A Comparative Literature Survey Of Islamic Finance And Banking

A Comparative Literature Survey of Islamic
Finance and Banking
BY TAREK S. ZAHER AND M. KABIR HASSAN
There has been large-scale growth in Islamic finance and banking in Muslim
countries and around the world during the last twenty years. This growth is
influenced by factors including the introduction of broad macroeconomic and
structural reforms in financial systems, the liberalization of capital movements,
privatization, the global integration of financial markets, and the introduction of
innovative and new Islamic products. Islamic finance is now reaching new levels of
sophistication. However, a complete Islamic financial system with its identifiable
instruments and markets is still very much at an early stage of evolution. Many
problems and challenges relating to Islamic instruments, financial markets, and
regulations must be addressed and resolved. In this paper, we provide a compre-
hensive comparative review of the literature on the Islamic financial system.
Specifically, we discuss the basic features of the Islamic finance and banking. We
also introduce Islamic financial instruments in order to compare them to existing
Western financial instruments and discuss the legal problems that investors in
these instruments may encounter. The paper also gives a preliminary empirical
assessment of the performance of Islamic banking and finance, and highlights the
regulations, challenges and problems in the Islamic banking market.
I. INTRODUCTION
Islamic finance was practiced predominantly in the Muslim world throughout
the middle ages. European financiers and businessmen later adopted many
concepts, techniques, and instruments of Islamic finance. In contrast, the term
‘‘Islamic financial system’’ is relatively new, appearing only in the mid-1980s.
In fact, all earlier references to commercial or mercantile activities conforming
to Islamic principles were made under the umbrella of either ‘‘interest free’’ or
‘‘Islamic’’ banking. This, no doubt, prohibits the receipt or payment of interest
as the nucleus of the system, but is supported by other principles of Islamic
doctrine advocating risk sharing, individuals’ rights and duties, property rights,
and the sanctity of contracts. Similarly, the Islamic financial system is not
limited to banking, but covers financial instruments, financial markets, and all
types of financial intermediation.
There is a debate among the Islamic community over the effectiveness of an
interest-based banking system. While it is acknowledged that banks play a
pivotal role in the development of a country through their role as financial
intermediaries, the question is how efficient an interest-based system is in
Financial Markets, Institutions & Instruments, V. 10, No. 4, November 2001 䊚 2001 New York
University Salomon Center. Published by Blackwell Publishers, 350 Main St., Malden, MA 02148,
USA, and 108 Cowley Road, Oxford, OX4 1JF, UK.

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156
performing this function. In fact, there is even some debate as to whether or
not an interest-based system actually contributes to cyclical fluctuations. A
Ž .
new system of banking has emerged known as Profit-Loss-Sharing PLS most
likely in response to the interest-based banking system debate, but more due
to religious beliefs in the Islamic community. Currently, this banking system is
integrated into over 60 countries throughout the world with over 250 Islamic
financial institutions in operation.
Aside from the economic debate, the main contributing factor in the
Ž .
emergence of a PLS-banking system is the prohibition of ‘riba’ or interest in
the holy Quran. The basic intention behind establishing Islamic banks was the
desire of Muslims to reorganize their financial activities to complement the
Ž .
principles of the Shariah the Islamic Law and enable them to conduct their
financial transactions without indulging in ‘riba’. The term riba is used in the
Shariah in two senses. First is riba al-nasi’ah, which is the fixing in advance of
a positive return on a loan as a reward for waiting to be repaid. Second, riba
al-fadl, is encountered in a hand-to-hand purchase and sale of commodities.
The Shariah prohibits both forms of ‘riba’. Clearly, with regard to riba
al-nasi’ah, the prohibition is on an increase occurring from the mere use of
money with no measurable real economic increase. On the other hand, the
Islamic community does not consider an increase in business activity derived
from invested money ‘riba’. It is important to realize that the Islamic commu-
nity has no objection to true profit as a return on entrepreneurial efforts that
benefits all of society. Furthermore, in the case of riba al-fadl, the Islamic
community is only interested in ensuring justice and fair play in spot transac-
tions to avoid any exploitation through unfair exchanges.
While the original basis for the prohibition of interest was divine authority,
recently Muslim scholars have placed a major emphasis on the lack of a theory
for interest. Muslim scholars have rebutted the arguments that interest is a
reward for savings, a productivity of capital, and provides for the difference
between the value of capital goods today and their value tomorrow. In terms of
interest being a reward for savings, they argue that interest could only be
justified if it resulted in reinvestment and subsequent growth in capital and not
solely as a reward for forgoing consumption. With regard to the productivity of
capital argument, modern Muslim scholars argue that the interest is paid on
the money and is required regardless of whether or not capital productivity
results, and thus is not justified. Finally, with regard to the argument that
interest enables an adjustment between the values of capital goods today with
their value tomorrow, the response is that this only explains its inevitability
and not its rightness. Specifically, if that is the sole justification for interest, it
seems more reasonable to allow next year’s economic conditions to determine
the extent of the reward, as opposed to predetermining it in the form of
interest.
Ž .
The Islamic community has rationalized the elimination of riba interest
based upon values of justice, efficiency, stability and growth. In terms of

A Comparati¨e Literature Sur¨ey of Islamic Finance and Banking 157
justice, the removal of riba results in the sharing of the risk of a project
between the borrower and the lender. In addition, by tying the reward to the
performance of the business venture, the resulting returns are more equitable
during good times and bad times. Finally, returns are only earned when the
business venture results in the addition of value, which benefits all of society.
Regarding the efficiency of allocation of capital argument, interest based
lending with adjustments for risk capital tends to result in serving the more
creditworthy borrowers and not necessarily the most productive projects. The
Islamic PLS- banking allocates financing to the most productive business
ventures, as the share in returns is more promising. In addition, profit sharing
results in both the borrower and lender working more closely together to
ensure the business venture’s success, which is more productive for society.
Finally, Muslim economists argue that the PLS system provides for cohesion
between social classes because financing is equally available to anyone with a
productive idea. With regard to the subject of stability, Muslim economists
argue that an interest-based banking system fosters inflation, as the creation of
money does not have any direct tie to whether or not a business venture is
productive. The result is a higher cost to society for failed projects that interest
was paid without any economic benefits.
There are many legally recognized forms of business arrangements in Islam,
which are derived from four main sources of Islamic law: the Quran, the
sunnah, the ijma, and the qiyas. Although modern Islamic banking is consid-
ered to be a recent development, it has a long historic background with its
Ž
earliest beginnings being traced to the practice of mudaraba an ancient form
. Ž .
of partnership used by the Prophet Muhammad Peace be upon him himself.
Another earlier business arrangement known as Musharaka was also prevalent
in ancient times. Both of these business arrangements are essentially agency
arrangements. The difference between the two is that in the latter, the agent
contributes to the capital for the project and thus may receive a higher share
of the profits and losses of the business venture. The former relieves the agent
from any loss potential, but provides for a lower share of the profit. Therefore,
modern Islamic banking was derived from these earlier forms of business
relationships, with the disparity being that today lenders are brought together
in a centralized location, the bank, so that their money can be lent to
entrepreneurs for investment in new business ventures.
In this paper we provide a comprehensive review of the literature on the
Islamic financial system. In section II we discuss the basic features of Islamic
finance and how they relate to traditional Western finance. In section III we
introduce the Islamic financial contracts that are currently utilized by Islamic
financial institutions around the world, and include a comparison of them to
existing Western financial instruments. We also discuss the legal problems that
investors in these instruments may encounter. Section IV reviews the progress
and growth in a major component of the Islamic financial system, the Islamic
banking market. Section V gives a synopsis of Islamic banking and finance

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experiences in Pakistan, Iran and Sudan. Section VI gives a preliminary
empirical assessment of the performance of Islamic banking and finance.
Section VII discusses the current practices and regulations of Islamic banking
and finance. Section VIII highlights the challenges and problems facing the
Islamic banking market. Section IX discusses the prospects and challenges for
development of another Islamic financial market, the equity market, and
Section X concludes the paper.
II. BASIC FEATURES OF ISLAMIC FINANCE
Islamic finance is a financial system, the fundamental aim of which is to fulfill
the teaching of the Holy Quran, as opposed to reaping maximum returns on
Ž .
financial assets. The basic principle in the Sharia Islamic Common Law is
Ž .
that exploitative contracts based on Riba interest or usury or unfair contracts
Ž .
that involve risk or speculation Gharar are unenforceable. However the Holy
Quran contains no condemnation of morally acceptable investments that yield
Ž .
fairrlegitimate profits and economicrsocial ‘‘added-value’’ Siddiqi 1999 . Two
more principles are fundamental to understanding Islamic finance. First, the
Ž .
Islamic law reflects the totality of Allah’ God’s commands that regulate all
aspects of the life of a Muslim. Second, Islamic finance is directly involved with
spiritual values and social justice. Under Islam, there is no separation of
Ž .
mosque and state or of business and religion Nicolas 1994 .
The fact that Islamic laws prohibit Muslims from paying or receiving
interest, prevents observant Muslims from taking out mortgages, carrying
balances on credit cards or investing in any fixed income securities such as
T-bonds, T-Bills, CDs or any other financial security that promises a guaran-
teed return. This does not imply that Islam frowns on making money or
demands that Muslims revert to an all-cash or barter economy, but means that
all parties to a financial transaction share the risk and profit or loss of a
venture, and that no one party to a financial contract gets predetermined
return. For example, ‘‘depositors’’ in Islamic banks are really shareholders who
earn dividends when the bank turns a profit, or lose a portion of their savings
if it posts a loss. In effect, the Islamic financing functions much like Western
equity financing. Investors and lenders have the right to a decent rate of
return; it is just the certainty of the return that is an issue. This direct
correlation between investment and profit differentiates Islamic banking from
conventional or western banking, which defines maximization of the sharehold-
ers’ wealth as the sole objective of the firm.
While the banning of interest is rooted in the Islamic theology, proponents
of Islamic finance provide economic rationales to support the ban of interest.
Some of these rationales are described by the International association of
Ž .
Islamic banks 1995, pp. 3-4 . First, in an Islamic profit sharing contract, the
return on capital will depend on productivity, and the allocation of funds will
be primarily based on the soundness of the project. This will improve the

capital allocation efficiency. Second, the Islamic profit-sharing system will
ensure more equitable distribution of wealth and the creation of additional
wealth to its owners. This system would no doubt reduce the unjust distribu-
tion of wealth under the interest system.
Third, the profit sharing regime may increase the volume of investments and
hence create more jobs. The interest regime would make feasible and accept-
able only those projects whose expected returns are higher than the cost of
debt, and therefore filter out projects which are otherwise acceptable under
the Islamic profit-sharing system. Fourth, the Islamic finance system will
reduce the size of speculation in financial markets, but still allow for a
secondary market for trading stocks and investment certificates based on profit
sharing principles. This will bring sanity back to the financial market and
promote liquidity to equity holders. Fifth, under the profit-sharing system, the
supply of money is not allowed to overstep the supply of goods and would thus
curb inflationary pressures in the economy.
Some Islamic bankers argue that Islamic finance may even have a role to
Ž .
play in underpinning the stability of the international economy Dudley 1998 .
Under the Islamic financing system, investments or finance is targeted to the
specific needs of an entity. Financiers or investors will need to satisfy them-
selves as to the reliability of a project, their lease rentals or the return
promised in any financing deal. The investors and financiers have to exercise
due diligence and careful monitoring of their investments. There is not much
room for raising a variety of unsecured debts that are not targeted to the
specific needs of borrowers. Conventional Western financing, on the other
hand, lacks a corrective mechanism to stop excessive borrowing beyond indi-
vidual companies’ means. In good times, raising funds is easy, while in bad
times the cost of raising funds is high; therefore, the risk to the financing
institution is increased. The amount of borrowing under a conventional system
is several times more than it would be under an Islamic system, and so are the
risks inherited from these excessive borrowings.
III. ISLAMIC FINANCING CONTRACTS
There are five basic Islamic Financing contracts. The underlying concept for
each technique is simple and can be compared to an existing Western financial
instrument. However, actual financing deals can become very complicated as
some banks modify the structure to suit the requirements of specific investors.
These deals may contain elements of more than one of the basic Islamic
contracts. In this section we discuss the basic features of these Islamic
financing contracts. We also discuss some of the legal problems that investors
in these instruments may encounter. Table 1 presents various modes of Islamic
finance.

