Over the last few decades, the Muslims have been trying to restructure their lives on the basis of Islamic Principles. They strongly feel that the political and economic dominance of the West, during past centuries has deprived them of the divine guidance, especially in the socio-economic fields. Therefore, after acquiring political freedom, the masses are striving for the revival of their Islamic identity to organise their collective life in accordance with the Islamic teaching. In the economic field it was the biggest challenge for such Muslims to reform their financial institution to bring them in harmony with the dictates of Shari'ah. In an environment where the entire financial system was based on interest, it was formidable task to structure the financial institution on an interest free basis. The people not conversant with the principle of Shari'ah and its economic philosophy sometimes believe that abolishing interest from the banks and financial institutions would make them charitable, rather than commercial, concerns which offer financial services without a return. Obviously, this is totally a wrong assumption. According to Shari'ah, interest free loans are meant for cooperative and charitable activities, and not normally for commercial transactions, except in a very limited range. So far as commercial financing is concerned, the Islamic Shari'ah has a different set-up for that purpose. The principal is that the person extending money to another person must decide whether he wishes to help the opposite party or he wants to share in his profits. If he wants to help the borrower, he must rescind from any claim to an additional amount. His principal will be secured and guaranteed. It is obvious that exclusion of interest from financial activities does not necessarily mean that the financier cannot earn a profit. If financing is meant for a commercial purpose, it can be based on the concept of profit and loss sharing, for which Musharaka and Mudarabah have been designed since the very inception of the Islamic Commercial Law. There are, however, some sectors where financing on the basis of Musharaka or Mudarabah is not workable or feasible for one reason or another. For such sectors the contemporary scholars have suggested some other instruments which can be used for the purpose of financing like Mudarabah, Ijarah, Salam or Istisna. This research will facilitate to understand the basic principal of Islamic Finance and the main points of difference between conventional and Islamic Banking System.
CHAPTER - 1
INTRODUCTION:
The world in which one lives today is based on a number of operations, and one of the most important ones to consider includes financial operations. Financial operations take place in several ways. However, there has been a mainstream mode that has been followed for a long time. This refers to the traditional private banking methods that have had every other financial process in sync with it. While this has been the case, in recent years there has been a shift that has accommodated an alternative method of financial operation, which is known as Islamic Banking. This form of banking has a significant amount of history to it; indeed, this history goes back centuries to the period when Islam was spread as a religion. Apart from many other tenets that covered social and political life in the Arab world, business was an arena of immense importance. This is primarily because it directly or indirectly has the propensity to affect social and political life. Therefore, keeping tight controls on the way finance was dealt with was observed as mandatory in the Islamic world. Broadly, any financial operation that was deemed unfair to a person or a group was termed 'haram'. The antonym of this is 'Halal'. Therefore, Islamic banking, as opposed to traditional private banking is prescribes 'Halal' banking and financial operations. It must be pointed out that many processes that are implemented in private banking are also practiced in Islamic banking. However, these are operations that are deemed 'Halal'.
In Pakistan today, Islamic banking has slowly and steadily grown as it has in a number of countries. This is because there is a significant market for its services; people who want to follow Islamic principles in their social, political and financial undertakings are the ones who opt for these services. Therefore, while traditional private banking is quite widespread, Islamic Banking concepts are growing popular. This is observed through expansion of private banking services, as many private banks have now opened branches within their networks that offer Islamic banking services.
The researcher in this study has endeavoured to explore and distinguish between traditional private banking and Islamic banking. This will help to explain why Islamic banking has started to grow alongside the private banking.
AIMS:
The main aims of this dissertation include determining:
What Islamic Banking is and how it differs from Private Banking. In doing so, there will be need to analyze Islamic banking growth in Pakistan.
What problem are faced by Islamic banking.
How Islamic banking is more advantageous than traditional banking in view of consumers and the economy.
Why people should adopt Islamic Banking.
How each banking system [Islamic banking or traditional private banking] can be judged to be the better one?
