the Book of Allah and the Sunnah of His Messenger (peace and blessings of Allaah be upon him) had a weighted mean of 4.51 or Strongly Agree. This means the Prophet (peace and blessings of Allaah be upon him) cursed the one who consumes Ribaa, the one who pays it, the one who writes it down and the two who witness it, and he said, They are all the same. Narrated by Muslim, 1598, from the hadeeth of Jaabir (may Allaah be pleased with him). Likewise, the Prophet (peace and blessings of Allaah be upon him) said: A dirham of riba consumed knowingly by a man is worse before Allaah then committing Zina thirty-six times. Narrated by Ahmad and al-Tabaraani, classed as Saheeh by al-Albaani in Saheeh al-Jaami, no. 3375. Like for example, if a loan is riba-based (as in the case with most banks), meaning that the bank will take interest from him, then it is not permissible for you to act as a guarantor for the borrower, because by doing so you are helping the borrower and the bank to engage in riba (usury, interest), which is forbidden by Allaah and His Messenger, and which the Muslims are unanimously agreed is haraam. Finally, the findings of the study revealed that on Islamic banking system may help to overcome global crisis and Islamic finance systems proven to be the best system in the Islamic state with a weighted mean of 3.52 or agree. On the other hand, the Islamic finance principles of Islamic or Western banks is a solution for worldwide economic crisis with a weighted mean of 3.5 or neutral. This means that the Western banks could use tools such as

10 the Islamic bonds, sukuk as collateral. Sukuk may be used to fund any projects as an alternative solution. On the hand, Islamic sukuk system is similar to bonus of capitalist system which is the lowest weighted mean of 3.5 or neutral. It can be noted that in sukuk, money is invested concrete projects and profit share is distributed to clients instead of interest earned. Pope Benedict XVI in his speech echoed on crashing financial markets saying that "money vanishes, it is nothing" and concluded that "the only solid reality is the word of God." The Osservatore's editor, Giovanni Maria Vian, said that "the great religions have always had a common attention to the human dimension of the economy as reported by Corriere Della Sera. 4.3 Principles and Prohibitions. Islam has its own financial system which has very special characteristics. Islamic finance is the provision of financial services under Islamic law (or Shariah) principles. Shariah literally meaning way" or "path" is the sacred law of Islam. Shariah is derived from two primary Sources of Islamic law, namely the divine revelations set forth in the Qur'an, and the sayings and example set by the Islamic Prophet Muhammad (P.B.U.H) in the Sunnah. Fiqh ("jurisprudence") interprets and extends the application of Sharia. These principles and regulations need to be adhered to make the financial system compatible with Islam. The basic principles of Islamic finance were: 4.3.1 Prohibition of Interest. The prohibition of interest is often considered the centerpiece of the Islamic banking system. The insistence on adherence to this rule is derived both from passages from the Qur'an and teachings of Muhammad. The central Qur'anic passage on which Islamic finance is based reads: Those who devour usury will not stand except as stands one whom Satan by his touch hath driven to madness. That is because they say: "Trade is like usury," but Allah hath 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 offense) are Companions of the Fire: they will abide therein (forever). (Robbins, 2010)28 The Arabic word Riba linguistically means an addition to, or an increase of, a thing over and above its original size or amount. In the Quran, the term Riba signifies an unlawful and forced addition to the payback value of money or goods lent from one person to another. Riba falls under two main categories: Riba A-Nasia, which is interesting on lent money; and Riba AlFadl, which is the exchange of the same commodity but of unequal quality and quantity. Both types of Interest are Haram and unlawful according to Quran and Sunnah. It was revealed in the Quran. Those who consume interest cannot stand [on the Day of Resurrection] except as one stands that is being beaten by Satan into insanity. They say, "Trade is [just] like interest." But Allah has permitted trade and has forbidden interest. So whoever has received an admonition from his Lord and desists may have what is past, and his affair rests with Allah . But whoever returns to [dealing in interest or usury] - those are the companions of the Fire; they will abide eternally therein. The Prophet Muhammad (P.B.U.H) also declared interest or Riba a sinful act. Abdullah Ibn Mas'ud narrated: The Apostle of Allah (P.B.U.H) cursed the one who accepted usury, the one who paid it, the witness to it, and the one who recorded it. (Sunan of AbuDawood, 3327). According to Vernados, 2005),29 a capitalist market economy, the banks are