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MURABAHA
A Murabaha transaction is basically a cost-plus profit financing transaction in
which a tangible asset is purchased by an Islamic institution at the request of
its customer from a supplier. The Islamic institution then sells the asset to its
customer on a deferred sale basis with a mark-up reflecting the institution’s
profit. The customer takes the responsibility of negotiating all of the key
commercial terms with the seller of the asset. The mark-up on the asset cannot
be altered during the life of the contract. The size of the mark-up is deter-
Ž
mined in relation to an interest rate index such as the LIBOR London
.
Inter-Bank Offered Rate or US- short T-bills rate, and is also a function of
the client’s credit rating, the transaction’s size and the type of goods being
financed. The Murabaha deals offer enough flexibility to be used in real estate
and project financing, but historically it has been used primarily for trade
finance.
A number of legal issues may be encountered by the Islamic financial
institutions that finance a Murabaha transaction. First, the Islamic financial
institution cannot earn excessive profits from the client. If the profit is
excessive, remedies may include a return of the ‘‘excessive’’ portion of the
profit to the client. A second legal issue is rejection of the goods. The
customer may reject the goods for non-conformity and leave the bank holding
the goods. To eliminate the possibility of rejection of goods, the customer will
generally act as the bank’s agent in determining the conformity of the goods
prior to acceptance. Finally, the Islamic financial institution may be exposed to
Ž .
contractual and statutory liabilities such as warranties resulting from its
ownership of the goods. These should be disclaimed to the extent possible or
be limited by indemnities received from the customer.
Ž .
IJARA AND IJARA WA-IQTINA ISLAMIC LEASING
Ijara and Ijara wa-Iqtina are Islamic leasing concepts similar to western
operating and finance leases. Ijara is similar to a conventional operating lease,
Ž . Ž .
where in an Islamic bank lessor leases the asset to a client lessee for agreed
on lease payments for a specified period of time, but with no option of
ownership for the lessee. The maintenance and insurance of the leased asset is
the lessor’s responsibility. On the other hand, Ijara wa-Iqtina is comparable to
the Western financial or capital lease, where the lessee has the option of
Ž .
owning the asset at the termination of the lease. In this case, the bank lessor
purchases the asset such as a building, piece of equipment or even an entire
project and leases it to the clients for an agreed on lease rental, together with
client agreement to make lease payments towards the purchase of the asset
from the lessor. The conditions governing both types of leasing are that assets
must have a longrsecure productive life, and must not be handled in an

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Table 1
TYPE DESCRIPTION COMMENTS
PLS Modes Profit and loss sharing modes At the core of Islamic banking
Trustee finance contract
Mudarabah The bank provides the entire capital needed for Three conditions need to be met:
financing a project, while the entrepreneur offers his 1. The bank should not reduce credit risk by
Ž .
labor and expertise. The profits or losses from the requesting collateral to this purpose: it
project are shared between the bank and the en- bears entirely and exclusively the financial
trepreneur at a certain fixed ratio. Financial losses are risk. Collateral may be requested to help
borne exclusively by the bank. The liability of the reduce moral hazard, e.g., to prevent the
entrepreneur is limited only to his time and efforts. entrepreneur from running away.
However, if the negligence or mismanagement of the 2. The rate of profit has to be determined
entrepreneur can be proven he may be held responsi- strictly as a percentage and not as a lump
ble for the financial losses incurred. sum.
3. The entrepreneur has the absolute free-
dom to manage the business.
It is usually employed in investment projects with short The bank is entitled to receive from the
gestation periods and in trade and commerce. entrepreneur the principal of the loan at the
end of the period stipulated in the contract, if
and only if a surplus exists. If the enterprise’s
books show a loss, this will not constitute
default on the part of the entrepreneur,
except for negligence or mismanagement.

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Ž .
Table 1: Continued
TYPE DESCRIPTION COMMENTS
PLS Modes Profit and loss sharing modes At the core of Islamic banking
It affects both assets and liabilities sides of banks’
balance sheet. On the liabilities side, the contract
between the bank and depositors is known as unre-
stricted Mudarabah because depositors agree that their
funds be used by the bank, at its discretion, to finance
an open-ended list of profitable investments and expect
to share with the bank the overall profits accruing to
the bank’s business. On the assets side, the contract
between the bank and the agent-entrepreneur is known
as a restricted Mudarabah because the bank agrees to
finance a specific project carried out by a specific
agent-entrepreneur and to share the relative profits
according to a certain percentage.
Equity participation contract
Musharakah The bank is not the sole provider of funds to finance a Banks can exercise the voting rights of corre-
project. Two or more partners contribute to the joint sponding to their share of the firm’s equity
capital of an investment. capital. Their representatives can sit in the
firm’s board of directors.
Ž .
Profits and losses are shared strictly in relation to the All parties invest in varying proportions, and
respective capital contributions. have the right to participate in the manage-
ment of the enterprise.
It is usually employed to finance long-term investment
projects.

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Non-PLS Non Profit and loss sharing modes They are used in cases where PLS modes
Modes cannot be implemented, for example, in cases
of small-scale borrowers or for consumption
loans.
Beneficence loans
Qard al- These are zero-return loans that the Quran exhorts Mus- Contrary to contracts based on the PLS principle,
Hasanah lims to make to ‘‘those who need them.’’ Banks are allowed modes such as markup, leasing, and lease purchase
to charge the borrowers a service fee to cover the adminis- have a predetermined and fixed rate of return and
trative expenses of handling the loan, provided that the fee are associated with collateral.
is not related to the amount or maturity of the loan.
Leasing
Lease purchase
Ijara Ijara A party leases a particular product for a specific sum and a In fact, banks add a certain percentage to the
wa iqtina’ specific period of time. In the case of a lease-purchase, each purchase price andror additional costs associated
payment includes a portion that goes toward the final with these transactions as a profit margin, and the
purchase and transfer of ownership of the product. purchased assets serve as a guarantee. Additionally,
banks may require the client to offer a collateral.
These instruments can be considered to be more
closely associated with risk aversion and they do not
substantially differ from those used in a conven-
tional banking system, other than in their terminol-
ogy and in some legal technicalities.
They are considered to conform to Islamic princi-
ples because the rate of return is meant to be tied
to each transaction, rather than to the time dimen-
sion. However, some Muslim scholars advocate a
stricter utilization of such modes.
Source: Kazarian, 1993; Iqbal and Mirakhor, 1987; Errico and Farahbaksh, 1998.

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un-Islamic way, meaning that the lease payments must be agreed on in
advance to avoid any speculation.
As with Murabaha transactions, there will be concerns relating to the
Islamic institution’s ownership of real property, disclaimers of warranties, the
application of strict liability and the enforceability of a fixed payment upon
default. The loss and destruction risks generally remain with the lessor, unless
caused by the negligence or default of the lessee. Although insurance is an
option for western lease financing, there may be issues as to whether insurance
in this context is acceptable under Islamic law. The lessee should start making
lease payments only after the leased asset has actually been delivered to him
Ž .
her . In addition, if the leased asset were destroyed, the lessee would cease
making payments to the lessor. This practice is contrary to the practice in most
western lease financing where the lessee continues paying rent even if the
property is destroyed.
Islamic leasing has also been criticized for being a complicated concept with
a limited scope for business. However, the product is becoming the most
popular form of Islamic finance. The products involved in Islamic leasing run
the standard gamut from European oil refineries to medical equipment in the
United States. Western banks offering Islamic instruments, such as Citicorp in
the USA and Kleinwort Benston in London are now more active in Islamic
leasing, and the leasing funds have been raised from both Muslim and
Ž .
non-Muslim investors Collett 1995 . Many investors, especially Islamic banks,
have been attracted to leasing by the promise of higher yields than Murabaha
Ž .
trade finance , which accounts for the bulk of Islamic banking activity. In
addition, since Islamic leasing has the advantage of dealing with tangible
assets, it has escaped the kind of criticism given to other Islamic products. This
suits the Islamic finance ethos, and as investors move towards providing
medium-term and long-term financing, the interest in Islamic leasing will
increase.
ISTINSA
Istinsa is a pre-delivery financing and leasing structured mode that is used
mostly to finance long-term large-scale facilities involving, for example, the
construction of a power plant. The Islamic institution could either own the
Ž .
plant, charge the lessee project company a fee based on profits, or sell the
plant to the project company on a deferred basis with a profit mark-up similar
to a Murabaha transaction. Unlike a Murabaha transaction, however, certain
expenses that cannot easily be reflected in a sale and purchase agreement can
be included in the fees to be paid to the Islamic institution by the project
company.
Legal issues relating to Istinsa include whether under local law the Islamic
institution can own real property and whether the concession or other rights

granted to the project company can be assumed or used by the Islamic
institution.
Ž
Although the Islamic mark-up contracts Murabha, Ijara, Ijara Wa-Iktina,
.
and Istinsa are widely used, their acceptability under Islamic law is disputed
because they can imply a fixed return on investment for the financing financial
institutions. Many Islamic scholars have suggested that mark-up contracts,
while permissible, should still be restricted or avoided out of fear that these
Ž
mark-up contracts may open a ‘‘back door’’ to interest Siddiqi, 1983, and
.
Khan 1987 .
Some researchers also argue that there is a formal equivalence between
markup contracts and debt, but the equivalence is not based on the payment of
Ž .
interest Aggrawal and Yousef 2000 . They argue that the salient feature of
Ž .
debt as described in the debt literature Hart and Moore 1998 is that it
transfers control of an asset to the debt holder in case of default. The main
feature of mark-up instruments is that the financial institutions retain owner-
ship of the asset and can seize it in cases of default. Thus, the control rights of
mark-up contracts are equivalent to the control rights of debt instruments.
However, there is a major advantage of Islamic mark-up contracts over
Western debt contracts. In cases of default on an Islamic mark-up contract,
there is no ambiguity about control of the assets. The financial institution
retains title to the asset until the agent makes all payments. On the other
hand, most defaulting western debt instruments triggers bankruptcy proceed-
ings while the agent continues to control the asset. The delays induced by
formal bankruptcy proceedings in the shift of ownership of the asset may
introduce bargaining problems that can significantly decrease the efficiency of
the investment. These problems are avoided when Islamic mark-up instru-
ments are used.
MUDARABA
Ž
Mudaraba is a trust based financing agreement whereby an investor Islamic
. Ž .
bank , entrusts capital to an agent Mudarib for a project. Profits are based on
a pre-arranged and agreed on ratio. Mudaraba agreement is akin to Western-
style limited partnership, with one party contributing capital while the other
runs the business, and profit is distributed based on a negotiated percentage of
ownership. In case of a loss, the bank earns no return or a negative return on
Ž .
its investment and the agent receives no compensation for his her effort.
MUSHARAKA
Ž
Musharaka is similar to a joint venture, whereby two parties an Islamic
.
financial institution and a client provide capital for a project which both may
manage. Profits are shared in pre-agreed ratios but losses are borne in

