Aug 2 - 8, 2010

Presently, it is a matter of great concern for the relevant economists and practitioners that the practice of Islamic banking and finance prominently differs from its theory. The root cause or main reason of this difference is that although new financial instruments have been invented or adopted in strict compliance of legal requirements of Shariah, the objective of Shariah has not been fulfilled yet.

Hence in order to do away with the above difference, it is absolutely necessary to make a comprehensive research and approach in the right direction and come forward with measures and solutions that ensure the combination of the Shariah legalities and essentially fulfilled Shariah objectives based merger of Islamic theory and practice.

Islamic banking and conventional banking differ from each other. The main distinguishable characteristic is interest or Riba. The most prominent financial instrument of conventional baking is interest or Riba whereas in the Islamic banking is strictly prohibited. Islamic banking emphasises on justice, fairness, honesty and general well being of the people.

It may add to the knowledge of many readers that professor SD Goitein records his research that partnership and profit-sharing rather than interest based borrowing and lending formed the basis of commerce and industry in 12th and 13th centuries in the Mediterranean region.

After growing freedom after World War II, the Muslims countries made some practical experiments in interest free financing with their past background of Muslims credit societies and cooperatives functioning on interest free basis the banking institutions exhibited rebalance in 1960s. Interest-free bank was established in Karachi in 1960s and it was based on profit sharing without interest.

The Dubai Islamic bank was established in the nineteen seventies taking deposit in current account and investment account and was engaged in profit making activities directly as well as through working partners.

The Islamic Development Bank started operation in 1975. It was designed to serve the Muslim countries by arranging finance for trade and development on non interest basis. With the passage of time, Islamic banks increased to a dozen. Non banking financial institutions like investment companies and insurance companies (IAIB 1997) were an addition to the financial strength.

Till the end of 1970, interest of loan by banks was replaced by profit sharing. This changed the nature of financial intermediation making the funds owners as well as the financial intermediaries share the risk of enterprise with fund users. It was argued that a positive return was not guaranteed by the environment conducting the productive enterprise and therefore it was not justified for money capital to claim positive return.

Unemployment, inflation, poverty and recurrent business cyclone problems could be solved by abolishing interest and replacing it by profit sharing. Islamic economists were able to fortify these claims by sophisticated economic analysis at the macroeconomic level. It is possible to have banking without interest. It would not affect saving and investment.

Economists have been giving arguments in favour of Islamic finance due to its possible contribution in the stability. Some economist argued that if the interest on loan is abolished, the clients would not have any attraction in investments. In 1970's, Murabaha or cost plus financing was introduced.

According to it, Islamic bank arranged the commodity needed by the client commodity was purchased by the bank on clients request with the promise to purchase the same from the bank at a price higher than its purchase price to be paid after a certain period of time. Funds investment in Murabaha transactions gained popularity and Murabaha gave big boost to Islamic finance. By the year 2004, Murabaha companies rose to 20 in number.

Although Pakistan had entered into the interest-free banking by establishing Islamic banking in 1970, the main conventional system continued. The Islamic financial institutions started spreading a cross the globe and the fund also increased. HSBC, ABN Amro Bank included Islamic banking in their system. Up to 1980, the results of profit sharing based financing were not as encouraging as expected. Murabaha was acknowledged and put into practice to become the dominant mode of Islamic Banking.


Macroeconomic implications of Islamic banking apply where sharing work without the assumption that it would be largely based on profit sharing. Financial intermediation based on profit sharing rather than lending will contribute greater stability in the economic system in general and financial market in particular. It will prove to be more effective than the conventional banking system.

Islamic finance integrates the financial sector with the real sector. In Islamic financial system, there are potential real assets corresponding to every financial asset contrary to the conventional system in which financial assets based on or derived from other debt based financial assets keep on multiplying which makes the banking system more vulnerable to inflation leading to instability. Islamic banking system has become more stable due to integration of financial and real sectors.

The financial benefits of Islamic economics with its positive impact on economy of clients have proved to be a stimulus to the growth progress and prosperity of Islamic banking system in Pakistan and the other countries.


1. Shariah advisors must focus on ensuring and enforcing Shariah compliance. Substitutes of financial products should be introduced to market and business community.

The financial products must be divided on the basis of their return into variable return products and fixed income products. For the trade/sales and investment based products fetching investment deposits with Islamic banks, investment certificates must be duly issued by Islamic investment companies.

2. Other sale based modes in Islamic banking are Salam and Istisna. Facilities like financing promotion of agriculture and various industries must be extended without interest by the Islamic banks.

3. Poverty reduction measures must be taken by offering interest-free loans to the poor people in rural and urban areas to help them established their small business industries and earn their livelihood.

Murabaha is sale with mark up on purchase price, payments being deferred. Ijara is sale of product, an equipment or real estate owned by seller. Murabaha proceeds on the basis of purchase order by a client who commits to buy the commodity involved. It is a contract between two parties. Both Murabaha and Ijara are accomplished or end up in the form of securities. Ijara bonds are investment certificates that indicate ownership of a real asset subject to a lease contract yielding predetermined yield. Murabaha and Ijara financing concepts must be practiced in the true spirit of Islamic ideology and concessions be granted to the public specially the poor and medium/low income group of persons by providing monetary benefits for construction of houses/shelters and other basic needs and comforts.

The author of this article is presently working as Head Department of Economics, Government National College, Karachi.