Islamic banking in Germany: opportunities and potential aspects

Islamic Banking in Germany: Opportunities and
Potential Aspects

MASTER – THESIS

Adviser: Prof. Dr. Lars Jäger
Co-Adviser: Dr. Johannes Engels
Course of Studies: International Business Administration and
Foreign Trade

UNIVERSITY OF APPLIED SCIENCES WORMS

Submitted by:

Islam Hamed
Gabriel-von-Seidl-Straße 75
67550 Worms
Islam_fathy@live.com

Matriculation no.:

666149

Winter Term 2013/2014
Worms, October 19th, 2013

In The Name of Allah,
The Most Beneficent, The Most Merciful

Dedicated to my father’s soul,
Fathy Abd-elaziz Hamed

Acknowledgements

Acknowledgements
First of all, I would like to thank Almighty Allah for everything in my life,
Without his guidance I would never be able to accomplish anything in my whole
life.

I would like also to thank my mother who has supported me with her prayers, as
well as her best dedication. I cannot forget my sister and my brother who had been
always beside me.

I am further grateful to thank all my family members, as well as my friends for
their support, without you it would be very difficult to overcome all the
challenges. I cannot say thanks enough to my beloved fiance, Sarah El-sadany,
who has inspired me with her hope, love and support.

Finally, I would like to offer my gratitude to my supervisors Dr. Jäger and Dr.
Engels for their support and guidance through this thesis.

Student’s Declaration

Student’s Declaration

I hereby declare that this thesis is my own original work and that no other than the
listed references have been used as sources of information.

I further declare that no part of this thesis has been previously submitted to this or
any other institution.

Worms, October 19th , 2013
Islam Hamed

Signature

Abstract

Abstract
The Islamic banking sector has grown rapidly with double digit rates in the past
decades. It is further considered the fastest growing segment in the global
financial system. Hence, several countries were attracted by the business around
the globe. In particular, several western countries who started to realize the
potential of its Muslim minorities, and started to open doors for Islamic banks. In
consequence, Islamic banks started to spread in several western countries. On the
contrary, other European countries with a large group of Muslims did not launch
the business yet, such as Germany.
The purpose of this thesis is to examine the German market and to investigate
whether it is potential for Islamic banking or not. It will further highlight the main
opportunities for the future growth of the business, as well as the main challenges
facing Islamic banks in the country.

Key words: Islamic banking, Islamic finance, Islamic banks, Market potential,
German banks and regulatory framework.

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Table of Contents

Table of Contents
Acknowledgements ................................................................................................... II
Abstract ................................................................................................................... IV
List of Figures ......................................................................................................... VIII
List of Abbreviations ................................................................................................. IX
Glossary ................................................................................................................... XI
1.

Research Overview ............................................................................................. 1
1.1.
1.2.

Purpose ............................................................................................................... 3

1.3.

Research Design & Methodology ....................................................................... 3

1.4.
2.

Introduction ........................................................................................................ 1

Thesis Structure .................................................................................................. 4

Islamic Banking: Introduction and Overview ....................................................... 6
2.1.

History & milestones .......................................................................................... 6

2.2.

Evolution of Islamic banking ............................................................................... 8

2.3.

Shariah & Fiqh..................................................................................................... 9

2.3.1.

The sources of Shariah.............................................................................. 10

2.4.
2.5.

The Prohibition of Gharar and Maysir .............................................................. 14

2.6.

Halal and Haram concept ................................................................................. 15

2.7.
3.

The Prohibition of Riba ..................................................................................... 13

Zakat ................................................................................................................. 16

Islamic Modes of Finance.................................................................................. 17
3.1.

Profit -and -Loss Sharing Instruments .............................................................. 17

3.1.1.

Mudaraba ................................................................................................. 18

3.1.2.

Musharaka ................................................................................................ 19

3.2.

Deferred Sales Contracts .................................................................................. 21

3.2.1.

Murabaha ................................................................................................. 21

3.2.2.

Forward Sales: Salam and Istisna‘a ........................................................... 22

3.3.

Ijarah - Leasing .................................................................................................. 25

3.4.

Qard Hasan ....................................................................................................... 27

3.5.

Retail Banking: Funding Accounts .................................................................... 27

3.5.1.
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Current Accounts ...................................................................................... 28

Table of Contents
3.5.2.
3.6.

Sukuk ................................................................................................................. 29

3.6.1.
3.7.
4.

Saving & Investment Accounts ................................................................. 28

Ijarah Sukuk .............................................................................................. 30

Takaful .............................................................................................................. 32

Corporate Governance In Islamic Banks ............................................................ 36
4.1.

The Shariah Supervisory Board (SSB) ............................................................... 37

4.1.1.

Functions and Responsibilities.................................................................. 37

4.1.2.

The Issue of Fatwa .................................................................................... 38

4.1.3.

Characteristics of The Board Members .................................................... 39

4.1.4.

Shariah Supervisory Boards & Western Regulators ................................. 41

4.2.

International Islamic Financial Infrastructure................................................... 42

4.2.1.
4.2.2.

IFSB ........................................................................................................... 42

4.2.3.

IDB............................................................................................................. 43

4.2.4.
5.

AAOIFI ....................................................................................................... 42

LMC ........................................................................................................... 43

Islamic Banking & the German Market .............................................................. 44
5.1.

Muslims in Germany ......................................................................................... 44

5.2.

Financial Behavior of the Muslim population in Germany ............................... 48

5.2.1.

Current Trends .......................................................................................... 48

5.2.2.

Market potential for Shariah-compliant products in Germany................ 50

5.3.

Regulatory Framework of The Financial Entities in Germany .......................... 54

5.3.1.

Banking Supervision in Germany .............................................................. 54

5.3.2.

Licensing of theIslamic Financial Entities in Germany .............................. 55

5.4.

Feasible key players in the German market ..................................................... 59

5.4.1.
5.4.2.

Commerzbank ........................................................................................... 60

5.4.3.
6.

Deutsche Bank AG .................................................................................... 59

Kuveyt Türk Participation Bank................................................................. 62

Conclusion ....................................................................................................... 63
6.1.

Opportunities for the Islamic Banking industry in Germany ............................ 63

6.2.

Challenges Facing the Islamic Banking Industry in Germany ........................... 64

References ................................................................................................................. i
APPENDIX 1 ............................................................................................................ viii
APPENDIX 1.1 ................................................................................................................ viii
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Table of Contents
APPENDIX 1.2 .................................................................................................................. ix
APPENDIX 1.3 .................................................................................................................. xi
Appendix2 ............................................................................................................... xii

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List of Figures

List of Figures
Figure 1 Thesis Structure .................................................................................................... 4
Figure 2 Trend in Global Islamic Banking Assets ................................................................ 8
Figure 3 Geographical Breakdown of Total Global Islamic Financial Assets ...................... 9
Figure 4 Mudaraba Model ................................................................................................ 19
Figure 5 Diminishing Musharaka Model ........................................................................... 20
Figure 6 Murabaha Model ................................................................................................ 22
Figure 7 Bai'salam Model.................................................................................................. 24
Figure 8 Istisna'a Model .................................................................................................... 25
Figure 9 Ijarah - Leasing Model......................................................................................... 26
Figure 10 Sukuk issuance .................................................................................................. 30
Figure 11 Structure of a generic ijarah sukuk .................................................................. 31
Figure 12 The global gross Takaful contributions ............................................................. 33
Figure 13 Takaful Mudarbah Model ................................................................................. 35
Figure 14 Muslims According to Region of Origin ............................................................ 46
Figure 15 Muslims according to denomination ................................................................ 46
Figure 16 Age Structure of Muslims According to countries of Origin ............................. 47
Figure 17:Bank preferences for Muslims in Germany with Turkish Background ............. 50
Figure 18 Attitude on Banks in Germany……………………………………………………………………… 51
Figure 19 Relevance of Shariah Compliance and Adherence of Islamic principles .......... 52
Figure 20 Importance of Islamic Investments by Religiousness ....................................... 53

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List of Abbreviations

A
AAOIFI

Accounting and Auditing Organization for Islamic
Financial Institutions.

ARCIFI

Arbitration and Reconciliation Centre for Islamic
Financial Institutions.

B
BaFin

Bundesanstalt für Finanzdienstleistungs-aufsicht
(the Federal Financial Super-visory Authority).

BOT

Build–operate–transfer.

C
CIBAFI

Council for Islamic Banks and Financial Institutions

G
GCC

Gulf Cooperation Council.

I
ICD

Islamic Corporation for the Development of the
Private Sector.

ICIEC

Islamic Corporation for the Insurance of Investment
and Export Credit.

IDB

Islamic Development Bank.

IFIs

Islamic financial instutions.

IFSB

Islamic Financial Services Board.

IIFM

International Islamic Financial Market.

IRTI

Islamic Research and Training Institute.

IX | P a g e


K
KFH

Kuwait financial house.

KTP

Kuvyet Türk participation bank.

KWG

Kreditwesengesetz (the German Banking Act).

L
LIBOR

London interbank offered rate.

LMC

Liquidity Management Centre.

P
PBUH

Peace be upon him.

PLS

profit and loss-sharing.

R
ROE

Return on equity

S
SDLT

Stamp Duty Land Tax.

SPV

special purpose vehicle.

SSB

The Shariah Supervisory Board.

X|Page

Glossary

Glossary1
Allah
Amana

is trust; the contract of amana gives rise
to fiduciary relationships and duties.

Bay (bai)

a comprehensive term that applies to the
sale transactions, exchange.

Bai bi-thamin ajil

a deferred payment sale by installments

Bai’muajjal

a deferred-payment sale.

Bai’salam

a pre-paid purchase.

Fatawa (sing. fatwa)

legal decisions or opinions rendered by
a qualified religious leader (mufti).

Fiqh

Islamic jurisprudence, the science of
religious law, which is the interpretation
of the Sacred Law, Shariah.

Fuqaha (sing. faqih)

Muslim jurisprudents who have
religious authority.

Gharar

uncertainty, speculation.

Hadîth (plural ahadith)

the technical term for the source related
to the Sunna; the sayings - and doings of the Prophet (PBUH), his traditions.

Hajj

The pilgrimage to Mecca.

Halal

means permitted according to the
shariah.

