Conversion to Islamic Banking

The banks converting from conventional to Islamic banking can continue to have demand and time deposits with different maturities. The main difference is that no interest can be paid on these deposits under the Islamic system.

This is not a problem for demand deposits as conventional banks usually do not pay any interest on these and actually charge for certain services or low balances. Islamic bank could continue to operate in a similar way. The bank can use these deposit for their operations with the potential to earn profits or suffer losses. However, the principal amount of the customer remains the same and must be paid on demand. These deposits are considered loans to the bank. Some banks, such as in Iran, call demand deposits Qard Hasan.

Another category of deposits of commercial banks is savings deposit. They are similar to demand deposit but earn a fix interest with some restrictions on time and amount of withdrawals. In Islamic system, these accounts cease to earn interest and become profit and loss sharing (PLS) accounts. The deposits share in the bank’s profits and also could suffer a loss if the bank loses money. In some cases, , the banks give prizes, bonuses, or service discounts or privileges in order to attract savings deposits.

In case of time deposits, a fixed return over a period is replaced by profits and loss sharing system. Since these accounts are akin to investment in the bank, they also termed as investment accounts or deposits. The term could be fixed like three or six months, or one or more years. Since they restrict withdrawals for the term of deposit, they usually earn higher portion of profits than the savings deposits.

All of the above deposits are pooled together for banks operations and profits are allocated based on the type of deposit. In some cases, investments are mobilized for a specific project and are used primarily for that purpose. The outcome of the project is then shared with the investors based on agreed upon formula.

In conventional banking, the deposits of other banks earn interest which has been a challenge for those banks which are converting to Islamic banking. The deposits of conventional banks have to be converted to Shari’ah compliant deposits either be in the form of Qard Hasan (no return) or on profit and loss basis. This might be much easier in areas where Islamic banking is prevalent or if the whole economy is switching from interest based to interest-free banking. In an otherwise secular economy, accommodations will have to be made with conventional banks to allow for the switch.

These arrangements might be even more difficult when dealing with banks in a foreign country which are not familiar with Islamic banking. A few decades ago when Islamic banking was in nascent form, this was an acute problem as most banks demanded interest on their deposits. Currently, this issue has subsided as Islamic banks have multiplied in recent times and conventional bankers have become familiar with the Islamic financial system. Islamic banks have secured correspondent banking arrangements which preclude interest payments. These arrangements include the following:

• Non-interest bearing deposits of Islamic banks with correspondent banks
• Promise by Islamic banks to settle any debit balances in expedient manner
• No charge of interest on debit balances of Islamic banks while allowing the correspondent bank to use the Islamic bank’s deposit profitably
• Charge of a cash margin as a non-interest bearing deposit by correspondent bank for guarantee on import letters of credit

Islam banks have developed a number of Islamic modes of financing to replace the interest based lending. These include participative financing with profit and loss sharing arrangements, sales and rental contracts, and benevolent loans with no returns under Qard Hasan.

Participative Finance

Mudarabah and Musharakah are forms of participative finance. In Mudarabah, the capital is provided by the bank to a mudarib and profits are shared according to an agreement. Conversely, the losses are absorbed only by the investing party. The mudarib is the trustee of the funds of the partnership and is not liable for loss of capital. The loss for the mudarib is the loss of his efforts for which he does not get paid. The manager has no ownership rights over the assets of the business so he cannot share in the appreciation of the asset value. The bank usually does not get involved in operations of the business. The duration of Mudarabah contract can be specified at the time of agreement or it could be at the end of the business activity for which the investment was made. Islamic banks use Mudarabah for trade or project financing for a single transaction or for all or part of a business. The liability of the bank is limited to the investment in the venture.

In contrast, both the banks and the working partner pool the capital or labor in Musharakah and share the profits and losses. The investment of the partners does not need to be equal. All the investors have the right to participate in the business decision making but they would normally assign this duty to one or more of the partners. The partners may also agree to pay the working partners certain amount of remuneration for their services over and above the profits. The losses are however, shared according to the investment ratio of partners. The assets of the partnership belong to all the investing partners in the ratio of their ownership and they share in any increase or decrease in the value of the assets over time. The duration of the contract can be for a specific period or permanent. Musharakah also allows any partner to terminate the contract at any time unless otherwise specified in the contract. Islamic banks may use Musharakah to get into Shari’ah compliant ventures with traditional banks to generate Halal profits for their customers and share holders.

Sales and Rental Contracts

Murabaha is an instrument where the bank acquires a product upon request from the customer and sells it at an agreed upon profit. This is an extensively used transaction by Islamic banks. There are variations of Murabaha in which the payment or delivery of the product can be on the spot or at a future date. Bai Mu’ajjal is a sale against deferred payment, either in a lump sum or in installments. Though Musharakah and Mudarabah are considered ideal transactions for Islamic banking, the scholars have allowed Murabaha due to practical difficulties in other two transactions.

Salam or Bai Salam is a sales agreement where the seller promises to provide the buyer with an agreed product at a future date in exchange for an advanced payment at the time of contract.

Ijarah is the transfer of a capital asset from the owner to a user for a specified period of time for an agreed upon amount. The owner, an Islamic bank for this discussion, remains the owner for the duration of the lease and earns the profit or loss from the transaction. In Ijarah wa Iqtina the asset is sold to the lessee at the end of the lease.

Qard HasanQard Hasan, which translates to a benevolent or a beautiful loan, is a special kind of Qard which a bank may grant someone in need without expecting any benefit back in return. QardHasan may be given by the bank as community support or as social welfare. Majority of Islamic scholars agree that the lender has the right to ask for return of his loan at any time. But since the loan is for community service and given to those in real need, the lender should be lenient in collection and give respite to the borrower in order achieve the true benefit of Qard Hasan. The scholars have allowed the levy of a service charge to recover the actual costs of the bank for these loans.