OBJEVTIVES:
The purpose of this dissertation is to explain the basic elements of Islamic banking interest free banking system, and the practical experience of such banking in a developing Muslim country, Pakistan. For this, the researcher will need to
Examine various financial instruments that are permitted under the Islamic Shari'ah principle which allows participating in the profit- loss of a business, but prohibits taking or giving fixed interest to a business. At the same time, there will be an examination of how traditional private banks carry out these operations.
Analyze how an Islamic bank can enhance rural development by channelling funds from savers to investors. At the same time, it would be worth analysing how private banking would mange this.
Examine a basic mechanism of designing a future contract which performs with Islamic Shari'ah. Once designed, such instruments can enhance the financial intermediation process in a market economy.
Examine the experience of a specific bank (Al Meezan Islamic bank of Pakistan) and other Islamic banks in order to compare their performance with that of other private banks in Pakistan.
Discuss the problems and prospects of Islamic banking practices in Pakistan.
BACKGROUND
THE NEED FOR A SOCIALLY INCLUSIVE FINANCIAL SYSTEM:
It has been proved over time that the development process should have public's participation and only this will help in achievement of consistent economic growth and an uplift in social standards of the general public. The financial system can facilitate such participation by making its services accessible as well as acceptable to the public. Keeping in view the guidelines and set of rules provided by Islam on economic, financial and commercial aspects of the life, Muslims have become highly concerned with consistency of financial services with Islamic legal requirements. The services provided by the Islamic Financial Services Industry (IFSI) can also attract demand from other segments of the population on the basis of the quality of services it provides.
Islamic Banking is a form of modern banking based on Islamic legal concepts (Shari'ah) developed in the first centuries of Islam using risk-sharing as its main method thereby excluding fixed pre-determined return on financing. It believes in sharing profits and risks in the business instead of developing credit relationships. In Islamic Banking the depositor, Bank and the borrower all share the risks and rewards of financing business ventures as against the interest-based commercial banking system where all the pressure is on the borrower. In conventional modes of financing the borrower must pay back his loan with the agreed interest regardless of the fact that the purpose for which loan is taken is successful or is a failure. Islam therefore, encourages investment such that the whole society benefits from it (Venardos, 2006, Pp 32-55).
CHAPTER - 2
LITERATURE REVIEW
WHAT IS PRIVATE BANKING?
In the term 'private banking', the word 'private' actually refers to mitigating taxes through fastidious allocation of assets. Private equity is another feature that the word 'private' refers to. This is fundamentally share ownership of an organization that is not available to the general public for purchase in a stock market. Clients that belong to private banking are usually permitted to invest in them.
Originally, however the use of the word "private", as in "private client" comes from the fact that originally these types of services were sold by major institutional and investment bank, who usually did not work with private individuals (instead normally working with public co-operations).
PRIVATE BANKING:
Private banking usually combines trust services, investment services, banking services, and tax services.
Private banking is a term for banking, investment and other financial services provided by banks to private individuals investing sizable assets. The term "private" refers to the customer service being rendered on a more personal basis than in mass-market retail banking, usually via dedicated bank advisers. It should not be confused with a private bank, which is simply a non-incorporated banking institution.
Historically private banking has been viewed as very exclusive, only catering for high net worth individuals with liquidity over $2 million, although it is now possible to open some private bank accounts with as little as $250,000 for private investors. An institution's private banking division will provide various services such as wealth management, savings, inheritance and tax planning for their clients. A high-level form of private banking (for the especially affluent) is often referred to as wealth management (Mullineux & Murinde, 2003, 23-25).
The word "private" also alludes to bank secrecy and minimizing taxes via careful allocation of assets. An offshore bank account may be used for this purpose.
The prohibitions against interest are founded on the Islamic concept of property that results from an individual's creative labour or from exchange of goods or property. Interest on money loaned falls within neither of these two concepts and is thus unjustified (Mullineux & Murinde, 2003, 23-25).