Haram

11

The Arabic word for God.

means forbidden according to the
shariah.

The definantions are according to the glossary from Lewis & Algaoud ( 2001) and Ayub (2007).

XI | P a g e

Glossary
Ijara contract

a leasing contract.

Ijara wa iqtina

a lease-purchase contract, whereby the
client has the option of purchasing the
item.

Ijma

means consensus among jurists based
on the Holy Qur’an and Sunna, and one
of the four sources of law in Sunni
Islam.

Ijtihad

means the act of independent reasoning
by a qualified jurist in order to reach
new legal rules.

Islam

is submission or surrender to the will of
God.

Istisnaa

a contract to manufacture.

Maysir

means gambling, from a pre-Islamic
game of hazard.

Mudaraba

contract is a trustee financing contract,
where one party, the financier, entrusts
funds to the other party, the
entrepreneur, for undertaking an
activity.

Mufti

is a jurist who is authorised to issue a
fatwa or legal decision on a religious
matter.

Murabaha

is resale with a stated profit, for
example the bank purchases a certain
asset and sells it to the client on the
basis of a cost plus mark-up profit
principle.

Musaqah

is a contract for the lease of agricultural
land with profit-sharing.

Musharaka

contract is an equity participation
contract, whereby two or more partners
contribute with funds to carry out an
investment.

Qard hasan

a benevolent loan (interest free).

XII | P a g e

Glossary

Qiyas

means analogical deduction.

Qur’an

is the Holy Book, the revealed word of
God, followed by all Muslims.

Rabb al-mal

refers to the owner of capital or
financier in a mudaraba partnership
agreement (also sahib al-mal).

Riba

is literally ‘excess’ or ‘increase’, and
covers both interest and usury.

Shariah

is Islamic religious law derived from
the Holy Qur’an and the sunna.

Sukuk

Certificates of equal value representing
undivided share in ownership of
tangible assets of particular projects or
specific investment activity, usufruct
and services.

Takaful

refers to mutual support which is the
basis of the concept of insurance or
solidarity among Muslims.

Zakat

is a religious levy or almsgiving as
required in the Holy Qur’an and is one
of Islam’s five pillars.

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Research Overview

1. Research Overview
1.1.

Introduction

The negative consequences of the global financial crisis have made both investors
and experts rethink the current financial system. Speculation schemes, as well as
sub-prime loans, drove the global economy to the so called “black hole”. Several
banks have gone bankrupt and as a result, customers started to lose trust in the
current financial system, particularly, in the banking sector (Ernst & Young,
2011). Despite the fact that governments began to pursue restrictive schemes
against speculations and credit lending, the situation was beyond recovering. The
Eurozone crisis has hit the financial system again, resulting with an ongoing
financial crisis, and the reason was still the same.
On the other side, the consequences were slightly lighter across the majority of the
Muslim countries, especially the ones that are operating according to the Islamic
financial system. The Islamic-financial system which based on the elimination of
both interest rates (riba) and speculation (gharar & maysir), has been very stable
against the global financial crisis. Following the crisis, some Investors started to
search for other alternatives than conventional banks. As a result, many investors
have switched to Islamic banks, as they could structure profitable products, with a
lower risk. Furthermore, Investors started to orient their investments into ethical
products, which could be found only in Islamic banks. In 2009, The Vatican
announced officially in its newspaper, that banks should learn from the Islamic
banking procedures in order to retrieve customers’ confidence.
All the above reasons and more have elaborated to make Islamic banking and
finance a hot topic among researchers and experts. Despite the fact that the
principles of Islamic banking and finance were set in the 7th century (the
Muslims’ golden age), the phenomenon began to evolve in the past 30years. In
particular, in the 1970s , with the rise of the Islamic banks in the GCC area. The
sector started to grow rapidly with double digit rates. According to the European
central bank (2013, p. 19), Islamic banking has shown annual sustainable growing
1|Page

Research Overview
rate by 15-20percent over the past five years, the handled assets by the Islamic
banks have reached $1.3 trillion at the end of 2012.
Western banks were also attracted by this profitable business. Hence, several
banks started to launch “Islamic windows” in many Arab countries, by offering
Islamic financial products through its subsidiaries (mainly GCC region).
Moreover, some western countries started to realize the potential of its Muslim
minorities, and thus started to launch Islamic financial banks in their countries.
The United Kingdom, with a potential market of more than 2 million Muslims,
was one of the leaders in Islamic finance and banking business in Europe since
1980s. It was the first Western country to open the doors for Islamic banking
with the first established Islamic bank in 1982 (Wilson, 2007, p. 420). Currently,
the UK is the centre of Islamic finance in Europe, with $19 billion of reported
assets and various banks delivering Shariah-compliant products (UKTI, 2013).
Other European countries have also a large group of Muslims as the UK or maybe
more; however, Islamic banking did not penetrate its markets yet, such as
Germany. The success of the UK raised the question of whether Germany can be
also a potential market for Islamic financial products or not. Despite its large
Muslim population and its strong economy, no serious actions have been taken to
launch the Islamic business till now. Several Islamic banks showed a real interest
in launching a subsidiary in Germany, however, regulatory and legal issues are
still the major constraints facing the implementation of this business.
The Kuveyt Türk Participation Bank was the first bank to take a serious step in
the Islamic banking business in Germany. The new Islamic bank has opened its
first branch in Mannheim, in 2010, with a limited license issued by BaFin (the
Federal Financial Super-visory Authority). However, the bank did not obtain the
Full license yet, due to the different regulatory constraints. In this regard, many
questions have been raised, such as is Germany really a potential market for this
business? What are the opportunities & challenges? This paper will try to
investigate about these questions.

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Research Overview

1.2. Purpose
The purpose of this thesis is to examine the German market and to investigate
whether it is a potential market for Islamic banking or not. In this context, the
paper will scrutinize the financial behavior of the German Muslim population. In
addition, the anticipated key players in the domestic market will be outlined. The
dissertation will further highlight the main opportunities for the future growth of
the business, as well as the main challenges facing the business. In this regard, the
regulatory restrictions as well as the other implications facing the business will be
discussed. It is important to note that the paper will not discuss further any legal
issues.

1.3. Research Design & Methodology
The research relied mainly on two methods. First, secondary data available
through the conducted research papers as well as authorized publications and
online sources. Secondly, Interviews with the Islamic finance experts which are
located in Germany. Therefore, several experts and banks' representatives across
Germany have been contacted via email. Unfortunately, there was no answer from
almost all of them, except Dr. Johannes Engels2 from the federal financial
supervisory authority (BaFin). For these reasons, the majority of the data in this
thesis is mainly based on the working papers, market surveys and other online
researches.

2

Dr. Johannes Engels is a Senior Advisor at The Federal Financial Supervisory Authority (BaFin)
– Germany. He has studied General Economics in Aachen and Cologne; he finished in at
University of Cologne with Doctor Degree. He has been working for the Federal Financial
Supervisory Authority for twenty two years, in the international dept. for eight years. Since
October 2012 he has been the lecturer for Corporate Governance at University of Applied Sciences
in Mainz. He has written several publications in the field of Islamic finance.

3|Page

Research Overview

1.4. Thesis Structure
The disposition of the Thesis chapters is illustrated in figure1 and followed by a
summary of the chapters’ content.

Research Overview

Introduction
& Overview

Islamic
Modes of
Finance

Corporate
Governance
In Islamic
Banks

Islamic
Banking &
The German
Market

Conclusion

Figure 1 Thesis Structure

This paper is divided into six chapters. This first chapter, is an introductory
chapter, which outlines the research objective as well as the methodology and the
chapters’ contents.
The second chapter gives a brief overview of the history and the evolution of the
Islamic banking, as well as the Islamic legal system (Shariah and Fiqh). In this
regard, the main principles of the Islamic finance and banking will be discussed.
The chapter is geared to provide the reader with the basic knowledge of the
Islamic finance & banking principles for a better understanding of the following
sections and chapters.
The third chapter introduces the main financial instruments offered by Islamic
banks. In this context, the structure of the several products and services will be
explained with practical examples presented graphically for understanding their
concepts better. Moreover, the chapter discusses other Islamic financial
alternatives, such as the Islamic insurance (Takaful) and Islamic bonds (sukuk).
Compliance structure and governance of Islamic banks will be discussed in
chapter four. The first section will be about the Shariah supervisory board in the
Islamic banks and its central role in assessing and monitoring the Islamic banking
business. The second section will examine the International Islamic financial
infrastructure. In this respect, the most important Islamic international
organizations will be addressed.
In order to investigate whether the German market has potential for Islamic
banking or not, this matter will be analyzed in chapter five. This
4|Page

chapter

Research Overview
scrutinizes the Muslim populations in Germany and its financial attitudes and
behaviors. In addition, the chapter will highlight the main key players in the
domestic market. Finally, the major regulatory and taxation issues facing the
implementations of this sector will be discussed.
In the last chapter, the research conclusion will be outlined.

5|Page

Islamic Banking : An Introduction & Overview

2. Islamic Banking: Introduction and Overview
Following the birth of Islam, almost 1400 years ago, new financial principles were
introduced by prophet Mohamed (PBUH), the prophet of Islam. This was mainly
based on the prohibition of riba (usury) and the reliance on the profit-sharing
concept (Lewis & Algaoud, 2001, p. 4), which modernly known as Islamic
finance. Approximately 40 years ago, the concept was absorbed by the modern
financial institutions, as they started to design products and services in
compliance with the Islamic law (Shariah). In consequence, a new banking
system has emerged, which is known as “Islamic Banking”.
The new banking system has expanded across both the Muslim and non Muslim
countries, currently there are more than 500 IFIs (Islamic Finance Institutions)
and the number is expeditiously increasing (Etzold, 2011). In spite of this wide
expansion, Many Muslims and non Muslims nowadays have a poor understanding
of this field concepts and practices (Lewis and Algaoud 2001, p. 1).
The following chapter will outline the Islamic banking history with its major
milestones. Furthermore, it will discuss the main sources of the Islamic law
(Shariah), as well as the main principles of that business.