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166
proportion to equity participation. It conforms to the principle of profit and
loss sharing and it is suitable for long-term project financing; hence, it is
considered to be the purest form of Islamic finance. Musaraka financing is
closer to a traditional equity stake with rights of control.
In addition to mark-up and profit sharing instruments, two more Islamic
instruments are used in futures trading, Bai-Salam and Bai-Muajjal. In a
Bai-Salam contract the buyer pays an agreed on price in advance for commodi-
ties that will be delivered at a future date, while in a Bai-Muajjal deal, the
seller allows the buyer to pay at a future price in either lump sum or
installments. The fixed price can be the same or higher or lower as the spot
price.
As part of their mission, Islamic financial institutions are encouraged to
Ž .
make charitable loans Qard Hassan to individuals or organizations. These
loans are called Qard Hassan, or social benevolent loans, and do not carry an
interest charge or mark-up. However, the borrower may willingly return the
loan with a small mark-up. These are clearly negative net present value
investments to Islamic banks and are not very common in most Islamic
countries.
Ž .
Recently a new Islamic mutual insurance type of fund Takaful has been
introduced. Participants pay installments into a fund and the bank acts as
managing trustee. In addition, a new Islamic banking product was tested in the
European market at the end of 2000. The product is an equity Repo, which is
Ž .
similar to a Murabaha or cost plus profit transaction Brooks, 1999 . The
typical maturity of the Islamic equity Repo is three months. The equity Repo
Ž
is the product of collaboration between Cedelbank a leading provider of
.
global Repo services and a major European bank in London.
IV. HISTORY AND GROWTH OF ISLAMIC BANKING
Islamic banking has established itself as an emerging alternative to conven-
tional interest-based banking and is expanding rapidly over the last two
decades in both Muslim and non-Muslim countries. No accurate figures exist
as to the actual extent of Islamic investment market, but according to Citibank,
in Bahrain, funds under Islamic financial institutions management are growing
at an annual rate of 15 to 20 percent per year. Some Islamic banking sources
suggest that the total value of Islamic funds management may well be over
$200 billion. In the past two decades, Islamic banks have recorded high growth
rates both in size and number around the world. Islamic banks operate in over
sixty countries, most of them in the Middle East and Asia. In three countries,
Iran, Pakistan, and Sudan, the entire banking system has been converted to
Islamic banking. In other countries, the banking systems are still dominated by
conventional banking institutions operating alongside Islamic banks. Now
there is a move away from the Middle East and Asian areas and a desire to

spread the risk. There is a diversification trend towards the United States and
Europe.
Islamic banking is the fastest growing segment of the credit market in
Muslim countries with Islamic banks. The market share of these banks has
risen from 2 percent in the late 1970s, to about 15 percent in the mid 1990’s, as
Ž .
measured by assets in the banking system Babai 1995 . Conventional commer-
cial banks have also started to offer Islamic financial contracts. Islamic
banking is becoming stronger industry and is not just a niche financial services
industry, but a niche market. Many bankers predict that Islamic banking could
be responsible for management of over 50% of savings in the Islamic countries
in the next decade. Global financial institutions have recognized this trend and
are capitalizing on the attractive niche market. Some of the western banks that
have established dedicated Islamic banking subsidiaries or have substantial
dealings in the field include, Citibank, Bank of America, Commerzbank,
Deutche Bank, Merrill Lynch, ABN AMRO, BNP Paribas, Pictet & Cie, UBS,
Standard Chartered, Barclays, HSBC, Royal Bank of Canada, American Ex-
press, Goldman Sachs, Kleinwort Benson, ANZ Grindlays and Flemings. A
growing number of western investment companies are now offering Islamic
investment products to interested Islamic investors worldwide. However, de-
spite the advances by western banks and investment companies, the mainstays
of Islamic investments continue to be the Islamic banks themselves.
Calculating the exact size of the Islamic banking sector is difficult. Pakistan,
for example, defines all of its financial institutions as Islamic even though
western bankers say that many of the transactions are still effectively conven-
tional banking. Saudi Arabia, on the other hand, does not formally admit the
distinction between conventional and Islamic banking. Some Islamic bankers
suggest that the number of banks that offer Islamic products around the world
total over 250. The asset size of Islamic banks has also experienced a high
growth rate. Today many Islamic banks are among the largest banks in their
Ž .
respective countries Kazarian 1993 and Ray 1995 .
In terms of service, the most dramatic change in approach has come in the
past five years. In the past, Islamic institutions were seen merely as a place for
those with strong Islamic convictions to place their money. Today, senior
managers of Islamic banks believe they must compete on commercial grounds
by offering a more cost-effective financial package to non-Islamic as well as
Islamic customers. The main factor fueling the dramatic growth is the spread
of the Islamic religion globally. Islam is the fastest growing religion in world,
and Muslims are increasingly searching for financial instruments that adheres
to the their principles. Some non-Muslims are also participating in Islamic
Ž .
banking because they consider it to be commercially sound Brooks, 1999 .
Traditionally, specialized Islamic banks have been well positioned to attract
deposits from Muslims and non-Muslims, but these institutions have generally
lacked the technical ability to invest efficiently. This gap has been bridged by

Zaher and Hassan
168
the services of Western banks that swiftly and efficiently deploy funds into
Islamically acceptable channels. This has often meant lower returns for Islamic
investors due to the second layer of inter-mediation. However, this trend is
changing. Islamic banks are becoming resourceful and are going global, in part
due to their increased integration with international markets. At the same
time, being aware of the potential of Islamic markets, Western banks are
Ž
reaching out to investors directly and eliminating the middleman the Islamic
.
banks or Islamic windows of banks in Muslim countries.
Advocates of Islamic banking argue that many Islamic banks operate
according to the profit and loss sharing principle and that the profit-sharing
Ž .
contracts equity are the superior financial security to debt for many reasons
Ž .
including the risk-sharing properties of equity Ebrahim and Safadi 1995 .
They also argue that by providing long-term financing to growth oriented-sec-
tors of the economy, Islamic banks will promote growth in the Islamic
Ž .
countries Chapra 1992, and Siddiqi 1983 . Conversely, a few recent studies,
Ž .
argue against these two views. Aggarwal and Yousef 2000 suggest that most
of the financing provided by the Islamic banks they examined in their study do
not conform to the principle of profit-and-loss sharing. Instead, much of these
financing activities are offered through debt-like instruments. Aggarwal and
Yousef also found that Islamic banks rarely offer long-term financing to
entrepreneurs seeking capital. This finding is also supported by Metwally
Ž . Ž .
1992 , and Pourian 1995 . The two studies provide evidence that the maturi-
ties of Islamic financing contracts offered by Islamic banks in Egypt and Iran
Ž . Ž .
during the 1980’s are mostly short one year or middle term 2-5 years . Few
of the contracts have longer than 5 years maturities.
The activities of Islamic banks tend to reflect the conditions of the country
Ž
in which they are based. There are strong retail operations in Iran though
.
they have played comparatively small role in international markets and Saudi
Arabia. In the more secular societies of northern Africa, Islamic banks
compete on the quality of their products, not their religious acceptability. In
Kuwait, well-established Islamic financial institutions have been involved in
substantial financing for the petroleum sector and real estate investment and
in the UAE the emphasis is on trade finance. In Iran, Islamic banks invest in
entrepreneurial projects in economic sectors that are typically viewed as
Ž Ž . Ž ..
growth oriented such as agriculture Kazarian 1993 and Saffari 1995 .
Bahrain, on the other hand, has enjoyed some success in marketing itself as
the region’s Islamic financial center because of its internationally respected
regulatory system. In Bahrain, there is a greater emphasis on investment
banking. However, more competition with international banks is expected in
the future. There is a gradual change as more Islamic institutions become
aware of the opportunities in local markets and around the world. They are no
longer looking at providing funding but they also want to play a major role in
the transactions.

V. ISLAMIC BANKING AND FINANCE EXPERIENCES IN
PAKISTAN, IRAN AND SUDAN
Islamic banking has thus far made substantial progress worldwide even though
the niche that it has been able to create for itself in the total volume of
international, or even Muslim world, finance is very small. The volume,
however, is not important, but rather the respectability that the interest-free
financial intermediation has attained and the positive evidence that it has
provided about the workability and viability of this system. While in the 1950s
and 1960s Islamic banking was only an academic dream of which few people
were aware even among educated Muslims, it has now become a practical
reality. It has also attracted the attention of Western central banks like the
Federal Reserve Board and the Bank of England, along with international
financial institutions like the IMF and the World Bank, and prestigious centers
of learning like Harvard and Rice Universities in the United States and the
London School of Economics and Loughborough University in the United
Kingdom. It has also received favorable coverage in the Western press.
Prospects for the future are expected to be better, particularly if the instability
that now prevails in the international financial system continues to accentuate
and leads to a realization that the instability cannot be removed by making
cosmetic changes in the system but rather by injecting into the financial system
greater market discipline of the type that the Islamic financial system stands
for.
Islamic banking, as an institution, has only been around for 25 years but that
is not to say that interest-free banks have not been tried before. There was one
in Malaysia in the mid-forties and another in Pakistan in the late-fifties.
Neither survived. In 1962, the Malaysian government set up the ‘‘Pilgrim’s
Management Fund’’ to help prospective pilgrims save and profit. The savings
bank established in 1963 at Mit-Ghamr in Egypt was very popular and
prospered initially, although it closed down for various reasons. However, this
experiment led to the creation of the Nasser Social Bank in 1972. Even though
the bank is still active, its objectives are more social than commercial.
The early seventies, on the other hand, saw the institutional involvement.
The Conference of the Finance Ministers of the Islamic Countries held in
Karachi in 1970, the Egyptian study in 1972, First International Conference on
Islamic Economics in Mecca in 1976, and the International Economic Confer-
ence in London in 1977 were the result of such involvement. The involvement
of institutions and governments led to the application of theory to practice and
resulted in the establishment of the first interest-free banks. The Islamic
Development Bank, an inter-governmental bank established in 1975, was born
of this process.
The first private interest-free bank, the Dubai Islamic Bank, was also set up
in 1975 by a group of businessmen from several countries. Two more private
banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt

Zaher and Hassan
170
and Sudan. In the same year, the Kuwaiti government set up the Kuwait
Finance House. Twenty-five years since the establishment of the first Islamic
bank, more than 250 Islamic financial institutions have come about. Although
most are in Muslim countries, there are some in Western Europe, North
America, and Asia.
Islamic banks have come a long way in a relatively short time and have
captured a significant market share from their conventional rivals. Some of the
penetration rates of Islamic banking services in Muslim countries are 5% in
Malaysia, 12% in Saudi Arabia, and 30% in Kuwait. It is anticipated that the
Islamic banking industry will be responsible for managing at least 40-50% of
the total savings of Muslims worldwide in 8 to 10 years. It is important to note
that Islamic banks tend to focus on their local markets while western institu-
tions such as Merrill Lynch target the high-net-worth segment. There are no
real global players in the field. There are no retail Islamic banks in OECD
countries. Also, Islamic banks do not have the in-house expertise to develop
Sharia-compliant products and thus, seek financial engineering expertise from
western institutions.
Although most of the countries under discussion have different Islamic
backgrounds, they all have been major players in revolutionizing Islamic
financial institutions. The pioneers of full Islamization were Pakistan, Iran,
and Sudan. Pakistan’s Islamic banking concept began as early as in the 1950s
when economists were keen on the ideology of Islamic banking. It was the first
country to embark upon a full Islamic financial system. Pakistan had been
persistent in making this concept work through change and reaffirming mea-
sures to achieve its goals. However, twenty years later, the picture had changed
when the leaders realized that the country’s inherent British system could not
be changed. Pakistan was trying to change too much too quickly. A relatively
young country, Pakistan was still under the influence of British legacy, the mist
of its independence and freedom.
The first phase of the economic reform in Pakistan began in 1979 when
Zakat was levied on all savings accounts in various kinds of banks. However,
this method did not prove effective. Those who opposed declared that it was
not Islamic to distribute Zakat through banks that are not the custodians of
the money. Another objection was whether the money actually goes to the
deserving or not, and its effectiveness in alleviating poverty.
Pakistan was the first country to revive the institution of Hisbah, the office
that controls the markets, which provides municipal services and settles
disputes. In the second phase of its Islamization, the Pakistani government
outlawed interest and introduced ‘brotherly and godly’ ways of generating
profits. Ironically, despite these local measures, foreign banking transactions
were still working on western systems. The government was caught in its own
web of conflicting cultures. The problem was further enhanced when it was
pressured by international organizations like IMF to privatize its banking
system. The system lacked planning. The matter got worse in 1992 when the