11 profit-making institutions. They need to maximize their profit by advancing money at a higher rate than the rate at which they obtain from it. However, the borrowing and lending of money take place at a price called the interest rate, which is the pivotal point of all banking activity. This means the practices of the modern commercial banking system are direct conflict with the principles of Islam, which strictly prohibit riba (interest or usury). 4.3.2 Profit and Loss Sharing. Profits sharing principle are based on the Mudarabah principle, the owner of a fund's shares the profits with the working partner but he alone bears all risks of loss. i.e profits will be shared by the owner of capital and the entrepreneur on the basis of contractual agreement whereas losses under normal circumstances would be written in capital (Kalif and Khan, 2009).30 This means that an interest in the profitability of the joint venture on the part of the creditor (the bank). The emphasis is not on payment on demand at set time intervals as with an interest-based system but, rather, on the long-term success of the joint venture. This has considerable implications at the macroeconomic level. First, working capital would theoretically tend to be greater; and the second, an economy with an Islamic banking system is less vulnerable to business cycles. With such an arrangement, the level of risk is spread between the bank and the entrepreneur in accordance with their respective participation (Akacem and Gilliam, 2002).31 Likewise, Vernados (2005) stated that Islamic banking allows prospective clients to borrow money while adhering to Shariah law through a profit-and loss-sharing sharing scheme of financing. Profit-and-loss-sharing (PLS) financing is a form of partnership where partners share profits and losses on the basis of their capital share and effort. Unlike interestbased financing, there is no guaranteed rate of return. 4.3.3 Risk Sharing. Islam is against all types of exploitations including economic exploitations. According to Islamic literature Interest is considered to be an unjust and an exploitative instrument of financing through which lender is assured a secure return without doing any work or sharing in the risk, while the borrower in spite of all his hard work may end up in loss. Under Islamic banking, risk is transferred partly to the lender. This forces the lender to know where the money is spent and how. The bank becomes an active partner whenever it lends money (Akacem and Gilliam, 2002). However, according to Iqbal (1997), risk sharing is an interest is prohibited, suppliers of funds become investors instead of creditors. The provision of financial capital and the entrepreneur share business risks in return for shares of the profits.32 4.3.4 Prohibition of speculative behavior and gambling. Islam prohibits all types of Gambling, speculative and extremely uncertain behavior. Allah (S.W.T) has revealed in the Quran. O you who believe, intoxicants, and gambling, and the altars of idols, and the games of chance are abominations of the devil; you shall avoid them that you may succeed. (Quran 5:90). Arabic word for uncertainty and deceit is Gharar. The Gharar is a fairly broad concept that literally means deceit, risk, fraud, uncertainty or hazard that might lead to destruction or loss. The Gharar in Islam refers to transactions about objects whose existence or description is not certain. This may be due to knowledge of the ultimate outcome. For example, the Prophet (P.B.U.H) has forbidden the purchase of the unborn animal in the mothers womb. Islam seeks protection from deceit, uncertainty, economic injustice, and ignorance for so it has clearly forbidden all business transactions, which leads to exploitation and injustice in any form to any of the parties of a contract. Islam has also categorically and firmly prohibited all forms of gambling.

