Concept and Ideology
Operational Techniques of Islamic Bank

The financial resources of the Islamic banks consist of ordinary capital resources comprising paid-up capital and reserves, and funds rose through borrowings from the central bank and other banks (inter-bank borrowing), and issue of Islamic financial instruments. The major part of their operational funds is, however, derived from the different categories of deposits accepted on the Islamic principles of Al-Wadiah (safe custodianship) and Mudaraba (trust financing). For the sake of ease of understanding we call these two sources as 'Primary' and 'Secondary'. These are discussed as under. 


Paid-Up Capital

Islamic banks are public limited companies incorporated under the companies Act, which are listed on the Stock Exchange. Individuals and institutions, local and foreign, have subscribed their capital. For example, the First Islamic bank of Bangladesh - Islami Bank Bangladesh Limited (IBBL)- is a joint venture of Bangladesh and overseas capital in the ratio of 38:62. Its local capital is owned by the Government of Bangladesh and private individuals and institutions. The overseas capital (62%) of the bank is owned by the institutions and individuals as follows.

i)           Islamic Development Bank, Jeddah, Saudi Arabia

ii)         Kuwait Finance House, Kuwait

iii)        Bahrain Islamic Bank, Bahrain

iv)        Jordan Islamic Bank, Jordan

v)         Al-Rajhi Company for Currency Exchange and Commerce, Saudi Arabia

vi)        Dubai Islami Bank, UAE

vii)      Islamid Investment and Exchange Corporation, Qatar

viii)     Ministry of Awqaf and Islamic Affairs, Kuwait

ix)        The Public Authority for Minor Affairs, Ministry of Justice, Kuwait

x)         Public Institution for Social Security, Kuwait

xi)        Ahmed Salah Jamjoom, Saudi Arabia

xii)      Fouad Abdul Hameed Al-Khateeb, Saudi Arabia

xiii)     Islamic Banking System International holding S. A. Luxembarg 

Similarly, joint-venture Islamic banks have been established in quite a few other Islamic countries like Egypt, Sudan, Senegal and Turkey. The Islamic Development Bank has also participated in the share capital (and represented in the Management Board) of a number of Islamic Banks set up in the OIC member countries in order to promote Islamic financial institutions.

The capital resources of the Islamic banks are mobilized through the issue of shares for which negotiable share certificate are used. With prior permission from the Government, shares are issued from time to time. Laws governing the shares correspond to the Musharaka laws of ShariahThe holders of shares have management (voting) right and participate in the profit/loss of the bank. The shares are transferable. In the case of the IBBL, its entire capital is denominated in the local currency - i.e. Taka, though the foreign shareholders had to pay for their shares in US Dollars.

The central bank requires the Islamic banks to have and maintain capital funds, unimpaired by losses or otherwise, in such proportion to such assets of their branches and offices as may be prescribed from time to time by the central bank by notice in writing. Capital funds mean paid-up capital and reserves and any other sources of capital as may be defined and computed in such manner as may be prescribed by notice in writing from time to time by the central bank. Banking rules of Bangladesh require that the paid-up capital and reserves together must not be less than 8-00 percent of the Islamic banks' risk weighted asset (total deposit liabilities). 


The central bank also requires that every Islamic bank shall maintain a reserve fund. Before any dividend is declared, an Islamic bank shall transfer to the reserve fund out of the net profits of each year, after due provision has been made for Zakat and taxation, a certain percentage of the net profits in order to build up adequate reserves. If the central bank is satisfied that the aggregate reserve fund of an Islamic bank is adequate for its business, it may by order in writing exempt the bank from this requirement for a period of one year. In Bangladesh, the IBBL besides maintaining the statutory reserve, has built up an Investment Loss Offsetting Reserve (ILOR) by appropriating 10 (ten) percent of the bank's annual investment profits. 

Liquid Assets

Every Islamic bank is further required to keep at all times minimum amount of liquid assets against its deposit liabilities expressed as certain percentage of the deposits, as may be prescribed from time to time by notice in writing by the central bank. For this purpose, liquid assets mean (i) cash in bank, (ii) balances with the central bank/other designated banks, (iii) Government Investment Certificates, and (iv) such other assets as may be approved by the central bank. Failure to keep the minimum liquid assets invokes penalty for each day of deficiency.  

Borrowing From Central Bank

To tide over temporary liquidity shortages Islamic banks, as member banks, are entitled to borrow from the central bank, as the lender of last resort. In such cases, IBBL does not pay interest like the conventional banks. Such borrowing from the central bank is treated as a PLS deposit with the Islamic banks and profit is paid at the rate payable on corresponding PLS deposit of the bank.  

Inter-Bank Borrowing

The Islamic banks have established interest-free fund arrangements with local and foreign banks on the basis of reciprocity. Normally, under prior arrangement, the Islamic banks keep surplus funds with selected banks. When needed, these banks also place interest-free compensating balance with the Islamic bank. If balances are not equal, then periods for which funds placed are adjusted. 



Like interest-based conventional banks, the main function of Islamic banks is to mobilize savings and provide financial support to the entrepreneurs. Yet there are differences in techniques applied in the process of savings mobilization and financing investment by the two banking systems. Depositors receive interest in a predetermined rate for their deposits made with an interest-based bank. Similarly, the investors are to pay a predetermined rate of interest to the bank. The technique, thus, involves each and every partner in the transaction process (i.e. the depositor, the investor and the bank) with the element of interest. Islamic bank, on the other hand, neither pays nor receives interest from any of its transactions thereby saving everybody from the curse of interest.

Islam disapproves hoarding of savings and encourages its productive investment (Chapra 1985). It puts emphasis on savings and the productive use of savings. Thus, the bank assembles the small deposits and savings of individuals into a common pool and makes these deposits available for large investment opportunities, ensuring the productive use of society's savings.

Islamic banking is a response to such exigencies. It mobilizes savings of the common people in line with Islamic Shariah. Techniques employed by Islamic banks for saving mobilization are as follows. 

Al-Wadiah Account

Islamic banks receive deposits in their Al-Wadiah account. This account is similar to the demand deposit account of interest-based banks. Conventional interest-based banks do not pay interest on this type of deposit account. In addition, depositors may withdraw all or a part of the funds deposited in this account without restriction. The term Al-Wadiah means deposit of money allowing somebody to claim the funds in the account. The bank as trustee preserves and safe keeps the funds deposited. Thus, depositors feel safe keeping their money with the bank because the bank provides assurance of returning their money on demand.

When an individual opens an Al-Wadiah account, he agrees to allow the bank to lend these funds to entrepreneurs seeking financing for their products or activities. In addition, the depositor understands that the bank may earn a profit from its lending activity.  However, any losses incurred from this investment activity are totally borne by the bank. The depositor is not liable for any losses incurred from this lending activity.

As the depositors do not take the risk of losses with Al-Wadiah accounts, they are not entitled to any profit from the use of their deposits by investors. On the other hand, the bank is entitled to all of the profits, if any, as the bank bears all of the risk.

Depositors are provided with a checkbook. They can withdraw any amount up to the balance at any time.  The bank may charge a fee on the account to cover transaction costs.  Al-Wadiah Deposits are short-term funds. Due to the liquidity to the depositor, they are not a reliable source of deposits to the banks. Thus, banks have to be very careful as to what type of projects is financed. 

General Mudaraba Account

Interest-based banks receive deposits from clients in return for being paid a fixed interest rate. These deposits are considered to be a loan from the depositors and, thus banks must pay a predetermined rate of interest based upon the daily average balance. So, under the interest-based banking system, the relationship between the bank and its depositors is essentially that of a debtor and creditor. In the case of checking deposits, depositors are provided with a checkbook. In most cases, a depositor may withdraw all or part of the funds on deposit at any time.  In some instances, depending on the type of account, notice may need to be provided to the bank for a withdrawal of money exceeding a specified amount.

The Mudaraba account of Islamic banks is different from the checking account of an interest-based bank. Mudaraba is a form of business contract where one party supplies money and the other manages the business by investing labor and time. Profits generated from the venture are shared by both in a proportion agreed upon at the time of contract. However, in this arrangement, the financier is solely responsible for any loss that may be incurred. The financier of the business is known as Sahib al Mal, Rabbul Mal or owner of the capital and the manager of the business is called Mudarib or entrepreneur.

Banks receive deposits in a Mudaraba account on the basis of a Mudaraba contract. Generally the Mudaraba account is not for any specific duration. Funds deposited in the Mudaraba account may only be invested in Shariah approved ventures through the application of a legitimate Islamic method of financing. This is why these deposit accounts are given the title Mudaraba deposits. Specifically, in this transaction, the depositor is the sahib al mal and the bank is the Mudarib. As mentioned above, profit sharing percentages are determined at the inception of the contract.  It is not uncommon for the profits generated by the investment to be distributed such that the Sahib al Mal would receive 50 to 75 percent of the profit and the bank would receive the difference. Islamic banks cannot reduce the ratio of the sahib al mal, but it can reduce its own share and increase the share of the sahib al mal, if it wishes. Here the relationship between the bank and the depositor is shareholder and not a debtor-creditor relationship as before. 

Islamic banks receive deposits in Mudaraba accounts that are invested into business ventures by the bank directly or through some other third party. Any profit earned from these investments is distributed among the Mudaraba depositors at a predetermined percentage and the bank retains the residual amount as its profit. In the event no profits are earned, the depositors receive nothing for their deposit. In addition, should a loss be incurred, the Mudaraba depositors are liable to share in the losses in the proportionate share of their deposits. However, if the loss incurred is due to the fault, negligence or non-adherence of bank rules on behalf of the bank or bank personnel, liability of loss is the banks sole responsibility.

Thus, unlike the deposits in the interest based system where the interest rate return is known with certainty, the returns in a Mudaraba account are uncertain.  The only thing that is known with certainty is that the depositor will share proportionately in the profits and losses of the lending or investing activities of the bank.  In the end, the depositor can withdraw the balance in the account plus or minus any profits or losses incurred from the loans. 

It may further be mentioned for the sake of clarity that Mudaraba depositors, in spite of being partners in the profits and losses, are not partners in the total profits and losses as in the case of bank shareholders. Rather, they are entitled to share in the profits or losses from the bank's lending activity in the proportion they actually have on deposit in the Mudaraba account. Some experts have recommended establishing a loss-offsetting fund in order to ensure that the money deposited by Mudaraba depositors is not reduced or exhausted by investments or loans that do not perform well (Ibid, p.44). This would be accomplished by depositing a percent of profits (5% or 10%) from favorable business transactions into a loss offsetting reserve account.  The loss offsetting reserve account would then be used to reimburse Mudaraba depositors for any losses due to unfavorable business deals.  

It should be noted that Mudaraba depositors do not share in the other sources of income to the bank such as profits from Al-Wadiah accounts, service charges, commissions, and other forms of income etc. Likewise, they are not liable for any losses or expenses incurred by these other banking activities either.

It is important to note that the bank is not entitled to wages, allowances or any other kind of remuneration for their time and labor spent in managing the funds deposited under Mudaraba accounts. However, they are entitled to reimbursement for normal and essential expenses associated with the managing of Mudaraba deposits.

Islamic banks distribute profit among the Mudaraba depositors on the basis of the average amount of money available in each depositor's account for a specific period of time such as one month, three months, six months or one year, depending on the contract.

General Mudaraba depositors are provided with passbooks and checkbooks. However, since the bank distributes profits to the deposit account holders, it has some regulatory control over the liquidity of the account. For example, the bank may limit the number of withdrawals allowed. The bank may require prior advance notice before withdrawing money from the account, and the bank may have a minimum required balance restriction on the account. Non-adherence to these conditions may result in the forfeiture of any profits. In addition, the bank may appropriate miscellaneous expenses to the accounts of those depositors who do not follow the account restrictions. Of course, this can only happen if the agreement includes clauses containing such restrictions.  As per Shariah rules, Mudaraba depositors cannot interfere in the activities of the bank and they do not have the right to take part in the management of the bank.  

Term Mudaraba Account

Interest-based banks receive different kinds of Term Deposits from the depositors. The deposits are generally for 3 months, 6 months, 9 months, one year, 2 years, or 3 years, and the bank pays a stated interest rate on each of these deposits, which varies depending on the term.   In general, the bank pays a higher rate of interest the longer the term of the deposit and lower rates for shorter time periods. In addition, a higher rate of interest is generally paid on term deposits than on saving deposits. Depositors are not generally allowed to withdraw money from a term deposit until the term matures. Premature withdrawal may result in penalties in excess of the interest earned, resulting in a negative return. Once a time deposit matures, the depositor may wish to reinvest for a new term. Term deposit arrangements under conventional banks result in a debtor-creditor relation as in the case of saving deposits. The bank receives deposits in exchange for a fixed rate of interest for a specific period of time. The depositors are not provided with checkbooks on term deposit accounts, but they are given term deposit certificates and as mentioned above, are paid a higher interest rate.

Islamic banks also receive term deposit from their clients. The term deposit is, of course, altogether different from that of the interest-based banks. Fixed term deposits received by Islamic banks are called "Term Mudaraba Deposits".  Generally an Islamic bank receives these types of deposits for a minimum period of 3 months to 3 years at the maximum. The bank invests the money, and shares any profits with the depositor based upon a percentage agreed upon at the time of contract. In the event a loss in incurred, depositors share the loss in proportion to the deposit in their account. At the end of the term the contract terminates and the depositors withdraw their money, plus or minus any gains or losses. The depositors, if they like, can again deposit their money for a new term under a new contract. No checkbook is issued against a Term Mudaraba Deposit, however, Term Mudaraba Certificate is provided to the depositor.

Since the term Mudaraba deposit has restrictions on the withdrawals, the bank can invest the money in projects that match the term without concerns of liquidity.  In exchange for this benefit, the bank offers higher rate of profit to a Term Mudaraba Deposit than that offered on a General Mudaraba Deposit. In fact, the longer the term deposit, the higher the profit sharing percentage and vice versa.  

Therefore, the basic difference between a term Mudaraba account and a general Mudaraba account is the specified term of the deposit. In other words, there is no specific duration or term for a general Mudaraba account, whereas the term Mudaraba deposit does have specific stated duration or term.  