2.1. History & milestones
The interest-free concept, which was introduced by prophet Mohamed, in the
seventh century, has declined over the years and was decimated after the World
War I, in particular, after the collapse of the Ottoman Empire. Consequently, the
interest –based concept dominated the new economic system and spread rapidly in
the western world. As a result of the World War I, Britain and France occupied
most of the Muslims countries (Abdul-Rahman, 2010, p. 191). Accordingly, the
British established the first commercial bank in the Muslim world in 1890s, in
Egypt. The main purpose was to manage the financial transaction regarding the
Suez canal construction. Nevertheless, the existence of the latter bank had faced a
wide rejection from the Muslim scholars at that time (IRTI &IFSB, 2007).
6|Page

Between 1990-1950s, the interest-based banking system spread rapidly in the
Arab regions as well as the Indian sub-continent. Hence, Islamic economists had
to put an effort to design alternatives in the scope of Islamic Shariah. The first
practical model was introduced by Dr. Ahmed Al Naggar in Egypt in the early
1960s. The young German-educated Egyptian established a small bank in
Zefta/Mit Ghamr, in order to finance the basic needs of the poor farmers. The
bank

showed a great success over the agriculture industry until it was

nationalized by president Nasser3 under the name of

“Nasser Social Bank”

(Abdul-Rahman, 2010, p. 192).
Another essential milestone was the Arab-Israeli war in, 1973; it pushed
tremendously the oil prices which created the first oil crisis. Subsequently,
massive cash flows entered the gulf area introducing a new class of dollars, the
petro-dollars. As a result, King Faisal of Saudi Arabia established the Islamic
Development Bank, IDB, which aimed to develop a new vision for the Islamic
banking system. Simultaneously, The establishment of the Islamic bank in Dubai
and the Kuwait financial house (KFH). Later in Egypt, the Faisal Islamic bank
was established by the King’s Faisal son, prince Mohamed Al Faisal. The bank
has grown rapidly in Egypt with many branches serving more than 700,000
customers. In addition, Sheikh Saleh Kamel established the Egyptian Saudi
Finance Bank (Bank Al Tamweel Al Misry Al Saudi) (Abdul-Rahman, 2010, p.
193). It is one of the major Islamic banks in Egypt with 22 branches.currently the
bank’s name has changed to “alBaraka Bank Egypt” (alBaraka, 2013).
In 1980s the scheme continued to spread in many countries with the existence of
new Islamic Banks and academic institutions. Pakistan , Iran, and

Sudan

announced the intention to transform their financial system to be governed by
Shariah . Additionally, the establishment of the Islamic Research and Training
Institute (IRTI) in 1981. Consequently, the IMF started to publish many research
papers on the topic, as it became a rapidly grown business. During the 1990s, the
Islamic banking business became a hot topic in the western academic world.
Moreover, commercial events on the topic took place in several countries. Most
3

President of Egypt (1956-1970), a leader of the Egyptian free officers revolution of 1952.

7|Page

importantly, the establishment of The Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI) (IRTI &IFSB, 2007).
The duration between 2000 and 2006 witnessed the real establishment of the
Islamic financial infrastructure which is considered as the backbone of the Islamic
Financial system. Specifically, the establishment of the Islamic Financial Services
Board (IFSB), the International Islamic Financial Market (IIFM), the General
Council for Islamic Banks and Financial Institutions (CIBAFI) and the Arbitration
and Reconciliation Centre for Islamic Financial Institutions (ARCIFI) (IRTI
&IFSB, 2007).
Recently, Islamic banking business has spread rapidly through the European
countries to serve the Muslim minorities. The Islamic Bank of Britain (IBB) is
one the main players in this business in Europe. It is worth pointing out that the
first customer in the Leicester branch of IBB travelled over 100 miles to open an
account , which reflects a high degree of service transparency (Ayub, 2007, p. 16).

2.2. Evolution of Islamic banking

The Islamic banking industry has shown substantial growth in the past decade. As
part of the Islamic finance industry, Islamic banking accounted for almost 80
percent of the Islamic financial assets with $1.3 trillion assets in 2012 (figure 2),
and with 15-20 percent annual growth for the past 5 years (ECB, 2013, p. 19).

Figure 2 Trend in Global Islamic Banking Assets (ECB, 2013, p. 20)

8|Page

The industry trend is expected to continue growing with a constant rate, which
made this industry the fastest growing segment of the entire global financial
system. The industry started to compete with the conventional banking industry.
In terms of profitability, Islamic banking average ROE in 2011 was 12 percent
compared to 15percent in conventional banking (Ernst & Young 2012). The
industry is mainly focused in the GCC region (i.e. Saudi Arabia, the United Arab
Emirates, Kuwait, and Qatar) as well as in South-East Asia ( i.e. Malaysia and
Indonesia) ( figure 3) (ECB, 2013, p. 19).

Figure 3 Geographical Breakdown of Total Global Islamic Financial Assets (ECB, 2013, p. 19)

2.3. Shariah & Fiqh
In the religion of Islam, Allah (the Arabic word for God) is the creator and the
owner of everything, it is He only who has the ultimate right to establish the right
path for the mankind. Therefore, Muslims believe that following Allah’s law is
essential, as it is established and ordained only by Him and not with a human
lawmaker (Kettell, 2010, p. 84).

9|Page

In fact, the term Shariah literally means ‘the way to the source of life’ (Algaoud
& Lewis, 2007, p. 38), ‘the way to a watering place’ (Kettell, 2010, p. 84), it can
be also translated as ‘the law’ (Abdul-Rahman, 2010, p. 63).
Shariah

represents a set of

duties which governs the whole Muslims life

including. It regulates the relationship between man and Allah (Fiqh Ibadah)
concerning worship duties and activities (prayers, fasting, pilgrimage, etc.). On
the other hand, it regulates the relationship among people in the society (Fiqh
muamlat) (Millar, 2008, p. 5), such as manners and morals, crime and commercial
transactions. In the latter case, in business transactions, Shariah

acts as a

regulator between the seller and the buyer. In this context, business transactions
can be divided into four classes: first, sales (bay), the transfer of a property’s
ownership to another entity with a beneficial value. Second, hire (ijara), the
transfer of the usufruct of certain property to another entity with a beneficial
value. Third, gift (hiba), a gratis transfer of the property. Fourth, loan (ariyah), a
gratis transfer of the usufruct (the right to use) of the property. Based on this,
almost all financial transactions fall in the context of the latter cases, for instance,
deposits, partnerships, guarantee, agency, etc. (Algaoud & Lewis, 2007, p. 38).

2.3.1. The sources of Shariah
The scope of Shariah is relatively wider than any other legislative system; it is a
unique legislative system that governs the relationship between man to Allah and
man to man. In fact, Shariah has two main sources, primary and secondary
(Kettell, 2010, p. 86). The Quran and the Sunna are the primary sources , whereas
Ijma (consensus) and Qiyas (analogy) are the secondary sources, as illustrated
below. (Visser, 2009, pp. 10-12).
2.3.1.1.

The Qur’an

The Qur’an is believed to be a revelation from Allah to his last prophet
Mohammed (PBUH) by the angel Gabriel in the city of Mecca. The Qur’an is
considered to be a verbal

miracle to prophet Mohammad (PBUH) and an

evidence of his Prophecy. The literal meaning of the word Qur’an is ‘reading’ or
10 | P a g e

‘recitation’; it was revealed in the Arabic language approxmaitely1400 years ago.
In fact, the Qur’an was revealed gradually based on certain situations over a
period of time. It contains 114 Suras (chapters) and 6235 ayat (verses) differed in
length (Kettell, 2010, pp. 87-88). It confirms the sequence of both prophets and
their revelations as stated in many verses of it (Abdul-Rahman, 2010, pp. 65-66).
In fact, approximately 500 verses of the Qur’an dealt with legal injunctions, these
cover marriage, rights and obligations, divorce, loans, punishment, inheritance,
etc. Therefore, it is the first primary source of Shariah (Kettell, 2010, p. 86).
2.3.1.2.

The Sunnah

Sunnah is the second primary source of Shariah. It means a path, or an example, it
refers to the way of prophet’s Mohammad life as it is practiced in the light of the
Qur’an. Sunnah represents the prophet’s life on the basis of the sayings,
comments and actions approved or done by him (Abdul-Rahman, 2010, p. 66). In
fact, the Qur’an was written and preserved in the life of the prophet Mohammad.
The Sunnah on the contrary, was recorded directly after his death by his
companions. They started to record all the prophet’s sayings ( Ahadith, the plural
of Hadith ) and doings . In addition, Sunnah is very important to understand the
context of the Qur’anic verses, whereas the verses were revealed based on a
certain situations during the life of the prophet (Kettell, 2010, pp. 89-91).
2.3.1.3.

Ijma (Consensus)

Apart of the confirmed primary sources of Shariah , the Qur’an and the Sunnah,
there are two secondary sources Ijma and Qiyas. The word Ijma derived from the
Arabic verb ajma’a, which means ‘to determine and to agree upon something’.
Thus, Ijma refers to a consensus on a certain opinion of the prophet’s early
companions and the followed Muslims jurists on a various Islamic matters
(Kettell, 2010, p. 92). Actually, Ijma applies just in cases where there is no
explicit or clear solution for a certain problem from the Qur’an or the Sunnah. The
process is only done by the Muslim jurists (fuquahaa ) and not by the individuals
(Abdul-Rahman, 2010, p. 68). Indeed , Ijma can just occur after the death of the
11 | P a g e

prophet and not in his lifetime, as he was the highest authority on Shariah. The
process began when several problems arose after his death, the companions
started to consult each other until they agree on one solution, the process passed
through the following generation and so on. Hence, once Ijma is settled, it became
an authority which cannot be rejected by anyone (Kettell, 2010, p. 93).
2.3.1.4.

Qiyas (analogical reasoning)

Qiyas is the second secondary source of Shariah. It means literally ‘measuring’,
and can also refer to a comparison to asses equality or similarity between two
things (Kettell, 2010, p. 94). In the Islamic context, qiyas is an analogical
approach done by Jurists on an original case in order to extract the rules from it,
and practice these rules on a new case. Usually, this new case does not have a
clear conclusion from the Qur’an or the Sunnah, and there is no Ijma on it (AbdulRahman, 2010, p. 68). For instance, the use of wine is considered to be strictly
condemned according to the Qur’an, similarly, the use of any other toxicants can
fall under the same prohibition as well (Visser, 2009, p. 12).
2.3.1.5.

