[This article was published in the 10th issue of Nida'ul Islam magazine (), November-December 1995]

Principles Of Islamic Banking

Read the Interview With MCCA

For millions of Muslims, banks are institutions to be avoided. Islam is a religion which keeps Believers from the teller's window. Their Islamic beliefs prevent them from dealings that involve usury or interest (Riba). Yet Muslims need banking services as much as anyone and for many purposes: to finance new business ventures, to buy a house, to buy a car, to facilitate capital investment, to undertake trading activities, and to offer a safe place for savings. For Muslims are not averse to legitimate profit as Islam encourages people to use money in Islamically legitimate ventures, not just to keep their funds idle.

However, in this fast moving world, more than 1400 years after the Prophet (s.a.w.), can Muslims find room for the principles of their religion? The answer comes with the fact that a global network of Islamic banks, investment houses and other financial institutions has started to take shape based on the principles of Islamic finance laid down in the Qur'an and the Prophet's traditions 14 centuries ago. Islamic banking, based on the Qur'anic prohibition of charging interest, has moved from a theoretical concept to embrace more than 100 banks operating in 40 countries with multi-billion dollar deposits world-wide. Islamic banking is widely regarded as the fastest growing sector in the Middle Eastern financial services market. Exploding onto the financial scene barely thirty years ago, an estimated $US 70 billion worth of funds are now managed according to Shari'ah. Deposit assets held by Islamic banks were approximately $US5 billion in 1985 but grew over $60 billion in 1994.

The best known feature of Islamic banking is the prohibition on interest. The Qur'an forbids the charging of Riba on money lent. It is important to understand certain principles of Islam that underpin Islamic finance. The Shari'ah consists of the Qur'anic commands as laid down in the Holy Qur'an and the words and deeds of the Prophet Muhammad (s.a.w.). The Shari'ah disallows Riba and there is now a general consensus among Muslim economists that Riba is not restricted to usury but encompasses interest as well. The Qur'an is clear about the prohibition of Riba, which is sometimes defined as excessive interest. "O You who believe! Fear Allah and give up that remains of your demand for usury, if you are indeed believers." Muslim scholars have accepted the word Riba to mean any fixed or guaranteed interest payment on cash advances or on deposits. Several Qur'anic passages expressly admonish the faithful to shun interest.

The rules regarding Islamic finance are quite simple and can be summed up as follows:

a) Any predetermined payment over and above the actual amount of principal is prohibited.
Islam allows only one kind of loan and that is qard-el-hassan (literally good loan) whereby the lender does not charge any interest or additional amount over the money lent. Traditional Muslim jurists have construed this principle so strictly that, according to one commentator "this prohibition applies to any advantage or benefits that the lender might secure out of the qard (loan) such as riding the borrower's mule, eating at his table, or even taking advantage of the shade of his wall." The principle derived from the quotation emphasises that associated or indirect benefits are prohibited.

b) the lender must share in the profits or losses arising out of the enterprise for which the money was lent.
Islam encourages Muslims to invest their money and to become partners in order to share profits and risks in the business instead of becoming creditors. As defined in the Shari'ah, or Islamic law, Islamic finance is based on the belief that the provider of capital and the user of capital should equally share the risk of business ventures, whether those are industries, farms, service companies or simple trade deals. Translated into banking terms, the depositor, the bank and the borrower should all share the risks and the rewards of financing business ventures. This is unlike the interest-based commercial banking system, where all the pressure is on the borrower: he must pay back his loan, with the agreed interest, regardless of the success or failure of his venture.

The principle which thereby emerges is that Islam encourages investments in order that the community may benefit. However, it is not willing to allow a loophole to exist for those who do not wish to invest and take risks but rather content with hoarding money or depositing money in a bank in return for receiving an increase on these funds for no risk (other than the bank becoming insolvent). Accordingly, under Islam, either people invest with risk or suffer loss through devaluation by inflation by keeping their money idle. Islam encourages the notion of higher risks and higher returns and promotes it by leaving no other avenue available to investors. The objective is that high risk investments provide a stimulus to the economy and encourage entrepreneurs to maximise their efforts.

