Ijarah in the context of Islamic finance

By: Graeme Laing is the head of leasing at BLME.

In the Middle East, Ijarah has been used as a method of fi nancing for hundreds of years as it allows individuals and businesses to use equipment that they would have been unable to purchase outright themselves due tocapital constraints. In more recent history however, the use of Ijarah has broadened to encompass the leasing and acquisition of all physical assets. It is a similar story for the conventional finance world, where leasing is well established in both the commercial and private spheres.

As with Ijarah most conventional leases are asset-backed and as such individuals and businesses that have previously leased assets in a conventional manner are comfortable making the transition to Ijarah structures. Ijarah is no different from other Islamic transactions which are also are asset-based, meaning that there is always an asset with an inherent value sitt ing behind the contract. This is one of the main reasons why leasing so naturally lends itself to Islamic fi nance. Consequently Ijarah is one of the most commonly used structures in Islamic finance products.

Ijarah has a familiar ‘look and feel’ to conventional leasing products, and businesses and customers accustomed to conventional fi nancing methods (many of whom are unused to Islamic financial products) are comfortable using Ijarah. Additionally, Bank of London and The Middle East (BLME) has found that counterparties find the process and the documentation of Shariah compliant leases very similar to those in the conventional world.

Leasing market in the UK
Leasing is a growing industry in the UK and the Islamic finance industry is well placed to take advantage of this opportunity. In order to service this growing market and take advantage of the opportunities, Islamic finance institutions offer two main Ijarah structures:

Operating Ijarah
The owner takes a residual value risk on the equipment. This means that when the lease comes to an end the equipment may not be worth enough to cover the original capital investment plus profit. An operating Ijarah is treated off -balance sheet for the lessee. This Ijarah can also be structured so that the lessee has an option to buy the asset at the end of the Ijarah.

Finance lease
The lease rents and any balloon payments cover the full capital investment plus profit. The lessee owns the asset and it is treated as on-balance sheet for the lessee.

Key features of Ijarah
• The period and conditions of usage of the leased items must be detailed within the contract.
• The amount and timing of Ijarah payments must be agreed in advance. However despite the requirement to agree to a schedule, the amount, frequency and timing of Ijarah payments do not need to be uniform.
• To finance Ijarah transactions, as long as the asset is fit for use, the lessor and the lessee can stipulate in the contract that the ownership of the asset can be transferred to the lessee on completion of the lease agreement.
• The asset that is leased in an Ijarah contract must be used for an economic activity; a perishable or consumable object, such as food, cannot be leased.
• Upon acquisition of the leased goods or upon utilizing the leased goods the lease payment schedule becomes active.
• The lessor must have full possession and legal ownership of the asset prior to leasing it.
• The leased asset must continue to exist throughout the term of the lease. Items which are consumed in the process of usage, such as seeds and petrol for instance, cannot be leased.
• In contrast with most conventional finance leases, the responsibility for maintenance and insurance of the leased item remains that of the lessor throughout the period of the Ijarah.
• In the event of a late payment of rental, the Ijarah agreement may be terminated immediately.
• The lessor may claim compensation for any actual damage caused to the leased assets as a result of negligence on the part of the lessee.

Differences between Ijarah and conventional leasing
In an Ijarah structure, the lessor is required to bear all the costs incurred in the process of purchasing the asset and as the lessor is the owner of the asset all liabilities resulting from the ownership of the asset are the responsibility of the lessor including maintenance and insurance.

However once the lessee has received the asset they are responsible for any losses incurred due to misuse or negligence. Generally, the maintenance and insurance obligations are assigned to the lessee to perform as an agent for the lessor. Another difference between Shariah compliant leases and conventional ones is that under Shariah, the lessor leases the usufruct and not the asset, of which he remains the owner. As such, the subject of the lease must be identifiable and quantifiable.

Sukuk
Ijarah is becoming more popular as a basis for Sukuk structures as leasing income which is paid periodically to Sukukholders provides a steady and reliable income stream. As with Ijarah financing the conventional market is comfortable with the structure of Sukuk Ijarah, with one of the most successful issuances over the last year being the Nomura Sukuk. By issuing this US dollar Sukuk, Nomura was able to actively enter the Islamic market and diversify its funding sources.

This issuance held an additional benefit for the Islamic finance industry, as it brought Sukuk to a conventional audience and promoted Islamic finance as an additional and diversified source of financing. Sukuk Ijarah can also be structured as a shorter-term Sukuk similar to conventional papers.

Sukuk Ijarah structured in this way permits short term funding and shorter-term liquidity for Islamic financial institutions. The Central Bank of Bahrain has issued several short-term Sukuk Ijarah with its June 2011 issuance being significantly oversubscribed.

The use of Sukuk Ijarah will continue to grow due to its accessibility and flexibility. 2011 has seen Turkey implementing new legislation ensuring tax neutrality for Sukuk Ijarah, for example.

Key features of a Sukuk Ijarah structure
• Lease payments can be fi xed or variable but they must be detailed in the contract.
• There must be a fixed maturity date.
• The ownership of the leased equipment remains with the originator or issuer.
• Sukuk Ijarah is usually issued on a sale and leaseback arrangement.
• The issuer applies the Sukuk proceeds to purchase the assets from the originator and then leases it.
• The originator undertakes to repurchase the assets at maturity or upon early settlement.
• The issuer is required under Shariah to undertake the maintenance of the assets, but it will often appoint the lessee as its agent to do so under the terms of the contract.

Economic benefits of Islamic leasing
Islamic leasing is increasingly thought to have considerable benefi ts relative to conventional banking. While the nature and scale of these benefi ts is the subject of debate, Islamic leasing is commonly regarded to be more advantageous because:
• It aways involves real assets, strengthening the linkage between the financial sector of the economy and the real economy in general. This relationship contributes to economic stability.
• It creates great potential for Shariah compliant securitization for Sukuk in Islamic finance. Sukuk Ijarah can be traded in the market, affording a convenient instrument for investment.
• It is suitable for some sectors of the economy where sharing-based modes provided can be relatively difficult to practice, e.g. the consumer sector and the public sector, particularly infrastructure.

Despite the progress and the potential market, Islamic leasing is still nascent, particularly in Europe. A lack of understanding of Islamic leasing by potential customers, as well as the limited off ering by both Islamic banks and Islamic windows of conventional banks, means that the market remains a large growth opportunity which has not yet reached its full potential.

Nevertheless, the fact that several institutions are actively able to grow their leasing business across Ijarah and conventional leasing with strong interest in both, suggests a bright future for leasing and Ijarah.

Risk management in Islamic Banking

By: Jeroen Thij s is the chief risk offi cer at Bank Islam Malaysia.

There are two questions which are often raised when discussing risk management in Islamic banking: 1) Is risk management actually allowed in Islamic banking; and 2) How does it differ from risk management in conventional banking?

As for the first question, the concept of risk is well accepted in Islamic finance but the management of it is sometimes mistakenly thought of as forbidden as parties share in the risk and reward of underlying transaction and the actual outcome is up to our creator. In fact, it is the bank’s fiduciary duty to manage the risks to protect its depositors and shareholders from adverse events because under the Mudarabah contract it can be argued that if the bank has been negligent in protecting the interests of its fund providers, they might not have to share in the loss.