Special Mudaraba Account

When an Islamic bank receives a Mudaraba deposit for investment in some specific business, sector, or project, the deposit is called a "Special Mudaraba Deposit". In this case, an Islamic bank, while receiving deposits, comes to an agreement with the depositors that the money to be received will be invested in some specific business such as the fertilizer or salt business; or in some specific sector like the industrial sector, textile sector, export-import sector; or in some specific investment sector of the bank such as real estate, shipping or a special project.  Profits earned from these types of specific projects are distributed between the bank and the Special Mudaraba depositors based a previously agreed to percentage. As before, in the event of a loss, the depositors share the loss in an amount proportional to their deposits in the account.

Special Mudaraba depositors will share only in the profit and loss of those particular businesses, sectors or projects for which they have deposited their money. They are not impacted by profits or losses from the other operations or projects in the general Mudaraba accounts. 

In summary, there are three types of Mudaraba accounts. First, is the General Mudaraba account, which does not have a specified term and is not restricted to being invested in specific project. In addition, deposits may be taken out of the General Mudaraba account on relatively short notice. A second type of account is the Term Mudaraba account. Just as the name suggests, this account is a time like deposits with a specified maturity, but is similar to the General account in that it is not restricted to specific projects. Third, is the Special Mudaraba account. These accounts can either be readily liquid like the General accounts or fixed for a specific term like the Term accounts. In addition, these accounts are invested into specific projects or industry, which is stipulated in the contract.  


1.             Chapra, M.U. (1985): Towards a Just Monetary System, published by Islamic Foundation, London, UK.  



An industrial project is a proposal for investing resources to develop facilities for the production of goods and services in a systematic manner. A project, whether a new venture or an expansion of the existing facility, is undertaken by entrepreneurs for the purpose of earning profit. The project proposal is prepared by the entrepreneur and submitted to the bank for financial assistance and support. As the bank's interest is linked with the earnings capability of the enterprise, it has to judge the worthiness or suitability of the project by applying suitable appraisal criteria. Any failure on the part of the bank to assess the soundness of the project would seriously affect the profitability of the enterprise. A project can be considered viable if it satisfies the various aspects of the appraisal criteria. The important criteria are discussed in Section 3 below. 


A sound industrial project apart from being technically and economically sound should be capable of producing early profits for both investors and the economy. They should also fit in with the long-term economic objectives of the country. The following are the general characteristics of a sound project:

a)      Readiness of a market

b)      Advantage in production costs compared to foreign or domestic competitors

c)       Long-term value to the economy.

Generally, a technically and economically viable project with a ready market and inherent cost advantage will have a prospect of high commercial profitability to attract investors. Such a project is difficult to find but can be identified if value of the project is judged by adopting scientific criteria. The major criteria for judging the value of a project are factor intensity, the plant size and complexity, foreign exchange benefits commercial profitability and natural economic criteria. Though these criteria are valuable tools for selecting a project, other non-measurable factors like politics, institutions, attitudes, social customs and the belief climate are also important.

Project appraisal provides a rational basis for determining if a project is viable. Appraisal involves detailed investigation into the various aspects of the project. The purpose is to find out whether the project is technically, economically, financially, commercially and managerially sound. The tasks of project appraisal involves determining whether technical investigation, analysis design have been adequate, whether economic study, commercial and financial study have been well done, whether financial structure is sound and whether entrepreneurial and managerial capability of the sponsors are adequate. It also involves evaluating the value of the project to the national economy. There are no standard criteria for project appraisal. Each agency has its own standards. Its objective is to determine whether those standards are met by the project. Islamic banks may develop their own standard project appraisal criteria keeping in view the Islamic principles. The viability of the project should be judged by examining the project in the following aspects.  


3.1 Technical Criteria

The purpose of technical criteria is to examine whether the project is viable with regard to every engineering and technological aspect of the project's specification and process. The technical feasibility study of a project covers a wide range of activities including a study of the availability cost, quality and accessibility of all the goods and services needed to make the project a success. It includes ensuring that the raw materials, supplies of fuel, power, water, land, labor, and heavy equipment are available in abundance.  Further technical study would examine the purpose and design of the project, technology used in the process of production, suitability of the machinery and equipment, availability of technical services and methods of quality control, schedule of implementations and sequence of balanced development of all related technical factors. A well-qualified engineer capable to assess the technical soundness of the project has to be appointed by the bank to review the plans to undertake the job. The technical report on the project should clearly show the appropriateness of the technology used in the production process and operation and its fitness in the coming several years.  Any technological advances taking place in the industry that might affect the technical and commercial soundness of the project should be indicated in the technical report of the project. As far as machinery and equipment are concerned the appraiser should particularly examine their detail specification like the year of manufacturing, materials used in it's manufacture, life of the machine, availability of spare parts, and prospects of replacement, to ensure the quality of the machinery and equipment is up to standard.  

3.2 Economic Criteria

Economic study of a project begins with a thorough analysis of the market for the product to be made or sold. Obviously no project can be a success unless there is market for its product. In a market study, it is necessary to find out the answers of three questions:  (a) How big is the market?  (b) To what extent it is likely to grow?  and (c) How much of it can the project capture?  To get the answers of these questions, the researcher must examine import statistics, which include domestic production of the item and the potential for growth in demand for the product. The critical factor in demand and market analysis is an estimate of the demand for specific product during the life of the proposed project. The size of demand, at any given point, is a function of several variable factors such as the composition of the market, the competition from the other sources of supply of the same product, the possibility of substitute products, income and price elasticity of demand, market responses to socio-economic patterns, distributive channels and consumption growth levels. Thus, while preparing the market report the analyst must carefully analyze these variables. Any mistake in the projection of demand may result in either excess production capacity or poor capacity utilization. In addition to these, the techniques used for market penetration as well as sales promotion methods should be examined carefully, so that actual sales do not fall short of the target.  

3.3 Commercial Criteria

The importance of assessing commercial viability of a project cannot be over emphasized, regardless of whether the project is a new one or an expansion of an existing business. The commercial viability is measured by determining the profitability of the project. Profitability indicates public acceptance of the product and shows that the enterprise can produce competitively. Profits provide the money for repaying the debt incurred to finance the project and are the source for internal financing of expansion.

The commercial viability of the project can be determined by estimating sales revenue, operating cost and profit margin at a given level of production and under a given set of operating conditions. In addition, the analyst should do a pro-forma analysis of the cost of production and profitability taking into consideration capacity of the entire plant, product mix, selling price, unit cost of production as well. The elements of costs covered in this computation are the direct costs including raw materials, chemicals, components, power, and labor. Repairs and maintenance, plant overhead, administrative expenses, packaging cost, sales expenses, financial expenses, and depreciation costs are also important elements of the cost of production. The analyst is to examine each element of the cost of production as well as the soundness of the sales forecast and selling price in determining the profitability of the enterprise.  

3.4 Financial Criteria 

The acceptability of the project to the bank is also dependent on the financial viability of the project. The financial study involves the analysis of capital structure, working capital financing plan, cash flow potential and profitability. Detailed analysis of proposed financial statements (Balance Sheet, Profit & Loss A/C) provide a useful indication for assessing the financial viability. In addition, calculating the usual financial ratios, debt-service coverage, fixed assets coverage, break-even analysis, return of investment, internal rate of return (IRR) should be examined carefully. The return on investment should be satisfactory compared to the opportunity cost of capital. The internal rate of return should be acceptable to the bank.  

3.5 Entrepreneurial Capability Criteria

Assessing entrepreneurial capability of the sponsor is crucially important to the financial institution as the success of the enterprise lies on his capability. The essential entrepreneurial qualities for starting and running an enterprise consist of self-confidence, ability to sense new ideas and translate them into realities, innovative and creative risk taking ability resourcefulness, profit-oriented, future oriented, hard working individuals with initiative, drive and compassion. He should also be capable of planning and managing the enterprise successfully. It is very difficult to assess the enterprising qualities of the sponsor, as there is no standard criteria to assess the enterprising quality. 

The evaluation of the entrepreneur should not be limited to assessing the above entrepreneurial qualities, but also to identify that the entrepreneur has a continuous strive for perfection in the industrial activities undertaken by him. Proper evaluation of entrepreneurs may help ensure a self-sustaining enterprise. In a developing country where financial assistance is easily available to setting up new enterprises, there is an inherent risk that unless enough precautions are taken such concessions might encourage dependence on promotional agencies.  While evaluating potential entrepreneurs, care should be taken to select those promoters who would not be satisfied with just setting up their own industries, but will collaborate in developing a self-sustained system which will help to further industrial growth of the economy. Managerial ability of the entrepreneur should also be carefully evaluated, as the key factor for successful business operation is the managerial efficiency.

 Currently there is no formal analysis put into the evaluation of the entrepreneur at most financial institutions. In order to evaluate the entrepreneurial capability of the sponsor, a bank must develop expertise in this area. One must be equipped with the required knowledge and techniques of evaluating entrepreneurs. The capacity to access entrepreneurial capability can be gained through years of experience of interviewing candidates. One must also have a clear understanding of the methods to be adopted, the characteristic traits and dimensions to be evaluated and the limitations of the techniques. A checklist may also be used to assess the essential qualities of potential entrepreneurs. In addition, modern methods of identifying the managerial qualities and risk taking ability of the entrepreneur should also be used.  

3.6 Managerial Criteria

Assessment of managerial capability of the sponsor is crucially important for any financial institutions before agreeing to finance a project.  Many enterprises fail due to the lack of managerial skills. Therefore, it is very important to assess the managerial capability of the entrepreneur.  If the entrepreneur does not posses managerial competence to run the enterprise, he may employ professional managers. Like entrepreneurial skills, there  is no standard criteria to assess managerial ability of the borrower. The managerial capability of the entrepreneur/managers can be assessed by studying the past experience, educational background, specialized training, planning ability, decision making strength, and leadership quality. Managerial competence can also be measured through interview techniques, and understanding his capability with regard to planning orientation and management techniques. In order to assess the planning orientations, a series of questions with regard to his choice of the business, process and production technology may be asked. The objective is to ensure that the candidate has the required knowledge and skills to manage the enterprise.  

3.7 Security Criteria

Every financial institution places emphasis on this aspect of the project appraisal process. The security coverage may be given by mortgaging fixed assets and freehold property, hypothetical pledge of machinery and equipment, personal guarantee of the sponsors and comprehensive insurance coverage on the project's assets and goods. It is essential to examine the title of the property and authenticity of the assets very carefully. While emphasis is placed here, it has been observed that the security coverage on a project is not an effective tool for recovering the investment. In addition, security requirements prevents a good number of emerging entrepreneurs from seeking assistance from the bank. Strict collateral requirements are not compatible with the goal of promoting entrepreneurship by the bank. The time has come for banks to find a compromise with regard to the collateral issue. Perhaps the introduction of a credit guarantee, or personal guarantee may be a solution step to the problem arising out of collateral issue.  

3.8 Benefit of National Economy Criteria

The suitability of the project can be judged by ascertaining its contribution to employment generation, value added to the economy, import substitution and the promotion of backward and forward linkage industries. The starting point for measuring national economic profitability is the calculation of commercial profitability. To estimate the economic profitability, a series of adjustments are made in the commercial cost and revenue estimates. The adjustments can be classified into three groups:

(a)    Adjustments to estimated operating cost items in which the real cost of the economy are either greater or less than the cost to the enterprise.

(b)    Adjustments to estimated operating income items in which the real benefit to the economy is either greater or less than to the enterprise.

(c)    Adjustments to estimated net operating income of the project to reflect measurable economic costs or benefits to the economy and from those that would affect the project as a commercial enterprise.

A project with high material economic profitability and low commercial profitability may be considered for financial assistance if such project warrants subsidy and special incentives from the government.

The overall decision on financing a project is the combined result of several sub-decisions made at various stages of project appraisal. The appraisal report on various aspects of the project provides a guideline for management who must ultimately decide the enterprise for financial assistance. If the bank has not yet developed a team of expertise to appraise the project, assistance from external competent experts may be sought to undertake this job.



Discounting techniques are one of the most important and meaningful tools for financial decision-making. They are of utmost importance in making a time-adjusted ascertainment of the cash flows that are expected to be generated over a period of time. These techniques have far reaching implications for present day investors in their efforts to make sound financial decisions. Islamic banking being one of the important constituents in the total financial setup of our country must take into consideration the applicability of discounting techniques to its various modes of financing. Discounting techniques are important parameters in evaluating the feasibility of a project and no meaningful capital valuation or financial analysis can be done without them.

Discounting techniques basically consider what is called in financial jargon "the time value of money". It takes into account the impact time has on the real value of money because of each cash flow is being generated/invested at different periods. This analysis is achieved by discounting the expected future cash flows with the help of a suitable rate, which is called the "discount rate or time preference rate". The application of this rate provides an investor with a sound basis as to whether to accept or reject a project. This is made possible by converting all the expected future cash flows into a present value with the help of discounting techniques, and comparing the expected outcome with the cost. Thus, if the present value of the expected outcome were greater than or less than the cost, the investor would decide to accept or reject the project respectively.


There are two discounting methods that fully recognize the timing of cash flows. The methods are: Net present value and internal rate of return. These are discussed as under.

2.1  Net Present Value (NPV) Technique

Under the NPV technique the present value of both cash inflows and outflows of a project/investment are calculated by discounting the expected cash flows using an appropriate discount rate/time preference rate. The NPV of the project is then determined by subtracting the present value of cash outflows from the present value of cash inflows. Only project/investment proposals yielding a positive NPV are accepted.

The equation for NPV assuming that all investments (cash outflows) have been made in the initial year would be:

NPV  =  [D1/ (1+ r) + D2/(1 + r) 2 + D3/(1 + r) 3 + .........  + Dn/ (1 + r) n ]  - A

Where, D1, D2, D3, ......Dn  =  Expected Cash Inflows

                                      r =  Cost of Capital/Discount Rate/Time Preference Rate

                         A =  Cost of the proposed Investment/Cash Outflows

                         n  =  Expected life of the project/investment.

In the above equation, the discount rate is assumed to be known in order that the NPV can be calculated. 