To resolve this dilemma from a legal and religious point of view, Islamic banking employs common terms: Musharaka or partnership for production; Mudarabah or silent partnership when one party provides the capital, the other the labour; and murabbahah or deferred payment on purchases, similar in practice to an overdraft and the most preferred Islamic banking arrangement in Sudan. To resolve the prohibition on interest, an interest-bearing overdraft would be changed to a murabbahah contract.
ISLAMIC BANKING:
The fundamental difference between Islamic and traditional banking systems is that in an Islamic system deposits are regarded as shares, which does not guarantee their nominal value. The appeal of the Islamic banks, as well as government support and patronage, enabled these institutions to acquire an estimated 20 percent of Sudanese deposits. Politically, the popularity and wealth of Islamic banks have provided a financial basis for funding and promoting Islamic policies in government (Mullineux & Murinde, 2003, 23-25).
Some people may answer by saying, 'In Islamic finance, interest is forbidden'. That is true because without a doubt, interest is forbidden in Islam but with every prohibition in Islam lies a fundamental reason or effect. And one must understand this effect or reason to appreciate the difference between Islamic finance & conventional finance.
My short version in the prohibition of interest is that it's exploitative because it caters for one side to be at a distinct advantage over another. One side will have their money back guaranteed while the other has to sweat and work hard to make sure he can pay back. Is this fair?
An interesting scholar, Umar Chapra in, 'Towards a Just Monetary System', says that from the Qur'an and the Hadith of Prophet Muhammad, Muslims are given principles to know what is fair and unfair, or what is 'justified' and 'unjustified', when it comes to one's earnings. He goes on to say,
"One of the important sources of unjustified earnings is receiving any monetary advantage in a business transaction without giving a just counter value."
So an answer to the difference between Islamic finance and conventional finance is that Islamic finance is fair. Islamic finance advocates financial products that provide 'just counter values'. In other words, Islamic finance aims to get rid of any unjustified or exploitative financial situation, product or service...not just in a loan transaction but in any bits that are unfair or exploitative in the financial world.
The outcome of this simple aim is asset-backed financial products that provide a 'just counter value' for all parties. If you've read Taqi Usmani's book, An Introduction to Islamic Finance, he describes asset-backed financing as financing which creates real assets...which can then be sold for money and consequently, earns a justified profit.
This is very much different from conventional systems that make money out of money (that is 'interest').
In other words, in Islamic finance, there is an asset that creates the profit, not 'Money + Interest = More money' but 'Money + Asset/Real factor of production = More money'.
Islamic banking is more complex than traditional banking in that products must conform not only to the secular laws of a country but also to interpretations of the holy Qur'an by local Islamic scholars. A central tenet of Shari'ah is riba, the prohibition of interest. Moreover, Islamic law does not permit use of funds for investments or purchases related to activities it deems impermissible (haram), such
as alcohol consumption or gambling. In general, anything not defined as haram is considered permissible (Halal) under Shari'ah. However, Shari'ah interpretations can vary by region and country because they are defined by local Islamic scholars. Banks endeavouring to offer Islamic Banking typically enlist local scholars to serve on the bank Shari'ah board or committee to assist in designing Shari'ah-compliant bank products and processes. Many larger conventional banks also have a specialized function to educate employees and ensure ongoing adherence to Islamic principles.
MAIN BANKS TO CONSIDER IN THIS STUDY:
In order to expose exactly how Islamic banking functions, there is need to draw a comparison between traditional banking and Islamic banking. Therefore, the researcher will need to consider a certain number of banks that belong to conservative banking and an equal number that belong to Islamic banking. The following paragraphs reveal the banks chosen from each type of banking, for this study.