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4.3.5 Prohibition of unethical use of funds. It is not permissible in Islam to trade and invest in products and industries declared to the Haram and illegitimate in Islam like Alcohol, Gambling, Narcotics and other socially irresponsible investments. The Muslims rely on Shari'a law for the proposition that investment in the following things, among others are haraam (forbidden): the charging of riba (interest), engage in excessively speculative ventures, contractual uncertainty or ambiguity, traditional insurance protection, and industries that deal in gambling, pornography, alcohol, tobacco, pork products, and even those that produce media products such as gossip magazines (Holly, 2010). 4.4 Principles and Prohibitions. The findings revealed that the highest weighted mean was 4.55 or Strongly Agree on financial provider must share the risk with the entrepreneur and not only the profits. This means the provider of financial capital and the entrepreneur share business risks in return for shares of the profits and losses. In an Islamic financial system employs the concept of participation in the enterprise, utilizing the funds at risk on a profit-andloss-sharing basis. This implies that investments with financial institutions are necessarily speculative. According to Cherrak and Touzani (2008) believed that this can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions.33 It is possible, that investment in Islamic financial institutions can provide potential profit in proportion to the risk assumed to satisfy the differing demands of participants in the contemporary environment and within the guidelines of the Shariah. The main principles of Islamic finance, are: (1) The prohibition of Riba which is the taking or receiving of interest; (2) Risk in any transaction must be shared; (3) The capital provider and the entrepreneur must share the business risk for a share in the profit; and (4) The prohibition of speculative behavior (Gharar), which means that gambling (Maysir) and extreme uncertainty is prohibited and consequently, contractual obligations and disclosure of information are central obligations to financial business transactions. The findings further revealed that Profits, symbolize successful entrepreneurship and the creation of wealth had a weighted mean of 4.53 or Strongly Agree. This prohibition is based on arguments of social justice, equality, and property rights (Iqbal, 1997).34 Islam encourages the earning of profits but forbids the charging of interest because profits, determined after the event, symbolize successful entrepreneurship and the creation of additional wealth whereas interest, determined before the event, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses. On the other hand, the concept of profit-and-loss sharing, as a basis of financial transactions is a progressive one, as it distinguishes good performance from the bad and the mediocre had a weighted mean of 3.59 or Agree. This means that in Islamic principles do not allow payment or receipt of Riba (interest) but do allow profit sharing. The concept of profit-and-loss sharing, as a basis of financial transactions is a progressive one as it distinguishes good performance from the bad and the mediocre, and encourages better resource management (Attijari Al Islami, 2011).35 The findings further revealed that the interest, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses had a weighted mean of 3.53 or Agree. This prohibition is based on arguments of social justice, equality, and property rights. Islam encourages the earning of profits but forbids the charging of interest, determined ex post, symbolize successful entrepreneurship and the creation of additional

13 wealth, whereas interest, determined ex ante, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses. However, on the statement that only business activities that do not violate the rules of Islamic law qualify for investment, (e.g. business dealing with gambling, pornography and casinos would be prohibited)got the lowest weighted mean of 3.25 or Neutral. This means that in Islam not only prohibits dealing in interest but also in liquor, pork, gambling, pornography and anything else, which the Shariah (Islamic Law) deems unlawful. Islamic banking is an instrument for the development of an Islamic economic order. Islamic banking, with 15 to 20% growth a year, has emerged as one of the vital pillars of the global economic system. Islamic financial institutions (IFI) are operating in over 75 countries, managing between $500 billion and $1 trillion assets (Cherrak and Touzani, 2008). 4.5 Traditions and Practices. The Islamic finance is also called Shari'ah-compliant finance, because its financial and commercial affairs conform to Shari'ah (Islamic law). These financial services abide by two major sources of inspiration: the Qur'an (the sacred book of Islam), and the Sunna (practices and traditions from the time of the Prophet Muhammad). The Islamic finance is practiced by Muslims in the Islamic world, but it is also expanding as an international financing practice in the global market. The Islamic financial market and its products are aimed at investors who want to comply with the Islamic laws (Sharia) that govern a Muslim's daily life. The most distinguishing features of Islamic finance are: (1) riba (interest) is prohibited, (2) profits and losses are shared by the capital provider and the entrepreneur; * transactions are backed up by the material, not intangible assets; (3) financing for businesses violating religious precepts (for example, alcohol or gambling) is prohibited. 4.6 Global Challenges and Opportunities. According to Rammal (2010)36, the Islam prohibits the charging and payment of interest on financial transactions and advocates social justice and equality through the distribution of wealth within the society. He further explained that following these principles, the Islamic banking and finance sector has experienced rapid global acceptance since the establishment of the first commercial Islamic bank in 1975. It was revealed that the annual growth rates of between 15 per cent and 20 per cent, the assets of the Islamic finance sector are expected to reach the US$2 trillion mark by the year 2015. In a 2009 report, the development of Islamic Finance in the GCC, published by the Centre for Study of Global Governance of the London School of Economics: the value of Shariah-compliant assets is impressive in the GCC. The current size of the global Islamic finance industry is at over $1 trillion (AED3.68 trillion), with GCC has $262.6 billion (AED964.5 billion). It was shown that Islamic finance in the UAE, has been recording a steady and impressive growth in the last few years with $73 billion (AED269 billion). Industry experts estimate the global industry size to rise to $2 trillion (AED7.3 trillion) in five years. However, the Islamic banks in Malaysia introduce more short-term sharia-compliant products to attract foreign investors. With the growth of the Middle East as a financial powerhouse and the increasing importance of local sovereign wealth funds to the global investment markets, sharia banking has become big business. There is already more than $1.2 trillion invested in banks that comply with strict regulations prohibiting them from either earning or paying interest. Sharia-compliant banking is the dominant form of banking in Iran and it makes up a sizeable share of the market in Malaysia and Saudi Arabia (Preston, 2011).37