2.2  Internal Rate of Return (IRR) Technique

The IRR is another discounted cash flow technique that considers both the amount and timing of cash flows. The IRR is defined as the rate that equates the present value of cash inflows with the present value of cash outflows of a project/investment proposal. In other words, it is that discount which yields a NPV of zero for a project. It is called the internal rate as it depends solely on the outlay and proceeds associated with the project and not on any rate determined outside the project/investment. The IRR can be determined by solving the following equation for 'r':


                        A  = [D1/ (1+r) + D2/(1 + r) 2 + D3/(1 + r) 3  + .........  + Dn/ (1 + r) n ]




A -   [D1/ (1+r) + D2/(1 + r) 2  +  D3/(1 + r) 3 + ........  + Dn/ (1 + r) n ] = 0


For capital valuation models in an Islamic economy vis-a-vis Islamic banking, the discounting rate is given below:

                                                P  = r  + aY                  

Where, P = Discounting Rate

 r  =  The required rate of return identified as the marginal efficiency of Investment

Y =  The percentage share of risk-bearing by the entrepreneurs

a  =  Suitable percentage representing the relative cost of production or investment for the



Islam forbids interest/Riba, but permits trade that inevitably assumes risk in the future. On the other hand, Islamic economic activities contribute to bringing about "Economic and non-economic" returns for the entrepreneur as well as to society. Therefore, any investment under Islamic principals should seek present welfare derived through employment, higher present earnings for the community and a reasonable return to the entrepreneur himself. The point to be examined here is what could be the relationship between risk and Islamic return (both economic and non-economic). In an Islamic economy the bank and its client jointly share the price of risk. The sharing of profits and losses are undertaken by both the Islamic bank and the clients. Under the Islamic framework a project with a low expected return may be accepted if the non-economic/social components of the project are significant.  The profit earned or the loss incurred are shared by the partners on a mutually agreed upon proportion under the different Islamic modes of Financing. Unlike the conventional means of project financing, where the bank-creditor is assured of a predetermined return in the form of interest payment, the Islamic banks share with their clients both the return and the risk that a project entails. Therefore, when the risks and returns are jointly shared by the partners, it is more important that the project be evaluated as realistically as possible as the interest of both the bank and its client are at stake. No realistic and sound financial evaluation of a project would be possible without considering the time value of money. Thus, Islamic banks employ the above discounting techniques in order to determine the feasibility of the project by adjusting the expected return of the project for the "time value difference". Without such adjustments, the project's feasibility studies would tend to completely overlook the difference in the real value of money caused by the different times at which they are invested/generated.

Discount rates are used to minimize risk for both the banker and the borrower by converting the future cash flows  (that are expected to be derived from a project) into the present value and then comparing it to the cash outlays. The IRR discount approach helps to enumerate a rate through a process of trial and error that equalizes the cash inflows and outflows of a project. A project failing to generate this rate of return cannot be considered to be economically profitable. Therefore, the investors will reject such projects.  However, one basic difference that underlies the acceptability of such a project under the Islamic system is that if the non-economic/social return of the project is significant, then the Islamic bank and its partners (investors) would still accept the project to ensure greater social well-being. Whatever may be the marginal efficiency of capital in such projects, in an Islamic economy, the choice to the investor is not between today's and tomorrow's consumption but rather between today's investment return and tomorrow's investment return. Therefore, discounting techniques act as the stimulus to identify the real economic picture of any project and make the entrepreneurs aware of the economic feasibility of any investment. This aids in understanding the extent of risk assumed and ways to minimize such risk.

There is no direct relation between Riba and the discount rate. Discount techniques are tools for ascertaining the profitability of a project and are used for taking into account the time value of money and also the diminishing value of cash flows over a period of time. While Riba/interest in Islam is a forbidden means of profit generation, discounting techniques are acceptable as a financial mechanism that is used for evaluating the acceptability of a project from an investor's viewpoint.   


In a pure Islamic economy, there is no existence of inflation or devaluation of money over time. On the other hand in a capitalist economy, inflation is an accepted-part of the system. As the Islamic banks operate in such unfavorable monetary arrangements, it must take into consideration the time value of money to develop and practice pragmatic banking policies. The commonly accepted concepts of trade discounts and cash discounts must be incorporated into the Islamic Banking system to encourage early payment and to save the time value of money. As Islamic banks share profits and losses with their clients in the business ventures undertaken, they must give adequate emphasis to the time value of money, which ultimately affects the profitability of the project. As such, Islamic banks must employ discounting techniques to ascertain a more realistic picture of the profitability of the proposed project.

The gamut of financial activities falling within the purview of Islamic Banks encompasses a broad horizon that includes equity, industry, commerce, agriculture, real estate, housing, transport, and other service sectors. Islamic Banks support all commercial activities based on the Islamic principles of Shariah. A close look into the applicability of discounting techniques to the different modes of financing under the Islamic System reveals its utility under such a system.

a)      Musharaka/Shirkat

Musharaka is a partnership in which each equity contributor has a right to share in the profits of the project. Here the Islamic bank and its client enter into a temporary partnership for the purpose of investing in some project for a mutually agreed period of time. Both parties contribute to the capital in the agreed upon proportion and share profits or losses accordingly.  The Bank usually does not actively participate in the management, but does provide an overall supervision of the business.

If such partnerships are undertaken in the commercial sector, it can easily take advantage of trade discounts, cash discounts, purchase discounts and other sales discounts that may be available. Here, there is no need to use either the NPV or IRR methods of discounting. However, if such partnerships are undertaken in the industrial sectors, both NPV and IRR can be applied to forecast and identify the cash flows that are expected to be generated over the projected life of the project. Discounted Cash Flow Techniques can be of considerable help in determining the feasibility and acceptability of the project by helping to ascertain the present value of both cash inflows and outflows. Such predetermined present values of cash flows provide a sound basis to judge the profitability of project and helps the partners, the Islamic bank and its client, to decide whether the proposed project would be financially beneficial for both of them.

b)      Mudaraba

Under this Islamic mode of financing, the bank provides all of the capital for the project while the Mudarib (client) only puts contributes his efforts and skills. Under this arrangement, the bank and the client share profits in a predetermined ratio, but any loss is solely the responsibility of the bank unless the loss has been caused by the negligence or willful act of the client. The discounting techniques are applicable to Mudaraba in the same manner as that of Musharaka.

c)       Murabaha

Murabaha is a system of purchase and sales of goods by the bank. It is an ordinary contract of sales of a commodity for a profit/markup above the original price at which the bank has purchased the commodity. In such investments banks purchase and keep custody of the goods until full payment has been made by the client. Under this system both the bank and its customer (ultimate purchaser) should know the original purchase price paid by the bank and also the profit made by the bank. No element of interest may be included in the original purchase price. The Murabaha sale is used to finance, both internal and external, trade operations of a country. In the event that the client fails to make payment, the bank cancels the contract and sells the goods purchased in the open market.

Murabaha is a purely short-term commercial venture. The bank usually purchases the commodity by making cash payment and it is seldom a credit transaction. Because of the nature of payment, the bank may get a trade discount that reduces the purchase price. As mentioned above, the goods are delivered to the client after full payment of the purchase price has been made. Since payment may be made in installments, the bank may offer cash discounts to the clients to encourage early payment. Apart from this consideration, the question of time value of money is not really a concern here as it is basically a short-term investment made by an Islamic bank.

d)      Bai-Muajjal

Bai-Muajjal means credit sale of goods by the bank to the customer. Such contracts provide for a margin of profit or mark-up to the bank as mutually agreed upon by the buyer (client) and the seller (bank). Goods are kept at the disposal of the customer/buyer and the sale price can be paid either in lump sum or in installments. It can also be used for both internal and external trade operations. Like Murabaha, Bai-Muajjal is also a short-term commercial investment and therefore, the concept of discounting technique is not really applicable here.

e)      Bai-Salam

Bai-Salam means forward purchase of the potential product. Under this arrangement, the bank enters into a contract to purchase a certain quantity of the product or commodity that is to be delivered to the bank at a future date. However, the payment for the aforesaid goods is made in advance. The price of the goods must be reasonable and the bank is free to sell the goods in the open market to earn a good profit.

Bai-Salam may be used on both short-term and long-term transactions of the Islamic bank. Under such arrangement of advance purchase, the bank may receive a trade discount, which ultimately increases its profit margin. The NPV and IRR concept of discounting techniques are not relevant in short-term Bai-Salam transactions but are applicable to long-term transactions.

f) Ijara (Leasing)

Ijarah is a rental agreement between the bank and the customer. It is a relatively long term financing arrangement. Under Ijarah, the lessor (the bank) retains the ownership of the assets and the lessee (customer) has the possession and use of the asset on payment of specified rental over a given period of time. The cost of insurance of the asset leased will be borne by the lessor to make the method conform to the principles of Shariah. After the maturity of the lease contract, the bank (lessor) maintains possession of the asset for further leasing.

Under the lease contract, the bank purchases some real property and then, leases it to the client. Therefore, both the IRR and NPV methods of discounting can be used to convert the expected future inflows of rentals (over the period of the lease) into present value to ascertain its profitability. Also the initial market price of the property and the estimated market value after the expiration of the contract can be converted to net present value to assess the cost of capital, profit margin and cost incurred on the property.

g)      Hire Purchase

The hire purchase method of financing enables a bank to finance the purchase of movable and immovable assets. It is a joint ownership agreement subject to the provision of security/surety provided by the client. In addition to the repayment of the principal amount, the bank receives a share in the net rental value after allowing for necessary deduction on account of depreciation of asset. This payment is made after adjusting the bank's outstanding share of the asset, which reduces with each installment payment made by the client. The cost of insurance of the asset is shared by the bank and the other party in proportion of their capital contribution to the asset. After the full payment has been made, the client becomes the owner of the asset. Until full payment has been made the client is only entitled to the use of the asset.

Since this mode of Financing involves inflow of cash over a considerable period of time, the discounting techniques can be applied to evaluate the acceptability of the project. Each and every expected installment payment should be converted to present value by applying the appropriate discount rate. The next step would be to sum up the present value of the streams of cash inflows and compare it with the purchase price. A proposal yielding a positive net present value would be accepted and otherwise rejected. The same concept applies while applying the IRR method, whereby the minimum expected rate of return is calculated which would equate the present value of cash inflows with the initial cash outflow. An investment proposal failing to yield this minimum required rate of return should be rejected.

h)      Others

There are other investment techniques in Islamic banking such as Direct Investment by the bank, Investment Auctioning, and Qard Hasan. Except for investment auctioning, both discounting techniques cannot be applied to these types of financing, as they are basically short-term financing.  In investment auctioning, the bank may determine profit to be a Margin received from the Auction. This profit can be determined by using the NPV method of discounting.  


From the above discussion, we may legitimately state that the application of the two discounting techniques would make the various Islamic modes of financing more scientific and realistic. The puritan and simplified version of an economy, as envisioned under the broad Islamic philosophy is non-existent in the present day world. Therefore, to establish an Islamic financial system and to make it thrive over the years, we must take into account the complex inter-relations that exist among the various variables in a modern day financial set-up. This realization is essential to formulate and practice a pragmatic financial policy under the Islamic economic framework. As an important step towards that end, we must encourage the application of discounting techniques to the various modes of finance under an Islamic economy to increase their acceptability as time-adjusted mechanisms of finance that reflect the actual profitability of a project.  


(1)      Ziauddin Ahmed, Munwar Iqbal and M. Rahim Khan (Eds) (1992), Fiscal Policy and Resource Allocation in Islam, Islamic Development Bank. K.S.A.

(2)      Akkas, S.M. (1991).  Relative Efficiency of Conventional and Islamic Banking System in Financing Investment, Unpublished  Ph.D. Thesis, Dhaka University, Bangladesh.

(3)      Mannan, M.A. Trade and Commerce in Islam.

(4)      Jarhi and Ziauddin (1983). A Monetary and Financial Structure of an Interest-Free Economy: Institutions, Mechanisms and Policy.


Is accounting a mere technical matter or is there any question of ideology or value judgment? In other words, is an accounting system followed by the conventional bank compatible to Islamic Shariah or is it necessary for Islamic banks to design their own accounting system? As we know Islam is a way of life where ends does not justify means rather both ends and means should be justified. Islam has its own objectives and the ways and means to achieve those objectives. Like all others spheres of life in the banking sector Islamic scholars have developed their own banking system that differs from conventional banking system both in terms of philosophy and operational mechanism. Undoubtedly the accounting system is a very technical matter but not without any principle or philosophy. So, the principles and philosophy of the accounting system of an interest-free bank should not be as that of a conventional bank. 

1. Objectives of Financial Accounting for Islamic Banks

              There are two approaches in developing objectives and concepts of financial accounting for Islamic banks:

a)      The first approach is to deduce such objectives and concepts from the Shariah. In this way we can establish the objectives of Islamic accounting based on the principles of Islam and then consider these established objectives in relation to contemporary accounting thought.

b)      The second approach is to start with objectives established in contemporary accounting thought, test them against Islamic Shariah, accept those that are consistent with the Shariah and reject those objected by the Shariah

From among these two mutually exclusive alternative approaches of establishing objectives for Accounting and Auditing Organization for Islamic Financial Institutions have decided to adopt the second approach.

Although there is a large degree of similarity between the proposed objectives for financial accounting for Islamic banks and those developed by Western accounting professional bodies, the former require the provision of additional information regarding the compliance of Islamic banks and financial institutions with the Shariah doctrines in their business transactions.  Furthermore, it is proposed that financial accounting for Islamic banks should provide information to assist in separating prohibited earnings which occur advertently or inadvertently, if any, and to verify that such earnings have been utilized for charitable causes.

The objectives of financial accounting for Islamic banks may be described as follows:

a)      To determine the rights and obligations of all interested parties, including those rights and obligations resulting from incomplete transactions and other events, in accordance with the principles of the Islamic Shariah and its concepts of fairness, charity and compliance with Islamic business values;

b)      To contribute to the safeguarding of the Islamic bank's assets, its rights and the rights of others in an adequate manner;

c)       To contribute to the enhancement of the managerial and productive capabilities of the Islamic bank, encourage compliance with its established goals and policies and, above all, compliance with Islamic Shariah in all transactions and events; and

d)      To provide, through financial reports, useful information to users of these reports, to enable them to make legitimate decisions in their dealings with Islamic banks. 

