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What is Financial System? 2 Conventional Financial System2 Flaws & Failures in Prevailing system3 Depressions due to capitalism3 Islamic Financial System4 What is Islamic Banking4 Philosophy of Islamic Banking4 Introduction5 Origin of Islamic banking in Pakistan5 Initiatives Taken in Pakistan5 Development of Islamic banking in Pakistan6 Present scenario of Present scenario of Islamic Banking System in Pakistan7 Conclusion8 What is Financial System? “Processes and procedures used by a firm’s management to exercise financial control and accountability.

These measures include recording, verification and timely reporting of transactions that affect revenues, expenditures, assets and liabilities. ” Financial systems are crucial to the allocation of resources in a modern economy. They channel household savings to the corporate sector and allocate investment funds among firms; they allow inter temporal smoothing of consumption by households and expenditures by firms; and they enable households and firms to share risks. These functions are common to the financial systems of most developed economies.

Financial system depends on five major components which are following: * Money * Financial Instruments * Financial Market * Financial Institutions * Central Bank Conventional Financial System Capitalism is an economic system in which the means of production and distribution and industry are privately owned and operated for a private profit; decisions regarding supply, demand, price, distribution, and investments are made by private actors in the market rather than by central planning by the government; profit is distributed to owners who invest in businesses, and wages are paid to workers employed by businesses.

There is no consensus on the precise definition of capitalism, nor how the term should be used as an analytical category. There is, however, little controversy that private ownership of the means of production, creation of goods or services for profit in a market, and prices and wages are elements of capitalism. There are a variety of historical cases to which the designation is applied, varying in time, geography, politics and culture.

Some define capitalism as where all the means of production are privately owned, and some define it more loosely where merely “most” are in private hands; while others refer to the latter as a mixed economy based toward capitalism. More fundamentally, others define capitalism as a system where production is carried out to generate profit, or exchange-value, regardless of legal ownership titles. Private ownership in capitalism implies the right to control property, including determining how it is used, who uses it, whether to sell or rent it, and the right to the revenue generated by the property.

Economists, political economists and historians have taken different perspectives on the analysis of capitalism. Economists usually emphasize the degree that government does not have control over markets (laissez faire), and on property rights. Most political economists emphasize private property, power relations, wage labor and class. There is general agreement that capitalism encourages economic growth while further entrenching significant differences in income and wealth.

The extent to which different markets are free, as well as the rules defining private property, is a matter of politics and policy, and many states have what are termed mixed economies. Capitalism as a deliberate system of a mixed economy developed incrementally from the 16th century in Europe, although proto-capitalist organizations existed in the ancient world, and early aspects of merchant capitalism flourished during the Late Middle Ages.

Capitalism became dominant in the Western world following the demise of feudalism. Capitalism gradually spread throughout Europe, and in the 19th and 20th centuries, it provided the main means of industrialization throughout much of the world. Flaws & Failures in Prevailing system The prevailing financial system in the world is based on capitalistic principles of RIBA (interest) and Speculation. Many religions have criticized or opposed specific elements of capitalism.

Traditional Judaism, Christianity, and Islam forbid lending money at interest, although methods of banking have been developed in all three cases, and adherents to all three religions are allowed to lend to those outside of their religion. Christianity has been a source of praise for capitalism, as well as criticism of it, particularly for its materialist aspects. Indian philosopher P. R. Sarkar, founder of the Ananda Marga movement, developed the Law of Social Cycle to identify the problems of capitalism.

Critics argue that capitalism is associated with the unfair distribution of wealth and power; a tendency toward market monopoly or oligopoly (and government by oligarchy); imperialism, counter-revolutionary wars and various forms of economic and cultural exploitation; repression of workers and trade unionists, and phenomena such as social alienation, economic inequality, unemployment, and economic instability. Capitalism is regarded by many socialists to be irrational in that production and the direction of the economy is unplanned, creating many inconsistencies and internal contradictions.