Federal Shariah Court declared that interest based banking is not Islamic and
therefore should be banned. Finally, in 1998 it decided to eliminate riba from
its banking system.
Pakistan’s model teaches us that interest free banking employing PLS as a
means of earnings is non-functional when 90% of the transaction is locked in
mark up. It also raises the question of Islamic moral hazard with many
businessmen who were taking advantage of the new banking model. This
experiment therefore did not achieve its desired result.
Foremost on Iran’s revolution was its desire to achieve economic indepen-
dence, break up the Shah’s economic policies and resolve the ideological
struggle between the conservative and free market. A country that was
exploited by western leaders was still injured by its shadows. The country was
again divided into two major groups, with one for the Shah and one against.
These conflicts were also translated into the economic scenario where one
group was pro communist while the other was in favor of a laissez faire. Early
financial transformation started when all banks were nationalized and taken
Ž .
over by Islamic foundations. Later political turmoil IranrIraq war led to the
centralization of the command economy, where allocation of goods, price
controls, and rationing were in the hands of the authority. By the late 1980s,
the country went to great lengths to implement constitutional and institutional
changes, which indicated that all forms of foreign loans, investments and
participation were forbidden so that the government agency or company is not
allowed. This changed, however, when the Soviet Union entered the market
and a number of ethnic groups saw the benefit of ties with other countries
such as Turkey, Saudi Arabia and the US. Financial policy then was revolu-
tionized to accommodate these countries. Over the next few years, the 1983
Usury free Banking Act, began to fade in the face of merger movements.
Foreign credits and exchange were available through banks but subjected to
regulation of central banks. This model also failed because by eliminating riba
from the financial system the country had created a worse condition through
its informal relationship with external financial communities. This area was
uncharted and gauged higher interest rates. There was not tight regulation to
conduce the Islamic financial model.
The largest country in Africa, Sudan, became independent in 1956. It holds
a culturally diversified population of Muslims and Christians and was also
under Egyptian influence. It proclaimed Islamization in 1983. A guideline for
banking systems was outlined and taxation was also included in this act. The
entire banking system took a new turn in 1983 when it was fully Islamized and
interest was outlawed. Another political wave hit the country and again the
Islamic model failed.
The Malaysian Islamic system is different than the other three models
because it does not attempt to fully dissolve conventional banking. In fact,
both systems work together. It focuses its goals towards harnessing information
technology to enhance efficiency. A country that is diverse with Chinese,

Zaher and Hassan
172
Indian, Malays and Muslims has always dominated the scenario due to the
pact they signed at the time of independence in 1957. One of the factors
showing that the financial system is working efficiently is their National
Economic Policy. This model is revised each decade to ensure the transforma-
tion has not hindered its progress.
The Malay Islamic model incorporated Islamic banking into the financial
system and harmonized it with the western practice. This is because an Islamic
system should be recognized as a tool for effective financial practice. This
smooth implementation is probably the result of Malay’s tolerance of other
traditions and nations. Unlike other countries, Malay had not attempted to
fully Islamize its institutions.
The authority promoted its Islamic banking by setting up institutions that
operated on Islamic principles. By making credit instruments like bills and
bonds Islamic, it opened up a new channel of innovative products for its
customers who were previously attracted by Islamization but reluctant to try it
again. Universities and research centers were opened up to inform and
educate the country of this new method of financing. The result was surpris-
ingly positive both from the Western investors as well as the East.
Offshore financing centers are the key for convenience in conventional
banking. Islamic banking in the Middle East, however, had other motives when
they stepped into Islamic Financing. They modernize by integrating new
policies for the region’s economy. Bahrain is one such example where the
small Gulf State used its diversity policy to change its focus from oil business
to financial services. It leverages a number of competitive advantages due to
geographic location, well-developed infrastructure, defined legal system and
liberal trade.
The international financial community is impressed and attracted to Bahrain
because of its regulatory system that imposes Basle capital ratios, maintaining
average capital asset ratio and a mandatory eight percent ratio. It also follows
the International Accounting Standards, meaning published financial state-
ments. This opens them up to stocks, bonds and provides international trade
related services. It is perhaps one of the best offshore models of Islamic
banking when the Bahrain Monetary Authority had Shariah advisers to help
with auditing, regulating, and developing short-term financial instruments that
would provide liquidity for Islamic financial products.
VI. ISLAMIC BANKING AND FINANCE:
PRELIMINARY ASSESSMENT
HISTORICAL PERFORMANCE
Due to a number of historical circumstances, the Muslim world lost its
technological and economic vitality. Consequently, a number of Islamic institu-
tions, including the Islamic system of financial intermediation, became dis-

placed by Western institutions. However, the independence of Muslim coun-
tries has led to the revival of Islam and there is a longing to gradually reinstate
most of the lost institutions, the Islamic financial system being one of them.
Two approaches have been adopted by Muslim countries for eliminating
interest from their financial systems. Three countries, Pakistan, Iran and
Sudan, have opted for the removal of interest from the operations of all their
financial institutions simultaneously. In contrast, a number of countries, in-
cluding some that are non-Muslim, have allowed the establishment of Islamic
banks alongside of conventional interest-based banks. According to data
Ž .
collected by the International Association of Islamic Banks IAIB , there were
more than 176 financial institutions in the public and private sectors of both
Ž
these groups of Muslim and non-Muslim countries by 1997 see Table 2,
.
Section A . They had a capital of $7.3 billion and reserves of $3.1 billion. Their
assets and deposits amounted to 147.7 billion and $112.6 billion respectively.
During 1997, these institutions made a net profit of $1.2 billion. The ratio of
their net profit to capital and assets was 23.1 and 1.2% respectively. While
most variables have registered a relatively high rate of growth, their capital
and reserves have not kept pace. They rather declined to 7% of their assets
Ž .
unadjusted for their riskiness in 1997 from 9.5% in the previous year. This
may perhaps have been partly due to the East Asia crisis, which adversely
affected nearly all financial institutions around the world.
Of the 176 institutions, 9 were in Europe and America, 47 in the Middle
Ž . Ž
East including 21 in the GCC countries , 35 in Africa, and 82 in Asia of
. Ž .
which 31 were in South East Asia and 51 in South Asia see Table 3 . In
addition, there were a number of banks, which had not yet become members
of IAIB. Moreover, the IAIB database does not include the rapidly expanding
deposits accepted by a number of conventional banks on the Islamic basis and
also the Islamic mutual and index funds marketed by both Islamic and
Ž .
conventional banks Chapra and Khan, 2000 .
COMPARISON OF ISLAMIC AND CONVENTIONAL BANKING FRAMEWORKS
Table 4 provides a synoptic comparison of Islamic and conventional banking
frameworks. There are several points that are worth noting. First, Islamic
banks guarantee neither the capital value of nor the return on investment
deposits, and these banks basically pool depositors’ funds to provide depositors
with professional investment management. This situation underscores an inter-
esting similarity between the operation of Islamic banks and investment
companies in the West. There is, however, a fundamental difference between
the two that needs to be recognized. It lies in the fact that investment
companies sell their capital to the public, while Islamic banks accept deposits
from the public. This implies that shareholders of an investment company own
a proportionate part of the company’s equity capital and are entitled to a
number of rights, including receiving a regular flow of information on develop-

Zaher and Hassan
174
Ž .
Table 2: Growth of Islamic Financial Institutions 000 US $
A. Aggregate Size Year-wise
Combined
Funds Combined
No. of Combined Combined under Combined Net
Year Banks Capital Assets Management Reserves Profits
1993 100 2,390,259 53,815,280 41,587,332 NrA NrA
1994 133 4,954,007 154,566,91 70,044,222 2,383,41 809,076
1 3
1995 144 6,307,816 166,053,15 77,515,832 2,918,99 1,245,493
8 5
1996 166 7,271,003 137,132,49 101,162,943 5,745,76 1,683,648
1 5
1997 176 7,333,079 147,685,00 112,589,776 3,075,52 1,218,241
2 6
Ž .
B. Sector Financing In Percentage of total Financing
Real
Year Trading Agriculture Industry Services Estate Others
1993 30.5 13.3 30.1 11.4 NrA 14.7
1994 26.96 13.32 27.54 14.79 5.44 11.96
1995 29.81 8.53 18.91 13.1 12.1 17.13
1996 31.17 7.5 18.82 13.17 11.67 17.67
1997 32 6 17 12 16 16
Ž .
C. Modes of Financing Percent of Total Financing
Murabaha Musharaka Mudaraba
Year h h h Ijarah Others
1994 41.54 8.17 12.56 8.70 26.79
1995 45.58 8.72 15.25 9.72 21.06
1996 40.30 7.20 12.70 11.50 28.30
1997 37.00 19.00 6.00 9.00 29.00
Ž .
Source: International Association of Islamic Banks 1997 ; Chapra and Khan,
2000.
ments of the company’s business and exerting voting rights corresponding to
their shares on important matters, such as changes in investment policy.
Hence, they are in a position to make informed investment decisions, monitor
the company’s performance, and influence strategic decisions. By contrast,
Ž
depositors in an Islamic bank are entitled to share the bank’s net profit or
.
loss according to the PLS ratio stipulated in their contracts. Investment
deposits cannot be withdrawn at any time, but only on maturity and, in the
best case, at par value. Moreover, depositors have no voting rights because
they do not own any portion of the bank’s equity capital. Therefore, they

A
Comparati
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Literature
Sur
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of
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Finance
and
Banking
175
Table 3: Growth by Region
Ž .
Summary of Financial Performance In thousands of US$
NO. OF
REGION SHARES % CAPITAL TOTAL ASSETS DEPOSITS RESERVES NET PROFIT
Amount % Amount % Amount % Amount % Amount %
South Asia 51 29 884,048 12 39,272,976 26 25,664,913 23 1,077,163 35 249,792 20
Africa 35 20 202,197 3 1,573,846 1 730,025 1 82,087 3 19,750 2
S.E. Asia 31 18 149,837 2 2,332,204 2 1,887,710 2 160,136 5 45,659 4
Middle East 26 15 3,684,136 50 83,136,100 56 69,076,443 61 382,286 12 252,185 20
G.C.C. 21 12 1,787,395 24 20,449,637 14 14,088,581 12 1,353,167 44 603,642 49
EuroperAmerica 9 5 616,795 0 908,922 1 1,139,541 1 20,613 1 66,707 5
Asia 2 1 3,452 0 5,727 0 2,563 0 24 0 282 0
Australia 1 0 5,219 0 5,590 0 NrA 0 50 0 224 0
TOTAL 176 100 7,333,079 100 147,685,002 100 112,589,776 100 3,075,526 100 1,238,241 100
Ž .
Source: International Association of Islamic Banks 1997 .