2. INFORMATION FROM financial reports

Financial reports, which are directed mainly to external users, should provide the following types of information:

a) Information about the Islamic bank's compliance with the Islamic Shari'ah and its objectives, and to establish such compliance; and information establishing the separation of prohibited earnings and expenditures, if any, which occurred, and of the manner in which these were disposed of;

b) Information about the Islamic bank's economic resources and related obligations (the obligations of the Islamic bank to transfer economic resources to satisfy the rights of its owners or the rights of others), and the effect of transactions, other events and circumstances on the entity's economic resources and related obligations. This information should be directed principally at assisting the user in evaluating the adequacy of the Islamic bank's capital to absorb losses and business risks; assessing the risk inherent in its investments and; evaluating the degree of liquidity of its assets and the liquidity requirements for meeting its other obligations;

c) Information to assist the concerned party in the determination of Zakah on the Islamic bank's funds and the purpose for which it will be disbursed;

d) Information to assist in estimating cash flows that might be realized from dealing with Islamic bank, the timing of those flows and the risk associated with their realization. This information should be directed principally at assisting the user in evaluating the Islamic bank's ability to generate income and to convert it into cash flows and the adequacy of those cash flows for distributing profits to equity and investment account holders;

e) Information to assist in the evaluating the Islamic bank's discharge of its fiduciary responsibility to safeguard funds and to invest them at reasonable rates of return, and information about investment rates of returns on the bank's investments and the rate of return accruing to equity and investment account holders; and

(f) Information about the Islamic bank's discharge of its social responsibilities. 


3.1 The Accounting Unit

The Islamic Fiqh states that Waqf (trust foundation), mosque and Dar -al-maal (treasury) are units of accountability. The recent Fiqh thinkers extend the application of this concept to companies including an Islamic bank. It requires the identification of those economic activities that are associated with the Islamic bank and can be expressed as the bank's assets, liabilities, revenues, expenses, gains and losses. In other words there will be a separation of entity between Islamic banks and owners in terms of assets and liabilities as resolved by the Council of the Islamic Fiqh Academy. "There is no objection in Shariah to setting up a company whose liability is limited to its capital for that is known to the company clientele and such awareness on their part precludes deception." However, some activities with which the Islamic bank is associated are the activities of other accounting units.  

3.2 The Going Concern

The Mudaraba and Musharaka contracts are for specific periods. However, these are assumed to continue until and unless one or all of the parties to the contract decide to terminate the contract. Islamic banks are based on the Mudaraba contract and are, therefore, assumed to continue unless there is evidence to the contrary. Wealth is deviled by Islamic Fuqaha into money and goods. Again goods are deviled into two categories, those that are available for sale and those that are not available for sale. Examples of the second category of goods are equipment and building, which are used for longer periods implying that the entity would continue in operation. Financial accounting assumes the continuation of such an entity as a going concern. This means that in preparing the entity's financial statements it is assumed that there is no intention or necessity to liquidate the entity. The major implication of this concept is that the Islamic bank's activities, under this assumption, are assumed to represent continuous streams and the task of financial accounting is to make the most significant measurements possible of the continuous flow of the entity activities.

The going concern concept has special implications for an Islamic bank. Assumptions are made about the continuity of the bank's activities in the future, including its investment activities. However, the relationship between the bank and owners of investment accounts may not continue until the liquidation of investments, when their actual results become known. It may, therefore, be appropriate to measure investments during the life of such investments at their cash equivalent values in order to achieve equity in determining the rights of the holders of investment accounts who wish to withdraw their funds before the actual liquidation of investments. 

3.3 The Periodicity

The periodicity concept means that the life of the Islamic bank should be broken into reporting periods to prepare financial reports that provide interested parties with information or directions by which they can evaluate the performances of the accounting units.

Islam assigns certain rights to money and wealth and associates those rights with periods of time to assure that those rights are fulfilled on a timely basis. Zakat is an example of this periodicity. Because, according to Islamic Shariah, Zakat is payable on money and wealth after one year of its reaching the 'Nisab'. As prophet (peace be upon him) has said, "No Zakah on wealth until a year passes" (Daraqutni, Baihaqui). Keeping this concept in mind it is believed that there is an obligation on Islamic banks to present periodic reports reflecting their financial positions as of a given date and the results of their operations during a specific period so that rights and obligations of Islamic banks and those of interested parties could be focused. 

3.4 The Stability of the Purchasing Power of the Monetary Unit

As we know financial accounting has to use the monetary unit of a particular currency to facilitate the expression of the basic elements of financial statements. The use of a monetary unit as a means of expressing the basic elements of the financial statements is a prerequisite for measuring the financial position, results of operations and other changes in the financial position of an accounting entity during a specific period. But as we know the value of money is not stable rather it has a tendency to be changed. A persistent increase in the general price level, which is otherwise called inflation, decreases the value (purchasing power of monetary units) and vice versa. In this context economists often question the use of monetary unit as a measuring rod.

There are two schools of thought in Islamic Fiqh with respect to the effect of changes in the purchasing power of money on financial rights and obligations. One school of thought believes that changes in the purchasing power of money should be taken into account when setting financial rights and obligations. The other school of thought believes that they should be ignored. For the purpose of financial accounting, the stability of the purchasing power of the monetary unit is assumed. Regarding the opinion of the first school of thought it can be said that if the changes in the purchasing power of money are taken into account during the setting of financial rights and obligations, then it is nothing but to subscribe the concept of Riba. The Islamic Fiqh Academy reviewed this issue in its meeting held in Kuwait in December 1988 and concluded that debt should be satisfied by an equivalent number of monetary units regardless of the changes, if any, in the purchasing power of the monetary unit to avoid any implications of payment of Riba

4.  Accounting Practices 

4.1 Cash Accounting vs Accrual Accounting

There are two types of accounting, namely the cash method and the accrual method. Conventional banks follow the accrual method of accounting. The cash accounting implies that only the incomes and expenditure items that involves inflows and outflows of cash will be given consideration. Accrual accounting, on the other hand implies any income or expenditure accrued will be accounted for accordingly. One example may help to understand the concept. In our country, conventional banks show in their income statement all the interest accrued on their total investment as their income. Experience indicates that only a part of the interest accrued is realized. In this context one can easily raise the question of whether or not it is a misrepresentation on the part of a conventional bank to treat the interest accrued as income knowing fully well that only a part of it could be realized in the end. Is it not fair to show only the part of the interest accrued as income that could be realized? Islam is against any kind of misrepresentation of fact, which is called window dressing in modern accounting. So, Islamic jurists are in favor of cash accounting rather than accrual accounting. But as a matter of fact Islamic banks all over the world do not follow the same accounting system. Even one single bank practices both cash and accrual accounting for different purposes, which is apparently contradictory. Islamic banks use different profit recognition methods for the investment mechanisms, which they use in their application of funds. For example, some Islamic banks recognize the profit generated from Murabaha transactions as soon as the deals are concluded, while other Islamic banks only recognize it either when the installment is due or received in cash or when the full amount due is paid. This suggests that some Islamic banks use cash accounting while others use accrual accounting for the same type of transaction. 

4.2 Treatment of Investment Accounts

The treatment of investment accounts (and fund under management) is another issue on which Islamic banks differ. Some banks treat these accounts as an on-balance-sheet item.  The classification of investment accounts as a liability reveals the contractual relationship of these accounts with the bank. Given that these accounts are based on Mudaraba contracts and, hence, bear their own risk in the event of loss, it is incorrect to classify them as a liability. Rather, each of these accounts should be classified as a separate category by itself on the balance sheet, as will be explained below.

There is no uniformity among those Islamic banks that treat investment accounts as an on-balance-sheet item. Some treat the returns on investment accounts as an expense deducted from the bank's reserves, while in other Islamic banks they are treated as an appropriation of income. 

4.3 Reporting of Social Services

Islamic banks are also divided on the manner of reporting their social services. Some banks issue a statement of the Qard fund (for good faith loans) and /or a statement of the zakah fund showing the amounts that the bank allocated to, or received from, the public to be spent on social services and how these funds were utilized. Other Islamic banks disclose in their annual report a lump sum that they have allocated to these activities, while others do not disclose information on these activities at all.

On the other hand, not all the accounting policies used by some Islamic banks in the preparation of their financial reports match with those advocated by generally accepted Western accounting principles. For example, the Statement of Financial Accounting Standards No. 115, Accounting for Certain Investment in Debt and Equity Securities issued by the Financial Accounting Standards Board in the USA (May, 1993) requires that equity securities classified as trading securities should be reported at fair value, with unrealized gains and losses included in earnings. Islamic banks tend to measure financial assets at cost or the lower of cost or market value and ignore unrealized gains. This is because if unrealized gains are included in earnings, unrestricted investment accounts would be entitled to receive their share in these gains when earnings from mixed investments are distributed between owners of these accounts and shareholders. Furthermore, while financial accounting and reporting in the West is based mainly on accrual accounting, the accounting practices of some Islamic banks tend to rely mainly on a cash basis. 

5. Accounting System of Islamic Banks

In regard to the accounting system of the Islamic bank, it is worth pointing out that the articles which govern this system, as stated in the Bank's Law, are explained and /or detailed by the bank's Board and Management, and that these explanations are subject to the approval of the bank's Shariah Consultant, who must, in turn, elaborate the Shariah standpoint on these explanations.  Some contracts from the bank's law are stated below: 

5.1 Profits Realized From Investments

a)   Profits and losses relating to financing and joint investment activities shall be separated in the accounts from the other income and expenditure relating to other activities and services offered by the bank. The same applies to the income and expenditure of investments for specific purposes, in respect of which a separate account must be kept for each particular project.

b)   In regards to the profit income connected with its financing and investment activities, the bank may not adopt a method of accounting which takes into account estimated or expected profits, but it must confine itself to the profits realized in accordance with the nature of the operations which the bank finances, and in accordance with the following rules:

i)  In the case of individual Mudaraba, the profits shall be realized on the basis of a final settlement of accounts carried out between the bank and the party utilizing the funds, such settlement should be based on actual receipt of the cash and realization of the income and should be duly approved and accepted. The profits of each year shall be entered in the accounts of the year in which such settlement is carried out, whether in respect of the complete project or a part of it.

ii)  In the case of decreasing participation, the profit or income shall be realized on the basis of the net income derived from the project concerned until the end of the financial year, even if such income is not in fact received in cash, as in such event, the income realized shall be treated as money due but not received.

iii) In the case of purchasing for others on a pre-agreed profit basis, the profit shall be realized upon the conclusion of the subsequent contract and on the basis of the difference between the actual cost and the price agreed upon with the party who ordered the purchase.

iv)     The various financing operations shall be charged with all the direct expenses and costs arising there from, and should not be charged with any part of the general overhead expenses of the bank.  

5.2 Apportionment of Joint Investments

a)    In order to replenish the special account for meeting investment risks, the bank shall deduct annually deducts an amount equal to 10% of the net profits realized from various investment operations during that year.

b)    The amounts so deducted annually are kept in a special account to meet any losses exceeding the total profits derived from investment in that year.

c)     The deduction of such percentage should be stopped as soon as the accumulative balance of this account reaches twice the paid-up capital of the Bank.  

5.3 Distribution of Profit Between Shareholders and Investment Account Holders

There are two differing aspects regarding the distribution of profits and losses between shareholders and investment account holders of an Islamic bank:

            a)   Should investment accounts share in all types of revenues and expenses of the bank, or

         b)   Should they only participate in the revenues and expenses pertaining to their investments? 

The latter expenses do not include the administrative expenses of the bank, the external auditor fees or the remuneration of the Board of Directors. Islamic banks tend to differ on the revenues and expenses that determine the return of investment accounts. These include, among other items, gains from foreign currency transactions, provisions for bad and doubtful debts and depreciation charges.  

5.4 Distribution of Profits between the Bank and the Investors

a)   The Board shall announce by public notice the general percentage of profit to be allocated to the general funds participating in joint investments. This announcement is to be made at the beginning of the same financial year and not later than the end of the first month of each year.

b)   The bank, as joint investor, is entitled to the remaining percentage after the deduction of the amount allocated to the investors. The bank shall also be entitled to participate in the profits of joint investments in proportion to the amount of its own funds or the funds, which it is authorized to risk in joint investments.

c)   In determining the funds participating in joint investment, priority shall be given to joint investment deposits and to the holders of Joint Muqarada bonds. The bank may not consider itself as a participant in financing from its own funds in excess of the amounts utilized in financing over the total balances of the investors.

The bank, as a joint investor, shall bear any losses resulting from any cause for which it is legally liable, including any cases where authority is exceeded or insufficient care or caution is exercised by the members of the Board of Directors, the managers, employees or workers of the bank. Insufficient exercise of care for which the bank is answerable shall include any cases of fraud, a4buse of trust, collusion and similar forms of misconduct which fall short of the standards of honesty expected in the management of a joint venture operated by the bank.

Losses incurred which are not attributable to misconduct involving the exceeding of authority or failure to exercise care or caution shall be deducted from the total profits realized for the year in which such losses are incurred. Any excess of losses over the profits that were actually realized during that year shall be deducted from the reserve account opened for covering the risks of investment.

If the total profits realized in the year, together with the reserves accumulated from the previous year are not sufficient to cover the losses incurred, the bank must carry out a comprehensive assessment of expected profits and losses, based on market rates, from operations which are financed by venture funds, which have not reached the stage of final settlement by the end of the financial year. If the result of such assessment indicates that the estimated profits are sufficient to cover the excess loss, the bank must carry forward the excess loss so that it may be covered from the proceeds of the expected profits when they are realized from the operations include in the comprehensive assessment.

If, on the other hand, the estimated profits are less than the excess loss, the bank may treat it as a loss carried forward, provided that the amounts withdrawn from the joint investment deposits and the joint Mudarada bonds shall be charged with a pro-rata of the excess loss, depending on the type of the account in each case.

The Islamic legal consultant who is appointed in accordance with the provisions of this law shall ascertain the existence of a legal doctrinal (Fiqhi) basis to support the charging of any loss resulting from joint investment operations to the bank.

In case of liquidation of the bank, the depositors' rights shall be dealt with as follows:

a)   The rights of depositors in trust deposit accounts, and other deposited funds, which are not intended for investment and participation in investment profits, shall be settled first.

b)   Next the rights of depositors in joint investment accounts shall be settled in accordance with the special conditions applicable to such accounts, as well as shall the rights of the holders of joint Mudarada bonds, who shall receive the same percentage as the depositors in joint investment accounts.

c)   The rights of depositors in specific investment accounts, and of the holders of specific Mudarada bonds, shall be linked to the projects specified for each investment, and they shall bear the risk of such specific investment.

d)   The rights of shareholders shall be settled on the basis of a distribution among them of the remaining fund, in proportion to the shares held by each of them.

e)   The balance of the reserve account for covering investment risks shall be transferred, upon the liquidation of the bank, to the account of the charity (Zakah) fund to be spent for the purposes prescribed under the special law of the aforesaid fund.  