As for the second question, the risk function at Bank Islam Malaysia is modeled around the Swalah (obligatory prayer), the most important constituent of the Muslim faith and one of the tenets of Islam. The basis of Swalah is built upon five important elements: namely niyyah, jamaah, shurut, rukun and qaedah. These elements are transformed into a framework by applying each of them to the five core areas of managing risk: mission and objectives, functional structure, policies and guidelines, processes and enablers, and tools. These are in turn applied to all key risk areas the bank is exposed to: namely credit risk, market risk, liquidity risk,
operational risk and Shariah noncompliance risk.

The process of risk management, such as risk assessment, risk quantification, risk monitoring and mitigation and risk reporting, is exactly the same at an Islamic bank. The actual risks the bank faces are also quite similar as compared to those in conventional banks but there are distinct differences. common risk types such as credit, market, liquidity and operational risks, but there are also unique risks, such as Shariah non-compliance risk, displaced commercial risk and much higher rate-ofreturn risks.

Credit risk
Credit risk, or the risk that a borrower does not perform according to contract, is exactly the same as for a conventional bank with the diff erence that only Shariah compliant fi nancings are allowed, i.e. all fi nancings must be structured according to the principles of Islamic commercial law and nominated Shariah contracts such as Musharakah, Murabahah, Ijarah, etc. In addition, it should not invade any prohibited (haram) activities. Furthermore, transactions must be accompanied by an activity that will generate legitimate income and wealth, thereby establishing a close link between the financial transaction and productive flows.

Hence over-exposure to risk associated with excessive leverage is mitigated. The potential loss for credit transactions in an Islamic bank might be greater due to the fact that it is sometimes difficult to recover the underlying collateral, i.e. the loss given default (LGD) might be larger. There could be partial transfer of credit risks to the profit-sharing investment accounts (PSIA), whose holders share in the profit according to the agreed profit sharing ration but should bear the full loss.

In practice however this might be difficult and often the bank might take the hit in order to protect its depositors. This risk, displaced commercial risk, will be discussed below. Hence there might be a perceived sense of security on some of the underlying credit assets specifically tagged to PSIAs. Lastly, different types of Shariah contracts might create different kinds of risk. For instance under the Musharakah contract, the credit risk might be greater as the financier is also a partner in the business. For instance, it is important to understand that Sukuk (structured under the Musharakah contract), unlike conventional bonds, are not debt certificates or ‘IOU’ instruments. Sukuk are certificates that provide evidence of an investment in either an asset or a project. The return to investors is not fixed or guaranteed but subject to the performance of this underlying asset. Moreover, being a partner in the business, the financier might not be able to undertake regular recovery activities if the Sukuk is impaired.

Market risk
Market risk or the risk of adverse movements in profit rates (closely linked to interest rates), FX rates or equity prices is a generic risk but more complicated at an Islamic bank due to three factors. Firstly, risks are more difficult to hedge due to the unavailability of liquid hedge instruments and available counterparty lines. Even if proxy instruments are used, the bank runs basis risk and wrong-way risk. Secondly, as the secondary market for Sukuk is extremely limited, i.e. there is a lack of liquidity, the risk related to these investments mainly stems from credit quality rather than from market movements.

Lastly, in certain transactions risk can move from market to credit and back to market. A good example is the non-binding Murabahah purchase order. When the underlying asset is in the hands of the bank, it runs market risk on this asset. Once the asset is sold, the risk is transferred to credit risk but if the client for whatever reason decides not to take delivery of the asset (as it is a non-binding transaction), the risk moves back to market risk. That is why banks are reluctant to enter into nonbinding agreements.

Operational risk
The defi nition of operational risk is the same for Islamic banks: the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. This risk category might be slightly more of a problem for Islamic banks than for their conventional counterparts. This is mainly due to the many, often complex contracts involved, the lack of knowledge by staff of underlying Shariah contracts and the fact that systems are relatively new and sometimes not capable of dealing with the specifics of Shariah-based contracts. It is extremely important for an Islamic bank to follow the proper sequence of the contract or akad and to meet the pillars of akad, otherwise a transaction can be voided at a later stage leading to possible losses.

Rate-of-return risk
This risk is similar to the banking book gap risk that a conventional bank runs, albeit significantly higher. Islamic banks
traditionally attract short-term deposits and invest those in longer-term fixed rate assets. Coupled with the fact that hedging is problematic due to the relative unavailability of hedge instruments, the economic value of equity exposure is on average four to five times larger than for a conventional bank. Islamic banks have only quite recently started to price asset contracts against a floating base rate, thereby allowing them to reduce the gap risk over time.

Displaced commercial risk
Displaced commercial risk is the risk of losing depositors due to a situation whereby, in order to remain competitive, the bank pays its investment (or Mudarabah) depositors higher than what should be payable under the actual terms of the contract by foregoing part of its own profit. An increase in benchmark rates may result in depositholders having expectations of a higher return. If the bank is not able to generate that required return from its assets then it will suffer displaced commercial risk.

There are a few smoothing techniques such as profit equalization reserve (PER) or investment rate reserve, but these are quite controversial. In fact there are parties in Malaysia that are lobbying hard for Islamic banks to abolish the PER altogether, although the Shariah board of the AAOIFI and the Shariah Advisory Council of Bank Negara Malaysia allow its practice. This would
be a major challenge for an Islamic bank; not only in the situation as just described, but in other potential scenarios. What if, for example, the bank had a major recovery from a bad account in a certain month? It would then have to pay out a significantly higher rate than the previous month.

Shariah non-compliance risk
The most important of all risks in an Islamic bank is of course Shariah non-compliance risk or the risk of loss of revenue due to non-observance of the tenets, conditions and principles espoused by Shariah. Non-compliance creates reputational risks. This is because many of an Islamic bank’s customers bank with it out of religious principles and the subsequent loss of trust could lead to a potential liquidity crunch.

Furthermore, income generated from non-Shariah activities cannot be recognized, hence the potential for loss of income. Another risk is that contracts could be challenged in court leading to legal losses apart from the monetary loss of voiding the original contract.

Conclusion
This article was writt en with the Malaysian banking environment in mind. The Malaysian banking landscape consists of many Islamic banks/windows and conventional banks and this dual environment create unique competitive pressures for Islamic banks. There is thus not much diff erence between products off ered by Islamic banks and their conventional counterparts. Risk management in an Islamic bank in Malaysia is also therefore very similar to risk management in conventional banks.

In other countries, such as Pakistan and Sudan, Islamic banks offer more equity based Musharakah and Mudarabah financing thereby creating a much stronger link between the underlying transaction and profi t-sharing.

In Malaysia there is an increased pressure on Islamic banks to move more towards equity-based fi nancing. However, this is not that straightforward. First of all clients do not demand these kinds of structures here as they are reluctant to have a bank as an equity
partner; and secondly these structures require a higher capital charge of 150% making it potentially more expensive for the customer.

Also, focusing on equity-based financing would put additional challenges on a bank in terms of risk management. As the return and potential loss is now much more dependent on how well the underlying project or business is managed, risk officers of the bank would need to have as much knowledge about the underlying business as the business itself. It is quite unlikely that this asymmetry between the capital provider (usually the bank) and the entrepreneur (the client) could be dealt with effectively.

WHY ISLAMIC FINANCE MATTERS?