c) Making money from money is not Islamically acceptable.
Money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it. Muslim jurists consider money as potential capital rather than capital, meaning that money becomes capital only when it is invested in business. Accordingly, money advanced to a business as a loan is regarded as a debt of the business and not capital and, as such, it is not entitled to any return (i.e. interest). Muslims are encouraged to purchase and are discouraged from keeping money idle so that, for instance, hoarding money is regarded as being unacceptable. In Islam, money represents purchasing power which is considered to be the only proper use of money. This purchasing power (money) cannot be used to make more purchasing power (money) without undergoing the intermediate step of it being used for the purchase of goods and services.

d) Gharar (Uncertainty, Risk or Speculation) is also prohibited.
Under this prohibition any transaction entered into should be free from uncertainty, risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. Also, parties cannot predetermine a guaranteed profit. This is based on the principle of 'uncertain gains' which, on a strict interpretation, does not even allow an undertaking from the customer to repay the borrowed principal plus an amount to take into account inflation. The rationale behind the prohibition is the wish to protect the weak from exploitation. Therefore, options and futures are considered as un-Islamic and so are forward foreign exchange transactions because rates are determined by interest differentials.

A number of Islamic scholars disapprove the indexation of indebtedness to inflation and explain this prohibition within the framework of qard-el-hassan. According to those scholars, the creditor advances the loan to win the blessings of Allah and expects to obtain the reward from Allah alone. A number of transactions are treated as exceptions to the principle of gharar : sales with advanced payment (bai' bithaman ajil); contract to manufacture (Istisna); and hire contract (Ijara). However, there are legal requirements for the conclusion of these contracts to be organised in a way which minimises risk.

e) Investments should only support practices or products that are not forbidden -or even discouraged- by Islam. Trade in alcohol, for example would not be financed by an Islamic bank; a real-estate loan could not be made for the construction of a casino; and the bank could not lend money to other banks at interest.

Islamic Funding Structures And Financing Vehicles

Islamic banks around the world have devised many creative financial products based on the risk-sharing, profit-sharing principles of Islamic banking. For day to day banking activities, a number of financial instruments have been developed that satisfy the Islamic doctrine and provide acceptable financial returns for investors. Broadly speaking, the areas in which Islamic banks are most active are in trade and commodity finance property and leasing. Some of the basic financial techniques of Islamic banking are the following:

Murabaha: This is the sale of a commodity at a price which includes a stated profit known to both the vendor and the purchaser. This can be called a cost plus profit contract. The price is usually paid back by the buyer in deferred payments. Under Murabaha, the Islamic bank purchases, in its own name, goods that an importer or a buyer wants, and then sells them to him at an agreed mark-up. This technique is usually used for financing trade, but because the bank takes title to the goods, and is therefore engaged in buying and selling, its profit derives from a real service that entails a certain risk, and is thus seen as legitimate. Simply advancing the money to the client at a fixed interest rate would not be legitimate. It is important to note that only a legitimate profit in addition to the actual price is considered lawful under Islamic law. Any excessive addition on account of deferred payments will be disallowed as it would amount to a payment based on the value of money over time i.e. interest. Mudaraba: This implies a contract between two parties whereby one party, the rabb al-mal (beneficial owner or the sleeping partner), entrusts money to the other party called the mudarib (managing trustee or the labour partner). The mudarib is to utilise it in an agreed manner and then returns to the rabb al-mal the principal and the pre-agreed share of the profit. He keeps for himself what remains of such profits. The following characteristics of mudaraba are of significance: The division of profits between the two parties must necessarily be on a proportional basis and cannot be a lump-sum or guaranteed return.
The investor is not liable for losses beyond the capital he has contributed.
The mudarib does not share in the losses except for the loss of his time and efforts.

Briefly, an Islamic bank lends money to a client - to finance a factory, for example - in return for which the bank will get a specified percentage of the factory's net profits every year for a designated period. This share of the profits provides for repayment of the principal and a profit for the bank to pass on to its depositors. Should the factory lose money, the bank, its depositors and the borrower all jointly absorb the losses, thereby putting into practice the pivotal Islamic principle that the providers and users of capital should share risks and rewards.

Musharaka: This is a partnership, normally of limited duration, formed to carry out a specific project. It is therefore similar to a western-style joint venture, and is also regarded by some as the purest form of Islamic financial instrument, since it conforms to the underlying partnership principles of sharing in, and benefiting from, risk. Participation in a musharaka can either be in a new project, or by providing additional funds for an existing one. Profits are divided on a pre-determined basis, and any losses shared in proportion to the capital contribution.