5.5 Final Accounts, Balance Sheet, Profit & Loss Accounts

            The accounts of the Bank are maintained in accordance with banking accountancy methods. The Final accounts shall be closed annually on the thirty-first day of December of every year.

The auditors who are elected in accordance with the provisions of the Articles of Association audit the Annual balance Sheet and Profit-and-Loss Accounts annually, prior to their presentation to the general meeting.

The Investment profits are distributed to investment depositors and holders of Muqarada bonds during the month of January of the following financial year.

The net profits accruing to the bank which are not realized until the end of the financing year shall be apportioned as follows:

a)   10% to the compulsory reserve account, until the balance accumulated in this account becomes equal to the capital of the Bank.

b)   5% to the remuneration of the members of the Board of Directors accounts, to be distributed among them in proportion to the number of meetings attended within the limit prescribed in the Company's Law.

c)   Any percentage the Board may deem necessary to provide a suitable reserve to meet the various liabilities, within a maximum limit of twenty percent of the net profits of that year.

d)   The balance of the profits is distributed to the shareholders in proportion to the number of shares which each of them holds.  


6.1 Murabaha and Murabaha to the Purchase Order

Measurement of asset value at accosting by the Islamic bank: Concepts of Financial Accounting for Islamic Banks and Financial Institutions stipulates that historical cost shall be the basis used in measuring and recording the assets at the time of acquisition. Therefore, the assets possessed by the Islamic bank for the purpose of selling them on the basis of Murabaha purchase order shall be measured at the time of their acquisition on an historical cost basis. In the cases where the asset value declines below cost whether due to damage, destruction or from other unfavorable circumstances, such decline shall be reflected in the valuation of the asset at the end of each financial period. 

In the case of Murabaha to the purchase ordered who is not obliged to fulfill his promise: If the Islamic bank finds that there is an indication of possible non-recovery of the costs of goods available for sale on the basis of Murabaha to the purchase order who is not obliged to fulfill his promise, the asset shall be measured at the cash equivalent (i.e. net realizable) value. This shall be achieved by creating a provision for a decline in the asset value to reflect the difference between acquisition cost and the cash equivalent value.

Potential Discount to be Obtained After Acquisition of the Asset

(a)         In cases where the Islamic bank is likely, at the time of concluding the contract with the client, to obtain a discount on the asset available for sale on the basis of Murabaha or Murabaha to the purchase order, and the discount is in fact received subsequently, such discount shall not be considered as revenue for the Islamic bank; instead, the cost of the relevant goods shall be reduced by the amount of the discount. Consideration should be given to the impact this will have on both the profits of the current period and future deferred profits.

(b)         The discount may, however, be treated as revenue for the Islamic bank if this is decided by the Shariah supervisory board of the Islamic bank. Such revenue shall be recognized in the income statement.

Murabaha Receivables

Short-term or long-term Murabaha receivables shall be recorded at the time of occurrence at their face value. Murabaha receivables are measured at the end of the financial period at their cash equivalent value. Thus, receivables are valued at the amount of debt due from the customers at the end of the financial period less any provision for doubtful debts.

Profits Recognition

Profits of Murabaha or Murabaha to the purchase order are recognized at the time of contracting if the sale is for cash or on credit not exceeding the current financial period.

Profits of a credit salewhich will be paid for either by means of one payment due after the current financial period or by installments over several future financial periods shall be recognized by using one of the following two methods:

(a)      Proportionate allocation of profits over the period of the credit whereby each financial period shall carry its portion of profits irrespective of whether or not cash is received. This is the preferred method.

(b)      As and when the installments are received. This method shall be used based on a decision by the Shariah supervisory board of the Islamic bank or, if it is required, by the Supervisory authorities. (In both 2/4/1 and 2/4/2 above, revenues and costs of goods sold shall be recognized at the time of concluding the sale contract, subject to the deferral of profits in 2/4/2.)

 Deferred Profits

Deferred profits shall be offset against Murabaha receivables in the statement of financial position.

Early settlement with deduction of part of profit

Deduction of part of profit at the time of settlement: If a client accelerates his payment of one or more installments prior to the date specified for such payment, the Islamic bank may deduct part of the profit to be agreed upon between the Islamic bank and the client at the time of settlement. The deducted amount shall be credited to the Murabaha receivable account and excluded from the profit recognized in respect of the installments. 

Deduction of part of the profit after settlement

The same accounting treatment in 2/6/1 applies if the client accelerates his payments one or more installments prior to the time specified for such payment and the Islamic bank did not allow the client a deduction of part of the profit but asked the client to pay the full amount and thereafter the Islamic bank reimbursed the client with part of the profit. 

Procrastination in payment by, or insolvency of, the client

Procrastination: If the client is delinquent in paying his debt installments, then any additional amount received by the Islamic bank from the client as a penalty (either by mutual agreement or by court ruling) shall be treated according to what the Shariah supervisory board of the Islamic bank deems appropriate either as:

            a) Revenue to the Islamic bank; or

            b) An allocation to a charity fund.

Insolvency: If it becomes evident that the client's non-payment was due to insolvency, then the Islamic bank cannot ask the client to pay any additional amount by way of penalty.       


Recognition of Mudaraba capital at time of contracting

Mudaraba financing capital (cash or kind) is recognized when it is paid to the Mudarib or placed under his disposition.

If it is agreed that the capital of a Mudaraba is to be paid in installments, than each installment is to be recognized at the time of its payment.

If the conclusion of a Mudaraba contract is contingent on the occurrence of an event in the future or is delayed to a future time, and the payment of the Mudaraba capital is conditional upon the occurrence of that event, then the Mudaraba capital is to be recognized only when it is paid to the Mudarib.

Mudaraba financing transactions are to be presented in the Islamic bank's financial statements under the heading of": Mudaraba financing." Mudaraba capital provided in the form of non-monetary assets is to be reported as "non-monetary Mudaraba assets." 

Measurement of Mudaraba capital at the time of contracting

Mudaraba capital provided in cash by the Islamic bank is to be measured by the amount paid or the amount placed under the disposition of the Mudarib.

Mudaraba capital provided by the Islamic bank in kind (trading assets or non-monetary assets for use in the venture) is to be measured at the fair value of the assets (the value agreed between the Islamic bank and the client), and if the valuation of the asset results in a difference between fair value and book value, such difference is to be recognized as profit or loss to the Islamic bank itself.

Expenses of the contracting procedures incurred by one or both parties (e.g., expenses of feasibility studies and other similar expenses) are not considered as part of the Mudaraba capital unless otherwise agreed by both parties. 

Measurement of Mudaraba capital after contracting at the end of a financial period

Mudaraba capital is to be measured at the time that the assets are provided to the Mudarib. However, any repayment of the Mudaraba capital is to be deducted from the Mudaraba capital.

If a portion of the Mudaraba capital is lost prior to the inception of work because of damage or other causes without any misconduct or negligence on the part of the Mudarib, then such loss is to be deducted from the Mudaraba capital and is treated as a loss to the Islamic bank. However, if the loss occurs after inception of work, it shall not affect the measurement of Mudaraba capital.

If the whole Mudaraba capital is lost without any misconduct or negligence on the part of the Mudarib, the Mudaraba is terminated and the account is to be settled with the loss being treated as a loss to the Islamic bank.

Recognition of the Islamic bank's share in Mudaraba profits or losses

Profits or losses in respect of the Islamic bank's share in Mudaraba financing transactions that commence and end during a single financial period shall be recognized at the time of liquidation. In the case of Mudaraba financing that continues for more than one financial period, the Islamic bank's share of profits for any period, resulting from partial or final settlement between the Islamic bank and the Mudarib, shall be recognized in its accounts for that period to the extent that the profits are being distributed; the Islamic bank's share of losses for any period shall be recognized in its account for that period to the extent that such losses are being deducted from the Mudaraba capital.

If the Mudarib does not pay the Islamic bank its due share of profits after liquidation or settlement of account is made, the due share of profits shall be recognized as a receivable due from the Mudarib.

Losses resulting from liquidation shall be recognized at the time of liquidation by reducing the Mudaraba capital.

The Mudarib shall bear the losses incurred due to misconduct or negligence on his part. Such loss shall be recognized as a receivable due from the Mudarib


Recognition of the Islamic Bank's Share in Musharaka Capital at the Time of Contracting

The Islamic bank's share in Musharaka capital (cash or kind) is to be recognized when it is paid to the partner or made available to him on account of the Musharka. This share shall be presented in the Islamic bank's book under a Musharaka financing account with (in the name of the client) and it should be included in the financial statement under the heading "Musharka financing". 

Measurement of Islamic Bank's Share in Musharaka Capital at the Time of Contracting 

a)         The Islamic bank's share in the Musharaka capital provided in cash is to be measured by the amount paid or made available to the partner on account of Musharaka

b)         The Islamic bank's share in Musharaka Capital provided in kind (trading assets or non-monetary assets for use in the venture) is measured at the fair value of the assets (value agreed between the partners), and if the valuation of the assets result in a difference between fair value and book value, such difference shall be recognized as profit or loss to the Islamic bank itself.

c)         Expenses of the contracting procedures incurred by one or both parties (e.g., expenses of feasibility studies and other similar expenses) should not be considered part of the Musharaka capital unless otherwise agreed by both parties. 

Measurement of the Islamic Bank's Share in Musharaka Capital  After Contracting at the End of a Financial Period 

a)          The Islamic bank's share in the constant Musharaka capital is to be measured at the end of the financial period at historical cost (the amount which was paid or at which the asset was valued at the time of contracting)

b)          The Islamic bank's share in the diminishing Musharaka is to be measured at the end of a financial period at historical cost after deducting the historical cost of any share transferred to the partner (such transfer being by means of a sale at fair value). The difference between historical cost and fair value shall be recognized as profit or loss in the Islamic bank's income statement.

c)          If the diminishing Musharaka is liquidated before complete transfer is made to the partner, the amount recovered in respect to the Islamic bank's share shall be credited to the Islamic bank's Musharaka financing account and any resulting profit or loss, namely the difference between the book value and the recovered amount, Is to be recognized in the Islamic bank's income statement.

d)          If the Musharaka is terminated or liquidated and the Islamic bank's due share of the Musharaka capital (taking account of any profits or losses) remains unpaid when a settlement of account is finalized, the Islamic bank's share shall be recognized as a receivable due from the partner.  

Recognition of the Islamic Bank's Share in Musharaka Profits or Losses

a)         Profits or losses in respect of the Islamic bank's share in Musharaka financing transactions that commence and end during a financial period is to be recognized in the Islamic bank's accounts at the time of liquidation.

b)         In the case of a constant Musharaka that continues for more than one financial period, the Islamic bank's share of profits for any period, resulting from partial or final settlement between the Islamic bank and the partner, is to be recognized in its accounts for the period in which the profits are distributed.  On the other hand, the Islamic bank's share of losses for any period is to be recognized in its accounts for that period to the extent that such losses are being deducted from its share of the Musharaka capital.

c)         Item 4(b) also applies to a diminishing Musharaka, which continues for more than one financial period, after taking into consideration the decline in the Islamic bank's share in Musharaka capital and its profits or losses.

d)         As implied by item 3(d) above, if the partner does not pay the Islamic bank its due share of profits after liquidation or settlement of account is make, the due share of profit is to be recognized as a receivable due from the partner.

e)         If losses are incurred in a Musharaka due to the partner's misconduct or negligence, the partner shall bear the Islamic bank's share of such losses. Such losses are to be recognized as a receivable due from the partner.

f)          The Islamic Bank's unpaid share of the proceeds as mentioned above in items 3(d) and 4(d), is to be recorded in a Musharaka receivables account. A provision is to be made for these receivables if they are doubtful.   


Banking services are probably the fastest growing services of the modern world. The industrial revolution was a milestone for the development of the banking industry. With the acceleration of the pace of industrialization throughout the world the growing need for financial intermediation was a reality. However, until World War-II there was no real development in this sector. After the World War was over, the banking industry played a vital role to rebuild the war-damaged countries. Japan, in particular became a unique example in this regard. The banking industry in Japan took the initiative to erect the modern industrialized Japan. But still no significant innovation was found until 1960. By February 1961, a key banking innovation occurred - the introduction of the first effective negotiable certificate of deposit (CD). The instrument was introduced by First National City Bank of New York (the present day Citicorp). The term "Liability Management" came into the banking arena after this innovation, because it permitted banks to purchase funds and thereby manage their liabilities. Since then, numerous financial and technological innovations have been introduced on an ongoing basis. While the 1960s and 1970s were a time of growth in the banking industry, the greatest number of innovations and changes (e.g. mergers, consolidations and failures) occurred over the past two decades.

7.1 Innovations of Financial Services and Emergence of Electronic Banking

Technological innovation in the banking sector has been manifested primarily in the form of electronic funds transfer system (EFTS or EFT systems). The basic components of EFTS are automated teller machine (ATMs), point of sale (POS) terminals and the automated clearinghouse (ACHs). Less visible than EFT, but more important to a bank's ability to operate efficiently is the bank's "back office technology" (i.e. its computer operating systems). Banking has come a long way from the times of barter trading. Modern banking uses three forms of transferring value: physical currency, checks, and in an age of technology, electronic fund transfers. However, checks are by far a dominant means of payment, but that may change in the years ahead.  

7.2 Structures and Classification of Electronic Banking

The concept of electronic banking system is a computer-based technology for rendering banking services. Electronic banking systems can be broadly divided into two categories, namely back-office electronic banking and front-office electronic banking services. Since inception of electronic banking, it has gone through a comprehensive evolution process. The evolution of electronic banking, both front and back office systems can be grouped into three categories; first, second and third generation electronic banking.

First Generation electronic banking rendered back office services like ledger keeping, cash management and so called Management Information Systems. The front office services were cash dispensers or ATMs.