This post is based on sections of IMF Staff Discussion Note titled "ISLAMIC FINANCE: OPPORTUNITIES, CHALLENGES AND POLICY OPTIONS" published on April 2015 by Alfred Kammer, Mohamed Norat, Marco Piñón, Ananthakrishnan Prasad, Christopher Towe, Zeine Zeidane, and an IMF Staff Team.

WHAT IS ISLAMIC FINANCE?

Islamic finance refers to the provision of financial services in accordance with Islamic jurisprudence (Shari’ah).Shari’ah bans interest (Riba), products with excessive uncertainty(Gharar), gambling (Maysir), short sales, as well as financing of prohibited activities that it considers harmful to society. It also requires parties to honor principles of fair treatment and the sanctity of contracts. Transactions must be underpinned by real economic activities, and there must also be a sharing of risks in economic transactions.

Islamic finance products are contract-based and may be classified into three broad categories:(Hussain, Shahmoradi, and Turk 2015):

1. Debt-like financing structured as sales, which could be sales with mark up and deferred payments (Murabahah) or purchases with deferred delivery of the products (Salam for basic products and Istisna’ for manufactured products), and lease (Ijārah) with different options to buy. Pure lending is allowed only on benevolent basis (Qard, which is often used for current deposits);

2. Profit-and-loss-sharing (PLS)-like financing with two modalities: (i) profit-sharing and loss-bearing (Mudarabah) whereby the financier (investor, bank) provides capital and the beneficiary provides labor and skills (profits are shared, but losses would be borne by the financier who does not have the right to interfere in the management of the financed operation, unless negligence, misconduct, or breach of contract can be proven); and (ii) pure profit-and loss- sharing (Musharakah) where the two parties have equity-like financing of the project and would share profits and losses; and

3. Services, such as safe-keeping contracts (Wadi’ah) as for current deposits, or agency contracts (Wakalah), which are also increasingly used for money market transactions.

Islamic finance now encompasses a wide range of services. Nonetheless, banking still dominates and represented about four-fifths of total Islamic finance assets in 2013 (IFSB 2014). The Sukuk market is also a fast-growing segment with assets equivalent to about 15 percent of the industry. Other services include leasing, equity markets, investment funds, insurance (Takaful), and microfinance.

IB differs from conventional banking in several dimensions. As a result of the prohibition on interest, Islamic banks are funded by non-interest-bearing current accounts (benevolent loans or safe-keeping contracts), as well as profit-sharing investment accounts (PSIA) where investors receive a return that is determined ex-post by the profitability of the bank or the pool of assets financed by these accounts. Correspondingly, on the asset side, banks do not engage in lending, but in sales, lease, profit-and-loss-sharing financing, and fee-based services. The return to the banks on these transactions is based on the profitability of the underlying transactions. There are some differences on the treasury side: Islamic banks are prohibited by nearly all jurisdictions from undertaking certain types of derivatives, such as foreign exchange forwards and futures.

Sukuk, the Islamic equivalent of bonds, are similar to asset-backed securities. Whereas a conventional bond is a promise to repay a loan, Sukuk constitutes partial ownership in receivables (Sukuk al Murabahah), a lease (Ijārah), a construction project (Istisna’), a deferred delivery of assets (Salam), a joint partnership (Mudarabah or Musharakah), or investment (Istithmar); the principal amount is typically not guaranteed and the return is linked to the performance of the underlying assets (Maziad and AlSaeed 2015). Sukuk can take the form of asset-backed securities, which involve true securitization of underlying assets, or they can be asset-based securities.

In practice, Islamic finance often involves structuring transactions in a manner that closely mimics conventional finance in so far as a periodic rate of return is provided. In certain types of Sukuk instruments, a predetermined rate of return is often paid to the investor; this rate is based on the expected return of the underlying assets that collateralize the Sukuk. In the case of debt-like financing by Islamic banks, interest is not charged; instead, debtors will provide predetermined and periodic payments to the bank, based on the expected profit that would accrue to the underlying asset (in the case of a capital investment), or on the rent that might be charged for the use of the underlying asset (in the case of a home or car loan). This leads to minimal differences in substance with conventional finance and, in some cases, requires a complex layering of transactions, involving third parties. These can create operational and other risks that may have to be managed carefully.

WHY ISLAMIC FINANCE MATTERS.

Islamic finance has grown rapidly in recent years, but remains concentrated in a few jurisdictions. Islamic finance assets grew at double-digit rates during the past decade, from about US$200 billion in 2003 to an estimated US$1.8 trillion at the end of 2013 (Ernst & Young 2014; IFSB 2014; and Oliver Wyman 2009). However, despite this growth, Islamic finance assets are still concentrated in the Gulf Cooperation Council (GCC) countries, Iran, and Malaysia, and represent less than 1 percent of global financial assets.

The growth of IB, in particular, outperformed conventional banking over the past decade. IB has thus increased its penetration in many countries, crossing the threshold of 15 percent as a share of banking system assets in 10 countries (Iran and Sudan with a full-fledged Islamic financial sector, Bangladesh, Brunei, Kuwait, Malaysia, Qatar, Saudi Arabia, the United Arab Emirates, and Yemen) (IFSB 2014). IB represents about 1¼ percent of global banking assets. During the recent global financial crisis, Islamic banks were less exposed to the toxic assets that contaminated the conventional banking world, but suffered from second-round effects, notably through the real estate slump. Asset quality and capitalization are still better on average than for conventional banks while profitability remains lower (although the industry averages mask wide variation across different jurisdictions, IFSB 2014).

Sukuk issuance has also increased rapidly. Global issuance has grown significantly since 2006, although from a low base. It reached US$120 billion in 2013, bringing the outstanding Sukuk to US$270 billion by end-2013, representing ¼ percent of global bond markets. Issuance is still concentrated in Malaysia and the GCC countries, although diversification is ongoing with new issuance in Africa, East Asia, and Europe. It is evenly split between sovereigns and corporate Sukuk, and mainly denominated in Malaysian ringgits or U.S. dollars. Demand is generally outstripping supply, leading to oversubscription on most issuances, lower yields (when the fundamentals of the issuer are strong), and less liquidity as investors prefer to “buy and hold.” These include particularly Islamic banks, which suffer from a shortage of Shari’ah-compliant liquid assets.

The strong growth reflects growing demand from Muslim populations, and strong economic growth in countries where the industry already exists. Islamic finance is also benefiting from innovation in products in trade, corporate, project, and consumer finance, improvements in the regulatory environment, ongoing diversification of Sukuk issuers eager to tap savings from the Islamic world, and strong interest in Sukuk issuance by banks seeking to strengthen their capital bases in line with the Basel III requirements. It remains to be seen, however, whether this strong growth will be sustained in light of the recent decline in oil prices as the industry is still concentrated in oil-exporting countries. Indeed, there is empirical evidence that the oil price is a determinant of IB diffusion (Imam and Kpodar 2010). Moreover, low yields and lack of liquidity could weigh on the long-term growth of the Sukuk market.

Islamic finance has the potential to contribute to higher and more inclusive economic growth. Large segments of the Muslim population are underserviced by conventional finance—only 24 percent of adults have a bank account and 7 percent have access to formal financing, compared with 44 percent and 9 percent, respectively, for non-Muslim populations (Demirgüç-Kunt, Klapper, and Randall 2013). Moreover, the principles of risk-sharing and the strong link of credit to collateral means that IB is well-suited to the financing of SME and startups, thereby contributing to more inclusive growth. And at the same time, Sukuk have shown their value in the area of infrastructure finance, and could also help in supporting investment and economic growth.