Environmentalists have argued that capitalism requires continual economic growth, and will inevitably deplete the finite natural resources of the earth, and other broadly utilized resources. Labor historians and scholars, such as Immanuel Wallenstein have argued that unfroze labor—by slaves, indentured servants, prisoners, and other coerced persons—is compatible with capitalist relations. The system has itself negated the previously discussed basic purpose of a financial system i. e. “The Fair Allocation of Resources”.

As a result of which we observe alarming rate of crime & suicides in the so called economically developed countries. Depressions due to capitalism If we take a look in to the past, we can see on numerous occasions that this system of capitalism is a failure. The world had faced great depressions in the following years: * Panic of 1837 * Long Depression (1873-1896) * Great Depression (1929-1933) * Regional depressions in the 1970s, 1980s, and 1990s Islamic Financial System What is Islamic Banking

Islamic banking has been defined as banking in consonance with the ethos and value system of Islam and governed, in addition to the conventional good governance and risk management rules, by the principles laid down by Islamic Shariah. Interest free banking is a narrow concept denoting a number of banking instruments or operations, which avoid interest. Islamic banking, the more general term is expected not only to avoid interest-based transactions, prohibited in the Islamic Shariah, but also to avoid unethical practices and participate actively in achieving the goals and objectives of an Islamic economy.

Philosophy of Islamic Banking Islamic Shariah prohibits ‘RIBA(interest)’ but it does not prohibit all gains on capital. It is only the increase stipulated or sought over the principal of a loan or debt that is prohibited. Islamic principles simply require that performance of capital should also be considered while rewarding the capital. The prohibition of a risk free return and permission of trading, as enshrined in the Verse 2:275 of the Holy Quran, makes the financial activities in an Islamic set-up real asset-backed with ability to cause ‘value addition’.

Islamic banking system is based on risk-sharing, owning and handling of physical goods, involvement in the process of trading, leasing and construction contracts using various Islamic modes of finance. As such, Islamic banks deal with asset management for the purpose of income generation. They will have to prudently handle the unique risks involved in management of assets by adherence to best practices of corporate governance. Once the banks have stable stream of Halal income, depositors will also receive stable and Halal income.

The forms of businesses allowed by Islam at the time the Holy Quran was revealed included joint ventures based on sharing of risks & profits and provision of services through trading, both cash and credit, and leasing activities. In the Verse II:275, Allah the Almighty did not deny the apparent similarity between trade profit in credit sale and Riba in loaning, but resolutely informed that Allah has permitted trade and prohibited Riba. Profit has been recognized as ‘reward’ for (use of) capital and Islam permits gainful deployment of surplus resources for enhancement of their value.

However, alongwith the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to be permissible, should be associated with goods, services or benefits. At macro level, this feature of Islamic finance can be helpful in creating better discipline in conduct of fiscal and monetary policies. Besides trading, Islam allows leasing of assets and getting rentals against the usufruct taken by the lessee.

All such things/assets corpus of which is not consumed with their use can be leased out against fixed rentals. The ownership in leased assets remains with the lessor who assumes risks and gets rewards of his ownership. Introduction Islamic banking system has emerged as a competitive and a viable substitute for the conventional banking system during the last three decades. It is especially true for Muslim world where presently Islamic banking strides at two separate fronts. At one side, efforts are also underway to convert the entire financial systems in accordance to Islamic laws (Shariah).

At the other side, separate Islamic banks are allowed to operate in parallel to conventional interest based banks. Pakistan and Malaysia are the two good examples of above mentioned approaches. Origin of Islamic banking in Pakistan The process of islamization the financial system of Pakistan is coincided with the globally resurgence of Islamic banking in the late seventies. Pakistan was among the three countries in the world that has been trying to implement Islamic banking at national level. This process started with presidential order to the local Council of Islamic Ideology (CII) on September 29, 1977.