Presently 42 countries are having proper Islamic Banking structure and regulations enforced. With the growth in IFSI 27 Muslims states are now opting for Islamic Financial system as alternative including Saudi Arabia, Iran, Malaysia, Brunei and Pakistan. 15 Non Muslim states are working on the same that includes Canada, Switzerland, South Africa, United States and United Kingdom after the change in scenario with the happening of 9/11 incident. Leading foreign banks have opened Islamic banking windows or subsidiaries. These include:
Citibank
HSBC
ABN AMRO
Standard Chartered Bank
American Express
In 2002 first ever Islamic bank was launched in Pakistan and since then SBP has started issuing Islamic Banking licenses to various banks. Presently on formal basis the following renowned names are working towards transforming themselves and bringing in growth of IFSI in Pakistan.
Meezan Bank Limited
AL Baraka Islamic Bank
MCB Islamic Bank Branch
Habib Bank AG Zurich Islamic Banking Branch
Bank Alfalah Islamic Banking Division
As one can see, the five banks mentioned immediately above here have operations that are based on traditional banking too. However, they have realized the market demand for those who wish to use Islamic banking services. This is the reason why they have opened specific Islamic banking branches.
MAIN PRINCIPLE OF ISLAMIC BANKING:
There are specific principles in Islamic banking that distinguish its functions from traditional banking. The Islamic values reflected in Islamic economic principles that underpin the Islamic Finance are as follows:
Any Predetermined Payment Over And Above The Actual Amount Of Principal Is Prohibited: Islam allows only one kind of loan i.e. qard-el-hassan (literally good loan) whereby the lender does not charge any interest or additional amount over the money lent. [As opposed to this principle, in traditional banking, this is not a major consideration; an exchange of funds would be left up to the parties involved].
The Bank Must Share In The Profits Or Losses Arising Out Of The Venture For Which The Money Was Financed: Unlike the interest-based commercial banking system where all the pressure is on the borrower, Islamic finance is based on the belief that the depositor, the bank and the borrower should all share the risks and the rewards of financing business ventures.
Making Money From Money Not An Acceptable Mode: In Islam, money represents purchasing power that in turn cannot be used for further enhancement in purchasing power (money) without undergoing the intermediate step of it being used for the purchase of goods and services (Maurer, 2005, 41-73).
Gharar (Uncertainty, Risk Or Speculation) Is Also Prohibited: Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions and should be free from uncertainty, risk and speculation. Parties cannot predetermine a guaranteed profit based on the principle of 'uncertain gains' which does not even allow an undertaking from the customer to repay the borrowed principal plus an amount to take into account inflation (Maurer, 2005, 41-73)
Investments Should Only Support Practices Or Products That Are Not Forbidden/Discouraged By Islam: Trade in alcohol, for example, would not be financed by an Islamic bank; real-estate finance could not be made for the construction of a casino and the bank could not lend money to other banks on interest.
ANALYSIS:
According to literature reviewed and the data compiled through the survey questionnaires, it can be said that there is more than sufficient evidence that points towards the benefits of implementing Islamic banking principles. To begin with, in the primary data, both consumers and employees at banks tend to believe that Islamic banking is more beneficial than conventional banking. Both data tend to back up and reinforce facts such as competitive advantage of Islamic banking. In this advantage, there are ideological Reasons, which say that 20% of the world's population with a 10% global share of GNP, are Muslims. Also, there are Global Interest in Islamic Finance, which include Multinationals e.g. General Motors, IBM, and Xerox that have raised funds. There is a Fast Growing Customer Base with 15 % p.a. as compared to conventional banks. Additionally, current assets exceed $ 180 billion in 40 countries (1975 base was $ 1 B).
It is important to pay attention to the structure/difference in both forms of banking. Apparently, the primary difference is the 'economy' that Islamic banking mainly focuses on. This point is also highlighted in the employee survey questionnaire. The respondents largely believe that they are aware of the policies in Islamic banking and believe that they are important in making this form of banking more effective and sustainable than conventional banking. The differences in each banking approach can be seen below (Maurer, 2005, 41-73).
Conventional BANKING
Subject matter of Bank's business is Money
Bank treats money as commodity and earns profit from pricing it.