Islamic finance may also help promote macroeconomic and financial stability. The principles of risk-sharing and asset-based financing can help promote better risk management by both financial institutions and their customers, as well as discourage credit booms. Indeed, IB resembles the proposal made in the 1930s under the Chicago plan, which required full backing of bank loans, and which recent research has suggested would lower macroeconomic volatility and the risk of bank runs (Benes and Kumhof 2012; and Wolf 2014). In the case of Islamic finance, a large portion of bank deposits are offered on a profit-sharing and loss-bearing basis (for example, 55 percent in the Middle East and North Africa region; Ali 2011) and so are explicitly “bail-inable” in the event of a banking sector facing distress. Finally, the underlying ethical precepts of Islamic finance provide, in principle, an important basis for high levels of ethical conduct, governance, and consumer protection.

Islamic finance faces a number of other constraints that may be impeding its development. Although Islamic regulatory bodies and standard setters have created principles and detailed technical standards, there is further scope for their implementation by national authorities, who are often more focused on global conventional banking standards. Lower economies of scale, and sometimes an uneven playing field with conventional finance, play a role. Similarly, large differences in practice across countries and limited standardization and securitization create additional uncertainty for Islamic finance customers. Scarcity of Shari’ah scholars with financial sector expertise, and a slow pace of innovation are also weighing on the industry. These challenges may not only be impeding its development, but could also encourage practices and products that are complex, thus carrying heightened risks.

Commodity Murabaha: Better the devil you know?

Controversy
The commodity Murabahah contract has been under the spotlight in the last few years due to the 2009 ruling by the OIC Fiqh Academy that commodity Murabahah was essentially organized Tawarruq and therefore deemed to be a “synthetic and fictitious” transaction impermissible under Shariah. As an alternative, the Fiqh recommended the use of Qard Hassan, a benevolent loan. However, as noted by Raja Teh Maimunah, the former head of global Islamic markets at Bursa Malaysia: “This is simply not a commercially viable option.”

The vast majority of market players and many Shariah scholars accept that as a cash management tool and liquidity facility, the Islamic finance industry currently has no alternative. The use of commodity Murabahah is central to Islamic liquidity management, and is also playing a pivotal role in industry innovation, being used to develop personal financing products, Islamic derivative and structured products, and to back Sukuk structures. The industry, and its Shariah advisory boards, appear to have reached an uneasy consensus that although Tawarruq where possible should be considered a product of last resort, its use is acceptable.

Regulation
In fact, the use of Tawarruq in commodity Murabahah is largely dependent on region. While in the GCC tax structures mean that commodity Murabahah without using the Tawarruq structure is commercially viable (and thus widespread), in other countries there are different regulations. Rodney Ballard, the head of trade fi nance at Bank of London and The Middle East (BLME), following the Fiqh ruling, explained that in European and OECD countries the tax treatment puts Islamic banks at a disadvantage. “We don’t promote the Tawarruq but because of tax reasons our scholars allow us to use it as the Murabahah structure generates a lot of taxes and stamp duties that we can’t recover. This has been the only way to grow Islamic trade finance against conventional finance in Europe. If the Tawarruq was removed without providing an alternative to the Murabahah taxing structure, Islamic trade finance would disappear in Europe and the OECD.”

Malaysia too, has decided that Tawarruq is permissible if regulated. Raja Teh explained that at least as far as Malaysia was concerned, the prohibition was not due to the practice itself but rather its questionable execution. “The industry had suffered some reputational issues regarding rogue trades whereby commodities purchased for this purpose were either encumbered, i.e. they cannot be freely dealt with; the same commodities were being sold to several parties simultaneously; or, in some cases, simply didn’t exist.” As a result, since then there has been an industry wide effort to standardize and regulate the market, kickstarted by the launch in August 2009 of the Bursa Suq Al Sila’.

The platform is a continuation of the Commodity Murabahah House (CMH) initiative by the Malaysian International Islamic Financial Center (MIFC), first mooted in 2007; an international spot commodity platform which facilitates commodity-based Islamic financing and investment transactions. Raja Teh commented upon its inception that: “Instead of disallowing Tawarruq we set some rules. No one has ever regulated commodity Murabahah – what constitutes a proper commodity Murabahah trade, what makes it invalid – this is exactly the rationale of setting up Bursa Suq Al Sila’.”

Liquidity management
Despite the debate surrounding its structure, commodity Murabahah fulfi ls a vital function in the Islamic money market, and is widely used across all major Islamic fi nancial markets to manage liquidity. In fact, it has been described by Raja Teh as:
“The one Islamic money market tool that can help provide liquidity in the Islamic banking system. There is no other instrument that is as widely used as commodity Murabahah, especially in the short-term money markets. Sukuk are generally of medium to long tenure whilst other contracts, for example Wakalah, may not appeal to some risk managers.”

Malaysia has quite literally put its money where its mouth is. In March 2007, Bank Negara Malaysia launched the Commodity Murabahah Program (CMP), a cash deposit program to help Islamic institutions manage liquidity, and added Bank Negara Monetary Notes Murabahah to its stable of money management instruments. In 2009, Malaysia introduced two standardized interbank master agreements for
Islamic deposit-taking and placement transactions (the Corporate Murabahah Master Agreement and Master Agency Agreement) to promote the uptake of commodity Murabahah as an interbank tool; as well as launching the Bursa Suq Al Sila’ the same year.

Following Malaysia’s example, several other financial exchanges have either launched or expressed interest in launching liquidity management services that incorporate Tawarruq or Murabahah components. The Bahrain Financial Exchange through Bait Al Bursa, its Islamic division, in March 2011 launched e-Tayseer, a fully automated platform for transactions in the supply, purchase and sale of
assets for facilitating Murabahah transactions. e-Tayseer allows suppliers to place their assets onto the platform ready to be purchased by financial institutions. Financial institutions can then purchase these assets and conduct Murabahah transactions with counterparties to fulfil their liquidity management requirements. In January 2011 the Jakarta Futures Exchange also announced its intention of launching commodity Murabahah products by July, although no product has as yet come to market.

Diversification
Eldred Buck, the managing director of Eiger Trading Advisors, confirms that: “Commodity Murabahah is seeing a recovery in demand from the much lowered levels of activity in 2009 and 2010.” With its application now generally accepted, and its use increasingly well regulated, the market is once more starting to push the limits of the structure, expanding from a vanilla money market tool into a diverse range of instruments backing an increasingly wide variety of Islamic financial services including trade finance, personal finance and Sukuk. “Bank treasuries remain the most significant users [but] looking forward, the development of retail products is also spurring growth,” says Buck. “We are seeing a real growth in specific transactions across a multitude of jurisdictions and products, from agricultural products to construction materials. There is definitely a very sharp move towards developing personal finance products backed by commodity Murabahah.”