Zaher and Hassan
176
Table 4: Comparison of Banking Frameworks
Paradigm Version of
Characteristics Islamic Banking Conventional Banking
Nominal value guarantee
of: Demand deposits Yes Yes
Investment deposits No No
Equity-based system where
capital is at risk Yes No
Rate of return on deposits Uncertain, not guaranteed Certain and guaranteed
Mechanism to regulate Depending on banks’ Irrespective of banks’
final returns on deposits performancerprofits from performancerprofits
investments from investments
PLS principle is applied Yes No
Use of Islamic modes of
financing: PLS and non-
PLS modes Yes NrA
Use of discretion by banks Possible for reducing moral
11
with regard to collateral hazard in PLS modes Yes always
Yes in non-PLS modes
Banks’ pooling of
depositors’ funds to
provide depositors with
professional investment Yes No
management
Ž .
Source: Errico and Farahbaksh 1998 .
Ž
cannot influence the bank’s investment policy as noted, their relationship with
the bank is regulated according to an unrestricted Mudaraba contract, see
.
table 1 . Second, because of the structure of their balance sheets and the use
of profit and loss sharing arrangements, banks operating according to a
paradigm version of Islamic banking appear to be better poised than conven-
tional banks to absorb external shocks. Indeed, as noted previously, these
Islamic banks have the ability to reduce the capital value of investment
deposits in the case of loss. Third, Islamic banks are not expected to reduce
credit risk by systematically requiring collateral or other guarantee as a
pre-requisite for granting PLS facilities. Fourth, a critical difference between
the two-permissible systems of operation needs to be recognized. Islamic banks
Ž .
can use all of their deposits demand and investments for their financing and
investment activities in Scheme A, while only investment deposits can be
utilized for such purposes in Scheme B. This makes Scheme A, where banks’
assets and liabilities are fully integrated far riskier than Scheme B, where

banks’ liabilities are divided in two windows. Indeed, in Scheme A, given the
Ž .
fact that 1 demand deposits are guaranteed in capital value and are re-
Ž .
deemable by the depositors on demand; 2 demand deposits can be used to
Ž .
finance risk-bearing investment projects; and 3 there is not a mandated
specific reserve requirement on demand and investment deposits, an assets-
liability mismatch can occur, leading possibility to negative net worth, or bank
Ž .
insolvency. Errico and Farahbaksh, 1998 .
ISLAMIC MUTUAL FUNDS
Shariah based investing incorporates seven main pillars that work together to
deliver competitive performance and to promote socially and ethically respon-
sible business practices, which in turn, contribute to improvements in the
quality of life throughout society.
a. Shariah Super¨ision by a qualified Shariah supervisory board is an integral
component of any serious Islamic equity fund structure. The board is
typically made up of prominent scholars, and well versed and disciplined
in Shariah, particularly in the areas of transactions and business dealings.
The board should be independent and should act in an advisory and
supervisory role with the fund’s management and assist in the develop-
ment of fund management policy, Shariah screens, investment strategy,
implementation, monitoring and reporting.
b. Screening is the practice of including or excluding publicly traded securi-
ties from investment portfolios or mutual funds based on the religious
and ethical precepts of the Islamic Shariah. Generally, Muslim investors
seek to own profitable companies that make positive contributions to
society. Certain businesses are incompatible with Shariah laws. There-
fore, stocks of companies whose primary business is not permissible
according to Shariah are excluded, such as: companies that receive a
major portion of their revenues from alcohol, tobacco and pork related
products; interest based financial institutions such as banks, brokerage
and insurance companies; and entertainment companies, including most
hotels, gaming, pornography and music. In addition, most of the Shariah
screens currently in use by fund managers include three financial-ratio
filters:
1. Excluding companies if total debt divided by total assets is equal to or
greater than 33%.
2. Excluding companies if accounts receivable divided by total assets is
equal to or greater than 45%.
3. Excluding companies if non-operating interest income is equal to or
greater than 5%.

Zaher and Hassan
178
c. Purification is the process of eliminating or cleansing the portfolio from
Ž .
income or gain resulting from interest Riba or other impure revenue
sources. The fund should have a strict, quantifiable formula and method-
ology of separating interest related and impure income from the portfo-
lio, including dividends and capital gains.
d. CharityrZakah: Impure portfolio income is donated to charities and
non-profit organizations with the conditions that the monies are not used
to build a mosque or print the Koran. The matter of calculating Zakah is
complicated in equity portfolios due to the timing of portfolio income
and capital gains. Zakah calculations may be provided through the
accounting process of the fund for investors. Tax deferred or exempt
arrangements, as well as trusts, further complicate this. Nonetheless,
Shariah Supervisory Boards may be asked to suggest guidelines that may
then be incorporated into specialized software. Zakah payments may be
administered and directed to the same organizations receiving donations
and charity from impure portfolio income and may be used for any good
purpose.
e. Shareholder Ad¨ocacy describes the actions many socially aware investors
take in their roles as owners of public corporations. These efforts include
dialoging with corporate management on issues of concern, and submit-
ting and voting proxy resolutions. Socially responsible proxy resolutions
are generally aimed at influencing corporate behavior and practices
toward a more responsible level of corporate citizenship.
f. Monitoring and Reporting involves a process of vigilance over the fund’s
holdings to ensure compliance with the Shariah filters, fund strategies
and policies. A screened portfolio is only the first step towards Shariah
compliance. Shariah compliance is an ongoing process and requires
diligent analysis of company financial statements, practices and revenue
sources. Ongoing management and shareholder reports are necessary to
provide fund principals and investors with timely information related to
Shariah issues, the fund, its practices and performance.
g. Community-Based In¨estment programs provide capital to people and
organizations that have difficulty attaining it through conventional chan-
nels or are under-served by conventional financial or lending institutions.
Ž .
Community Development Venture Capital CDVC funds for low- in-
come housing and small business development in the United States and
abroad may also be established. Community-based investments enable
people to improve their standard of living, develop their own small
Ž
businesses and create jobs for themselves and their neighbors. Valpy,
.
2000 .
Table 5 provides three-year historical returns of 37 Islamic Mutual Funds.
From this table, we can ascertain that ethical investment does provide a very
good return compared to regular mutual funds.

Table 5: Mutual Fund Performance Data
Returns Return since
Fund Name 1999 1998 1997 Inception
1 Islamic Multi-Investment Fund 31.80% 3.90% NrA 14.80%
2 GAM AIKawthar 24.87% 16.60% y13.15% 6.70%
3 AIBaraka Global Equity 12.14% 24.60% NrA 41.30%
4 Al Rajhi Global Equity 38.30% 17.13% 17.60% 88.05%
5 Al Rajhi Egypt Equity 0.48% y14.01% 5.00% y16.06%
6 Al Rajhi Local Share 14.01% 0.00% y11.10% y33.48%
7 Al Rajhi Middle East Equity 32.97% 0.00% y11.10% 22.53%
8 Al Rajhi Small Companies 44.89% NrA NrA 44.89%
9 Al-Safwa International Equity NrA 16.48% y3.74% 16.75%
10 Tabung Ittikal Arab-Malaysian 45.53% 8.72% y27.20% 28.55%
11 Amanah Saham Bank Islam 10.01% y36.68% NrA y48.10%
12 Citi Islamic Portfolios A&B 54.95% 16.24% 10.60% 81.80%
13 Mendaki Global 52.10% 39.61% y20.62% 29.40%
14 Mendaki Growth 55.30% 40.00% y42.80% 12.60%
15 Amanah Saham Wanita 41.53% 9.29% NrA 51.00%
Ž .
ASNITA
16 Miraj Global Equity 40.45% 16.57% NrA 56.10%
17 Al Kawthar Fund 27.31% 13.00% NrA 42.00%
18 Alfanar Investment Holdings 36.70% 13.20% NrA 49.90%
19 Alfanar Essex Technology 102.70% NrA NrA 102.70%
20 Alfanar US Capital Growth 49.70% NrA NrA 49.70%
21 Alfanar US Capital Value 25.70% NrA NrA 25.70%
22 Alfanar Europe 18.10% 1.60% NrA 18.10%
23 RHB Mudharabah 35.70% 53.33% y32.81% 0.30%
24 Oasis International Equity 24.32% 10.80% 16.70% NrA
25 SAMBA Global Equity 5.03% NrA NrA 5.03%
26 Amana Growth 99.42% 16.80% 4.46% 24.36%
27 Amana Income 8.68% 14.07% 23.62% 10.88%
28 Pure Specialist Fund 42.19% 26.24% y24.93% NrA
29 Alkhawarizmi Fund 1.67% 3.56% 4.00% 9.50%
30 Ibn Majid Emerging Markets 49.10% y25.50% 2.32% 32.40%
31 TII Small-Cap Equities 87.29% y8.12% y1.89% 69.50%
32 Al-Dar Eastern Europe 33.34% y40.10% NrA y20.13%
33 Al-Dar Europe Equities 24.26% 23.62% NrA 53.61%
34 Al-Dar World Equities 47.23% 26.03% NrA 85.67%
35 Al-Bukhari Global Equity 20.90% 6.10% NrA 27.00%
36 Hegira Global Equity 31.00% 33.20% NrA NrA
37 ZAD Growth Fund LP 62.21% NrA NrA 68.28%
Source: Failaka International, Inc.

Zaher and Hassan
180
DOW JONES ISLAMIC INDEX
Dow Jones Indexes has created a family of equity indices for people who wish
to invest according to Islamic investment guidelines. The Dow Jones Islamic
Market Indexes track Shariah Law compliant stocks from around the world,
providing Islamic investors with comprehensive tools based on a truly global
investing perspective. The Dow Jones Islamic Market Indexes currently in-
Ž .
clude the DJ Islamic Market Index DJIM , the DJ Islamic Market US Index
Ž . Ž .
IMUS , the DJ Islamic Market Technology Index IMTEC , the DJ Islamic
Ž .
Market Extra Liquid Index IMXL , the DJ Islamic Market Canadian Index
Ž . Ž .
IMCAN , the DJ Islamic Market UK Index IMUK , the DJ Islamic Market
Ž . Ž .
Europe Index IMEU , and the DJ Islamic Market AsiarPacific Index IMAP .
Ž .
Dow Jones web site .
The Dow Jones Islamic Market Indices are constructed from the 2,700
stocks in the Dow Jones Global Indexes family, which means they are accessi-
ble to investors and are well traded. The DJGI methodology removes issues
that are not suitable for global investing. The Dow Jones Islamic Market
Indices include the most liquid securities meeting the Shariah investment
criteria in the market, and reflect the industry breakdown of the global market.
The Dow Jones Islamic Market Indices are capitalization weighted. The
indices are calculated and disseminated to major market data vendors in real
time. Index calculation is based on Laspeyres’ formula; it does not include
reinvested dividends.
Certain businesses are incompatible with Shariah Laws. Thus, stocks of
companies whose primary business is in areas not suitable for Islamic invest-
ment purposes are excluded from the Dow Jones Islamic Market Index.
Excluded products include: alcohol, pork related products, conventional fi-
Ž . Ž
nancial services banking, insurance, etc. , entertainment hotels, casinosr
.
gambling, cinema, pornography, music, etc. . Shariah scholars also do not
advise investments in companies that produce tobacco andror defenser
weapons. These incompatible lines of business, represented by 18 of the 122
industry groups within Dow Jones Global Indexes, are removed from the
‘‘universe’’ of stocks considered for the Dow Jones Islamic Market Index.
Other companies classified in other industry groups also may be excluded if
they are deemed to have a material ownership in or revenues from prohibited
business activities.
After removing companies with unacceptable primary business activities, the
remaining universe is tested by three financial-ratio ‘‘filters.’’ The purpose is to
remove companies with unacceptable financial ratios. The filters are: 1. Ex-
clude companies if Total Debt divided by Total Assets is equal to or greater
Ž
than 33%. Note: Total debtsShort-Term DebtqCurrent Portion of Long-
.
Term DebtqLong-Term Debt ; 2. Exclude companies if Accounts Receiv-
Ž
ables divided by Total Assets is equal to or greater than 45%. Note: Accounts
.
ReceivablessCurrent accounts receivablesqLong-Term Receivables ; 3. Ex-