Ijtihad

Ijtihad is considered to be an important source when developing new Shariahcompliant products. In fact, it took over an effective role in developing the Islamic
Banking and finance industry. Ayub ( 2007, p. 489) defined Ijtihad as :
[a]n endeavor of a qualified jurist to derive or formulate a rule of law to determine the
true ruling of the divine law in a matter on which the revelation is not explicit or certain,
on the basis of Nass or evidence found in the Holy Qur’an and the Sunnah.

Indeed, there are strong debates about ijtihad, which is mostly concerned about
who can perform ijtihad, as he should be a very qualified scholar (Millar, 2008, p.
5). Ayub ( 2007, p. 441) further argues that ijtihad is the main cause for the non
standardized products across the IFIs, due to the different Shariah interpretation.

12 | P a g e


2.4. The Prohibition of Riba
The prohibition of riba (usury) is one of the main principles of the Islamic
financial system. The term riba literally means “increase” or “addition” or
“surplus”(Visser 2009, p. 31). Generally, it refers to an addition cost imposed on
the borrower at the maturity date (Kettell 2010, p. 13). The Holly Qur’an and the
Sunnah strongly condemn riba in many places (Appendix 1.1 & 1.2). In fact, Riba
was also condemned in all of the revealed religions, such as Christianity and
Judaism. With regard to riba in Islam, there are no debates among Muslims about
the prohibition of riba, as almost all Muslims regard it as a great sin (Ayub, 2007,
p. 44). However, Muslim scholars have been arguing about its frame in the
modern life and particularly in business activities.
On that basis, Muslim scholars argued that the concept of riba is wide and can
take different forms other than interest rates. In this regard, Muslim scholars have
divided riba into two categories (Kettell 2010, p.13):
1- Riba al-nasia, where an increase imposed on the loan by the case of
deferment (conventional banking interest rate).
2- Riba al-fadl, where unequal exchange takes place between two
commodities (e.g. good quality dates for less quality dates).
It can be obviously concluded that the ban on riba is not limited just to money; it
is also over the exchange of goods (Visser 2009, p. 34). The conventional banking
system which is based on the credit lending falls in the first category (Riba alnasia). One might think that the Islamic rejection of interest neglects the time
value of money. However, the time value is widely recognized in the case of
credit sales as it is permitted in Islam. It was explicitly stated in Sura 2:275, trade
is permitted but riba is not (Visser, 2009, pp. 36-37). In other words, credit sales
and interest rates may have the same mechanism, but one is allowed, and the other
is forbidden. The reason behind the latter case, the money itself does not have
value (not a commodity) (Ayub, 2007, p. 52). Money has only one function,
which is “ medium of exchange”, unlike any commodity which has value and can
be traded. This will lead to further discussion about the reasons behind the
13 | P a g e

prohibition. The Qur’an and the Sunnah did not provide a clear justification about
its reasons. However, Muslim scholars have provided different reasons concerning
the condemnation.
The unfairness of the loan contract is one of the major reasons,where one party
(the borrower) takes over the risk of losing its money and effort in the case of
project failure. On the contrary, the other party (the creditor) will receive the
principal plus the interest at any case (Kettell 2010, p.16). Another reason, riba
increases the gap between rich and poor in the society by transferring wealth from
poor to rich people. In addition, it drives people in the society to be non
productive relying on their interest returns (Visser 2009, p. 38).

2.5. The Prohibition of Gharar and Maysir

There are other prohibitions governing the business activities side by side with
riba, such as gharar (uncertainty) and maysir (gambling) (Visser 2009, p. 45).
The latter type, maysir, is derived from the Arabic word usr (ease and
convenience), which refers to “mass wealth without effort” (Algaoud and Lewis
2007, p. 39 ). The prohibition of maysir is to be found in the Holy Quran in many
verses, for instance, ‘O you who believe! Khamr, Maysir, Ansab, and Azlam are a
filth of Shaytan’s handiwork. So avoid that in order that you may be
successful’(Holy Quran, 5:90). In this context, any form of gambling is forbidden
in Islam, as it is based on hazards and speculation. Moreover, it is against the
concept of fairness in Islamic law (Algaoud and Lewis 2007, p. 39 ). Therefore,
Islamic banks are not allowed to engage in any gambling games, lotteries,
disproportionate prizes as well as conventional insurance (Ayub, 2007, p. 76).
The other type is gharar, which literally means “risk” or “deception”( Visser
2009, p. 45). This ban implies that both commercial parties should have a fair deal
and to be aware of the real counter value of the business transaction. Professor
Mustafa Al-zarqaa defined the forbidden gharar as ‘the sale of probable items
whose existence or characteristics are not certain, the risky nature of which makes
transactions akin to gambling’ (Abl-rahman 2010, p.43).
14 | P a g e

In fact,the ban on gharar was not explicitly mentioned in the Holy Quran,
however, it is against the Quranic terms of fairness and contract information
disclosure (verses 6:159, 17:35, 83:1-6 ) (Abl-rahman 2010, p.43). The
condemnation is mainly relied on the Ahadith (the sayings - and doings - of the
Prophet) which condemn the sale of the “uncertain outcome”. For instance, ‘the
sale of the birds in the sky or the fish in the water’ and ‘ the sale of the unborn
calf in his mother’s womb’ (Visser 2009, p. 45). The latter cases dealt all with the
risk of uncertainty and/or the risk of deception. Avoiding risk in contracts is
indeed impossible, since the risk margin cannot be avoided. Therefore, Muslim
scholars separated between excessive gharar which violates the contract, and
minor gharar which cannot be avoided (El-Gamal 2006, p.58).
Professor Al-Darir identified significant reasons for a forbidden gharar (El-Gamal
2006, p.58). First, the risk of uncertainty must be extremely high, in other words,
cannot be anticipated. Second, it must affect a financial contract between two
parties (e.g. sales). Finally, if it affects the primary components of the sales
contract (e.g. the price or object of sale). In this regard, selling a pregnant cow
with a higher price is permitted, whereas selling unborn calf in his mother’s womb
is forbidden. In the latter case, a primary object of the sales contract does not exist
yet; therefor, it encounters a great risk . Typical gharar contracts examples in the
modern economy can apply for the book-out contracts. In the latter type, the
customer purchases and sells the asset without any physical ownership or
possession. This applies for commodities and stocks in foreign exchange markets,
which involves excessive speculative activities. The majority of Muslim scholars
rejected the concept of these contracts as well as the concept of unknown risk
( the case of conventional insurance) (Ayub, 2007, p. 144; Algaoud and Lewis
2007, p. 40 ).

2.6. Halal and Haram concept
As previously discussed, Shariah rules promote ethical manners, mainly in
business activities. Thus, all the financial products and investments must be in the
context of “ethical investment” (Algaoud & Lewis, 2007, p. 39). The commonly
15 | P a g e

used terms when describing the situation of transactions or activities, are halal for
permitted actions and haram for forbidden actions. Accordingly, both investors
and financial institutions are not allowed to deal or invest in any type of haram
business. For instance, ‘alcohol, tobacco, pork, pornography, gambling, illegal
drugs, and other harmful products’ (Samad, et al., 2005, p. 74). Moreover, the
main concern is to satisfy the factual needs of the Muslim society. In this regard,
Producing and marketing of the luxury goods over the essential goods and
services such as clothing, health and education is rejected from the Jurisprudence
point of view (Algaoud & Lewis, 2007, p. 39).

2.7. Zakat

According to the Islamic faith, Allah owns all wealth and property (Holy Quran,
31:26), private property is given by Allah’s trustee to people in order to achieve
integration and prosperity in the community (Abl-rahman 2010, p. 32). Justice and
equality in the society are major concerns in Islam, everyone should have equal
rights, irrespective of their positions, rich or poor (Algaoud & Lewis, 2007, p. 40).
Accordingly, Islam designed a new system called “Zakah” which allows a fair
transfer of wealth from the rich to the poor. Zakah literally means “purity”and
“cleanliness” (Visser 2009, p. 27), it is considered to be one of the five pillars of
Islam (Appendix 1.3), which guarantees a fair redistribution of wealth (Algaoud
and Lewis 2007, p. 40). It is an obligation for every adult Muslim to pay a
percentage of 2.5 per cent on any assets held for one year if it reached a specific
agreed amount of money ( nisab in the Arabic language) (Algaoud and Lewis
2007, p.40). Islamic banks are obligated as well for paying zakah in addition to
regular income taxes. In consequence, the proceeds from the bank and individuals
are to be transferred to special zakah funds established by each bank (Samad, et
al., 2005, p. 74).

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Islamic Modes of Finance

3. Islamic Modes of Finance
Apparently, there is no difference in the concept of funding in both Islamic and
conventional banks, whereas, the main purpose is to generate profits. However,
Islamic financial systems are governed by Shariah rules which imposes main
restrictions on the financial products. Most significantly, the rejection of “making
money out of money” concept, as it is considered a medium of exchange, which
has no value in it (kettle 2010, p. 7). In addition, the rejection of the
predetermined “fixed return” concept (kettle 2010, p. 5).
Islamic economists have developed special financial techniques with regard to
Shariah. The techniques are divided into two main groups (kettle 2010, p. 24-25).
The first group is the“profit and loss share contracts”, where the bank invests with
another partner in a certain business and shares profit and losses (based on the
mode of finance). This type is used normally for equity finance.
The second group is the “deferred sale contracts” (also known as markup), this
technique is similar to the conventional debt-financing schemes. Whereas the
customer purchase a commodity from the bank with an agreed mark-up
percentage to be paid in periodical installments.
The following sections will briefly examine the two groups in practice with a
focus on the main Shaiah-compliant products (the most popular). It is worth
mentioning that some of the following products can be named differently in other
literature; however, there is no difference.