Along with the diversification of applications, commodity Murabahah structures are increasingly spreading into new asset classes for their underlying commodity base. Buck confirms that: “There is clearly a desire to diversify away from the traditional commodities.” While Islamic banks in the Middle East have traditionally used contracts based on the London Metals Exchange (LME) to manage their liquidity positions, Malaysia took a step forward in 2007 by using its own abundant crude palm oil resources to back its commodity Murabahah monetary notes. However, both of these commodity classes are subject to disadvantages including volatile price fluctuations and (in the case of LME contracts) forex fluctuations, and other potential asset classes have proliferated. “We are seeing a number of potential assets, particularly those that are held at a regional level, such as rice, steel and cement,” comments Buck.

Bahrain’s e-Tayseer now offers multiple Shariah compliant assets including cars, car parts, industrial equipment, soft commodities and metals, while the Jakarta Futures Exchange plans to create commodity Murabahah products based on olein, coffee, and gold.
In August 2009 RHB Islamic signed a groundbreaking agreement with Sedania Media Group and E-Pay to use mobile phone airtime as a commodity Murabahah asset class for its classical Tawarruq products (including its personal financing facility), asserting that the asset not only increases efficiency and reduces operating cost but is highly liquid and not subject to price or forex volatility.

There is no doubt that commodity Murabahah has its limitations. Yet the industry continues time and again to return to it as a stalwart fall-back option. Although alternatives have been promoted (such as the Ijarah lease structure to finance the purchase of equipment, Wakalah to replace Tawarruq, and Musharakah for project finance) none have yet gained enough traction to represent a realistic substitute.

It looks as though for the time being, having survived everything the industry has thrown at it, commodity Murabahah is here to stay.

Source: IFN 3rd August 2011.

Money laundering: an Islamic perspective

BY: Ibraheem Musa Tijani. Research Officer, International Shariah Research Academy, ISRA.

Introduction.

Money laundering is a very serious offence and may cause severe economic repercussion. According to the United Nations, an estimated $1.6 trillion was laundered globally in 2009, which is destroying society and economy (Roberto, 2012). Money laundering is basically the concealment of unlawful money that is acquired via unlawful methods.

There are various views on the how the term 'money laundering' was coined, with one of the views being that mafia/drug dealers would set up laundromat outlets as means to cleanse their illegal proceeds (Yasin,2012: 296). The paper identifies some of the regulations that are created to combat money laundering globally including Muslim countries. However, the aim of the paper is to highlight the Islamic perspective of money laundering, by stating what Islam recognizes as money and what activities could be consider as unlawful usage of money.

Money Laundering Regulations.

One of the earliest legislations crafted to combat money laundering in the United State was the Financial Recordkeeping and Reporting of Currency and Foreign Transactions Act of 1970, referred to as the Bank Secrecy Act (BSA). The purpose of the act was "to require financial institutions to maintain appropriate records and file certain reports which have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings" (United States, 1984: h-57).The intent behind this regulation was to capture those involve in criminal activities. Then there was the Money Laundering Control Act of 1986, which made money laundering a federal crime in the United State. Then came the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (Patriot Act), which came in being as a result of September 11, 2001 that happen in the United States of America. This act is said to be a means of countering terrorism and money laundering offences committed globally (Patriot Act).

At the international level, the Financial Action Task Force (on Money Laundering) (FATF) is playing a major role in controlling money laundering. This is an inter-governmental body that was established in 1989. The purpose of the body was "to set standards and promote effective implementation of legal, regulatory and operational measures for combating money laundering, terrorist financing and other related threats to the integrity of the international financial system. The FATF is therefore a "policy-making body" which works to generate the necessary political will to bring about national legislative and regulatory reforms in these areas" (The Financial Action Task Force).FATF currently comprise of 36 member countries as FATF-Style Regional Bodies (FSRBs) with over 180 jurisdictions are committed to their recommendations including most Muslim countries under the Middle East and North African Finance Action Task Force (MENAFATF) and other Muslim countries such as Malaysia, Indonesia, Pakistan, Afghanistan, etc. (The Financial Action Task Force). These are merely a few of the numerous laws and regulations that are set in place to combat money laundering. Islamic concept of Money laundering It must be understood that in Islam money is merely a means of exchange within the society. Hence, its usage is to obtain a particular object and it is not considered as a commodity by itself, therefore it does not really contain any intrinsic value within itself; it is by exchanging money that its value is determined.

There is indeed a social need for money in the society. However, money in the form of wealth can be a test from Allah; Allah says: "And surely We will test you with a bit of fear and hunger, and loss in wealth and lives and fruits (Surah 2: 155). . However, within the context of money laundering the Quran states how, wealth, money or property can be consumed illegally or improperly, which is sinful; Allah says: "And do not eat up each other's property by false means, nor approach the authorities with it to eat up a portion of the property of the people sinfully, while you know" (Surah 2: 188); this verse will be further explained below.

The definition of wealth is frequently discussed among classical jurist in the chapter of muamalat (transaction). For example, Ibn Abidin defines mal as "what human nature inclines to, and which can be conserved until time of need" (n.d.: 57). Mal is defined in Majallah (1967,article 126) as "something desired by human nature and which can be put aside against time of necessity. It comprises movable and immovable property." While al-Shatibi defined it as "that on which ownership may be established, and which can become exclusive for its owner apart from others when he acquires it in the manner that is appropriate for it" (1997: 17). Hence, although in details the meaning is different but in contemporary practice these definition can also be applicable to modern money/currencies. Illegal trading was prohibited in Islam over 1400 years ago in an environment that all manner of trading was acceptable and everyone was left to his/her customs, whether it is just or not. There are numerous trading activities that Islam prohibited during the time of Prophet Muhammad (peace be upon him) which are codified in modern money laundering acts and regulations as illegal activities and proceeding, such as counterfeiting, forgery, embezzlement, funding activities that endangers the society, funding suicide, murder, etc.

In Islam, the origin of things is ibahah (permissibility) including money. However, there are means in which activities and utilization of money becomes impure or illegal. The usage of such forbidden money in an Islamic society would represent the meaning of money laundering. Hence, an Islamic perspective of money laundering would be activities that are categorized according to Islamic sources as unlawful, i.e., haram. Unlawful activities according to Islam are as follows:

a. Riba(interest). Riba(interest) under the category for money laundering would appear very strange to most conventional regulators. However, due to the severity of its prohibition in the Quran and Sunnah, it would rank as the highest offense of money laundering in Islam. Allah says: "...they say: Trade is just like usury; whereas Allah permits trading and forbids usury... Allah has blighted usury and made alms giving fruitful. Allah loves not the impious and guilty" (Quran 2: 275-276). From the Sunnah, it is narrated that Jabir said that Allah's Messenger (peace be upon him) cursed the acceptor of interest and its payer, and one who records it, and the two witnesses, and he said: They are all equal (Muslim, 10/3881). In another report, Abu Hurairah related that the Prophet said: On the night of the miraj I came upon a group of people whose bellies were like houses. They were full of snakes which could be seen from outside their bellies. I asked Gabriel who they were, and he told me that they were the people who had practiced riba (Imam Ahmad). Abdullah ibn Hanjalah related that the Prophet said: A dirham of riba (interest) knowingly taken by a man is a sin worse than committing Zina (fornication) 36 times (Imam Ahmad). These and other such reports that indicate that riba and all its forms are unlawful; hence, making riba (usury) among the offenses in Islam that would be recognized as money laundering activities and proceeds.