clude companies if the sum of Non-Operating Interest Income plus other
impure income divided by Revenues is equal to or greater than 5%. Compa-
nies that pass these screens are included in the Dow Jones Islamic Market
Index investable universe, from which index components are selected.
The Dow Jones Islamic Market Indexes are based at December 31, 1995.
The base value is set at 1000. The Dow Jones Islamic Market Indices are
reviewed quarterly, with component changes implemented on the third Friday
of March, June, September and December. This frequency assures that the
indices reflect the latest trends and developments in the global stock market.
Table 6 provides performance measures of Dow Jones Islamic Index, which
Ž .
has been in operation for five years 1996-2000 . Based on number of criteria,
we can conclude that DJIM is performing at par with other broad-based
market indices.
VII. CURRENT PRACTICES OF ISLAMIC BANKS
AND REGULATIONS
CURRENT PRACTICES OF ISLAMIC BANKING
Islamic banking in current practice diverges in several important ways from the
ideal version. These differences can be summarized in four main points. First,
all deposits, including investments, are always explicitly or implicitly guaran-
teed. In some cases, the capital value guarantee is formally written in laws and
regulations; in other cases, it is based on implicit understanding among the
authorities, banks, and the public. Second, The PLS principle is never strictly
applied. There are various degrees of noncompliance with respect to the PLS
principle in current banking practices. In some cases, the bank guarantees the
expected rate of return on investment deposits. Moreover, this rate of return is
de-linked from banks’ profit. As a result, the expected rate of return for each
type of deposit is the same for all banks, irrespective of banks’ different levels
of profitability. In other cases, the PLS principal is partially implemented
through complex formulas aimed at maintaining the link between returns to
financial assets and profits originating from banks’ investment of deposited
funds. However, central banks discourage large variations in the rates of
return that banks are allowed to offer to customers in order to avoid destabi-
lizing shifts in deposits. This is accomplished through the imposition of ranges
Ž .
differentiated by sectors of the economy and nature of borrowers within
which banks and customers are allowed to bargain and agree on the terms of
Ž .
specific transactions. Errico and Farahbaksh, 1998 .
Third, financing is mostly carried out through non-PLS modes. On average,
Islamic banks operate through the less risky, shorter-term non-PLS modes,
notably: mark-up, leasing, and lease purchase transactions typically related to
trade financing. The most recent available aggregate data indicate that, in
Ž .
1996, non-PLS modes accounted for 72.2 percent 72.8 in 1995 of total utilized

Zaher and Hassan
182
Ž .
Table 6: Performance Measures of DJIM 1996᎐1998
Volatility 1996 1997 1998 History
DJIM 8.30% 13.40% 16.00% 12.94%
DJ US 11.47% 17.23% 19.70% 16.46%
DJ World 7.08% 12.39% 16.48% 12.56%
S&P 500 11.58% 17.82% 19.86% 16.76%
MSCI World 7.42% 12.78% 16.36% 12.71%
Returns 1996 1997 1998 History
S&P 500 20.26% 31.01% 26.67% 99.57%
DJ US 20.49% 31.69% 26.78% 101.17%
DJ World 10.99% 12.58% 20.22% 50.20%
DJIM 20.24% 18.79% 25.91% 79.84%
MSCI World 14.81% 20.76% 19.15% 65.21%
Sharpe Ratios 1996 1997 1998
S&P 500 1.31 1.44 1.12
DJ US 1.35 1.53 1.13
DJ World 0.84 0.59 0.96
DJIM 1.83 1.01 1.34
MSCI World 1.32 1.21 0.90
Annualized Tracking Errors 12r31r95 to 12r31r98
S&P 500 DJ US DJ World DJIM MSCI World
S&P 500 ᎏ 0.62% 6.52% 4.73% 6.41%
DJ US 0.62% ᎏ 6.30% 4.55% 6.18%
DJ World 6.52% 6.30% ᎏ 2.76% 2.17%
DJIM 4.73% 4.55% 2.76% ᎏ 3.17%
MSCI World 6.41% 6.18% 2.17% 3.17% ᎏ
Correlation 12r31r95᎐12r31r98
S&P 500 DJ US DJ World DJIM MSCI World
S&P 500 ᎏ 99.86% 82.01% 92.26% 83.91%
DJ US 99.86% ᎏ 82.69% 92.52% 84.61%
DJ World 82.01% 82.69% ᎏ 94.74% 96.62%
DJIM 92.26% 92.52% 94.74% ᎏ 93.35%
MSCI World 83.91% 84.61% 96.62% 93.35% ᎏ
lines of credit made available by the Islamic Development Bank to the
Ž
forty-eight member countries to promote Islamic banking. Islamic Develop-
.
ment Bank, 1996 . Fourth, there is discretion with regard to collateral. Islamic
banks are allowed to use a degree of discretion in deciding if collateral is
needed before granting their facilities, including the PLS modes of financing.

As a result of the above practices, the element of uncertainty needed to
legitimize the bargain for possible profits has been substantially reduced and,
in some cases, eliminated. Moreover, PLS modes of financing have been made
similar to non-PLS modes through the reduction of their risk element. There-
fore, it can be concluded that, for all practical purposes, Islamic banking is
currently carried out in a hybrid way that is somewhere in between the
paradigm version and conventional banking. The degree of divergence from
the paradigm version is specific to each country where Islamic banking
principles are followed and need to be assessed on a case-by case basis.
The more current Islamic banking practices diverge from the paradigm
version, the more Islamic banks lose their distinctive features and tend to
resemble conventional banks. Hence, supervisory standards and best practices
developed by the Basle Committee on Banking Supervision become increas-
ingly applicable to Islamic banks and should be implemented accordingly.
Table 7 indicates how the shift from the paradigm version to current practices
should affect the focus of banking supervision in an Islamic framework.
Table 7: Islamic banking in Practice: Shift in the Focus of
Banking Supervision
Paradigm Version Islamic banking
Issue of Islamic Banking in Practice 1
Robustness to absorb external Higher Lower
shocks
.
1 Liquidity risks Less likely More likely
.
2 Insolvency risks Less likely More likely
Relative importance of:
Assessment and management
of operational risks:
Ž .
1 Reliance on appropriate Higher Lower
procedure and adequate
infrastructure
Ž .
2 Reliance on human Higher Lower
technical expertise.
Prudential standards Relevant; to be assessed Crucial
on a bank-by-bank and
country by country
basis
Information disclosure Higher Lower
requirements
1. Depending on the degree of divergence from the theoretical model. At the
end of the spectrum, Islamic banking may coincide with conventional banking,
Ž .
except for the terminology. Source: Errico and Farahbaksh, 1998 .

Zaher and Hassan
184
ISLAMIC BANKING SUPERVISION
Table 8 provides a summary of existing regulation of the OIC Member
Countries. A thematic presentation of its salient features are given below.
Compliance with International Standards
1. Most member countries reviewed here have adopted the international
standards, including the Basel Committee’s Core Principles and mini-
mum risk-weighted capital requirements and the International Account-
ing Standards Committee’s international accounting standards.
2. Some countries are implementing crash programmers to adopt the inter-
national standards but report difficulties, particularly in the risk-weight-
ing of assets created by the Islamic modes of finance. A few countries
have not revealed the state of their compliance with international stan-
dards.
3. Compliance with the standards set by the Accounting & Auditing Organi-
Ž .
zation for Islamic Financial Institutions AAOIFI , has not yet fully
Ž .
materialized; only two countries Bahrain and Sudan have so far explic-
itly adopted the standards set by it.
4. Since most Islamic banks are small, some countries have announced a
program of mandatory merger of Islamic banks and strengthening of
their capital to make them viable in an international environment, which
has become characterized by mega-banks.
5. Three countries, Iran, Pakistan and Sudan, which have initiated the
transformation of their entire economies in accordance with Islamic
teachings, have announced major restructuring programs for their bank-
ing sectors. Each of the three countries have active plans for the
privatization of banks. Pakistan and Sudan have announced a mandatory
program for strengthening the capital of banks and of mergers to the
Ž
extent to which this is necessary for the purpose. Chapra and Khan,
.
2000 .
OFFSITE AND ONSITE SUPERVISION
1. Iran, Malaysia, Pakistan and Turkey have put in place both offsite and
onsite supervision systems to realize the standard objective of such
systems.
2. Malaysia follows the CAMELS rating system. The CAMELS rating
system refers to capital adequacy, assets quality, management quality,
earnings, liquidity, and systems for internal controls.
VIII. PROBLEMS AND CHALLENGES OF ISLAMIC BANKING
AND MARKETS
Islamic financial markets are operating far below their potential because
Islamic banking by itself cannot take root in the absence of the other

Table 8: Important Features of Islamic Banking and Supervisory Regimes in
Muslim Countries
Country Salient Features of Islamic Banking Supervisory Systems
Ž .
Bahrain Regulated by the Bahrain Monetary Agency BMA ⽧ BMA
Ž
regulates both commercial banks and investment banks securities
.
firms ; insurance companies are under separate regulatory author-
Ž .
ity ⽧ Dual banking Islamic and conventional banking system;
Basel capital requirements and core principles adopted for both
.
groups, ⽧ Four Islamic banking groups: a Islamic commercial
. .
banks, b Islamic investment banks, c Islamic Offshore banks,
.
and d Islamic banking windows in conventional banks ⽧
Consolidated supervision ⽧ International Accounting Standards
adopted, ⽧ Each Islamic bank must have a Sharı’ah board ⽧
Compliance with AAOIFI standards under active consideration ⽧
Investment deposits, current accounts and capital allocation for
assets must be declared, ⽧ Mandatory liquidity management by
adopting the standardised maturity buckets of assets ⽧ Islamic
and conventional mixed system
Ž .
Gambia Regulated by the Central Bank of Gambia CBG ⽧ Islamic
banking law exists ⽧ Dual system ⽧ Separate Sharı’ah board
required ⽧ Compliance with Basel capital requirements and core
principles and International Accounting Standards not clear
Ž
Indonesia Regulated by the Central Bank of Indonesia Bank Sentral
.
Republik Indonesia᎐BSRI ⽧ Separate regulatory bodies for
banks and securities firms ⽧ Separate Islamic banking law does
Ž .
not exist; Islamic Sharı’ah banking is covered by added section
Ž .
in the banking law Act No. 10 1998 and Act No. 23 1999 ⽧
Separate Sharı’ah board required ⽧ Islamic windows allowed ⽧
Consolidated supervision ⽧ Basel capital requirements and core
principles adopted ⽧ International Accounting Standards adopted
⽧ Major financial transformation in process to strengthen bank
capital and solvency ⽧ Active Sharı’ah bank development strat-
egy in place by the government
Ž
Iran Regulated by the Central Bank of Iran Bank Jamhuri Islami
.
Iran ⽧ All banks in the public sector with a plan for minority
privatisation ⽧ Bank regulation and supervision is strongly
effected by monetary as well as fiscal and other government
Ž .
policies ⽧ Single Islamic banking system under the 1983 Usury
Free Banking Law ⽧ Modes of finance are defined by this Law ⽧
Recent policy orientation towards adopting the Basel capital and
supervisory standards and International Accounting Standards ⽧
No Sharı’ah board for individual banks ⽧ Onsite and offsite
supervisory methods and objectives defined and applied ⽧ Banks
and insurance companies are supervised by different regulatory
authorities