3.1. Profit -and -Loss Sharing Instruments
PLS instruments are simply based on equity-finance modes. In fact, they represent
the ideal forms of finance with regard to Shariah. In PLS contracts, the capital
provider and the borrower share not only profits but also losses with an exception
in some cases (Visser 2009, p. 53). The most common techniques under this
method are “Mudaraba” and “Musharaka”, as presented in the following sections.
17 | P a g e

3.1.1. Mudaraba
Mudaraba is a form of business agreement between two parties, the capital owner
and the entrepreneur. The capital owner (also called rabb al-mal ) provides the
needed capital, while the other party, the entrepreneur (mudarib) brings the
knowhow and the labor needed for the project. In fact, mudaraba is a form of
sleeping partnership, in other words, the capital provider does not have the right to
interfere in any of the management decisions. However, the financier has all the
rights to guarantee that his money is well managed and invested properly.
Islamic banks use this technique as a term of finance, where the bank acts as
“rabb al-mal” and the agent as “mudrib” (figure 4). Profits are shared based on a
pre agreed ratio, in contrast, losses are endured just by the capital provider (kettle
2010, pp. 36-37). In the latter case, the main cause is that according to Shariah
‘one cannot lose what he does not contribute’(Visser 2009, p. 54).
There are two types of mudaraba, “Al Mudarabah Al Muqayyadah” (restricted
mudarabah) and “Al Mudarabah Al Mutlaqah” (unrestricted mudaraba) (Usmani
2002, pp. 98-99). Under the restricted Mudaraba, the capital provider (rab al-mal)
has the right to choose a specific agent (mudarib) with a specific type of business.
In contrast, under the unrestricted mudaraba, the agent is free to launch any type
of business, however, there are several restrictions governing the rights of the
owner. For instance, engaging other mudarib in the business and/or mixing the
investment with others without permission from rab al-maal.

18 | P a g e


Customer
(Mudarib)
Know-How
Business Activity
Kmk;lk;
Kmk;lk;

Islamic Bank
(Rab-al-mal)
Kmk;lk;

Negative

e.g. 60%
from profits

e.g. 40%
from profits

Outcome

Positive

Figure 4 Mudaraba Model (iFIS, n.d.)

3.1.2. Musharaka

Musharaka is a form of financial partnership, where two parties or more agree on
launching a set of business, in order to generate profit. Unlike mudaraba, the
parties contribute either with equity or labor together, in other words, it is a
similar form of a joint venture where the parties have the same rights.
Accordingly, they share both profit sand losses based on the equity contribution
(Visser 2009, pp. 55-56).
Another type of musharaka is “Diminishing Musharaka” which was developed
recently. This mode of finance is used mainly in financing the various types of
fixed assets. Under this scheme, both financier and client are participating in the
ownership of certain asset with a predetermined equity percentage. The share of
the financier is split into a number of units, and the client will purchase unit after
unit periodically based on a former agreement. In this sequence, the share of the
financier will decrease, whereas the share of the client will increase until he
acquires all financier’s shares (became the ultimate owner of the asset) (Usmani,
2002, p. 108).
For further understanding of the mechanism, an example of diminishing
musharaka model from Ayub ( 2007, p. 341) will be explained. Under the latter
19 | P a g e

model, the Islamic bank will finance a house for a client; both parties agree on the
equity percentage, as 20 percent for the client and 80 percent for the bank (figure
5). The finance duration is 10 years with 7 percent as a return rate (benchmarked).
The bank will lease his share (80 percent) to the client for a return of 7 percent, in
addition, the bank’s share is divided into 120 equal units (equal to the number of
months). The client will have to pay monthly payments divided into two parts,
firstly the rental payment, secondly, an amount of one share. Under this process,
the rental payment will decrease each month as the bank’s share is decreasing. At
the end of the ten years, the financier’s shares will be fully purchased by the
client, and in consequence, the client will become the owner of the house.

Islamic Bank

Payments to increase

Customer

ownership
20% of the payment

80% of the payment

Asset
Figure 5 Diminishing Musharaka Model (Own illustration)

Even though it seems that interest-based and PLS systems are looking alike, there
is a significant difference between their mechanisms. Under the latter system,
there is no fixed yield, or maybe there is no yield based on the profit, whereas,
under the former there is a fixed yield translated into a form of a predetermined
interest rate. Moreover, PLS systems represent a physical share of profits and
losses, which indicates a strong concern from the both sides in terms of project
profitability. In contrast, the interest-based system is just concerned about the
default of the loan, in other words, the periodical interest payment regardless of
the profit or loss of the other party. For this and other reasons, Scholars asserted
that PLS contracts aim to develop and sustain the financial market, as it
20 | P a g e

encourages banks to focus more on long term projects instead of the short term
lending techniques. In addition, banks will be obliged to monitor the ongoing
projects with its clients as it became a real partnership and not equity finance.
Indeed, this will increase the overall cost; however, it will develop the
investments in the financial markets (Mirakhor & Zaidi, 2007, pp. 49-50).

3.2. Deferred Sales Contracts
The second financing technique is the “Deferred sales contracts”, this type is
accepted by the Islamic jurists and widely used by the different Islamic banks.
These contracts are based mainly on selling an object with a markup percentage
(as a compensation to the seller ), which will be paid back in the future in a form
of periodical installments. The main contracts for this type are “Murabaha”,
“Salam”, “Istisna’a” and “Ijara”( Kettell 2010, p. 24). These instruments will be
successively discussed in the following sections.

3.2.1. Murabaha

Murabaha is derived from the Arabic word ‘ribh’, meaning profit. It is a
commonly used instrument by the Islamic financial institutions. In Islamic banks,
murabaha is a trade contract between the bank and the client, where the bank
purchases a certain good from a third party and resell it to the client with a markup margin. murabaha contracts are commonly used for the financing of
‘machinery, consumer durables, trade supplies and means of transport’ (Visser
2009, p.57-58). In fact, there are two types of murabaha. Under the first type, the
bank purchases the assets/goods and makes them available for sale. Similarly, the
second type, also called “ Murabaha to purchase order”, the bank purchases the
asset on behalf of the customer based on an agreed promise. The most important
concept in this formula is that the bank commits to reveal the original cost of the
purchased goods to the client. In addition, both parties must agree on the mark-up
margin (figure 6) (Kettell 2010, p. 26-27). In fact, Banks commonly use the
London interbank offered rate (LIBOR) as an indicator for the mark-up
percentage (Visser 2009, p. 57).
21 | P a g e


ownership transfer to the
customer

Ownership transfer to the
bank

Seller

Payment of the purchase
price

Islamic Bank

price + profit margin

Customer
Kmk;lk;

Kmk;lk;

Figure 6 Murabaha Model (iFIS, n.d.)

In fact, It can be seen that the respective model operates similarly as the interestbased model, however, several reasons contradict this argument. First, the markup margin is for a service done by the bank (intermediary service), which stands
for a certain effort. Second, in contrast with the interest based model, the mark-up
is a pre-agreed ratio which not linked to a certain time factor. Therefore, it will not
increase if the customer fails to pay in the case of deferred payment. Finally, all
risks which might occur before the possession by the customer will be borne by
the bank, as he is the owner of the goods (Mirakhor & Zaidi, 2007, p. 52).

3.2.2. Forward Sales: Salam and Istisna‘a

According to Shariah, there are basic terms govern any sales contract and prevent
any occurrence of gharar. First, The commodity must exist at the time of the sale.
Second, the commodity must be owned by the seller at the time of the sale.
Finally, after the execution of the contract, there must be a physical transfer of the
commodity’s ownership from the seller to the buyer as well as the associated
risks. However, Some contracts do not fulfil all the latter criteria; nevertheless,
they are still accepted by the Islamic Shariah (Ayub, 2007, p. 241). The following
will discuss two examples of these contracts, which are Salam and Istisna‘a
contracts (Ayub, 2007, p. 241).

22 | P a g e

3.2.2.1.

Bai’salam

Bai’salam or salam (also known as forward sale contract) is a trade contract,
whereby the seller agrees to deliver a certain commodity in the future with an
immediate payment of the buyer. As a result , both parties can benefit from this
transaction. The seller covers any liquidity shortage, whereas the buyer gets a
cheaper price of the goods, as the price is always cheaper than the market price
(Usmani, 2002, p. 126). In fact, Salam has been permitted by the holy Prophet
(PBUH) himself under certain terms to prevent any excessive gharar. The main
terms are:a specific measure and weigh; a known quality; agreed price with a
specific delivery time (Ayub, 2007, p. 242). Bai’salam can be used as a way to
finance agricultural products and fungible manufactured goods, as well as for
small traders as a form of working capital finance (Visser, 2009, p. 61). On the
contrary, salam finance is not permitted in the case of gold, silver, and currency
trading (Ayub, 2007, p. 244).
In practice, the Islamic bank acts as the ultimate buyer (the financier) and the
client as the seller. In this sequence, the Islamic bank can practice salam finance
in two ways. Firstly, the banks can get a promise from a third party to purchase
the commodity with a predetermined price. In this respect, the bank pays a full
payment for the first seller, later on when the bank receives the commodity, he
will deliver it to the third party with a higher price (figure 7). Alternatively, The
bank can enter a parallel salam contract. Parallel salam is two independent
contracts which are not linked to each other, whereby, the bank acts as a buyer in
the first one and a seller in the other one. In this case, the bank delivers the
received goods from the first contract to the buyer of the second contract with a
higher price (Usmani, 2002, pp. 128-129). Indeed, guarantees are important in the
case of Salam. Therefore, the bank may ask for a specific security or mortgage
which can be delivered to the buyer in the case of default (Kettell 2010, p. 76).

23 | P a g e


Delivery of the goods on schedule

Seller

Advanced payment of the
purchase price

Kmk;lk;

Islamic Bank
Kmk;lk;

price upon delivery

Delivery of the
goods on schedule

Customer
Kmk;lk;

Figure 7 Bai'salam Model (iFIS, n.d.)

Ayub (2007, p. 243) argues that Salam contracts are an effective way to stabilize
the price in the market as well as protecting both buyer and seller from any
speculative transaction. The argument is based on the fact that Shariah prohibits
any reselling of Salam contracts before maturity; thus, there will not be any room
for speculative actions.
3.2.2.2.