Majority of the transactions are interest based
Islamic BANKING
Subject matter is the Economy
Bank earns profit from participating in the economy by sharing risk and reward through pricing of goods services and benefits
No interest based contracts. (Venardos, 2006, Pp 32-55)
Islamic economics converts money into assets on such basis that in turn measures the utility derived through it. This is a clear reflection of the Islamic banking policies implemented. Also, while Islamic banking forfeits the concept of time value of money to the extent of pricing the advances, it does not uphold generating rent to the capital as interest does in credits and advances leading to a renter class in society. For example, in accordance with rules of the Shari'ah, the future conversion of Rs 1000 is of prime importance into an asset that may be worth more or less in future and leads to profit or loss. This change to assets is dependent on a well established set of rules that govern profit/loss sharing, trading and leasing. The following is an illustration of modes in Islamic banking and conventional banking. It is evident that the Islamic banking mode produces goods and services for the benefit of the client, as opposed to the conventional mode in which the bank tends to gain more for itself and not as much for the client (Venardos, 2006, Pp 32-55).
Basic difference between Islamic & conventional mode:
Conventional Model
Money
Bank
Client
Money + Money (Interest)
Islamic Model
Client
Goods & Services
Bank
This Islamic mode is based on fundamentals in Islam. According to Surah Al-Imran: 145-146:
"… And whoever desires a reward in (this) world, We shall give him of it; and whoever desires a reward in the Hereafter, We shall give him thereof. And We shall reward the grateful."
"And many a Prophet fought (in Allah's cause) and along with him (fought) large bands of religious learned men. But they never lost heart for that which did befall them in Allah's Way, nor did they weaken nor degrade themselves. And Allah loves As-Sabirun (the patient)."
Also, in Surah Al-Baqarah: 41, it says:
"And believe in what I have sent down (the Quran), confirming that which is with you, and be not the first to disbelieve therein………and buy not my verses a small price (i.e. a small gain by interpreting my verses as per you liking) and fear Me and Me alone."
In the Hadith, it says:
[Narrated Abu Huraira (R), the Prophet (p.b.u.h.) said]:
"Whoever takes the money of the people with the intention of repaying it, Allah will repay it on his behalf, and whoever takes it in order to spoil it, then Allah will spoil him." (Venardos, 2006, Pp 32-55)
While the respondents in the consumer survey largely feel that they benefit more from Islamic banking, there is evidence of how Islamic banking benefits stakeholders. The paradigm on which Islamic financial services rests is expected to lead to better utilization of the society's financial resources and promoting financial stability. This provides strength to Islamic banking as its intrinsic features are consistent with most of the efforts that are being at national, regional and international forums to enhance transparency, financial stability and efficiency.
It is known that weak controls and corporate governance systems are major causes of failure of institutions and financial instability. Due to its emphasis on ethical premises and self regulation through Shari'ah supervision, the Islamic finance pattern is expected to strengthen internal control systems thereby promoting soundness and sustainability (Lewis & Algaoud, 2001, 77-109).
Additionally, recurring financial crises cause unforeseen divergence in the balance sheet along with changes in market values of assets, loss of wealth, employment opportunities and an increase in social insecurity. Besides causing failure in corporate structures, such crisis is mushroomed by unnecessary and speculative flow of short-term funds coupled with high leverage. Islamic finance, however, is based on "real" assets and equity type profit and loss sharing facilities. Risk sharing through equity type facilities on the asset side and profit sharing investment accounts on the funding side in Islamic mode of financing thus contributes in balancing debt and equity sides thereby fostering stability.
Since, Islamic financial services are based on "real" assets and services that create limitations on the use of cash, it is in the nature of asset and the kind of financing carried out that the institutions must gauge and collect maximum information about their clients and the uses to which the funds would be put to use. This process is controlled as well as closely monitored by the Shari'ah boards and the same is referred to as a mechanism of self regulation. Hence, better utilization of the society's vital resources can be ensured by this (Saeed, 1999, 24-45).