The Second Generation of electronic banking got some extended back-office services like transaction, processing (off-line), ACHs, record keeping and fund transfer systems. The front-office services that evolved during this phase were telephone bill payment, point-of-sale (POS) systems, check verification, ATMs and authorization.

The present status of the electronic banking system could be termed The Third Generation of electronic banking. This era of electronic banking enjoys back office services like on-line transaction processing, centralized processing at country level, internet banking, and inter bank transaction processing to name a few. The front-office services of this era are automatic fund transfer, on-line banking, electronic home banking, and direct deposit, check truncation, lock box check truncation, electronic fund transfer electronic check representation and internet banking

Banks to provide higher quality financial services to their customers are using information technology.    

7.3 Status of Electronic Technology in the Banking Sector of Bangladesh

Bangladesh Bank, the "Central Bank" of Bangladesh, has installed computerized MIS (Management Information Systems) very recently to ensure the efficient flow of information among its different locations throughout the country. However, it should be noted that it has yet to get its MIS fully automated to get the desired performance. The MIS, within the bank, is mainly performed by the Computer Department. Data which are collected from different banks and primary sources are stored in the bank's database. This data bank is used for the following purposes:

i)   to conduct research on various issues relating to banking and finance;

ii)  to determine trends in different aspects of banking operations;

iii) to publish articles in journals, monthly bulletins, annual reports and other information;

iv) to disclose all types of information to the top management of the bank; and

v) to supply the Government with necessary information to facilitate the formulation of policy regarding  money and capital markets.

In Bangladesh nationalized, private and foreign commercial banks are engaged in business. Most of the local banks have limited computer systems. All the banks have their own computer department in the main office location and have added the highest volume branches to the network. Unfortunately, most of the banks are not serious about the utilization of high information technology for collecting information, processing, analyzing and implementing. The use of computer technology in the local banks is still in an infant stage. In a limited sphere they are installing modern technology. Network system between the Bangladesh Bank and various banks' head offices have not yet been developed. In most of the local banks personal computers are used on a stand-alone basis.  Due to lack of inter-branch communication, customers are not receiving the quality service that they deserve. Foreign banks are already using computerized banking systems. In fact, some of the foreign banks have already introduced 24-hour withdrawal facilities to their customers.

There is a positive attitude among the top management of the local nationalized and private commercial banks towards the modernization of their information systems, but the success is not yet realized as most of the data is being collected on the basis of a batch processing system. Sonali Bank is making an effort to develop an integrated computerized system through creating networks with their 68 zonal offices and 7 GM offices (outside Dhaka). Currently, information is provided to management from the research and planning department, central accounts department, international division, audit and inspection department, branches department, and various other parts of the bank. However, the research and planning department, on a monthly basis, submits statistical information about Sonali Bank to the top-level management, which is mostly collected through disks or in a prescribed format. Similarly, the computer division of Agrani Bank collects information on a prescribed format to submit to their management. The Agrani Bank tried to link a branch on a test basis in Dhaka City through a network system from Head office, but the experience was not a success due to a disruption in the telecommunication system. Currently Agrani Bank has created a MIS cell as a means of utilizing technology.

The MIS department of Janata bank collects information from 64 regional offices and other departments and divisions through disk. It has also made continuous efforts to strengthen its MIS by creating a network system. Rupali bank has its own MIS department, but is not very effective and efficient in utilizing high information technology. Uttara bank has established the MIS and computer department but it is still using a blend of manual and computer based systems.  Development banks and financial institutions like BKB, BSB and BSRS are still lagging behind the utilization of modern technology based information management.

Most of the foreign banks are trying to use computerized systems in order to take advantage of the superior technology available to provide quality customer service better information to management. Foreign banks, through the successful use of a global network, have increased the timeliness and accuracy of information, benefiting its customers, its employees and also its management. Hongkong Bank, ANZ Grindlays Bank and Standard Chartered Bank are using more or less an integrated network. They are collecting information through on-line systems and providing network links to their valued customers. American Express Bank is also using a proprietary network system. Citicorp, uses technology to gather relevant information about the bank's operations at month end, organizes the data and sends it to it's home office via electronic media. Finally, Habib Bank Ltd. has only one branch that collects information and sends reports to its Head Office on monthly basis.   

7.4 Need for Using Modern Technology and Appliance by an Islamic Bank

In today's advanced society it is obvious that technology is needed to render better service to bank customers. Islamic banking is no exception. Like any other bank an Islamic bank can also enjoy the following advantages by introducing modern machines and appliances in its accounting and other systems. 

a)      By introducing a modern system in accounting, Islamic banks can improve their customer service. In a traditional accounting system a manager has to apply a time consuming process, which involves a number of employees to supply the required information to a valued customer. In contrast, the same customer could be served with a modern system simply with the touch of a button Cashing a check would be an easier transaction for customers of the bank.

b)      By introducing an electronic banking system an Islamic bank can be more competitive. It should not be forgotten that this is the age of electronic service. In this context, the sooner the Islamic banks adopt modern technology, the better for the sustainability and development of Islamic banking as an alternative banking system.

c)       Presence of a well-designed MIS with fully electronic banking system will enrich the research department of Islamic banks. Research information on various banking operations will be much easier to generate.

d)      A well-constructed MIS will be able to provide management with updated information on a timelier basis. Top management will be in a position to evaluate the performance of the bank both at micro and macro level without depending on the manual systems.

e)      Electronic banking will save time for both bank management and the clients. Initially it may increase the transaction cost but with the passage of time the cost of transaction will go down.

f)        A full MIS supported by electronic banking will uphold the image of Islamic banks. The bank will be more attractive to the modern clients.



Liquidity is the ability to raise funds easily by selling assets (Hornby 1974).  It is a measure of how easily an asset can be turned into cash. Generally, liquid assets are measured by deducting the value of inventory from current assets. An increase in cash assets enhances liquidity and reduces liquidity risk, which in turn affects the level of profitability. Therefore, liquidity management involves a trade-off between risk and return. It involves forecasting a company's cash needs and providing for these needs in the most cost-effective way (Pandey 1986, pp.336-37). In a nutshell, liquidity management is the management of risk and return of investments.

For banks, liquidity management involves the estimation of the demand for funds by the public and the provision of sufficient reserves to meet these needs. It is the function of liquidity management to estimate the size of demand for funds and fulfill the demand in a manner consistent with the maximization of shareholder's wealth. A bank always must be in a position to fulfill the demands of its depositors. Hence it requires holding in reserve that amount of cash necessary to satisfy the demands of depositors. If a bank does not maintain sufficient liquid assets to meet such demand requirements, it is likely to have liquidity problems.  Failure to maintain the necessary liquidity could lead to the banks ultimate failure.  So maintenance of comparatively small percentage of liquid assets is not favorable to running a bank successfully. With this end in view, Bank Company Act-1991 provides the provision for maintenance of liquid assets for each bank in Sections No. 25 and 33. Accordingly, banks are required to monitor liquidity in two ways: (a) Cash Reserve Ratio and (b) Supplementary Reserve Ratio. When combined, these are known as Statutory Liquidity Requirement.


Short Term Liquidity: The fundamental objective in managing a legal reserve position is to meet the minimum requirement at the lowest cost. Because vault cash needs are determined by customer preferences, they vary largely with the payments patterns of the bank's customers and local businesses. They also exhibit well-defined seasonal patterns that are easily forecasted. When a bank needs additional vault cash, it simply requests a cash delivery from its Central Bank or a correspondent bank. It similarly ships any excess cash when appropriate.

Long-term Liquidity: The long-term liquidity planning involves projecting funds needs over the coming year and beyond if necessary. Projections can be separated into four categories viz., base trend, short-term, seasonal, and cyclical values. The analysis may assess a bank's liquidity gap, measured as the difference between potential uses of funds and anticipated sources of funds, over monthly intervals. 


Liquidity is of vital importance to the daily operations of a bank. Maintenance of a sound liquidity position of the bank is necessary to protect the bank against uncertainties of its business. But the pertinent question is that how much liquidity should be maintained to ensure the profitability of the bank?  In other words, if the bank maintains a small deposit balance, its liquidity position becomes weak and suffers from a paucity of cash to make payments. On the other hand, investing released funds in some profitable opportunities can attain a higher profitability. When the bank does not have an adequate deposit reserve to cover liquidity needs it may have to sell its marketable securities to raise the necessary liquidity.  On the other hand, if the bank maintains a high level of deposit reserves, it will have a sound liquidity position, but forego the opportunities to earn profit through investment. The potential profitability lost on holding large deposit involves an opportunity cost to the bank. Thus, the bank should maintain an optimum level of deposit balances, i.e., neither too small nor too large of a deposit reserve balance.

It appears that maintenance of liquidity bears both risk and return. A trade off between these two elements can minimize the conflict between liquidity versus profitability of a bank. Koch (Ibid, pp.485-86) believed that there is a short-run trade off between liquidity and profitability. The more liquid a bank is, the lower are its return on equity and return on assets, all other things being equal. Both asset and liability liquidity contribute to this relationship. The composition and maturity of funds influence asset liquidity. Large holdings of cash assets clearly decrease profits because of the opportunity cost of forgone investment income. In terms of the investment portfolio, short-term securities normally carry lower yields than comparable longer-term securities. Banks that purchase short-terms securities thus increase liquidity, but at the expense of higher potential return.

He also argued that a traditional bank's loan portfolio displays the same trade-off. Loans carrying the highest yields are the least liquid. Yields are high because default risk or interest rate risk is substantial and the investment administration expense is high.  Loans that can readily be sold usually are short-term credits to well-know corporations or government-guaranteed instruments and thus carry minimal spreads. Amortized loans in contrast, may provide liquidity even though they are frequently long term because the periodic payments increase near-term cash flow.

Further the author described that in terms of liability liquidity, banks with the best asset quality and highest equity capital have greater access to purchased funds. They also pay lower interest rates and generally report lower returns in the short run. Promised yields on loans and securities increase with the perceived default risk of the underlying issuer. Banks that acquire low-default risk assets, such as US government securities, forego the risk premium that could be earned. Interestingly, many banks buy US agency securities because the incremental yield more than compensates for perceived differences in default risk relative to US treasuries. Similarly, banks with greater equity financing exhibit lower equity multipliers and thus generate lower returns on equity, even with identical returns on assets. These banks can borrow funds more cheaply because a greater portion of their assets has to be in default before they might fall.

Again he advised Bank Management by saying that liquidity planning focuses on guaranteeing that immediately available funds are available at the lowest cost. Management must determine whether liquidity and default risk premiums more than compensate for the additional risk on longer-term and lower-quality bank investments. If management is successful, long-term earnings will exceed peer banks' earnings.  In addition the bank's capital will increase resulting in overall better liquidity. The market value of bank equity will increase relative to peers as investors bid up stock prices.


When liquidity needs are filled in an unplanned way (e.g., selling long-term investments or calling loans), shareholders' value is likely to be reduced. The damage to the shareholders' position from poor liquidity planning is particularly evident when failing to satisfy depositors' demand or not accommodating legitimate investment requests causes shortfalls.  The inability of an institution to satisfy depositors' withdrawal requests can lead to severe regulatory action, culminating in assumption or liquidation and thus, the complete destruction of shareholder's value. Inadequate funding of the investment portfolio disrupts customer relationships and could permanently reduce a bank's market share. However, this is not to say that liquidity policy should be completely defensive. On the contrary, a flexible liquidity strategy includes the ability to seize unexpected profit opportunities.

Timothy W. Koch (second edition, pp.483-85) mentioned that historically, liquidity management focused on assets and was closely tied to investment policies. Under commercial loan theory prior to 1930, banks were encouraged to make only short-term, self-liquidating loans. Such loans closely matched the maturity of bank deposits and enabled banks to meet deposit withdrawals with funds from maturing loans. An inventory loan, for example, would be repaid when the borrower sold the items that coincided with the need for financing to accumulate additional inventory. A bank was liquid if its loan portfolio consisted of short-term loans.

The shift ability theory represented the next extension by recognizing that any liquid asset could be used to meet deposit withdrawals. In particular, a bank could satisfy its liquidity requirements if it held loans and securities that could sell in the secondary market prior to maturity. The ability to sell government securities and eligible paper effectively substituted for illiquid, longer-term loans with infrequent principal payments.

Around 1950 the focus shifted to the anticipated income theory, which suggested that liquidity requirements and thus loan payments should be tied to a borrower's expected income. Banks were still encouraged to invest in marketable instruments but now structured loans so that the timing of principal and interest payments matched the borrower's ability to repay from income. The primary contribution was the emphasis on cash flow characteristics of different instruments because a borrower's cash flow generally varied closely with his or her income. This encouraged the growth in amortized loans with periodic interest and principal payment and staggered maturities in a bank's bond portfolio.

According to the liability management theory, banks can satisfy liquidity needs by borrowing in the money and capital markets. When they need immediately available funds, they can simply borrow from the central bank or other commercial banks. This theory became increasingly popular as banks gained the ability to pay market interest rates on large liabilities. The fundamental contribution was to consider both sides of a bank's balance sheet as sources of liquidity.

Today, banks use both assets and liabilities to meet liquidity needs. Available liquidity sources are identified as compared to expected needs. Management considers all potential deposit outflows and inflows when deciding how to allocate assets and finance operations. Key considerations include maintaining high asset quality and a strong capital base that both reduces liquidity needs and improves a bank's access to funds at low cost. 


Items in details under Demand and Time liabilities are shown below:

Various items of demand and time liabilities should be shown in the weekly statement of position as per the following classification:

A.      Demand Liabilities

a)      Demand Deposits (General)

i)                    All Current Accounts except from Banks

ii)                   All Investment (Cash Credit) Accounts Credit Balances

iii)                 Demand Portion of Savings Bank Accounts

iv)                 Overdue Fixed Deposits A/Cs

v)                   Call Deposits A/Cs other than from banks (on Demand)

vi)                 Unclaimed Balances A/Cs

vii)                Profit (Interest) accrued on above A/Cs.

viii)              All other Deposits payable to public on demand e.g. 