Istisna’a

Istisna’a is a trade contract whereby the buyer requires the seller to manufacture a
specific item for him. In this context, both parties agree on the price and the
delivery date. In principle, the item will be manufactured from the seller’s raw
material and the payment method can be either lump amount or instalments.
Istisna’a is similar to salam contract, as the product does not exist at the time of
the contract. However, the payment can be deferred based on the contract
agreement, unlike salam (Kettell 2010, p.66). Istisna’a contracts can be used for
different modes of finance, for example, house finance, constructing buildings and
plants as well as BOT arrangements (Usmani, 2002, p. 134).
In theory, both Manufacture (seller) and the buyer can go together in a direct
istisna’a contract. However, in practice, the Islamic bank takes over the mediator
24 | P a g e

role by entering in back-to-back istisna’a contract, or Parallel contract. In essence,
istisna’a parallel contract does not substantially differs from the salam parallel
contract. The bank will first make an agreement with the customer where the
customer provides all the details about the desired constructed item and the
payment method, either lump or installments. Upon approval, the bank
simultaneously enters a second agreement with the supplier, or the manufacture.
The desired specification from the customer will be handed to the manufacture by
the agreed date, and the bank will pay the manufacture directly all the cost. Upon
completion of the constructed item, the bank will deliver it to the customer as
agreed, then the customer will pay the agreed price based on the agreed method
(figure 8). The bank will profit from the differences between the two contract
prices (Kettell, 2010, pp. 67-68).

Delivery of the goods on schedule

Manufacturer

Advanced payment of the
purchase price

Islamic Bank
Kmk;lk;

price upon delivery

Delivery of the
goods on schedule

Customer
Figure 8 Istisna'a Model (iFIS, n.d.)

Kmk;lk;

3.3. Ijarah - Leasing

Ijarah is one the major financial schemes in the Islamic financial system. The
term is permitted by the majority of Islamic scholars as it was viewed in both the
Quran and the Sunnah. Literally, ijarah is derived from the Arabic word “al-‘Ajr”
which means compensation (Ayub, 2007, p. 279). Ijarah or leasing is a contract
25 | P a g e

between two parties, the lessor and the lessee, where the lessor transfers the
usufruct (the right to use) of a particular asset to the lessee for an agreed
periodical rent amount (Kettell, 2010, p. 54).
The latter is the first type of ijarah, where the transaction is based just on the
transfer of the usufructs of a certain asset. This type is similar to the operating
lease in the modern finance, however, ijarah is based on shariah principles (the
prohibition of Riba and Gharar). Under this ijarah type, The bank (lessor) will
purchase the required item for the client (lessee) directly from the supplier and
lease it back to the client after adding a profit margin. All risks associated with the
ownership of the asset shall be borne by the bank during the time of the contract,.
Upon the end of the lease contract, the bank will retrieve the asset again (Kettell,
2010, p. 55; Ayub, 2007, p. 289). In order to determine the profit margin, The
Islamic bank can use LIBOR interest rate as a benchmark (Usmani, 2002, pp.
140,145).
There is another type of ijarah similar to the conventional finance lease. This type
is called “Ijarah Wa Iqtina”(leasing and promise to gift) (Usmani, 2002, p. 151).
Under this type, the agreement between the lessor and the lessee is similar to the
normal ijarah, however, the lessor is obliged to transfer the ownership of the asset
at the end of the lease period (figure 9). In practice, the bank amortizes the cost of
the asset, in addition to a profit margin over a certain period (based on an
agreement between the two parties), in a way that he receives the principle and
transfer the asset to the lessee at the end of the lease period (Ayub, 2007, pp.
289,291-292).
Ownership transfer under
“Ijarah Wa Iqtina”

Ownership transfer to the
bank
price

Seller
Kmk;lk
;

Lease payments

Islamic Bank
Kmk;lk;

Customer
Kmk;lk;

Figure 9 Ijarah - Leasing Model (iFIS, n.d.)

Both ijarah and Ijarah –Wa- Iqtina are widely practiced by the Islamic banks;
several assets can be leased under this mode of finance, for example, aircrafts
26 | P a g e

building, cars and machinery. It is worth pointing out that the first Islamic lease in
the modern history was between the AL Rajhi Banking and investment
corporation (ARBIC) and the Bubai-based Emirates Airline, where the former
leased the latter an A310-300 Airbus with an amount of $US 60 (Kettell, 2010, p.
61) .

3.4. Qard Hasan

Qard hasan is a financial instrument without any intention to generate profit, it
means literally “good loan”, and also called a zero-return instrument. Normally,
qard hasan is offered as financial assistance for solidarity intentions and social
activities. For example, poverty projects and health care projects which mostly run
through governments in the Muslim countries. In fact, qard hasan’s providers are
seeking the reward in the hereafter; therefore, there is no intention to make profit
out of their deposits. Normally, Full repayment of the loan at the face value is
guaranteed by the government (Khan, 2007, p. 294). Islamic financial institutions
can also provide qard hasan to individuals; this will be also for social activities
and training programs for students who cannot afford studying expenses. For
instance, the Islamic development bank offers several academic scholarship
programs for students; the repayment of the loan would be in easy installments
and after graduation and gainful employment (IDB, 2013).

3.5. Retail Banking: Funding Accounts
Retail banking business is one of the major funding techniques for the
conventional banks. Recently, Islamic banks adapted the phenomena to offer
Islamic retail banking products in accordance to Shairah. The following sections
will briefly explain some Islamic retail banking products such as the current,
saving and investment accounts.

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3.5.1. Current Accounts

The Islamic current accounts are way similar to the conventional accounts. The
main benefit from these accounts, is to build an effective relationship with the
customer in order to gain his trust and to profit from his/her investments in the
future. These types of accounts are held by the trustee of the bank without any
interest charges at any level. However, the Islamic bank can charge an
administration fee to cover its cost, as well as a penalty fee in case of overdraft.
Furthermore, the deposits amount support and strength the bank’s balance sheet in
order to meet the regulatory requirements (Millar, 2008, p. 32).
The Islamic current accounts are justified by the Islamic Shariah based on the
concept of al-wadiah (trust or safekeeping). Wadia can be defined as ‘setting up
an agency contract for the purpose of protecting one’s wealth’ (Lewis & Algaoud,
2001, p. 47). In other words, the bank does not have the right to invest these
accounts at any type of investment.

3.5.2. Saving & Investment Accounts

Both conventional and Islamic saving and investment accounts are equal in their
nature, but are way different in their mechanism. Under the Islamic saving
accounts, the bank guarantees a full repayment of the deposits’ nominal value
with a small return (based on the applied method ). Whereas under the investment
accounts, the full repayment of the deposits’ nominal value is not guaranteed, and
the return is higher. The return on the both former types of deposits is not fixed;
otherwise it would endure a sort of riba transaction such as in the conventional
system.
The Islamic saving accounts can operate under several methods. The first method
is according to al-wadiah principle (please refer to 3.5.1.), under this scheme the
bank invests the deposits in a Shariah complaint business with a pre-permission
from the depositors. In return, the bank guarantees a full return of the value with a
shared profit. The second method is to deal with the saving deposits as a qard
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hasan ( please refer to 3.4.) from the depositors. The third method is to deal with
the saving deposits as investment deposits, in other words, the depositors will
permit the bank to invest their deposits in an investment pool, and they will agree
to share profits and losses on the basis of mudaraba (Lewis & Algaoud, 2001, p.
47).
The Islamic Investment accounts are subjected to al mudaraba al mutlaqa
principles (please refer to 3.1.1.), as its main purpose is to earn profit. The
mechanism is similar to the third method of the saving accounts (illustrated
above), however, other requirements will apply such as higher fixed minimum
amount, longer duration of deposits and most importantly the possibility of losing
some funds in case of loss occurrence (Lewis & Algaoud, 2001, p. 47).

3.6. Sukuk

The Islamic capital market has grown expeditiously after the 1990s; it started in
the GCC region and spread across Europe and Asia. Several products have been
introduced as an alternative to the conventional financial instruments; indeed, the
new Islamic products had attracted the worldwide investors.
The most famous type of these Islamic instruments is the Islamic bonds, or sukuk.
The new sukuk market has been the fastest growing market after Islamic banking.
Sukuk refers to ‘certificates of equal value representing undivided share in
ownership of tangible assets of particular projects or specific investment activity,
usufruct and services’ (Ayub, 2007, p. 494). At the end of 2012, the value of the
outstanding global sukuk recorded $229.4 billion. The latter number has increased
due to the new issuances by $131.2 billion (figure10 a). The GCC countries, as
well as Indonesia have been the major players in the growth of the sukuk primary
market (figure10 b). In fact, it is expected that the demand for sukuk will grow by
significant numbers in the next decades (ECB, 2013, pp. 20-22).

Sukuk were developed by Shariah scholars as a substitute for the conventional
bonds. In essence, Shariah does not reject the idea of bond investment itself;
however, the rejection is related to its mechanism, as it relies mainly on interest
29 | P a g e

rates. Equally important, the investor does not care about the company that owns
this bond, as he cares more about the profit. In consequence, the investor might
invest in a company which produces any products related to haram activities
(please refer to 2.6.).

Figure 10 Sukuk issuance (ECB, 2013, p. 21)

In contrast, the mechanism of the Islamic sukuk is based on ‘the exchange of an
approved asset (for example, the underlying assets could include buildings, hire
cars, oil and gas pipelines and other infrastructure components) for a specified
financial consideration’ (Mirakhor & Zaidi, 2007, p. 53). In this regard, Islamic
sukuk are based on the several Islamic financial contracts such as mudaraba,
murabaha, ijara, etc.. The following section will briefly explain the mechanism of
the most famous and important type of sukuk, ijara sukuk .

3.6.1. Ijarah Sukuk
This type of sukuk has gained wide acceptance in the market among both scholars
and investors. Several governments and corporate entities have used this type as a
strategy to raise funds, as well as for long-term project finance. Its mechanism is
based on the ijarah finance contract (please refer to 3.3.), in which the structure is
based on three parties (figure 11), the originator (beneficiary), the special purpose
30 | P a g e

vehicle (SPV) with an independent legal structure, and the investors (sukuk
holders) (Ali, 2005, p. 3).