b. Bribery. Bribery is completely prohibited in Islam. Allah says: "And eat not up your property among yourselves in vanity, nor seek by it to gain the hearing of the judges that you may knowingly devour a portion of the property of others wrongfully" (Quran 2:188). Therefore, whatever proceeds or instrumentalities that were used and acquired as bribery would be part of money laundering in Islam. The Messengerof Allah (peace be upon him) cursed the one who pays bribes and the one who takes bribes (Abu Dawud, hadith no. 3573). The Prophet (peace be upon him) said: "It is not permissible for a man to take his brother's wealth unlawfully" (Ahmad, hadith no. 426)

c. Usurping others' property. Usurping of another person's property is clearly warned against in the Quran and Sunnah as an offence and ill-gotten means of acquiring money. Allah says: "And eat up not one another's property unjustly (in any illegal way e.g. stealing, robbing, deceiving, etc.), nor give bribery to the rulers (judges before presenting your cases) that you may knowingly eat up a part of the property of others sinfully" (Quran 2: 188). This may also relate to usurping other people property, which is illegal. The Prophet (peace be upon him) said: "It is not permissible to take the wealth of a Muslim unless he gives it willingly" (Ahmad, hadith no. 20172). Therefore, any property or money acquire through such mean will fall with the Islamic view of money laundering.

d. Fraud Fraud is highly shunned upon in Islam; it is a type of deception. Allah says: "It is not for any Prophet to take illegally a part of booty, and whosoever deceives his companions as regards the booty, he shall bring forth on the Day of Resurrection that which he took (illegally). Then every person shall be paid in full what he has earned, - and they shall not be dealt with unjustly" (Quran 3: 161). Hence, if such an act is not acceptable in war booty then certainly any money or proceeds acquired through such means could be deemed haram (illegal). Similarly, Allah say: "Woe to those that deal in fraud, those who, when they have to receive by measure from men, exact full measure, but, when they have to give by measure or weight to men, give less than due. Do they not think that they will be called to account?" (Quran, 83:1-4). From the Sunnah, the Prophet said "When you enter into a transaction, say: There should be no attempt to deceive" (Muslim,10/3663). Hence, all form of deceive, fraud, trickery to acquire the money or property of another person would be illegal.

e. Theft and Robbery. Theft in Islam is a major offence, to the extent that the punishment for it can be up to the amputation of the hand. Allah says in the Quran: "Cut off the hands of thieves, whether they are man or woman, as punishment for what they have done – a deterrent from Allah: Allah is All-Powerful, All-Wise." (Quran 5: 38). This verse is meant as a deterrent from committing such a crime and to show the severity of the offence. Therefore, any activity or proceed acquired through this means would be render as money laundering.

f. Gambling and Alcohol. Gambling and alcohol, or better yet the sale and consumption of alcohol, are clearly prohibited in the Quran and Sunnah. Allah says: "O you who believe! Intoxicants (all kinds of alcoholic drinks), gambling, al-ansab and al-azlam (arrows for seeking luck or decision) are an abomination of shaitan's (Satan) handiwork. So avoid (strictly all) that (abomination) in order that you may be successful. With intoxicants and gambling, Satan seeks only to incite enmity and hatred among you, and to stop you remembering God and prayer. Will you not give them up?(Quran 5: 90-91).The Messenger of Allah said: "Allah and His Messenger have forbidden the sale of alcohol, dead meat, pork and idols" (Bukhari; Muslim). The companions also asked him regarding this matter, when they asked: "O Messenger of Allah, what do you think of the fat of dead animals, for ships are caulked with it and animal skins are daubed with it, and the people use it to light their lamps?" He said: "No, it is haram." Then the Messenger of Allah (peace be upon him) said: "May Allah curse the Jews, for when Allah forbade them animal fat, they melted it down and sold it, and consumed its price" (al-Bukhari, hadith no.1212; Muslim, hadith no.1581). Hence, clearly stating that whatever proceeds or instrumentalities received from these activities would also be considered from an Islamic perspective as money laundering.

Conclusion.

In conclusion, money laundering from an Islamic perspective is much wider and vast than the conventional legal aspect. This is because basically most of the activities that are generally agreed upon by global regulatory standards on money laundering activities would generally be considered as haram activities in Islam, such as counterfeiting, forgery, embezzlement, funding activities that endangers the society, funding suicide, murder, etc. The Prophet (peace be upon him) said: "Everybody that is nourished on haram things, the fire is more fitting for it" (al-Tabarani, hadith no. 4519). The Messenger (peace be upon him) also lay down a very fundament principle when he said: "When Allah forbids a thing, He (also) forbids its price" (Abu Dawud, hadith no. 3488). This gives an overview of why it's best to restrain from gaining wealth or money through illegal (haram) means. Therefore, the Prophet (peace be upon him) said: "Allah is Good and only accepts that which is good..." and he mentioned a man who has been traveling for a long time and is unkempt and covered with dust, and he raises his hands to the heavens (and says), "O Lord, O Lord," when his food is haram, his drink is haram, his clothes are haram, and he is nourished with haram, so how can he receive any response? (Muslim, hadith no. 1015) Therefore, the prohibition of money laundering activities in Islam is not only meant to create a stable and just society, but also as means to better the person's life in the hereafter.

The Role of Central Banks in Islamic Banking-Final

Assertions:

8. Removal of interest and all its derivatives (i.e. lending on interest, money market and speculation) from an economy will lead Islamic banks to finance investment projects through PLS. The criteria to be used by such banks are both profitability and feasibility of the projects. Hence, projects compete with each other on the bases of their Internal Rates of Return (IRR). However, the criterion used by a potential investor is IRR of a specific project. The role of the central bank in determining arrays of IRRs for different sectors and various activities is highly valuable in channelling resources into proper projects. Ranking IRRs in descending order, an investor would first choose the project with the highest IRR. However, the rule, which seems appropriate in choosing the amount to be invested, is "cut-off rate". The maximum amount one investor is willing to invest in a project is determined by the IRR of the next project whose value is almost equivalent to the chosen project, without it being "the opportunity cost" of capital.

Cut-off rate, seems to me, has long been mistakenly interpreted as opportunity cost. In investment decision making most of the times we are dealing with the cut-off rate concept (even in an interest based economic system) but very rarely with opportunity cost. In capitalistic system, rate of interest is justifiably used as the opportunity cost of capital. It is well justified that interest rate is essentially determined independently from the rate of return in the real sector of the economy. However in the absence of interest, projects compete with each other to obtain finance from Islamic bank on the basis of their IRR because there is no other alternative.

Comparison among various IRRs brings about the role of cut-off rate without anyone of them becoming opportunity cost of another project. Cut-off rate functions as a signal to show an investor up to what point he should invest and where to stop and select another project. Interdependencies among various investment projects produce cut-off rate the special character and function of which differ from those of interest rate. The reason, seems to the author, that we often fail to distinguish between these two concepts is the interdependence condition. Furthermore, choosing one, IRR of one project as the opportunity cost of another project in the same activity (on the basis of the principle of next best alternative) will lead one to a whole range of so-called opportunity cost list, none of which have possibly the same value. Hence, different cost calculations in the same activity. Whereas cut-off rates could be numerous for many producers in the same activity without making them run into any problem. In the absence of interest rate there is nothing to compare IRR of an investment project with. Therefore, we can conclude that in an Islamic economy opportunity cost of capital is zero.