* In this case, the bank enters into a partnership with a client in which both share the equity capital- and perhaps even the management - of a project or deal, and both share in the profits or losses according to their equity shareholding.

Ijara Wa Iktina: Equivalent to the leasing and installment-loan, hire-purchase, practices that put millions of drivers on the road each year. These techniques as applied by Islamic banks include the requirement that the leased items be used productively and in ways permitted by Islamic law.

Muqarada: This technique allows a bank to float what are effectively Islamic bonds to finance a specific project. Investors who buy muqaradah bonds take a share of the profits of the project being financed, but also share the risk of unexpectedly low profits, or even losses. They have no say in the management of the project, but act as non-voting shareholders.

Salam: A buyer pays in advance for a specified quantity and quality of a commodity, deliverable on a specific date, at an agreed price. This financing technique, similar to a futures or forward-purchase contract, is particularly applicable to seasonal agricultural purchases, but it can also be used to buy other goods in cases where the seller needs working capital before he can deliver.

Besides their range of equity, trade financing and lending operations, Islamic banks world-wide also offer a full spectrum of fee-paid retail services that do not involve interest payments, including checking accounts, spot foreign exchange transactions, fund transfers, letters of credit, travellers' cheques, safe-deposit boxes, securities safekeeping investment management and advice, and other normal services of modern banking.

Almost every Islamic bank has a committee of religious advisers whose opinion is sought on the acceptability of new instruments and who have to provide a religious audit of the bank's end of year accounts.

The concepts of equity and morality are at the root of Islamic banking. In Islam moral and equitable values form an integral part of the rules of law governing contractual and financial relations to such an extent that the relationship which exists between equity, law and religion is an organic rather than supplementary relationship. The importance of Islamic banking has increased dramatically over the past 10 years. The main difference between Western and Islamic-style banking is the concentration on people and their businesses rather than on accounts- it is a much more 'grass roots' banking according to one expert.

Islamic Investment In Australia

With the aim to present a practical model of Islamic banking to the Muslim community and to the Australian society at large, and to provide Muslims in Australia with an alternative to the existing interest-based financial products and services, Muslim Community Co-operative Australia was established in February 1989 with ten members and a starting capital of $22,300. Operating from its head office in Burwood, Victoria, MCCA's activities involve financial dealings and transactions based on Islamic finance principles. Transactions that involve interest are completely excluded from MCCA's activities. Its activities also include the provision of an institutional framework for converting the charitable funds into a socially beneficial and economically productive tool.

MCCA manages five types of funds: Murabaha, Musharaka, Mudaraba, Qard-el-Hassan and Zakat funds. It has enjoyed phenomenal growth since its inception and it currently contains more than 560 members with an asset base of $2,320,000 compared to only $105,700 in 1991. The rate of return on investment has jumped from 5.4% in 1991 to around 9.75% in 1995, a return which is much higher than fixed rate of return offered by interest-based banks.

In an interview conducted in October 1994, Peter Moody of the Australian Taxation Office summed up the activities and purposes of MCCA as follows:

1- A place for the advancement of the principles of the Muslim faith, and the evolution of a "community" that overlooks its members and shareholders. MCCA funds can be, and are used to help those in need within the community. Donations are received and applied for this purpose. A separate fund has been created for this end, and is known as the Qard Hassan Fund.

2- To operate as a housing co-operative that assists with the purchase of mainly residential properties for and on behalf of its shareholders. The purchase of other asset classes is undertaken in a similar fashion, mostly the purchase of motor vehicles, computers, and some limited business finance. The purpose of the provision of this facility is solely centred around the Muslim doctrine that forbids the payment of interest. MCCA charges an upfront "administrative" charge for their involvement, but thereafter, the loan is interest free. This conforms to all the requirements of their religion, and such transactions are held to be Halal, which means that they are "allowable" under Muslim doctrine. Repayments under these types of transactions are known as repayments of Murabaha.

3- To accept funds and issue shares in the co-operative from time to time, and to distribute the trading surplus of the co-operative back to the members in the form of dividends.

MCCA's objectives is to build up funds available for investment to $45 million; to educate and train on the concept and operations of Islamic Finance aiming to qualify at least 10 Muslims in managing and operating an Islamic Financial Institution: 5 in Victoria, 3 in NSW and 2 in WA; to open 3 branches for MCCA : 1 in Victoria, 1 in NSW and 1 in WA; and to establish and develop an institutional framework aiming for the best possible utilisation of charitable funds into economically productive and socially beneficial structure.