(1)          Outstanding Bills

(2)          Payment orders

(3)          Telegraphic Transfers

(4)     Outstanding Drafts

(5)     Drafts Payable Account

(6)     Demand Drafts

(7)     Hajj Deposits

(8)     Bonus Scheme Remittances Payable

(9)     Branch Remittances Payable

(10)   Bill Payable

(11)   Certificates Payable

b)      Deposits from Banks

i)                    Current Accounts and demand portion of savings account

ii)                   Call Deposits

iii)                 Profit (Interest) Accrued on Call Deposits

c)       Borrowings from Banks

i)                    Borrowings from Banking Companies

ii)                   Call Loans or sale of T.Ts. or D.Ds. (other than from Bangladesh Bank).

d)      Other Demand Liabilities (e.g)

i)                    Cash Security (Margin) on L/Cs

ii)                   Cash Security (Margin) on Guarantees

iii)                 Lockers Key Security Deposits

iv)                 Unclaimed Dividend/Dividend Payable

v)                   Credit Balance and Adjustment Account

vi)                 Security Deposit A/C (amount deposited by Supplier of Stationary and furniture etc. as security)

vii)                Sundry Deposits A/C

viii)              Any other miscellaneous deposits payable on demand 

B.       Time Liabilities 

a)      Time Deposits (General)

i)                    Fixed Deposits from Customers other than from banks      

ii)                   Special Notice Deposits other than those from other banks

iii)                 Time portion of the Savings Bank Deposits*

iv)                 Short Term Deposit A/Cs

v)                   Recurring Deposits

vi)                 Profit (Interest) accrued on all above accounts 

b)      Deposits from Banks

i)                    All Deposits from banking companies not payable on demand such as:

a)                  Fixed Deposits

b)                  Short Term Deposits

c)                   Special Notice Accounts

d)                  Time portion of Savings Bank Accounts 

ii)         Profit (Interest) accrued on all above deposits 

c)       Borrowings from Banks

i)                    Fixed Loans 

d)      Other Time Liabilities

i)                    Employees' Provident Fund Accounts

ii)                   Staff Pension Fund

iii)                 Employees' Security Deposits

iv)                 Staff Guarantee or Security Fund

v)                   Contribution towards Insurance Fund

vi)                 Any other miscellaneous liabilities payable on notice or after a specified period 


            Statutory Liquidity Requirement (SLR) is determined on the basis of the assets and/or liabilities of the banks during an accounting period. This is composed of, as stated above, two terms viz., (a) Cash Reserve Ratio and (b) Supplementary Reserve Ratio. The current SLR in Bangladesh is 20% of the total demand and time liabilities. These ratios are explained thus.

6.1 Cash Reserve Ratio (CRR)

            Every deposit money bank (DMB) is required to place on deposit with the central bank a prescribed percentage of the bank's deposits.  In Bangladesh, the current percentage is 4 of the total demand and time liabilities. By varying this reserve, the central bank can either broaden the monetary base or sterilize part of the commercial bank's money creating powers.

Banks hold cash assets to satisfy four main objectives. First, banks supply coin and currency to meet customers, regular transactions needs. The amount of cash in a bank's vault corresponds to customers' cash deposits and the demand for cash withdrawals. Both exhibit considerable seasonal fluctuations, rising prior to holidays such as the Eid Festival. Second, regulatory agencies mandate legal reserve requirements that can only be met by holding qualifying cash assets. Third, banks serve as a Clearing House for the Nation's check payment system. Each bank must hold sufficient balances at the Central Bank so that checks written by its depositors will clear when presented for payment. Finally, banks use cash balances to purchase services from correspondent banks.

Obviously, banks prefer to hold as little cash as possible without creating shortage problems that would interfere with the daily operations. Since cash does not generate interest income, excess holdings have a high opportunity cost represented by the interest or profit that could be earned on an alternative investment. As the bank's reserve rises, so do the opportunity costs and the incentive to better manage the cash assets. There are, however, significant risks in holding too little cash. Imagine depositors' concerns if they were told that their bank did not have enough currency on hand for withdrawals. A bank must similarly keep enough deposit balances at the central bank to cover deposit outflows or it will be forced to replenish its balances under duress. Failing to maintain sufficient cash assets potentially creates liquidity problems and increases borrowing costs.

The amount of cash that management chooses to hold is heavily influenced by the bank's liquidity requirements. The potential size and volatility of its cash requirements in turn affect the liquidity position of the bank. Transactions that reduce cash holdings normally force a bank to replenish cash assets by issuing new debt or selling assets. Transactions that increase cash holdings provide new funds. From the opposite perspective, banks with ready access to borrowed funds can enter into more transactions because they can borrow quickly to meet cash requirements.

6.2 Supplementary Reserve Ratio (SRR)

Banks are required to maintain SRR on all days of the month amounting to 16% for the conventional banks and 6% for the Islamic banks of their total demand and time liabilities. The assets that are used by the DMB to meet this requirement in Bangladesh include:

(i)                  DMBs deposits with the central bank, commonly known as scheduled banks balances with the Bangladesh Bank (BB),

(ii)                Cash in tills or vault cash with the DMBs,

(iii)               Investments in Government Securities and treasury Bills,

(iv)               Investment in BB Bills,

(v)                Balances with Sonali bank as agent of BB,

(vi)               Benefits and barter accounts and Investment in unencumbered Approved Securities, and

(vii)             Any other Monetary and fiscal instruments as prescribed by the BB. 

Currently in Bangladesh, SRR is 16% for the conventional banks and 6% for the Islamic banks.

6.3 Calculation Procedure of SLR

      (A Hypothetical Example) 

The calculation for the appropriate reserve amount is calculated on Thursday, the last working day of the week, and is required to be kept on deposit throughout the next week until the reserve requirement is calculated again. In Bangladesh, Islamic banks are, as stated above, required to maintain 4% as CRR and 6% as SRR (SLR = 10%), whilst a conventional bank is required to maintain 4% as CRR and 16% as SRR (SLR = 20%). Calculation of SLR is illustrated in Tables 1 and 2.

Table - 1

Total Deposits of Private Commercial Banks

(AS on December 2000) 

1st Week

2nd Week

3rd Week

4th Week

5th Week



















4671.06 (20%)

2335.53 (10%)

As depicted in Table 1, the weekly average of total deposits of the Private Commercial Banks (PCBs) stood at Tk. 23355.31 crores as on December 2000. The required level of SLR for the PCBs is Tk. 4671.06 crores as per 20% provision for the conventional banks, whilst the same for the Islamic banks is Tk. 2335.53 as per 10% provision. Of the 20% or 10%, each bank is required to maintain 4% of the SLR as CRR in cash as stated above. Therefore, after keeping 4% cash reserve with the BB as CRR (i.e., Tk. 186.84 crores) for the conventional banks or Tk. 93.42 crores for the Islamic banks, the remaining 16% or 6% (as the case may be) must be maintained as SRR.

In Table 2 are shown the breakdown of the demand and time liabilities of the PCBs. 

Table - 2

Breakdown of the Demand and time Liabilities of the PCBs

(As on December 2000) 

Deposits Including Inter-Bank Items  

1st Week

2nd Week

3rd Week

4th Week


Demand Liabilities

1         Deposits (General)

2         Deposits from Banks

3         Borrowings from Banks

4         Borrowings from the Non-banking Financial Institutions

5         Other Demand Liabilities










































Time Liabilities

6. Deposits (General)

7. Deposits from banks

8. Borrowings from Banks

9. Other Time Liabilities







































Deposits Excluding Inter-Bank items (Items: 1 & 5 + 6 & 9):

      Demand Deposits

       Time Deposits



























 The contents of Table 2 gives that the average deposits to be considered as base figure for calculating SLR is Tk. 23355.31 crores. 


7.1 Primary Reserve

 Once bank management has estimated the overall liquidity requirement, the first allocation of funds is made to primary reserves. This conceptual asset category includes vault cash, deposits at the central bank, balances with other depository institutions, and cash items in the process or collection. The high priority of primary reserves is the result of several factors: First, commercial banks are required by law to keep a specified percentage of total deposits in the form of primary reserves. Second, cash reserves are needed in the daily operations of commercial banks for paying and clearing checks. Finally, excess reserves may provide a first line of defense against unexpected deposit outflows or an unanticipated strengthening of investment demand.

7.2 Secondary Reserve

 Secondary reserves provide protective liquidity for forecastle cash needs as well as for more remote contingencies. Secondary reserves of traditional banks consist of short-term open market securities. Islamic banks can also hold Islamic bonds and securities like Mudaraba and Musharaka or other securities approved by Islamic Shariah. In contrast to primary reserves, secondary reserves can earn an explicit return, thus enhancing the profitability of the institution. The average maturity of the securities included in secondary reserves may vary. In addition to having near-term maturates, the securities in this category must have a low default risk and a market value with limited exposure interest rate movements. Being highly marketable and reversible, secondary reserves provide the commercial bank with its principal source of liquidity.


  1. Hornby, A.S.(1974 ). Oxford Advanced Learners' Dictionary. Oxford University Press.

  2. Koch, Timothy, W., Bank Management, Second ed. (The Dryden Press, N.Y.).

  3. Pandey, I.M. (Ed.) (1986). Financial Management. Vikash Publidhing House (Pvt) Ltd. New Delhi.



Working capital may be defined as those assets held for current use within a business, less the amount due to those who await settlement in the short term for value supplied in whatever form. A business enterprise has to maintain an adequate amount of working capital to ensure its liquidity so that the firm does not face any difficulty to meet its current obligations.

There are two concepts of working capital namely gross working capital and net working capital. Gross working capital refers to the firm's investment in current assets. Current assets are those assets that can be converted into cash within an accounting year or within the operating cycle, whichever is greater. It includes cash in hand, cash at bank, bills receivable, sundry debtors, stock in trade, prepaid expenses, accrued incomes and temporary investments. The term net working capital implies the difference between current assets and current liabilities. Liabilities that are payable within the next accounting year or operating cycle are referred to as current liabilities and include bank overdrafts, short-term loans, outstanding expenses, advance incomes, bills payables, sundry creditors, dividends payable and taxes payable. When current assets are greater than current liabilities a firm has positive net working capital and vice versa.

Working capital is further classified into two categories; permanent and temporary. The amount of working capital that persists over time  regardless of fluctuations in sales is called permanent working capital. A trading firm, for example, has to maintain a minimum level of inventory to meet daily sales. This level of inventory is part of the firm's permanent working capital. The additions to inventory made for the holidays or festivals are part of the temporary working capital. In other words, temporary working capital is the additional assets required to meet variations in sales above the permanent ordinary levels.  


Working capital may be regarded as the lifeblood of a business; its effective provision can do much to ensure the success of a business and while its insufficiency or insufficient management can lead not only to a reduction of profits, but also to the ultimate downfall of what otherwise might be considered as a promising concern. Businesses require working capital for the following reasons:

a)  It helps daily operation

Businesses require working capital to run day-to-day business activities. The purchase of raw materials, payment of wages and salaries, purchase of office supplies, payment of regular bills, rent, conveyance and transportation costs, and entertainment expenses are all examples of daily operations for which working capital is required.

b)  Investment in current assets

For many firms current assets constitute more than 50 percent of total assets or capital employed. For example, in India during the fiscal year 1975-76, 1650 large and medium public limited companies reported that current assets constituted 62 percent of total net assets.

c)  Full use of fixed assets

Given a fixed asset structure a firm is in need of sufficient amount of working capital to reach the maximum level or to ensure full use of its fixed assets. Under utilization of capacity due to insufficient working capital will simply increase fixed cost per unit resulting either in losses or at least a reduction in profit.

d)  Increasing sales

If a firm plans a special sales promotion, it must increase the amount of working capital to support the higher expected sales generated by the promotion or program.

e)  Payment of current obligations

Current obligations are claims that mature within the accounting year or operating cycle of a firm. Payments are made against these claims from the working capital fund. Long-term obligations like lease installments are also paid by working capital as they come due. In the absence of sufficient working capital, a firm having a lot of fixed assets could become technically insolvent if it is unable to make timely payment on it's current obligations.

f)  Supporting credit sale

In today's business world, the majority of sales are made on credit, which results in accounts receivable. The collection period of these receivables is determined by the terms of the credit sales. Depending on the terms of the credit arrangement, it could take weeks or even months before cash is received in final payment of the credit sale. Thus, having an appropriate level of cash to meet current obligations of the company is vital to the success of a business.

g)  Taking advantage of cash discount

Sometimes creditors or suppliers offer a cash discount, if payment can be made within a prescribed time. Thus, in order for a company to take advantage of a cash discount, it must have sufficient working capital.

h)  Hedging (advance purchase) against price fluctuations

Sometimes a trading firm has to make advance payment against a future supply of goods. These payments are made to ensure regular and timely supply of materials. Advance payment guarantees quality goods and sometimes is done to protect the company from price fluctuations.

i)  Facing unforeseen adverse conditions

From time to time a company is faced with some unforeseen circumstances. For example, a decrease in sales volume or fall in sales price may reduce the amount of expected revenue. Similarly a rise in the price of raw materials or labor will increase variable cost reducing the profit margin of the product. All these undesirable events have an adverse impact on the liquidity position of the company. A company may be able to absolve this shock if it maintains a reasonable level of working capital.

j)  Need for small firms

Small firms tend to rely more heavily on working capital since they are unable to secure long-term financing. Small firms generally have less fixed assets and higher current assets such as cash, accounts receivable and inventory. Small firms current liabilities are also more significant. Thus, working capital management is critical for small firms.

3. Guidelines for estimating working Capital  

There is no hard and fast rule in estimating the working capital investment of a firm. The factors that may be considered for estimating the amount of working capital are as follows.

Nature of Business: A trading firm such as a retail shop has very little investment in fixed assets but requires a large sum of money to be invested in working capital in the form of inventory. A service industry, on the other hand, depends less on working capital; examples of service companies are; Clinics & Hospitals, utility companies, hotels and transportation companies. These companies have huge fixed assets in their capital. The amount of working capital in the manufacturing industry as a percentage of total assets differs heavily from that of the mining industry. In 1983, current asset as a percentage of total assets for various manufacturing companies namely: aircraft, industrial, chemical and mining industries in the United States of America were 49.2%, 66.8%, 33.2% and 19.2% respectively.

Life Cycle: long-term securities increase. Inventories reach their peak proportion during The working capital need of an individual firm is also influenced by the stage of the industry's life cycle. The life cycle is generally divided into four phases. The level of working capital is highest during the early phases of the life cycle and diminishes as the firm matures. In the pioneering phase of development, the firm is small and holds a relatively large proportion of its asset in cash and accounts receivables. As the firm increases in size and maturity, the proportion held in cash and receivables declines sharply while funds invested in the expansion phase. The point is that the proportion and composition of working capital changes significantly over the life cycle of a firm.