Also, providing banking services in compliance to the Islamic laws enhances access to finance and hence has potential positive proposition for justice, development and peace. This also promotes development of formal and regulated financial markets. Muslim communities in many countries might face a state of cultural, social and economic exclusion in case such an Islamic system does not exist.
Islamic finance places more emphasis on the feasibility of projects and real economic activities instead of relying only on the notion of the creditworthiness of their clients. This is also contributes to enhancing the efficiency in resource allocation (Ahmad, 2000, Vol. 9).
There are also areas where Islamic finance modalities exist or can be developed. Like the conventional system, Islamic financial system may have two types of Financial Instruments:
Fixed profit yielding (not interest bearing) debt securities or debt instruments carrying fixed return payable in future that can be issued in respect of Bai Muajjal or leasing based transactions.
Equity Instruments that have a claim to share in the net income and the assets of a business.
Debt securities in a conventional framework can be issued with or without any real transactions. The debt security in Islamic framework may normally result from a real transaction based on Bai-Muajjal or Bai Salem transactions or from an 'Istisn'a contract. If a debt security is not a result of a real transaction it will not carry any time value of money. However, if a debt security is a result of a real transaction, time value can be implicitly included as an integral part of the transaction (Ahmad, 2000, Vol. 9)
.Besides equity instruments in the form of shares of any company, Islamic financial system has other redeemable participating instruments representing ownership in the assets and hence entitled to participate in the profit/loss resulting from the operations of the assets. Various types of participatory instruments can he based on:
Profit/Loss sharing (Mudarabah/Musharaka) like Participation Term Certificates (PTCs).
Rent sharing in the form of Diminishing Musharaka or otherwise. (Ahmad, 2000, Vol. 9)
Islamic Banking Services Coping with Technological Development:
Islamic banks have managed to cope with the technological development in banking services and have presented, in most cases, up-to-date banking services. They can provide following services:
Credit Cards, ICs, Visa Cards, ATM, etc.
Islamic Banks provide such services in return for a fee through agreements they conclude with international issuers of such documents such as Visa card. The relationship between the issuer and the Islamic bank could be that of an agency. Once it sells the Traveller's Cheques, for example, it has to debit the account of its customer simultaneously i.e. accounts should be on a spot basis and there should be no forward foreign exchange dealings.
In the case of Visa cards and Credit cards in general, Islamic banks should look into what goods and services these cards are used in buying. Islamic banks can only deal in such cards if no interest is charged when deferred payment is involved. It is also necessary that an Islamic bank should restrict the use of such cards to Halal activities and should issue clear instructions to its customers as to which goods, services and dealings are not allowed. Any breach would result in invalidation of the use of such a card (Ghannadian, 1991, 373-84).
OIC Fiqh Academy defines the Credit card as, "A Credit card is a document that a bank issues to a natural or legal person according to a contract between them. The card holder purchases goods or services from those who accept the card without immediate payment of the price. Payment is made from the account of the bank who afterwards charges the card holder at regular time intervals depending upon the terms of the contract and the situation" (Ghannadian, 1991, 373-84).
The Fiqh Academy in its Session (23-28 September, 2000) resolved that: "It is not permissible to issue a Credit card or use it if its conditions include imposition of interest. This is so even if the card holder has the intention to pay (the price) within the moratorium period that precedes imposition of interest. However, it is permissible to issue Credit cards that do not carry a condition of imposing interest on the credit. The bank can take from the card holder a specific amount of money at the time of issuing or renewal of the card as fee that the issuer deserves according to the services it provides to the card holder and any charge over and above this fixed amount is impermissible because of being usurious."
"It is also permissible for the bank to take a commission from the merchant on the goods or services purchased by the card holder, provided that such goods or services are sold at the same price whether in cash or credit." (Ghannadian, 1991, 373-84)
It, therefore, implies that charging an initial membership or periodic Ice on credit cards does not pose any Shari'ah problem. However, financing through credit cards on the basis of interest will be prohibited. Thus, in the new situation, the credit cards will become 'charge cards' where charges for the issuance of the card and recurring annual charges can be recovered from the card holders and transaction charges and commission can be recovered from the merchants. If a loan or debt is created, no return could be charged thereon from the card holders (Ghannadian, 1991, 373-84).