In a recent interview with the manager of MCCA, Br. Mohammed Nasser Abdel-Hakim, "Nida'ul Islam" posed some questions regarding its formation and functions.

MCCA's contact numbers & address:
Tel: (03) 889 6644, Fax: (03) 889 1211 
Head Office: 1342 Toorak Rd. 
Burwood, Victoria, 3125 


Interview With The First Islamic Financial Institution in Australia, MCCA

* Can you introduce MCCA, its functions and how it started?

MCCA first started in February 1989. There were about nine Muslim youths in a study group, and I was explaining the conept of Islamic finance in contrast to the Riba-interest-system. We then decided to apply what we had learned.

We went through the procedures to incorporate the co-operative explaining to the officials how we were going to operate. They initially did not accept our proposal; but, however, when I explained to them that I was in the USA and I was involved in developing a similar organisation in USA and Canada, they looked more closely at our proposal and approved. All of the hassles were just because we wanted to put in the constitution that we are going to operate according to the Islamic code of life, that we are not going to operate according to the interest system.

Each type of financial service that is offered by the usury system (Riba System) we have an Islamic alternative for, and before we do anything we check our references- we check with the scholars (Ulama) and we make sure that what we do is according to Islamic Sharia'ah.

We have got three types of funds:

1) Mudaraba: which is mainly for business ventures;

2) Musharaka or Partnership: which is mainly in housing finance. The relationship between us and the house buyer is partners in the house. It is not a creditor to a debtor type of relationship, where the bank takes mortgage and puts the sword on the neck of the occupant saying: "you pay or else we kick out of the house." We don't sacrifice the security because our name will be on the title together with the buyer but we also give the buyer security that he or she will not be kicked out of the house in case of inability to pay us.

3) Murabaha: used for the purcahse of any commodity - car, computer, furniture.

These are the main investment avenues that we use. But that's not the only Islamic tool of finance. To complete the cycle, to make the Islamic finance comprehensive we also have what we call Qard Hassan fund and we have Zakat and Charity funds. When you look at the picture you see that if I am in need to pay a hospital bill, for example, or some other kind of emergency, we feel and believe that we should not really take advantage of the weak position of the person and charge more. In this situation we hand out an interest free loan.

* So in fact you're trying to provide a microcosm of a bigger Islamic economic system which should be in existence...

That's right- so you help me without even knowing me by putting money into the organisation and I get money from the organisation.

* Where did you obtain the idea for this venture?

Actually the idea was clear in my mind when I went to the USA. In 1981, after finishing my MBA I was offered a job to be the finance director of one of the largest Islamic organisations in the USA - ISNA (Islamic Society of North America) and from that position then I had the opportunity to be involved in developing a sort of Islamic financial organisation in USA and Canada.

The ideas that I got from the USA from my position was not all-encompassing- it was just a start. The ideas started to mature in my mind and started to develop in my mind until the picture was very clear in my mind and all the activities that we now have in MCCA.

* Who actually supports MCCA?

Australian Muslims from all over Australia. We have at the moment 560 members from all over Australia- Sydney, Canberra, Melbourne, Darwin, Perth, and other states and territories. Also, we do have some investors from overseas, from students who used to be here and then went to Malaysia. So we are sort of a national organisation, not only a Melbourne organisation. In our future plans, within the next five years we would like to have a branch in Sydney, Perth and may be in Queensland because the community in Perth and Sydney are very active.

* Can you tell me how MCCA is different from other Investment Institutions that are founded in Australia?

The main difference is that we did not alhamdulillah deviate from the main goal when we started out as ten, or when we are 560 or when we become 5000. The main goal is to offer the Islamic alternative of finance to Muslims in Australia, and eventually to non-Muslims after we have full control over our operations. This area of finance is a very important area in the life of all people, so practising Islam in this area is a way of Da'wah, showing people that Islam is giving you an answer to your financial matters.

Any other organisation's main objective is the shareholder's equity, how much profit was made and so on. That's the big thing that all organisations are pro-ud of whereas our pride is in introducing Islam through our specialised area.

Report Prepared by Nida'ul Islam


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