The council was asked to prepare the blueprint of interest free economic system. The council included panelists of bankers and economists who submitted their report in February 1980, highlighting various ways and sufficient details for eliminating the interest from the financial system of Pakistan. This report was a landmark in the efforts for Islamizing the banking system in Pakistan. Initiatives Taken in Pakistan The Islamic banking movement in Pakistan was a nationwide and comprehensive. As it was a mammoth task, the switch-over plan was implemented in phases.

The process was started by transforming the operations of specialized financial institutions like National Investment Trust (NIT), Investment Corporation of Pakistan (ICP), and House Building Finance Corporation (HBFC) to the system conforming to the Islamic principles with effect from July 1, 1979. Separate Interest-free counters started operating in all the nationalized commercial banks, and one foreign bank from January 1, 1981, to mobilize deposits on profit and loss sharing basis. As from July 1, 1985, all commercial banking operations were made ‘interest-free’.

From that date, no bank in Pakistan, including foreign banks, was allowed to accept any interest-bearing deposits. All existing deposits in banks were treated to be on the basis of profit and loss sharing. However, foreign currency deposits/loans were continued to govern on interest basis. The government meanwhile also passed Mudarabah Companies Act 1984, enabled financial institutions or business groups to setup special Mudaraba Companies in a country. Development of Islamic banking in Pakistan

The change management with regard to the introduction of new system is always a sophisticated job requiring long term planning and commitments. This is particularly true in case of present day financial system wherein the interests of the stakeholders are embedded and considered important ingredient. Only a well thought out plan with committed and continue efforts could lead to success. Unfortunately the economics managers in Pakistan lost the desired path of success. Currently, there is hardly any transaction deal in inter-banks, intara-banks or the government related financial activities which can be called as Islamic.

In the beginning of islamization process the banks expressed some anxiety to adjust them to the new system and tried to develop methods to eliminate the interest from their transactions. But the issuance of BCD circular No. 13 of June 1984 allowed banks to provide finance on mark-up and on buy-back agreement basis. The technique of buy-back agreements are nothing but disguised forms of interest. With the help of new terminology the financial institutes retained the conventional methods of interest bearing finance.

The Islamic modes of finances such as musharikah, mudarabah, ijara, ijara wa iktina, were not adopted in majority of the cases. The aggressively established Mudaraba Companies also failed to continue their existence; most of them are either in losses or are in the process of agglomerated with other financial institutions. The present day financial system is largely based on ‘mark-up’ technique with or without buy-back arrangement. This procedure was, however, declared un-Islamic by the Federal Shariat Court in November 1991.

Appeals were made to the Shariat Appellate Bench of the Supreme Court of Pakistan (the apex court). The Supreme Court delivered its judgment on December 23, 1999 rejecting the appeals and directing that laws involving interest would cease to have effect finally by June 30, 2001. In the judgment, the Court concluded that the present financial system had to be subjected to radical changes to bring it into conformity with Islamic laws (Shariah). It also directed the government to set up, within specified time frame, a commission and task forces for the transformation of financial system, to achieve the objective.

The Court also indicated some measures related to the infrastructure and legal framework, which needed to be taken in order to have an economy conforming to the injunctions of Islam. The Commission for Transformation of Financial System (CTFS) set-up in the State Bank of Pakistan submitted its report in August 2001 that mainly comprised the recommendation given in the two Interim reports submitted earlier in October 2000 and May 2001. Currently, a task force is working in the Ministry of Finance to suggest the ways to eliminate interest from government operations.