Figure 11 Structure of a generic ijarah sukuk (Ali, 2005, p. 5)

For better understanding of the mechanism, an example from Mirakhor & Zaidi (
2007, p. 54) will be illustrated. A corporation wants to raise funds with $50
million for the purchase of a piece of land. The corporation (originator) starts the
process through the SPV by issuing sukuk with small denominations (e.g. $10000
each) totalling $50 million. In this respect, the corporation transfers the ownership
of the land to the SPV, which will then securitize the asset by issuing certificates
to the investors. Consequently, the investors became the real owners of the
acquired asset. The funds generated from the sales proceeds will then be
transferred to the SPV and further to the corporation. The asset now is leased back
to the originator, in other words, the investors became the lessor, whereas the
corporation became the lessee. Afterwards, The rent proceeds from the originator
is divided between the investors through the SPV.
Apart from GCC sukuk market, sukuk had penetrated the western capital markets
as well. Germany was the first European country to introduce Ijarah sukuk to the
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Western market. Saxony-anhalt issued the first ijarah sukuk in 2004 by total
amount of €100 million. The respective sukuk were designed to target investors
from gulf area as well as from Europe. Finally, 60 percent of the issue was
acquired by investors from Bahrain and the UAE, the remaining 40 percent were
acquired by investors in France and Germany. The sukuk amount was fully
redeemed in 2009 (ECB, 2013, p. 26).

3.7. Takaful

The need for insurance coverage by individuals and institutions arose over time. It
became the only way to mitigate the several types of risks associated with their
wealth and lives. Despite the fact that, the conventional type of insurance is
rejected from the Shariah point of view, the IFIs had to find other alternatives in
order to fulfil this needy gab. The new Islamic insurance (Takaful) system has
been developed over several decades in accordance with Shariah principles.
Currently, large number of financial institutions are providing the service with
wide acceptance from customers in the Muslim communities (Ayub, 2007, p.
417).The following will briefly discuss the new scheme and its mechanism;
furthermore, it will highlight the main differences between takaful and
conventional insurance system.
Takaful industry which started in Sudan in 1979 has evolved over decades to
spread across the Arab and Muslim countries. The rapid growth and success in
the Muslim countries made it an attractive investment for the western world as
well. Several non Muslim countries started to launch takaful in their countries,
such as Germany (Hannover-Re entered both Takaful & re-Takaful insurance in
2007 & 2010 respectively), Britain (the establishment of Salam insurance in
2008) and Switzerland (Swiss-Re in 2009) (E&Y, 2012).
According to Halim (2012), The main takaful business is to be found in the GCC
region and southeast Asia. Saudi Arabia considered to be the largest takaful
market with approximately US$4.3 billion and 51.8 percent of the whole industry.
Malaysia contributes with US$1.4 billion while UAE contributes with US$818
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million. In addition , Sudan is the main player in Africa with contributions of
US$363 million.
The Ernst & Young takaful report 2012 shows a relatively lower increase with 19
percent in 2011 in comparison with 2010 in the takaful business. Nevertheless, the
industry curve continues to grow with a double digit as in figure 12.

Figure 12 The global gross Takaful contributions (E&Y, 2012)

The new insurance Scheme differs substantially from the conventional insurance
in terms of concept and mechanism. Khan & Coopers (2008, p. 23) define
conventional insurance as ‘an agreement whereby an insurer undertakes (in return
for the agreed premium) to pay a policyholder a sum of money (or its equivalent)
on the occurrence of a specified event’. Even though that Islamic Shariah does not
reject the idea of risk mitigation, the rejection of the conventional insurance has
been debated between Muslim scholars for other reasons (Hussain & Pasha,
2011).
The rejection is based on the idea that conventional insurance involves all
prohibited transactions; this includes riba, maysir and gharar ( please refer 2.3. &
2.4.) (Visser, 2009, pp. 102-104). With regard to the involvement of riba, it is
directly involved as a result of any excess between the amount of paid premiums
and the sum insured, moreover, it is involved indirectly as the insurer normally
invest the money in an interest-based business. Concerning gharar and maysir,
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the uncertainty about the subject matter involves a high degree of risk, for
instance, in life insurance whereby the policyholder receives a sum of money in
case of death, this is seen by scholars as a sort of gambling as well as gharar
(Ayub, 2007, p. 419).
On the contrary, takaful system is based on the basis of Islamic principles which
promote solidarity and mutual cooperation (Ayub, 2007, p. 421). Under the
takaful system, policy holders can share both profits and losses. This idea is based
on the concept of donation rather than investments, ‘whereby policy holders
agree to pool their contributions and share the liability of each policyholder. So if
one policyholder has to be paid a claim, this is paid out of the combined pool’
(Khan & Coopers, 2008, p. 129).Thus, the new system has eliminated any sort of
gharar and/or gambling as it became risk sharing system under a voluntary
contribution (Visser, 2009, p. 105) .
Several models of takaful have evolved over time, the commonly used models by
the IFIs are : Wakalah4(practiced mainly in the Middle east), mudaraba (practiced
mainly in Asia), waqf (a kind of endowment) or wakalah with waqf (Ayub, 2007,
p. 423) .
For further understanding of the mechanism, an example of mudaraba model
from Akhter (2010, pp. 3-4) will be explained. The takaful mudaraba model is
based on the principles of mudaraba contract (please refer to 3.1.1.), where
participants act as rab-almal who provides capital and the takaful operator acts as
mudarib who provides expertise and know-how.
The takaful fund under this model is divided into two accounts (figure13), the first
account called “Participants Account” (PA) where the majority of the participants’
contributions is deposited. The second account called “Participants Special
Account” (PSA) where small portion is deposited and used to pay claims and
underwriting costs (risk management account). The contributions from the
participants are divided between the two accounts with a higher percentage to PA
4

Wakala: the term means agency and refers to the absolute power of attorney where a
representative is appointed to undertake trasactions on another person’s behalf (Kettell, 2010, p.
232)

34 | P a g e

over PSA (as in figure13, 80 percent and 20 percent respectively). Both accounts
are invested in Shariah based instrument(s), in case of surplus after deducting any
claims, both of the participants and operator share the profit based on a pre-agreed
percentage. On the other hand, in case of loss which exceed the amount in the
PSA, the loss is borne just by the participants and not by the operator. In this
context, shareholders can provide a form of qard hasan (please refer to section
3.4.), in order to compensate the loss.
In fact, several scholars have criticized the mechanism of the several takaful
models. For instance, In the case of mudaraba model, neither the participant’s nor
the operator has the right to profit from a donated contributions, as it is a form of
tabaruu ( voluntary donations). While according to Shariah, the nature of tabaruu
is not complying with profit purposes (Akhter, 2010, p. 15). However, the
different issues from some scholars do not affect the business, as it is approved
from the wide variety of scholars from the different fiqh schools. In addition, the
business of each takaful organization is monitored by an independent SSB.

Figure 13 Takaful Mudarbah Model (Akhter, 2010, p. 4)

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Corporate Governance In Islamic Banks

4. Corporate Governance In Islamic Banks
The need for governance arose over time as a result of the separation between
management and ownership. Nienhaus (2007, p.128 ) stated that ‘[t]he core issue
of governance of a corporation is how to ensure that managers will use a
company’s resources in the interest of the shareholders’. In the banking sector,
governance differs than other sectors. The root cause is that information
asymmetries between insiders and outsiders are relatively hard due to the nature
of the business (risky business).
In conventional banks, depositors (financiers) share part of the risk with
shareholders, especially in the case of insolvency, which can be hedged by typical
insurance schemes (Nienhaus, 2007, p. 128). On the contrary, in Islamic banks,
depositors bear higher risks comparing to conventional banks. The reason is in the
mechanism of the Islamic deposits, which differ substantially from conventional
deposits. According to Islamic banking principles, deposits (saving and
investment accounts) are subjected to mudaraba rules (please refer to 3.5.), in
other words, the principal amount is not guaranteed for full repayment . Therefore,
depositors and shareholder are likely to share an equal risk (Nienhaus, 2007, p.
129).
For these reasons, the corporate governance in Islamic system is different from the
conventional system. In Islamic Banks, Stakeholders’ confidence is a major aspect
for the success of the business; thus, the bank must gain trust of its stakeholders
and customers. In particular, they must be assured that all products are compliant
to Shariah rulings (Grais & Pellegrini, 2006). Hence, IFIs tend to pursue an
independent ‘legitimate control body’ in order to supervise the business from a
religious point of view, which is known as the Shariah Supervisory Board (SSB)
(Rammal, 2006).
The following sections will discuss the governance and the compliance structure
of the Islamic banks. The first section will discuss the SSB and its main duties,
moreover, it will highlight the main constraints facing the SSBs in the western
36 | P a g e

world. The second section will highlight the main Islamic international
organization, additionally; it will discuss its major role in setting standards and
regulations for the IFIs.

4.1. The Shariah Supervisory Board (SSB)
The Shariah Supervisory Board (SSB) (also known as Shariah Committee) is a
form of religious supervision in the IFIs. The SSB members are a group of
authentic Islamic Scholars who are highly credible in the society. The board
undertakes an important role in the process of examining the financial products in
order to certify that the issued products are conducted according to shariah
principles (Kettell, 2010, p. 102). Almost all the Islamic financial institutions have
or deal with a Shariah committee, moreover, the admission of some international
Islamic organizations strictly requires an active SSB (Rammal, 2006).
Rammal (2006) pointed out in his research regarding the different SSBs that
some institutions neither have a Shariah adviser nor a full board. However, they
rely on fatwas (religious opinions) issued by the leading Islamic organizations like
“Al Azhar” university in Egypt. On the other hand, other institutions (e.g. Meezan
Bank in Pakistan) rely on other type of SSB whose members are located in
different boards around the world.

4.1.1. Functions and Responsibilities
The SSB has several responsibilities regarding monitoring and assessing the
business in the light of Shariah. According to Abdul-Rahman (2010, pp. 77-78),
the main functions and responsibilities of an active SSB are:


Study and analyze the previous fatawa concerning the current business
transactions, in addition, issuing new fatawa based on banking and
financial questions.



Supervision of the banking day-to- day operation to insure that Shariah
principles are fully implemented.

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

Assist in the product manufacturing process in accordance with developing
new

products

with

the

banking

professionals

to

increase

its

competitiveness.


Assist in designing the product manuals which contain detailed procedures
for the operation process.



Review and monitor any agreements or contracts related to any conducted
business inside or outside the bank to guarantee that they are complying
with Shariah.



Participate in the bank’s training programs. In this context, employees
learn the main aspects of the Islamic finance principles and the Islamic
ethics of business transactions (Fiqh Muamlat).