Zaher and Hassan
186
Ž .
Table 8: Continued
Ž .
Jordan Regulated by the Central Bank of Jordan CBJ ⽧ Separate
regulatory bodies for banks and securities firms ⽧ Islamic
banking law exists ⽧ Dual system ⽧ Separate Sharı’ah board
required ⽧ Consolidated supervision ⽧ Basel capital require-
ments and core principles adopted ⽧ International Accounting
Standards adopted
Ž .
Kuwait Supervised by the Central Bank of Kuwait CBK ⽧ CBK
Ž
regulates both commercial banks and investment banks securities
.
firms ; insurance companies are under separate regulatory author-
.
ity ⽧ Dual banking system ⽧ Two Islamic banking groups: a
.
Islamic commercial banks, and b Islamic investment banks.
Conventional banks not allowed to have Islamic banking windows.
⽧ Consolidated supervision ⽧ Basel capital requirements and
supervisory standards adopted ⽧ International Accounting Stan-
dards adopted ⽧ Separate Islamic banking law under active
consideration ⽧ Separate Sharı’ah board for each bank necessary
Ž
Malaysia Regulated by the Central Bank of Malaysia Bank Nagara
.
MalaysiaᎏBNM ⽧ Insurance companies and banks under same
regulatory authority; securities firms under separate authority ⽧
Private banks ⽧ Dual banking system ⽧ Islamic windows allowed
in conventional banks ⽧ Consolidated supervision ⽧ Basel
capital requirements and core principles adopted ⽧ International
Accounting Standards adopted ⽧ CAMELS rating system adopted
⽧ Onsite and offsite supervision well defined with clear objectives
⽧ Separate Sharı’ah boards at institutional level in the BNM and
Securities Exchange Commission ⽧ Islamic money market and
liquidity arrangement exists ⽧ Ministry of Finance closely associ-
ated with the supervision of Islamic banks
Ž
Pakistan Regulated by the Central Bank of Pakistan State Bank of
.
Pakistan-SBP ⽧ Securities firms, and Insurance Companies are
regulated by separate regulatory bodies ⽧ Major banks in the
Public Sector; bank regulation and supervision effected by govern-
ment policies ⽧ Islamic banking law does not exist ⽧ Mudarabah
Companies Law exists ⽧ Sharı’ah board concept does not exist ⽧
Islamic banks are not identified distinctly ⽧ Basel capital
requirements and supervisory standards adopted ⽧ Bank merger
is on cards to strengthen capital ⽧ Concept of onsite and offsite
supervision exists ⽧ Major financial transformation is called for
by the Supreme Court of Pakistan to introduce Islamic banking
and financial system; a Financial Services Transformation Com-
mittee has been established by the SBP.

Ž .
Table 8: Continued
Ž .
Qatar Regulated by the Central Bank of Qatar CBQ ⽧ Dual banking
and separate regulatory system ⽧ No separate Islamic banking
law exists ⽧ Islamic banks supervised by special directives of
CBQ ⽧ Separate Sharı’ah boards for banks required ⽧ Standard-
ised transparency requirements for Islamic banks exist
Ž . Ž .
Sudan Regulated by the Central Bank of Sudan CBS ⽧ Single Islamic
system ⽧ Islamic banking law in place ⽧ Separate Sharı’ah
boards for banks required, also the Central Bank has a Sharı’ah
Supervisory Board ⽧ Substantial public sector control; supervi-
sion and regulation is effected by other government policies ⽧
Evolution of financial instruments underway ⽧ Compliance with
the capital adequacy and supervisory oversight standards of the
Basel Committee not clear ⽧ Major bank merger is planned to
strengthen bank capital
Ž
Turkey Regulated by the Central Bank of Turkey Turkeyi Cumhuriyet
.
Merkez BankasiᎏTCMB ⽧ Banks and securities firms regulated
by separate bodies ⽧ Law about Special Finance Houses covers
Islamic banks ⽧ Dual system; no Islamic windows allowed ⽧
Basel Committee capital adequacy requirements and supervisory
standards recently introduced ⽧ Major financial transformation
underway ⽧ Onsite and offsite supervision concepts and methods
exist
UAE Regulated by the Central Bank of UAE ⽧ Islamic banking law
exists ⽧ Dual system ⽧ Islamic banking windows allowed ⽧
Separate Sharı’ah boards required ⽧ Basel Committee capital
adequacy requirements and supervisory standards in place ⽧
International Accounting Standards in place
Ž .
Yemen Regulated by the Central Bank of Yemen CBY ⽧ Islamic
banking law exists ⽧ Dual system ⽧ Islamic banking windows
allowed ⽧ Separate Sharı’ah board required ⽧ Major policies
and standards set by the CBY are equally applicable to all banks
⽧ Separate supervisory office for Islamic banks inside the CBY
under active consideration ⽧ Compliance with the Basel stan-
dards not clear
Sources: Compiled from Country Case Studies referred to in the bibliography,
Ž .
Babikir 1999 and Web Sites of respective central banks, also given in the
Ž .
bibliography, and Chapra and Khan 2000 .
necessary components of an Islamic financial system. A number of limitations
and challenging issues will have to be addressed before any long-term strategy
Ž .
can be formulated Dudley 1998, and Naughton 2000 .
First, a uniform regulatory and legal framework that is supportive of an
Islamic financial system has not yet been developed. Existing banking regula-

Zaher and Hassan
188
tions in Islamic countries are based on the Western banking model. Further,
Islamic financial institutions face difficulties in operating in non-Islamic coun-
tries owing to the absence of a regulatory body that operates in accordance
with Islamic principles. The development of a regulatory and supervisory
framework that would address the issues specific to Islamic institutions would
further enhance the integration of Islamic markets and international financial
markets. None of the sizable and organized financial centers can claim to be
functioning in accordance with Islamic principles. In addition, while the stock
markets in emerging Islamic countries such as Egypt, Jordan, and Pakistan are
active, they are not fully compatible with Islamic principles. The stock markets
in Iran and Sudan may come closest to operating in compliance with Islamic
principles.
Second, there is a need for risk analysis and risk-management tools to
provide agents with hedging instruments to hedge against the high volatility in
currency and commodities markets, especially for Islamic banks in Western
markets. Interest rates play a key role in managing liquidity, pricing risk and
allocating credit. In the absence of interest rates, the risk manager in an
Islamic bank faces a greater challenge than the risk manager of a similar size
Western bank. In addition to this burden, Islamic banks are unlikely to benefit
from a critical mass of similar institutions with which an Islamic interbank
market can be developed, thus requiring Islamic banks to hold higher levels of
liquidity than Western banks, with a consequent negative impact on their
ability to compete.
Third, a need exists for sound accounting procedures and standards that are
consistent with the Islamic laws. Western accounting procedures are not
adequate due to differences in the nature and treatment of financial instru-
ments. Well-defined procedures and standards are necessary for information
disclosure, building investors’ confidence, and monitoring. Well-established
standards will also help the integration of Islamic markets with international
markets. Islamic institutions also have a shortage of trained personnel who can
analyze and manage portfolios, and develop innovative products according to
Islamic financial principles. Only a limited number of Islamic institutions can
afford to train their staff and deploy resources in product development.
Fourth, there is a lack of uniformity in the religious principles applied in
Islamic countries. Since there is no universally accepted central Islamic reli-
gious authority, Islamic banks have formed their own religious boards for
advice and guidance. Islamic banks have to consult their respective religious
Ž .
boards, or Shariah Islamic law advisors, to seek approval for each new
instrument. Differences in interpretation of Islamic principles by different
schools of thought may mean that identical financial instruments are rejected
by one board but accepted by another. Thus, the same instrument may not be
acceptable in all countries. Another problem is that many people do not
understand Islamic banking. The basic principle is clear, that it is contrary to
Islamic law to make money out of money and that wealth should accumulate

from trade and ownership of real assets. However, there does not appear to be
a clear definition of what is or is not an Islamic banking product; nor is there a
clear definition of an Islamic bank. These two problems can be addressed by
forming a uniform council representing different schools of thought. The
council will consist of religious scholars and banking scholars with interna-
tional exposure. The role of the council is to define cohesive rules and to
expedite the process of clearly defining and introducing new products
Fifth, another challenge that Islamic banks must also address is size. Many
of the Islamic financial institutions are extremely small and cannot remain
serious players in the Islamic market as it continues to expand and attract
large international banks. In order to be competitive in a global sense, Islamic
banks have to reach mutual understandings to merge or cooperate. They also
have to take fundamental strategic decisions about the type of banks they wish
to become. The areas of development might well be in specialization. For
example, in Africa the focus might be on agriculture, and in Asia the focus
could be on industrial and service sectors and on trade. In Europe and USA,
capital and financial leasing could be their specialty.
Sixth, Islamic banks are excluded from the lender of last resort function in
many traditional banking systems in Muslim countries. The only exception is
Malaysia because it has an active interbank money market and an Islamic
clearing system that is run by the central bank. It is in the process of setting up
a liquidity management house to internationalize their system, which could
ultimately develop into a lender of last resort. The central bank in the West
traditionally stands behind the banking system to offer liquidity lending to
banks if there is a shortage of funds in the system. Islamic banks may not be
able to use this facility because of the interest payments due on the loans.
Seventh, classification of risk sharing funds placed with Islamic banks is a
further difficulty. The fundamental issue is to judge if these funds are capital
certain. If they were capital certain they would be defined as a bank deposit
under Western banking laws. However, if they were defined as investments in
a collective investment scheme, they are not bank deposits. The classification
of these funds has implications for Islamic banks’ capital requirements. In
addition, regulators in Western countries can, and do argue that because
Islamic banking is relatively new and because their assets are often long-term
and illiquid, the Islamic banks should carry more, rather than less capital. For
example, a new financial reform bill was recently introduced in Turkey. The
bill is to bring the Islamic banks and other special finance houses under the
Ž
same body of legislation as conventional interest-bearing banks Gorvett,
.
1998 . As a result, Islamic banks in Turkey are now expected to hold an extra
6 percent of liquidity in form of Treasury bills and to invest an additional
50 percent from their own capital. Islamic banks are also required to insure
the investors’ deposits.
Finally, the secondary market for Islamic products is extremely shallow and
illiquid, and money markets are almost nonexistent, since viable instruments

Zaher and Hassan
190
are not currently available. The development of an interbank market is
another challenge. The pace of innovation is slow. For years, the market has
offered the same traditional instruments geared towards shortened medium-
term maturities, but it has not yet come up with the necessary instruments to
handle maturities at the extremes. The lack in liquidity-enhancing instruments
eliminated a large segment of potential investors. However, more liquid
instruments are emerging through securitization. Three types of Islamic funds
are becoming more popular: equity, commodity, and leasing. Equity funds, the
largest share of the Islamic funds market, are the same as conventional mutual
funds but with an Islamic touch that requires a unique ‘‘filtration’’ process to
select appropriate shares. The filtration process ensures that the mode, opera-
tion, and capital structure of each business the fund invests in are compatible
with Islamic law, eliminating companies engaged in prohibited activities and
those whose capital structure relies heavily on debt financing to avoid dealing
with interest.
The future of Islamic equity funds is bright in part because of a new wave of
privatization under way in Muslim countries such as Egypt and Jordan, and in
high-growth Islamic countries such as Indonesia and Malaysia, where the
demand for Islamic financial products is growing rapidly. Commodity and
leasing funds are other forms of Islamic funds. Commodity funds invest in base
metals. Leasing funds pool auto, equipment, and aircraft leases and issue
tradable certificates backed by the leases. International and regional institu-
tions are working with Islamic finance and are contemplating the introduction
of derivative products and syndication to enhance project finance. While the
introduction of derivative products is being cautiously studied, it is suspected
that these incorporate interest and may also support speculative activities.
Simple derivatives, such as forward contracts, are being examined because
their basic elements are similar to those of the Islamic instrument of deferred
sale. Project finance, which puts emphasis on equity participation, is another
natural fit for Islamic finance.
IX. ISLAMIC STOCK MARKET: PROSPECTS
AND CHALLENGES
Many Muslim countries or with a majority Muslim population such as Egypt,
Jordan, Turkey, Kuwait, Bahrain, Saudi Arabia, Karachi, Lebanon, Iran,
Indonesia and Pakistan have well established stock markets. These markets
are Western style markets with practices and regulations that do not strictly
adhere to Islamic Laws. Many of these markets are now attempting to apply
Islamic principles to trading. Malaysia, on the other hand, has already made
great progress towards establishing the necessary infrastructure to facilitate
trading according to Islamic principles. Islamic brokerage houses and an
Islamic stock index consisting of 170 stocks that trade on the Kuala Lumpur
Stock Exchange were also established.