Another task force has been set-up in the Ministry of Law to suggest amendments in legal framework to implement the Supreme Court’s Judgment. Present scenario of Present scenario of Islamic Banking System in Pakistan Pakistan after the gap of twenty years has now decided to shift towards interest free economy in a gradual and phased manner without causing any further disruptions. Some extracts from the affidavit submitted by the Deputy Governor of the State Bank of Pakistan (SBP) in the Supreme Court of Pakistan reflected the future policy of the Bank for the time being. That having taken a series of steps to promote Islamic banking………. and considering all other practical problems associated with the complete transformation of the financial system, discussed herein, it is State Bank of Pakistan’s considered judgment that the parallel approach will be in the best interest of the country. This means that Islamic banking is introduced as a parallel system, of which beginning has already been made; it is provided a level playing field vis-a-vis the existing conventional banks, and its further growth and development is supported by Government and State Bank of Pakistan through appropriate actions.

The approach will eliminate the risk of any major cost/damage to the economy, give a fair chance to Islamic banks to develop alongside the conventional banks, and will provide a choice to the people of Pakistan, and the foreigners doing businesses in/with Pakistan, to use either of the two systems”. State Bank of Pakistan issued detailed criteria in December 2001 for the establishment of full-fledged Islamic commercial banks in the private sector. Newly established Islamic bank can be listed on the stock exchange provided minimum of 50 percent of total shares must be offered to the general public.

At least 15 percent of total paid-up capital should be subscribed personally by sponsor directors. Islamic bank are also required to maintain a minimum capital adequacy ratio of 8 percent based on risk weighted assets. Meezan Bank Limited (MBL) received the first Islamic commercial banking license from SBP in January 2002. At the end of 2003, MBL has a small net-work of 10 branches with total deposits of US $ 130 million. In January, 2003 the State Bank issued detail instructions upon setting up subsidiaries and stand-alone Islamic banking branches by existing commercial banks.

Accordingly six existing commercial banks including one foreign bank are allowed to open separate Islamic banking branches. Out of which eight branches of four banks have already started their operations since June 2004. Islamic banks are also allowed to maintain statutory liquidity requirements (SLR) and special cash reserve (SCR) deposits in current account with the State Bank to the maximum extent of 40% of SLR and SCR for other banks in order to avoid interest. Some developments have also been witnessed in the capital market with regard to Islamization.

During the last few years, numbers of companies have issued Term Finance Certificates (TFC) to raise redeemable capital on the basis of Musharika. The payments of profit of or sharing of loss with the TFC holders are linked to the operating profit/loss of the TFC issuing companies. Therefore, the investors assume the risk of sustaining losses proportionate to their principal amount in case of operating losses incurred by the company. In September 2002, Securities and Exchange Commission of Pakistan (SECP) also allowed the Mudaraba companies to float Musharikah based TFC’s.

Another significant development during the year 2003 is the permission to set up ‘SME Modaraba’ with the participation of about 20 Modarabah companies to undertake SME businesses in the smaller towns and distant areas. SME Modaraba will resolve the problem of the individual Modarabah companies which do not have a big branch network to reach out to the prospective clientele. Conclusion Islamic banking has proved vital potential as a competitive and better substitute against conventional banking system in many countries of the world. Currently, two different approaches are experienced towards the development of Islamic banking.

First way experienced by Pakistan, Iran and Sudan is to implement Islamic banking on a country wide and on a comprehensive basis. Second, way is to setup individual Islamic banks in parallel to the conventional interest based banks. Pakistan and Malaysia can be assumed as the two leaders of Islamic Finance. Both countries selected different tracks to achieve the same goals of developing full fledge Islamic banking but gained different results. The Governments of Pakistan has tried to employ Islamic banking system at once at national level.

The overnight exercise of islamization didn’t produce the required results due to lack of required support and continue efforts to eliminate the interest (Riba) from the economy. Most of the Islamization efforts either had been reversed or at least, further progress was stopped. Since 2001, the Central Bank of Pakistan has started adopting the gradual policies of implementing Islamic banking which Malaysia has adopted twenty years back. Al-Meezan Bank in Pakistan (fully Islamic and independent commercial bank) and full fledge separate Islamic banking branches from few commercial banks are healthy indicators for positive expectations.

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