The foregoing statements were justified on the basis of economic logic; accountants do not seem to have any reason to believe otherwise. One final remark can be added to above statements. Opportunity cost of capital can also be used as the cut-off rate but the reverse is not true. After their feasibility and profitability have been confirmed by Islamic bank's qualified personnel, projects become eligible to obtain finance; furthermore, the projects themselves become collateral for finance. Central bank's role in providing guidelines about both of these two aspects will certainly be appreciated by Islamic banks. As long as there are unemployed factors of production suitable to be utilized in investment, projects have to be financed by Islamic banks no matter how much money is required to finance them. This gives appropriate apparatus to materialize the assertion made by S. M. Bagher Sadr when he says; "Tools of production are treated servants in Islam and man the master". It is the right of labour, in Islam, not to be kept unemployed. In the final analysis, every piece of bank note coming out of an Islamic bank in response to financing an investment project can be called Certificate of Asset Building (C.A.B.). These C.A.B.'s are appropriate both to production and household sectors.

9. In dealing with various modes of contract, Islamic banks finance profitable and appropriate projects. Appropriateness of projects are expected to be determined by the central bank; however, to determine which projects are more profitable to finance is the task of each individual Islamic bank.Central bank's task is to instruct Islamic banks to give priority to those projects, which are more compatible with the country's economic plan (be it either explicit and written or unwritten and implicit).

Islamic modes of contract can be classified into two broad categories:
1. Those with variable return and (2) with fixed return. Musharakah and Mudarabah contracts fall into the first classification and Instalment Sales, Hire-Purchase, Joalah, and the like into the second one. Musharakah (i.e., PLS) has well and rightly been recognized as the core of Islamic banking. In Mudarabah contract labour has no responsibility as to any loss that may occur provided that it had done its best. The second class of contracts may be defined as auxiliary contracts, which could be used in conjunction with and after the first category has been utilized. Risk is involved with the first type but the second is risk less which is more appealing to Islamic banks.

To reduce or even to eliminate the burden of risk from the shoulders of investors it requires another paper, which IS beyond the scope of this presentation. However, to make sure that the guideline controlling the complementarity of the second type contracts has properly been observed, the Islamic central bank is supposed to keep close eye on the contracts signed by each individual Islamic bank. I skip going into the mechanism of how the burden of risk can be lessened or even eliminated; to determine the degree of risk in different sectors and regions throughout the country. This is another crucial task of an Islamic central bank. This will facilitate the task of Islamic banks in determining the relative share of their own profit vis-à-vis that of the investor. This task not only is beyond the capabilities of an individual Islamic bank, but also provides a uniform procedure for all Islamic banks for various sectors, locating in different regions of the country.

10. Whether an Islamic bank uses the variable or fixed- rate-of-return contract, accountants are very keen about costs that are supposed to be deducted from, total revenue.Accountants who are responsible to approve and submit both balance sheets and profit and loss statements to tax authorities do not accept anything under the heading of cost from neither of the two types of contracts provided that they have been financed by Islamic banks. It is a fact that economists use these two valuable documents for economic analysis and their own interpretations without being able to adjust them on the basis of their own interpretation of cost.

Nevertheless, neither of the two professions (accounting and economics) can deny that the Islamic banks' share of profit paid by investors (i.e. financees) is in fact sort of dividend which is essentially determined after all costs have been subtracted from revenue and hence can no longer be considered cost.

To sum up the role of a central bank in an Islamic state, we come up with six different crucial functions to be performed at different levels of rigorousness:
a) Active participation in the process of preparing economic development plan.
b) Informing individual Islamic banks about the priorities of investment projects as outlined in the country's economic development plan at different regions and various sectors.
c) Calculating and submitting to Islamic banks the profit shares of banks relative to those of capital for different projects at various regions and sectors.
d) Calculating and submitting to Islamic banks the value of risk involved in different projects, different regions, and various sectors of the country.
e) Constant inspection and supervision to make sure that projects have properly been financed relative to the priorities and the value of risks. Note: To do all above functions effectively an Islamic central bank is supposed to be well equipped with highly qualified personnel in portfolio and risk management and project appraisal. This is also a must for each individual Islamic bank.
f) After making sure that Islamic banks have concisely followed the central bank's instructions they can safely be allowed to gradually reduce RRR down to zero.

Let me admit that monitoring cost in Islamic banking compared to the conventional banking is relatively high. However, potential benefits as to its effects on reducing unemployment and keeping prices constant over-shadow the cost. Most important, distribution of income and wealth is expected to be more equitable than otherwise. Such a scheme of distribution guarantees sustained economic development. The role of an Islamic central bank in a uniform distribution of information and prevention of moral hazard cannot be overstated.Whether it is the Islamic banking or the realization of Keynes' expectation to reach full employment, it is yet to be seen.

In closing my presentation, I would like to cite what Keynes has to say about this whole issue: "If I am right in supposing it to be comparatively easy to make capital goods so abundant that the marginal efficiency of capital is zero, this may be the most sensible way of gradually getting rid of many of the objectionable features of capitalism." Nonetheless it seems that these two models, in the final analysis, converge. He, in this respect, admits that "...it is to our best advantage to reduce the rate of interest to that point relatively to the schedule of the marginal efficiency of the capital at which there is full employment."

The Role of Central Banks in Islamic Banking Part 1.

By: Dr. Iraj Toutounchian and Prof. C. G. Harcourt.

"...ideologies...affect the topics discussed, the manner of discussion, the factors included or left out or inadequately stressed in arguments, comments, and models and attitudes shown, sympathetic or hostile,...to past and contemporary economists' works and views. "

Based upon above statement it can be argued that there are a lot of differences between Islamic and conventional banking systems both at micro and macro levels. These differences are in approach, in concepts, and in the resulting behaviour.

My presentation is based upon the following primary and secondary assertions, which are the result of 27 papers and 3 books. The last book: "Comparative Money and Banking in Capitalistic and Islamic Systems", in 856 pages, has been recognized in February 2002 in Iran as "The Economic Book of The Year". These assertions and the final conclusion may seem rather unorthodox, but they are the product of their own logical reasoning. The essence of my paper is thus nothing but one of the logical consequences, among others, of the following assertions everybody is able to derive.Primary assertions are those, which can directly be used to reach the final conclusion of this paper. Secondary assertions are key issues to be used, one way or another, to lead one to the problems in implementing Islamic Banking.

These two types of assertions, however, constitute separable sets. Based upon the fact that the primary function of banks is to deal with "money", one cannot speak about " banking" without referring to money. Hence, it seems a "must" to understand money first. Otherwise many Miss-interpretations may arise as the result. Interest and profit, although being clear concepts, have been subjected to many misunderstandings. To be sure, let me make them clear at the outset. Interest and profit are rewards to money and capital investment, respectively. In other words, capital investment produces profits and money produces interest.

Furthermore, it has constantly and mistakenly written and quoted by some writers that the price of money is 1 (unity). One is the exchange rate of money with itself; but the price of money is interest (rate). Some of my findings about the nature and role of profits closely correspond to those of Prof. Adrian Wood in his seminal book " A Theory of Profits ". With the abolishment of interest (as it has in Islamic school of economic thought), the LM curve loses its total validity and becomes redundant and useless. All in all, interest is a normative concept (basically discussed in schools of economic thoughts), which can neither be proved nor refuted by use of scientific tools of analysis. It is a value judgement. In evaluating an economic system, economists are supposed to take it for granted.