In principle, if the SSB has any doubt regarding a specific product or
transaction(s), which might not be fully bound by Shariah, the board will try to
find other alternative in order to execute the transaction; otherwise it will not
processed.
In case of any deception from the financial institution, the board will take a
serious action towards the underlying transaction. In this regard, any profit
generated from the underlying transaction will be transferred to the charity
account, in addition, financial penalty will take place for non-compliance as well
as adverse publicity (Rammal, 2006).
Equally important, at he end of the financial year, the SSB submits an annual
report to the bank’s directors. The report should summarize the board’s opinion
over the bank’s business transactions as well as the financial products (AbdulRahman, 2010, p. 78).

4.1.2. The Issue of Fatwa
A fatwa (the plural is “fatawa”) is an Islamic religious opinion, which has to be
issued by a recognized religious authority, or alternatively by a Muslim scholar
whose knowledge is based on wisdom and honesty (Kettell, 2010, p. 205).

38 | P a g e

Issuing fatawa is one of the primary roles of the SSB, once a fatwa is issued; it is
considered binding and became an authentic guarantee for a Shariah compliant
service. However, the process of issuing any fatwa is a bit complicated which
endures significant challenges. The reason is that a fatwa is a juristic opinion
based on a particular Shariah school, and due to the existence of different Shariah
schools , some conflicts might take place.
As a result, different debates and disagreements sometimes takes place when
developing Shariah compliant products due to the different views in each Shariah
school .This lead in some cases to Inconsistency of fatawa (Belder & Sapte,
2008, pp. 186-187). Nevertheless, the CIBAFI (General Council for Islamic
Banks & Financial Institutions) sampled about 6000 SSB’s fatawa across different
banks, and found that 90% of them were consistent (Grais & Pellegrini, 2006).

4.1.3. Characteristics of The Board Members

As one of the main components of the Islams banking structure, SSB members
are chosen based on specific criteria. The AAOIF’s Governance standard No. (1)
pointed out that the board must contain at least three members, and should have a
high expertise members in economics, and/or law, and/or accounting, etc.. Most
importantly, the board must not include any influential person from the institution
administration or the shareholders (Al-Qattan, 2008).
The IFSB (2009, p. 5) has issued guidelines to strengthen the governance structure
of the Islamic financial institutions. In particular, it includes a specific criteria
concerning the selection of the SSB members in order to ensure a high level of
expertise. The main criteria are summarized in the qualification (competence) and
independence of the board members.

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4.1.3.1.

Qualification

Any SSB member who is responsible for issuing a fatwa is considered to be a
mufti5. According to Al-Qattan (2008), such an important role as mutfi requires a
high level of qualification on both educational and expertise levels. In particular,
he must be a Muslim, adult, pious and knowledgeable person with high capability
of Ijtihad (please refer to 2.3.1.5.). In addition, he must be an intelligent character,
who can interact with different people and deal with cases of cheating and
deceiving. Furthermore, he must be cooperative as he should consult with the
other members . Equally important, he must be aware of the societal conditions in
general and the country condition in particular, for a better understanding of the
several fatwa conditions.
The IFSB (2009, p. 13) pointed out that the Islamic financial institutions must
provide the SSB members with special training programs mainly in the business
and financial transactions. In consequence, the member will be aware of any case
from the technical aspect as well as the religious aspect. These factors will
contribute to a continuous professional development of the board members (AlQattan, 2008).
4.1.3.2.

Independence

According to the AAOIF’s Governance Standard No. 1, ‘Sharia’a Supervisory
Board is an independent body of special jurists in fiqh almua’malat,and can issue
fatwas and rulings which shall be binding on the Islamic financial institution’
(Nienhaus, 2007, p. 136).
However, the board independence can be affected by its dual rule, as it acts as an
auditor and an employee at the same time. In other words, the dual relationship
might lead to a possible conflict of interest. The conflict can be represented in a
way that the board will not take any strict opinion against a profitable transaction
5

A mufti is one who reports the rule of Allah on His behalf, or he is the one who is capable of
knowing the
Sharia’a rulings for events with their evidence and who has memorized most fiqh issues.

40 | P a g e

(haram transaction ) in order to maintain the profitability curve of the financial
institution .
Nevertheless, such a risk in practice can be mitigated by the ethical standards of
the SBB members. In fact, the SBB members are mostly scholars with high
reputation, therefore, such any conflict action would inflict the scholar’s
reputation as well as the financial institution.
Equivalently, any management intervention in the SSB’s compliance work will
negatively affect the stakeholders’ confidence. For these reasons, the dual relation
of the SSB is likely not to affect the board’s independence as well as the quality of
the competence job (Grais & Pellegrini, 2006).

4.1.4. Shariah Supervisory Boards & Western Regulators
There are serious challenges facing the implementation of the SSBs across the
western region. Abdul-Rahman (2010, pp. 117-118) stated three main issues
facing the implementation of the SSBs in the western countries.
1- In the majority of the western countries, there is a strong separation
between church and state across the different sectors. Hence, it is quite
sensitive to implement any religious laws at any financial institution, as it
might lead to religious discrimination for customers from other religions.
2- The fact that there will be two supervisory boards, where one can be
superior over the other, may lead to ultimate conflict. In consequence, it
will negatively impact the bank’s safety and performance.
3- The majority of the scholars do not have professional expertise in the
banking operation, however, Islamic banks can offer an intensive training
for this issue (please refer to 4.1.3.1.). Other issues, that some scholars are
located in different countries, which is nearly difficult to meet the local
challenges.

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4.2. International Islamic Financial Infrastructure

Generally, International Financial infrastructure is essential for an effective legal
and regulatory framework. Hence, it was mandatory for Islamic banks to have a
set of supporting institutions in order to facilitate monetary and financial policymaking at a national level. Furthermore, to coordinate and develop a set of
guidelines and best practices to achieve the financial integration. In the following
section, the main Islamic international organisations will be successively
discussed.

4.2.1. AAOIFI

The Accounting and Auditing Organization for Islamic Financial Institutions
(AAOIFI) is an Islamic-nonprofit organization that aims to develop standards in
accounting, auditing, governance, ethics and Shariah for the IFIs. AAOFI plays a
major role in enhancing the industry’s human resource by providing professional
qualification programs. The organization was founded in 1990 and was officially
registered in 1991 in the state of Bahrain. The present membership is 200
members from 45 countries including different participants from the Islamic
finance industry regionally and worldwide (AAOIFI, 2010).

4.2.2. IFSB

The Islamic Financial Service Board (IFSB) is an international Islamic
organization started its operations in 2003, and based in Kuala Lumpur, Malaysia.
The main objective is to promote the Islamic financial system stability through
issuing guiding standards to the different sectors of the financial system including
banking, capital markets and insurance sectors. The process is mainly conducted
through researches in addition to organizing seminars and conferences with the
main market players. Moreover, IFSB participates in developing instruments for
efficient operational and risk management. IFSB’s members are gradually

42 | P a g e

increasing; the present membership is 187 members including supervisory
authorities, inter-governmental organizations and market players (IFSB, 2010).
4.2.3. IDB

The Islamic Development Bank (IDB) is an international financial institution and
part of the IDB group, it was founded in 1973 and started officially in 1975. The
bank plays an important role in the economical and social development of its
member countries and the Muslim communities, according to Shariah principles.
In this regard, the bank provides financial assistance in the form of loans and
equity capital participation for the productive projects in the repective countries.
The present membership is 56 countries, the Bank’s head office is in Jeddah in the
Kingdom of Saudi Arabia, furthermore, the bank has four regional offices (IDB,
2013). IDB group involves 4 main organizations: The Islamic Development Bank
IDB, the Islamic Corporation for the Insurance of Investment and Export Credit
(ICIEC), the Islamic Corporation for the Development of the Private Sector (ICD)
and the Islamic Research and Training Institute (IRTI) (Iqbal, 2007, p. 361).

4.2.4. LMC

The Liquidity Management Center B.S.C was established in the Kingdom of
Bahrain in 2002 (Kettell, 2010, p. 181). The main purpose is to provide liquidity
assistance to the Islamic financial institutions. In other words, LMC plays an
effective key role in the interbank market by facilitating the surplus funds of the
Islamic financial institutions into short and medium term financial instruments.
Furthermore, it provides Islamic advisory services as well as sourcing assets from
both private and public sectors and transform them to innovative investment
instruments (LMC, 2009).

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Islamic Banking & The German Market

5. Islamic Banking & The German Market
With approximately 38 million Muslim citizens across Europe (Including Russia
& Ex. Soviet Union), Muslims constitute the largest minority in Europe. In fact,
the European Muslims Origins go back to several centuries, as they used to live
in the Baltic and Balkan countries, as well as Cyprus and Sicily. In Germany, the
Muslim population trend increased between the 1960s and 1990s as a result of the
foreigner workers' immigration (Farhoush & Schmidt, 2011, p. 236). Currently,
Germany contains the largest Muslim population in Europe (approximately 4
million), Moreover, it is the fifth largest economy in the world. For these reasons,
Germany seems to be a very potential market for Islamic banking and finance.
This chapter will examine the potential aspects of the Islamic banking in Germany
as well as the major obstacles facing the business. In this regard, the Muslim
population in Germany will be scrutinized as well as its financial behaviour and
demands. It will further highlight the main key players in the domestic market.

5.1. Muslims in Germany

As Christianity (mainly Protestant and Roman catholic confessions) is the major
religion in Germany, Islam represents the second major religion, and the largest
minority in the country. In fact, the first Muslims incomers were in the 18th
century as a result of military and economic agreement between Germany and the
Ottoman empire (Yorulmaz, n.d.). Two centuries after, particularly from 1960s1990s, immigrant waves of “guest workers” started to enter Germany from several
Muslim countries. The immigrants from Turkey, Morocco, Tunisia and
Yugoslavia, were expected to stay for a limited time, but they could settle down
their conditions to stay in Germany and not to go back to their countries.
In fact, there was and still a lack of research concerning the Muslim population in
Germany. After 11 September 2001, the German government started to take
critical steps in order to analyse the structure of its Muslim population. The
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Islamic banking in Germany: opportunities and potential aspects

Islamic banking in Germany: opportunities and potential aspects

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