Business Cycle: Changing business conditions also influence working capital decisions. In general, a firm's working capital needs increased during the recovery and prosperity stages of the business cycle when business activity is expanding and reduce during the recession and depression stages of the business cycle when business activity declines.

Operating Cycle: The operating cycle begins with the purchase of inventory and ends with the collection of receipts from goods sold. In other words the operating cycle is the time it takes to manufacture, sell and receive payment on the sale of a product. The longer the operating cycle of a company, the greater the need for working capital and vice versa. subtotal of average age of inventory and average age of receivables. Broader the operating cycle of a firm, larger the amount of working capital required and vice versa.

Size of Business: The size of business as measured by the scale of its operation is also a determining factor in calculating working capital needs. A firm with a larger scale of operation will need more investment in working capital than that of one with a smaller scale of operations.

Production Policy: Seasonal fluctuations affect the working capital requirement of the firm. During peak demand, increasing production may be expensive for the firm. Similarly, it is expensive during slack or down times when the firm has to sustain its work force and physical facilities without adequate production and sales. A firm may, follow a policy of steady production irrespective of the seasonal changes or it may adopt a varying production schedule in accordance with its changing demand. The point is that a company needs to take into consideration the firm's production requirements when estimating its working capital needs

Credit Terms: Credit policy greatly influences the working capital needs of the firm. A liberal credit policy will necessitate a huge amount of working capital in the form of accounts receivable. A tight credit policy will require a relatively lesser amount of working capital to be financed, as receivables will be collected more quickly. However, a tighter credit policy could also lead to lower sales. Thus, the firm should carefully consider the credit standards of its customers and other relevant factors, prior to determining its credit policy.

Availability of Credit: The working capital investment of a firm also depends on the availability of long term credit to the firm. Easy access to financial markets and strong relationships with its financial partners and creditors will reduce the need for high levels of working capital.


We now discuss the methods of financing working capital of Islamic and conventional banks. 

4.1 Conventional Banks 

When a firm does not have enough cash to meet short term operating obligations, it must borrow the cash needed in order to continue its operations.  The following is a discussion of various arrangements that can be utilized at a conventional bank.

      Overdrafts: The extension of financing through overdrafts can only occur when there is an existing demand deposit account. An overdraft occurs when the amount of a check presented for payment to the bank exceeds the clients deposit balance. The banks may choose to pay on the item, thereby causing a negative balance in the client's account.  This negative balance is effectively an extension of financing and can be a prior arrangement with the bank. In addition, overdraft facilities may be extended against deposit certificates and/or government promissory notes.

      Cash Credit: Cash credit is a popular mode of borrowing by traders, industrialists and agriculturalists. It is a separate account by itself and does not require having any other account with the bank. It resembles the use of overdrafts on a checking account. It is an arrangement whereby the borrower may withdraw funds as needed for day-to-day operations without the delay associated with making a loan. The borrower may not exceed a predetermined limit and must deposit cash back into the account as funds become available from daily operations.

Demand Loan: Sometimes conventional banks provide very short-term loans to its clients payable on demand.

Discounting Bills Receivables: Conventional banks discount bills receivables

Factoring Bills Receivables 

The chief disadvantages of these modes of financing are as follows:

      The borrowing firm has to pay a fixed rate of interest on the loan used to finance working capital needs. In other words, even if the borrowing firm does not make a profit on his investment, the firm still has to repay both the principal and the accumulated interest on the loan. The Shariah does not justify the payment of interest and it is also very difficult for a firm that is not profitable to satisfy the lender by repaying both principal and interest. The conventional bank is only interested in recovering its loan along with the interest profit. Thus there is less of a concern for the welfare of the business. In many cases, the conventional bank will request collateral to ensure repayment of the loan with interest.  

4.2 Islamic Banks  

Now, let us look at financing working capital needs through the Islamic banking system.

              Investment Mode: The Islamic Bank can meet a firms working capital needs with cash credit, over-draft and demand loan facilities on a profit/loss sharing basis (PLS). Under the PLS system, the entrepreneur can secure financing for his working capital needs in exchange for a share in the profits of his business. If the business results in a loss, he is not liable to pay anything to the bank. In fact, if the arrangement is one of Mudaraba, the bank incurs the entire loss. On the other hand, if the arrangement is one of Musharaka, the entrepreneur shares the loss with the bank.

              "Buy" Mode:  In addition, the firm can request that the bank purchase the goods on its behalf in exchange for repayment in lump sum or installments. There are two "buy" arrangements available to the firm. If the arrangement one of Murabaha, the bank purchases the goods and retains possession until the firm can pay the bank in full. On the other hand, If the arrangement is one of Muajjal, the bank buys the goods, but allows the firm to take possession of the goods in exchange for payment at a later date.

      Bills of Exchange: Islamic banks can also finance against bills receivables but they are not allowed to receive a discount on such an investment. However in this regard the council of Islamic Ideology recommends as follows: Since the bank accepts the responsibility of realizing the amount due to the drawer, from the drawee, it is permissible under the Shariah that the bank may realize a commission for rendering this service. This commission will be according to the amount of the bill but not according to the period of payment.



5.1 Risk of Selecting the Right Project 

While investing in working capital the bank professionals should be careful in evaluating the projects to be financed. Before selecting a firm for investment the short-term solvency and long term solvency should be measured with appropriate techniques. Short-term solvency of a firm is usually measured by working capital ratios while long-term solvency of a firm is measured by equity ratios. Firms with high debt ratios should be avoided while firms with low debt ratios in its capital structure should be accepted for working capital financing.

5.2 Selection of Appropriate Entrepreneur

Character of an entrepreneur is an important consideration for investment in working capital of a firm. Character, like reputation, refers to the borrower's honesty, responsibility, integrity and ability to manage the business. Investment worthiness is a combination of financial soundness and integrity of the entrepreneur. A capable, efficient and experienced, as well as honest, entrepreneur with a relatively weak financial background should be preferred to a dishonest entrepreneur with a strong financial background.

5.3 Mode of Investment

The type of financing to be used to fund a working capital request should be given careful consideration. The investment may be made in cash or in kind. Investments made in kind are less risky, but most Islamic banks choose to invest with cash. Cash investments involve the risk of the funds being used for a different purpose than was given to the bank. Thus, when cash is provided, the bank needs to ensure it is used for the purposes intended in the request.

5.4 Risk of Over- and under-Investment

The bank needs to give careful consideration to the amount of working capital being requested by the firm. If a firm borrows more than they actually need, the excess sits idle and carries with it the opportunity cost of other foregone investment opportunities. On the other hand, if the firm does not borrow enough, the business becomes unprofitable they are still unable to meet their operating needs. In either case, the banks anticipated return on the investment is less than it originally calculated. Thus, banks must verify that the amount of financing being requested meets the firm's needs. 

6. Working Capital Finance Against Receivables

Islamic banks can finance the working capital requirements of a firm with receivables as collateral. Receivables can take two forms. Accounts receivables means the amount of trade credit recorded on the balance sheet of the seller. Bills receivables, on the other hand, is that part of accounts receivables which is drawn as a bill by the seller and accepted by the drawee to pay a fixed amount after a certain period. Bill receivables are a kind of negotiable instrument generally accepted as collateral by traditional lenders. 

There are two methods found in modern finance literature to finance against receivables:

(i)         Pledging, and

(ii)       Factoring.

These methods are discussed as under.

6.1 Pledging

            Types of pledging

 Seasonal basis: This is a type of arrangement where occasionally receivables are pledged and there is no continuity. Each installment is considered as an independent pledge. After one pledge is over a fresh contract is required between the bank and the client to effect another pledge. The new contract is initiated with new terms and conditions.

             Continuous basis: This is an arrangement whereby a chain of pledging one after another occurs. For example, a borrower has a 5 lacs continuous pledge with a bank. Suppose at sometime in the future, receivables worth Tk 2 lacs is collected and settled. The client is required to deposit another two lacs worth of similar receivables to the bank within the context of the existing terms and conditions. In this way the receivables remain at the same level throughout the financing arrangement.  

Things to be Satisfied by the Bank for Pledging

Goodwill of the drawee firm of the bill

The period of transaction between the drawer firm and the drawee firm

The solvency of the firm which is offering the pledge

            That the bill being placed for pledging is not an outdated one. 

 Cost of Pledging with Conventional Banks

  Interest cost: Interest cost of pledging is higher than normal  rate of interest on loan

Service charge: This includes filing cost, correspondence cost and cost of collection by the bank on behalf of the seller.

Cost of Pledging with Islamic Banks

As previously mentioned, it is not appropriate for Islamic banks to charge interest or Riba on a financing arrangement. However, the bank can participate in the profit and loss of the investment on a Mudaraba basis. In addition, the bank can also charge a commission from the client if the bank is assigned to collect the amount of the bill from the drawee.   

6.2 Factoring

Factoring simply means selling the bills receivables to a factor to meet the financing need. Generally the commercial banks or finance companies act as a factor. Factoring is popular in developed countries. Factoring is mostly practiced in manufacturing industries like textile, furniture, shoe and floor covering.  

Methods of Factoring and Factoring Cost

Under the conventional system when bills receivables are placed for factoring, the factor scrutinizes the merits and quality of the bills being sold. If the factor is satisfied with the quality of bills than he claims:

a) A certain percentage commission on the face value of the bill

b) A precautionary reserve (say 10%) of the total amount of bills to be factored

c) A certain percentage of interest on an advance amount to be paid by the factor (bank) to the seller of the bill receivable.

Advantages of Factoring


  No interest for compensating balance

  No restrictive conditions

  No cost for collecting bills receivables

Disadvantages of Factoring

  High cost

Selective factoring: That is, factoring is available only for the firms with strong financial background and sound lending policy.

It should be noted that factoring is not permissible by Islamic banks, because it is not compatible with the Shariah.

Caution for Investment Against Receivables

Before accepting bills receivable as a pledge, two things should be taken into consideration by the investment banker, First, the credit rating of the owing firm should be evaluated. The credit rating of a firm is a function of goodwill, financial solvency, regularity of cash inflow and previous repayment record. Second, the age of the bills receivables should also be carefully looked into so that bills from firms with a weak credit rating and substantially overdue bills may not be accepted as collateral. Most investors prefer to invest against a few receivables from well-established companies that do not customarily return the merchandise they have purchased.

Generally the amount of investment is less than the full face value of the bills receivable pledged as collateral, the percentage that the investor is willing to invest depends on the size, number and quality of the receivables.   

If an Islamic bank wants to invest to meet the working capital requirement of a manufacturing firm or industry it must carefully study the working capital management of the concerned organization. In this regard the following issues related to management of receivables should carefully be observed:

      Credit policy of the firm: A firm may have a strict or liberal credit policy. A liberal credit policy generates higher sales and profit as compared to a strict credit policy. However,  a firm can incur higher costs in the form of bad debt, losses and liquidity problems with a liberal credit policy. A strict credit policy, on the other hand, minimizes the cost of bad debts and problem of liquidity, but it also restricts sales and profits. So, the firm whose credit policy has been determined by a reasonable trade-off between liquidity and profitability should get priority to the investment portfolio of an Islamic bank.

      Credit standard: Islamic banks must also look at the credit standard maintained by the firm applying for the working capital investment. A firm may sell on credit to any firm indiscriminately or it may be selective as to whom it extends credit. A liberal credit policy of a firm generates a high level of sales and receivables and vice versa. But it increases the risk of bad debts as well. The Islamic bank should prefer those firms who follow a strict credit standard when considering a loan against receivables.  


Qualities of inventories to be mortgaged for financing

Loans can also be made with inventory as collateral. An Islamic bank must take the following things into consideration when considering/making a loan collateralized by inventory.

            Durable: The bank must be sure that the inventories being mortgaged are durable goods and not perishable in nature.

            Easily identifiable: If the inventory differs in terms of quality, size, color, or some other characteristics, then the amount of inventory earmarked to be mortgaged must be clearly described so that no confusion arises during the identification of the item.

            Easily marketable: The item of inventory being mortgaged must be of such quality and nature that it can be sold easily in the market. For example, clothing is more marketable than printing machines and computers are more marketable than electronic type-writers. 


8.1 Floating Lien

 All inventory of the borrowing firm is automatically brought under this mortgage. Goods remain in the hands of the borrower. The borrower can produce by using raw inventories and can sell finished inventory, but the proceeds of the sale should be paid to the lender. Any new purchase of the borrowing firm comes automatically under the fold of the present mortgage. 

Advantages of Floating Lien

The borrower can obtain more credit/investment by mortgaging all its  inventory.

The Mortgagor could sell the mortgaged goods. In other words, this type of mortgage does not interrupt normal business activities.

Disadvantage of Floating Lien:

The lender usually only extends a loan up to 60% of the value of the inventory.   

8.2 Trust Receipts

In this case a particular item (not all inventory) is mortgaged to the bank. The lender takes title of the product as a lien and releases the same after full recovery of the loan. The borrower can sell the product but he has to pay the lender out of the sale proceeds. For example, suppose Progati Industries of Bangladesh has a sale contract for 10 vehicles with a dealer that is financed by Sonali Bank.  The dealer is allowed to sell the cars, but the title of these cars remains with the bank. The bank will release the title in favor of the buyer only after receiving the full payment on the loan.  

8.3 Chattel Mortgage

Under a chattel mortgage personal, tangible and clearly identifiable assets of the borrower are mortgaged. The lender holds title of the property as a lien, which is not released until the loan is paid in full. Generally the most valued items are chosen for this type of mortgage. It is customary to register the mortgage. 

8.4 Warehouse Receipts

Terminal Warehouse Receipt: The lender holds, controls and ensures the physical security of the mortgaged goods. The mortgaged goods are kept in a public warehouses. The lender retains the warehouse receipts in his possession. Goods are released only after the consent of the lender, usually upon final payment of the loan.

Fields Warehouse Receipt: A temporary warehouse is built adjacent to the borrower's property. The goods being mortgaged are kept in this temporary facility until the loan is paid in full. The key of the warehouse remains in the hands of the lender and the cost of preservation of the inventory, including the payment of the security guard is the responsibility of the borrower.

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