At present, Islamic banks act as agents to card issuers and they charge fees both to the card holders and the sellers in return for the services they provide at the point of sale. They allow their customers free use for a number of days without any provision beyond that. They also take fee for cash withdrawals as the bank incurs expenses in respect of each withdrawal.
Some scholars have suggested that credit cards be designed on the basis of Mudarabah, whereby the bank will buy the goods from the store and then sell them on deferred payment to the customer. This will be when it is issuing its own credit card. Alternatively, a Musharaka basis could be used whereby the bank would enter with such stores into an agreement according to which the bank will provide pie-finance to these stores on the basis of profit-sharing and the bank or a group of banks will issue credit cards which the customers will use to purchase goods from such stores, the stores administering the act of selling while the banks administer all other banking services. In return, the bank and the departmental stores will agree as to how they will share profits (Ghannadian, 1991, 373-84).
Foreign Exchange Transactions
Islamic banks are allowed to deal in foreign exchange remittances and the buying and selling of foreign exchange on a spot basis. However, differences in time zones between different foreign exchange markets necessitate allowing for two days difference for the clearing of such operations, but the operation will be finalized on the rates of the date on which the transaction was effected. Banks can undertake remittance transactions domestically and externally. Externally they will need to have a correspondent relationship with many banks (Ghannadian, 1991, 373-84).
Letters of Guarantee (DC):
Jurists generally do not allow fees or remuneration based on guarantees. However, some jurists consider that the bank can take commission and fees since a guarantee is created as a service. Banks services involve some administrative expenses; therefore, they can recover expenses by way of fee or guarantee commission. However, if the guarantee is called, banks will be entitled to recover their principal amount only (Ghannadian, 1991, 373-84).
Letters of Credit (L/C):
Letters of Credit are essential banking services in the area of international trade. Shari'ah scholars have different views on how letters of credit should be treated. In literature on Islamic banking, L/Cs are covered under various contracts like Wakalah), (agency), Musharakah, Murabaha and Kafalah (Guarantee). Some say that they should be treated as a service and charged at a fixed rate that will not vary with the duration or the volume of the letter of credit. Other scholars allow for the fees to vary with their volume, as more or less work and effort will be involved. Some Shari'ah boards have suggested a rate structure based on brackets rather than on a percentage basis. Other Shari'ah boards have decided that Letters of Credit should be treated on the basis of an agency arrangement at a fixed percentage.
It is necessary that we treat DC as banking services and not as guarantees, except in the ease of standby letters of credit, which reused as a form of guarantee. However, L/Cs differs in that, some allow partial shipment, some are revolving, some need confirmation and others have a red clause. In each case fee will differ as the effort exerted will differ with each type of L/Cs. Time will not be an element in the variation of fees except as it involves more or less administrative work.
Letters of Credit could be opened on the basis of Murabaha or Musharakah. In the former case, the bank would open the L/C for itself and when it possesses the goods it could sell them to the customer either on an FOB or on a CIF basis. Fee could be added to the total cost of goods (Ghannadian, 1991, 373-84).
Musharakah is more flexible as the L/C may be in the name of the customer or the bank and when the goods are received, the partner may sell them and the Musharakah liquidated or the partner may buy the share of the bank. In case of Mushrakah either the bank or the customer administers the L/C; this will give more flexibility to both parties and some legal Shari'ah and procedural problems which are encountered by Mudarabah L/C. It is also possible for the bank to act as an agent (a beneficiary on behalf of the issuing bank and, in return, charge fee against the L/C.
However, the general view so far is that banks may be allowed charge commission or fee for Letters of Credit as service charge which can not be time related. In the words of CTFS, "To guard against practice of Riba, no charges can be recovered where guarantee commitment's given for repayment of a debtor a loan" (Ghannadian, 1991, 373-84).