14 According to Husain (2011)38 the global Islamic finance assets are projected to grow to US$1.6 trillion (RM5.13 billion) in 2012. The Islamic finance industry has had a compound annual growth rate of 19 per cent from 2006 to 2010 and there are more than 10,000 publicly traded Shariah compliant companies in more than over 40 countries. The findings revealed that Malaysias Islamic banking assets rose 15 percent to 389.3 billion ringgit ($123 billion) in the first seven months of 2011, strengthening the countrys position as the global hub for Shariah compliant financing, a government report. It was reported that Malaysia has the most established Shariah regulatory and legal infrastructure in the world. The Islamic capital market now exceeds $1 trillion and is growing as rapidly as the conventional capital market. 4.7 Islamic Finance Systems Model. The Islamic financial system is based on equity whereas the conventional banking system is loan based. Islam is not against the earning of money. In fact, Islam prohibits earning of money through unfair trading practices and other activities that are socially harmful in one way or another (Lahkani, 1998).39 Those who swallow down usury cannot arise except as one whom Shaitan has prostrated by (his) touch does rise. That is because they say, trading is only like usury; and Allah has allowed trading and forbidden usury. To whomsoever then the admonition has come from his Lord, then he desists, he shall have what has already passed, and his affair is in the hands of Allah; and whoever returns (to it) these are the inmates of the fire; they shall abide in it [Sura 2:275].

Figure 1. The Conceptual Paradigm of an Ijarah Sukuk Transaction (Adopted Model from Andreas A. Jobst, 2007)