Assertions:

1. In economics we are basically dealing with two inter-related concepts; one is legal (or conventional) concept and the other is real concept. To distinguish one from another, one does not need to focus on the physical features of each one. All contractual agreements like marriage, ownership, organizational hierarchy, money, interest, and the like fall into the first category; while human beings, commodities, buildings, amenity, and the like are included in the second category. Each one of these two concepts is able to produce the other or be transformed into itself. Let us call these two properties " Completeness" and " Reflexivity", respectively. Hence, money itself being a legal concept is capable to producing another legal concept (actually its derivative) called "interest" or to produce real concept like capital equipment.

2. Money as a potential capital is a legal (conventional) concept capable of being transformed into actual capital. A simple example would be Mudarabah contract, among others, in which as soon as one person's money is legally combined with another person's labour force, the nature and the function of money is changed into capital. Given that in an Islamic framework there is no reward to money lending (i.e. interest being zero) yet capital (i.e. money's transformed version) is eligible for part of the profit earned.

3. Various modes of contract available to Islamic banks are the major source of transforming money deposits of individuals and firms into capital (or asset). Any type of financing under any modes of contract by these banks will essentially increase the value of the asset of the economy. However, some modes of contract like Musharakah and instalment sales (originated by firms) increase the productive capacity of the economy. Any positive change in the firm's asset values (rather than their capital values which is by itself a vague concept responsible for some obscurities) can be called " investment". Following this practice it is easy to calculate, rather than to estimate, the amount of investment, which has taken place in an economy during one specific year with relatively high precision. This can be done by reading the asset values off the current balance sheets, firms submit to tax authorities. By putting asset values, instead of capital, into the production function, not only it becomes more precise, but also meaningful. Firms' rate of profit is, hence, logically defined as the ratio of profit to their assets. Since the value of firms' assets is normally greater than their value of capital, therefore, the rate of profit defined as the ratio of profit to the value of capital, underestimates the true rate of profit.

4. Based upon J. M. Keynes' criticism on the classical economists inability to recognize speculative demand for money in the presence of interest (rate), it can easily be shown that interest is both necessary and sufficient condition for speculation. In other words, there is a two-way relationship between interest and speculation. It is probably for this reason that he has also recognized commodities rates of interest in addition to money rate of interest that he was much concerned about. That is, whenever a commodity is speculated upon a specific rate of interest would emerge. With the abolishment of interest, speculative motive of the demand for money, logically derived from interest, would disappear.

Speculation, which necessarily entails artificial risk in any market, be it in money, bond, gold, commodities and the like, is not permissible in an Islamic setting. All of these can safely be taken under the heading of "gambling". A corollary to the above assertion is that with the disappearance of bond market stocks are expected to be exchanged in an Islamic stock market based upon their book values. In terms of Tobin's Q this quotient is supposed to be close to unity (one). It is because in a world with perfect markets, economic value (EV) and replacement cost (RC), will coincide. This brings the quotient to unity. An implication of this is that in a world with perfect markets valuing the firm would be easy; i.e. we could read the economic value of the firm off the current balance sheet. Risk is essentially interwoven with investment. It can be considered "natural" and hence permissible in Islam. However, impermissibility of artificial risk may be grounded upon the fact that any income received by speculator will eventually bring about excess demand for goods and services (without the speculator having any share in productive activities). This excess demand, in turn, becomes the main source of inflation. Let me conclude discussing about this assertion by citing two statements correctly made by Prof. Gardner Ackley: a) "Speculation - if mistaken - tends ultimately to be self -correcting in any commodity market. " b) " ...the real cause of unemployment is speculative demand for money".

5. The natural consequence of elimination of interest, as said earlier, is the elimination of money market. Hence, the major motive to use money is for transaction purposes, which underlies the structure of ordinary demand and supply schedules for goods and services. Furthermore, based upon the logical statement that "the speculative motive is derived from money's use as an asset, as a store of value", money can no longer possess the "store of value function" in an Islamic framework. In the absence of interest, money market and speculation, and all monetary policy tools used in conventional banking, would lose their validity in Islamic banking. Let us call the policy followed in this new setting "Financial Policy". The unique and powerful tool of financial policy is to determine the share of profit relative to that of capital for all investment projects submitted to Islamic banks. This is probably the most important role a central bank can play in an Islamic banking. There are many factors underlying the determination of this share, especially in the face of natural risk. This share if effectively used would make bank's sources of finance properly channelled into asset building processes without worrying about money whirlpool to emerge. To determine equilibrium in this market the relative profit rate of the Islamic bank (call it financier) to that of the investor (call it the financee) can be constructed. This rate is especially useful in cases where different risks are involved. To prepare a list of different risks involved in various investment projects is another important task of a central bank.

6. Western economists have always and justifiably been worried about unnecessary expansion of money supply the volume of which is hard to control by central banks. This is due to the fact that considerable portion of it (very difficult to determine if not impossible due to uncertainties involved in interest rates) goes to money whirlpool. This is probably the reason Prof. Milton Friedman in his paper addressing the problem of stabilization policy has advocated the Required Reserve Ratio (RRR) to be raised to one hundred percent. It is clear that such a banking, if possible, would lose its own entity and merely becomes safe-deposit office. If Islamic banks are prohibited to lend on interest nonetheless different modes of contract, as mentioned earlier, are available to them to finance specific needs of both firms and individuals upon their proper requests. If constant and effective supervision is conducted on a random basis by the central bank the chances are very slim a money market, which could be outlawed, to be developed. So the kernel of Islamic banking is Profit and Loss Sharing (PLS). By preparing accurate information and making them available to the general public, central bank in Islamic banking system would be able to provide symmetric information and prevent moral hazard, to a great extent.

7. Money's inability to be a tradable entity and its production and volume being closely watched by the central bank (which is apart of the public sector), seems appropriate to be classified as "Impure Public Good" in an Islamic state. For the sake of brevity some properties of (impure) public goods which also applies to money, in this setting, will be outlined as follows:
a) Non-existence of money market.
b) Elimination of speculation.
c) Demand for it can be constructed by vertical summation of individual demands.
d) Externality of money can be derived from its capability of becoming actual capital; hence, government's (i.e. central bank's) intervention.

Furthermore, it benefits each person simultaneously and is thus equally available to each person. Simultaneous benefit is not a "must" for a "thing" to be public. A good example is highway. Highways do not generate simultaneous benefit to all individuals; they are equally available to all individuals. Non-exclusion principle also applies here. Additional individuals looking for money may be added at zero marginal cost. e) Indivisibility of money refers to its purchasing power and not its physical character. f) Its velocity is greater than unity implying that one is not supposed to "capture" it as opposed to the case of private good whose velocity is unity implying that it can be "captured". A caveat is in order here. Money has two distinct attributes; one at micro and the other at a macro level. At the micro level, it is part of the asset of an individual possessing it. But at macro level it cannot be added to the assets of the economy. To count money as wealth (or asset) of a nation will lead one to commit both fallacy of composition and double counting problem. This property of money may be the only one that makes it distinct from other "public goods". This could probably be the consequence of money being the medium of exchange.

To continue...