The development of an Islamic equity market brings forward a number of
Ž .
problems and challenges Naughton 2000 . One of the most difficult aspects of
Ž .
designing an Islamic stock market is the issue of Qimar gambling . This
concept covers speculation in the stock market, that is, buying and selling
stocks solely for short-term gains resulting from uncertainty in the market. In
Western markets, moderate levels of speculation are quite acceptable. Specu-
lators keep the market more watchful of what is happening and their trading
Ž .
improves the liquidity in the market Figlewski, 1979 . The interaction of
rational investors, who trade on ‘‘true’’ information relating to the stock, and
speculators, who trade on ‘‘noise’’ help to keep the market efficient in a
Ž .
Western sense Black, 1986 . A number of issues relating to speculation need
to be resolved before a fully functioning Islamic stock market can evolve.
Related to speculation is the practice of arbitrage and short selling; neither is
an acceptable practice. An arbitrageur seeks to obtain a risk free return with
zero investment and a short seller borrows a stock from a broker in anticipa-
tion of price decline where he can then buy the stock back at a lower price.
Both activities are unacceptable because of its association with gambling and
excessive risk.
The creation of excessive uncertainty, or Gharar is another unacceptable
practice related to speculation. Buying or selling stocks in a highly volatile
market that would produce excessive risk in the transaction is not permitted.
Both buyers and sellers should not transact business when the outcome of the
Ž .
deal is highly uncertain Kazmi, 1994 . However, stocks are risky and market
participants are attracted to them because of the expected higher return
associated with high risk.
Certain transactions that take the form of Ikrah are not permissible. This
happens when one party to a trade imposing a contract on an unwilling party,
Ž .
or imposing conditions that are unacceptable to the other party Kazmi, 1994 .
From a Western perspective it is difficult to see any problem in this regard.
Ž
Market participants willingly buy and sell derivative securities options and
.
futures on daily basis. They know in advance the terms and possible outcomes
of such contracts. From an Islamic perspective this would not be a problem in
the case of traditional stock trading. However, in the case of options this is not
acceptable. The option contract implies that option buyers will exercise the
contract only when it is beneficial to them, while being a potential loss for the
seller. The very fact that the buyer can impose a loss on the seller may make
such a contract unacceptable in Islam. In addition, the reality that the loss is
related to a derivative position, and not to an identifiable transaction in goods
or services, creates further difficulties.
Trading in derivatives also raises the question of hedging or insurance.
Traditional Western style insurance is prohibited in Islam. Hedging using
derivatives is a form of insurance. Investors may seek to protect their underly-
ing investments by buying and selling options or futures. In addition, the
derivative market depends on the interaction of speculators and hedgers and

Zaher and Hassan
192
therefore, also has an element of speculation, which is a form of usury in
Islam.
Confidentiality and the use of superior information for gain are generally
acceptable in a Western stock market, provided it is not privileged price
sensitive information being used by insiders. Western markets typically treat
insider trading as an illegal activity. Manipulation of stock prices, for instance
through creating a false market in a stock, is also typically illegal in Western
countries and is another aspect of exploitation that would be regarded as Riba
in Islam.
Deregulation is a major feature of all Western financial markets. Markets
are allowed to function with little or no government interference. In the case
of stock markets, there is some intervention because of the need to protect
investors from insider trades, price manipulators, excessive risk taking and
Ž .
other aspects of moral hazard Ghon Rhee, 1992 . The main argument in favor
of deregulation is that it improves market efficiency. From an Islamic perspec-
tive, a broader definition of market efficiency is needed. A definition that is
similar to the concept of social efficiency under which financial markets in
general, and stock markets in particular, should be efficient in the sense that
Ž
they support social justice, fairness and the well being of society Samuels and
.
Yacout, 1981 . This is not a strong feature of traditional Western views of
efficiency. Some would argue that stock markets actually create social ineffi-
ciency by encouraging unequal distribution of wealth. Rash speculation also
creates systemic risk and can have a destabilizing effect on the economy. The
Wall Street crash of the 1920s and the Stock Market crash of 1987 are
examples of the threats that stock markets pose. The collapse of the Kuwait
stock exchange in 1982, due to the failure of major speculators and their
financiers, is an example of the dangers faced by Muslim countries when
uncontrolled speculation is permitted. In addition to speculation, stock mar-
kets provide opportunities for insider trading. Such activities can have an
adverse effect on moral standards and business ethics.
The lack of strong form information efficiency in the Islamic secondary
market may also create difficulties. There would be no confidential informa-
tion if markets were efficient in the strong form. Many firms in Islamic
countries try to keep confidential certain aspects of their activities, while
market analysts following stocks of these companies elicit this information
through painstaking research. Institutional investors who have highly skilled
analysts aim to profit from this information by trading ahead of the rest of the
market. This leads to a form of information asymmetry, which is a potential
problem when considering acceptable contracts in Islam.
Finally, the basic western financial securities such as common stocks, bonds
and preferred stocks, create problems when they are utilized in an Islamic
Ž .
economy. The reason stems from a lack of clear Shariah Islamic law guidance
on their acceptability. Common stocks are perhaps the simplest, yet there
appears to have been little in the way of comprehensive examination of their

acceptability in modern Islamic society. Since common stocks closely adhere to
the profit and loss sharing principle, it is difficult to fault common stock as an
Islamic security. However, not all common stocks would qualify for trading on
an Islamic stock exchange as we discuss below.
Bonds on the other hand, present problems if utilized by Islamic firms and
made available to Muslim investors through the stock market. A traditional
Western style corporate bond is likely to fail any test of acceptability because
they are interest based, paying fixed interest payments and in event of default
penalties are imposed on the borrower. Such penalties are deemed to be
un-Islamic as they are close to usury, the principle reason for the prohibition
Ž .
of interest in Islam Siddiqi, 1995 . One possibility is to utilize loans in the
Ž .
form of Qard Hassan benevolent loan . Although these loans are already in
use on a small scale, their use on an ongoing large-scale commercial finance in
banking is not feasible. The solution of Islamic debt securities is likely to lie
in transforming traditional bonds into transaction based contracts. Murabaha
or Bai Muajjal contracts can be used to create debt instruments tied to a
particular transaction such as the purchase of an asset by a firm. Subscribers to
a bond issue would first buy the asset then resell it to the borrower at a price
higher than the original cost, and receive payment for the sale over a specified
period of time. This transaction is basically a collateralized bond, where the
bondholder retains the claim on title of the asset until maturity. Even such
transactions have been challenged on the grounds that it has similarities to
contracts with interest.
Preferred stock is a fixed income security that closely resembles traditional
debt financing. Hence traditional Western style preferred stocks are also not
acceptable. However, restructuring of preferred stock to give them more
equity features is likely to be acceptable, provided the return to investor is not
Ž .
a fixed return on the original amount invested Mohsin 1983 . Preferred stocks
could also be structured as a transaction contract discussed above.
Listings on the Islamic stock exchange and the type of activities that are
permissible should be addressed also. Only companies operating in acceptable
areas of business activities can be listed on the exchange. Activities such as
Ž .
gambling services, pork products and alcohol products are Haram expressly
forbidden in Islam. However, there are a number of other activities that could
Ž .
be considered Makruh discouraged but not forbidden. There is merit in
avoiding such activities but no wrongdoing being involved. Activities relating to
environmental degradation may fall within this category. It is the role of
Islamic funds managers and directors of Islamic stock exchanges to filter out
those companies that are involved in Makruh activities. This practice is not
new to investors in the U.S, where many investors are turning to ethical
investment funds or socially responsible funds. The funds will not invest in
stocks of companies that are involved in activities that are judged to be
unethical or socially irresponsible. Pollution creation, association with gam-

Zaher and Hassan
194
bling and alcohol, tobacco products, and weapons production are a few
examples of these activities.
X. CONCLUSION
During the last twenty years, a large-scale growth in Islamic finance has grown
in Muslim countries and around the world. This growth was a result of several
factors such as the desire for sociopolitical and economic systems based on
Islamic principles and a stronger Islamic identity. Islam remains the fastest
growing religion in the world. Muslims now constitute about 27 percent of the
world population. The introduction of broad macroeconomic and structural
reforms in financial systems, liberalization of capital movements, privatization,
global integration of financial markets, and introduction of innovative and new
Islamic products have also paved the way for the expansion of Islamic finance.
Islamic finance is now reaching new levels of sophistication. However, a
complete Islamic financial system with identifiable instruments and markets is
still at an early stage of evolution. Many problems and challenges relating to
Islamic instruments, financial markets, and regulation must be addressed and
resolved.
The lack of developed markets in which Islamic financial instruments can be
traded is one of a number of problems caused by lack of cooperation among
Muslim financial institutions. There is disagreement over what is prohibited
and over the terminology used. There is a shortage of recognized instruments,
and the legitimate use of each instrument is also a subject of dispute. Banks’
regulation is different at different countries and range from under regulation
which allowed the defunct Bank of Credit and commerce International to set
Ž
up so easily in Abu Dhabi to over-regulation such as in Yemen Freeland
.
1998 .
The further growth and development of the Islamic financial system will
depend largely on the nature of innovations introduced in the market. Finan-
cial and human resources should be deployed to develop Islamic financial
instruments to enhance liquidity, develop secondary and interbank markets,
and perform assetrliability and risk management.
The Islamic financial system can also offer alternatives at the microfinance
level. Securitization is a step in the right direction, but even this requires more
sophistication. More unbundling and repackaging of financial assets to en-
hance their marketability, negotiability, and liquidity in Islamic financial mar-
kets is needed. Current market operations are restricted by the dearth of
liquidity-enhancing products; secondary markets lack depth and breadth; and,
more important, instruments for assetrliability management are simply nonex-
istent. We expect that with the expansion of securitization, the customer base
of Islamic financial systems will grow as institutional investors, who have access
to broader maturity structures and are attracted to the market, the secondary
market will develop and assetrliability management will become a reality

because of the collateralized nature of their cash flows. In addition, because of
the collateralized nature of their cash flows, real estate, leasing, and trade
receivables are also strong candidates for securitization.
An Islamic financial system can play a vital role in the economic develop-
ment of Islamic and non Islamic countries by mobilizing dormant savings that
are being intentionally kept out of interest based financial channels and
facilitating the development of capital markets. Further, the development of
such systems would enable savers and borrowers to choose financial instru-
ments compatible with their business needs, social values, and religious beliefs.
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XII. NOTE ON CONTRIBUTOR
Tarek S. Zaher is a professor of Finance and the Finance Program Coordina-
tor at Indiana State University, Terre Haute, Indiana.
M. Kabir Hassan is LREC Chair Professor of Economic Development and
Finance and Associate Chair in the Department of Economics and Finance at
University of New Orleans, Louisiana.

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