15 The Concept of an ijarah suksuk transaction was adopted by the present researcher. Jobst (2007) emphasized that the asset-based (ijarah) sukuks are the most common form of Islamic securitization; sukuks on other Islamic financial transactions have been structured. The term Ijarah sukuks are financial obligations, issued by a lessor, and backed primarily by cash flows from lease receivables from a credit lessee (guthrie), such as sovereign governments, regional governments, corporations, and multilateral lending institutions (Richard, 2006). The sale-leaseback ijarah sukuk transaction structure or commonly known as sale model. The SPV (issuer/lessor) holds legal title to the assets, which are leased back to the originator in return for rental payments (and possibly other cash flows from the assets depending on the transaction structure) to service payments on the issued sukuks. In Figure 1 shows the SPV (issuer/lessor) holds a repurchase obligation for a price equal to the amount of outstanding debt in order to insulate the transaction from an adverse performance of the underlying assets. The headlease-sublease ijarah sukuk model, the owner of the assets headleases them to the issuer and rents them back. Since this arrangement does not include a repurchase obligation of transferring assets like a sale-leaseback ijarah sukuk, the credit risk of non-performance by the sub-lessee is usually covered by a quasi-guarantee on payments due to sukuk note holders (Jobst, 2007). One of the best examples of such a transaction was the US $250 million sukuk issued by the Bahrain Monetary Agency International Sukuk Company in June 2004 as an unconditional, unsubordinated, unsecured and general-payment obligation, backed by the full faith and credit of the Kingdom of Bahrain as stated by Andreas Jobst.40 The central concept is justice. Transactions that could be unjust for either the borrower or the lender are discouraged. For any financial undertaking, the risks must be shared. To get around the Korans ban on interest, Islamic banking has relied heavily on what is called murabaha: a loan or sale in which a markup is added to the transactions cost. So when a Muslim borrower goes to a bank to buy a car or house, he agrees to a contract in which he pays back the cost of the item, plus a certain amount of profit. The bank is technically a partner, rather than just a financier. These methods are believed to meet the spirit of the law because they avoid the exploitation of the borrower. Using this model, Islamic banks have created scores of financial products for Muslims to avoid Western style interest or risk. The result is a parallel system of Islamic offerings that mirror those available from conventional banks: Islamic mortgages, Islamic car loans, Islamic credit cards, and Islamic insurance. An ijara, or Islamic laws, allows a bank to buy a car or a house for a customer and then earn a profit by renting it to them. An Islamic investor who wants to start a business can go to a bank and embark on a mudharaba, or partnership, in which the bank supplies the money and the customer, brings the business skills. Profits are shared in a predetermined ratio; losses are borne by the bank. For insurance, companies offer policies in which a group of subscribers creates a pool of funds that can then be invested and drawn on in cases of legitimate claims. Unclaimed profits are then distributed among policyholders (Power, 2009).41 Finally, in this research paper, the response rate was 82 percent out of 150 respondents of professional practitioners and Islamic bankers employed in the Islamic financial institutions, Islamic banking, non-profit organizations, and commercial establishments in GCC. Statistically, the respondents for Saudi Arabia (13.33%), United Arab Emirates (12.00%), Bahrain (16.67%),

16 Kuwait (13.33%), Oman (14.00%) and Qatar (12.67%) with a total of 82% were the retrieval rate respectively. The survey was launched April 15, 2011 and ended November 1, 2011. The researcher assumed that the retrieval rate was statistically fair and significant. The results of this study have practical implications in different field of specialization, especially the entrepreneurs, business professionals, Islamic bankers, faculty, students and future researchers of Islamic banking and finance. 5. Conclusions and Recommendations 5.1 Conclusions. Based on the findings, the following conclusions are deduced: 5.1.1 5.1.2 Islamic finance in the Arab world established financial systems without interest which worked at a profit and loss sharing basis. The Islamic concept focuses on the profit that accepts risk, and proves fairness, honesty, avoidance of hoarding, and avoidance of tort which is an integral part of sharia law. The concept of Islamic Finance according to Shariah prohibits the fixed or acceptance of specific interest or fees which is called Riba or usury. Islamic financial institutions in the GCC are noteworthy sources of capital and are contributing to the development of Islamic finance globally.

5.1.3 5.1.4

5.2 Recommendations. Based on the findings and conclusions, the following recommendations are offered: 5.2.1 5.2.2 Regulatory authorities shall issue standards for compliance with all laws and regulations and responsibility pertaining to Shariah governance. A uniform regulatory and legal framework supportive of an Islamic financial system must be developed in accordance with Islamic principles not contrary to the existing laws and regulations. A well-defined rules and regulations of Islamic Financial Systems especially in the international market and for future development of Islamic financial systems they can offer a micro-finance as alternative solutions in the international market. The Islamic financial system needs broad financial accounting systems, standard and procedures especially in the international markets.

5.2.3

5.2.4

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