AAOIFI Standard Number Six – Bank Conversion to an Islamic Bank

AAOIFI Standard Number Six – Bank Conversion to an Islamic Bank
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An overview of AAOIFI Standard Number Six is presented. It should be noted only a summary and overview of the standard is presented, the full standard is available from AAOIFI.

Scope of AAOIFI Standard Number Six

This standard is issued on 4 Rabii l 1424 H corresponding to 16 May 2002.
This standard discusses fundamental mechanisms for converting a conventional bank to a bank that comply with Shari’a rules and principles right after the decision to undertake immediate comprehensive conversion within a particular designated period that is announced, whether such a decision comes from within the bank or from outside the bank to be converted by outside parties interested in converting it. The standard deals with the time frame required for the conversion, the effect of conversion on the methods used to solicit and receive deposits, and the method to be used to invest such deposits. The standard provides guidance on how to treat the receivables and liabilities of the bank prior to the conversion, whether or not such receivables and liabilities are received or paid. The standard includes a treatment of the prohibited assets that are in the possession of the bank before conversion and the appropriate ways of disposing of them.

1. The time frame for the conversion

It is necessary that all Shari’a requirements be executed in the process of converting a conventional bank to a potential Islamic bank. It is also necessary that the Shari’a rules and principles be observed in respect of all new transactions after conversion. In principle, the transactions that are concluded before the decision to convert must be ceased or disposed of immediately. It is not permissible to delay clearing out non-permissible transactions unless such delay becomes a necessity or a pressing need. Thus, the circumstances surrounding the conversion must be taken into consideration in order to avoid the risk of failure or a breakdown of the bank’s operations, taking into account that the provisions of this standard will be applied to accommodate the situation.

2. The necessary measures for conversion

For the success of the process of conversion, it is necessary that the bank set up all necessary procedures, create the required tools, explore alternatives to non-permissible financial practices, and train and promote the personnel required for proper implementation of the procedures of conversion.

3. Dealings with banks

Exerting all possible efforts to adapt the ways of dealing with central banks regarding deposits, liquidity needs or otherwise in a way that does not conflict with the rules of Shari’a, especially rules that govern riba transactions. The possible alternatives to the reserve amount required by law include, among others, depositing receivables represented by commercial paper to be paid later by customers instead of accepting the freezing of the cash account. The bank can also finance government projects using Islamic instruments. Among the possible alternatives for the purpose of set-off is for the bank to maintain current accounts that accrue no interest or disposing of the interest earned and adapting the ways of dealing with the central bank for acquiring liquidity, for example, by the opening of investment accounts for the central bank.

4. Providing banking services in permissible ways

In providing banking services, it is not permissible for the bank to receive interest as compensation for services rendered. It is a requirement that an Islamic alternative be worked out, such as treatment of uncovered documentary credits through Murabaha to the purchase order, Musharaka or Mudaraba in accordance with the rules of Shari’a. It is not permissible to take a commission for providing a mere facility. However, the commission may be linked to expenses incurred for the execution of the credit facility accordingly.

5. The effect of conversion on the interest based receivables and their Shari’a alternatives

All traces of conventional transactions whereby the bank originated monetary assets and is liable to pay interest for them must be liquidated. This is the rule whether such transactions involve individuals, banks or central banks. This liquidation includes, among others, the conditions relating to the deposits, preference shares, investment bonds and interest-based certificates that were issued by the bank before the decision for conversion.

6. The effect of conversion on investments

All interest-based investment instruments must cease to be used and must be replaced by permissible investment instruments such as Mudaraba, all Shari’a-nominate partnerships, diminishing Musharaka, sharecropping partnerships (agricultural, planting or irrigation partnership) or financing by way of deferred sales, Murabaha to the purchase orderer, salam, Istisna’a, operating ljarah, ljarah Muntahia Bittamleek or other permissible financing and investment instruments.

7. Treatment of the bank’s non-permissible existing receivables before the decision to convert

a. Non-permissible assets of the bank originated or acquired before the decision to convert

Starting from the financial period in which the bank decides to convert, the following must be done:

  • If a conventional bank is acquired with the intention to convert it to a bank, the new owners are not obliged to dispose of interest and impermissible earnings that have been earned before such acquisition.
  • If a conventional bank is converted by its existing shareholders into a bank, then the process of disposing of interest and impermissible earnings should be considered as commencing at the beginning of the financial period in which the conversion starts to take effect. However, for any impermissible earnings that have been distributed prior to conversion, it is necessary, on ethical grounds, for the shareholders and depositors to whom these earnings have been distributed to dispose of them personally. The bank is not bound to do so.
  • Revenues not yet received that are of doubtful permissibility are not subject to compulsory disposal, whether they were earned before or during the financial period in which the bank decides to convert. The same rule applies to revenues of doubtful permissibility that have been already received because of a belief that they are permissible on the basis of (a) an interpretation of a person who is qualified to perform ijtihad on issues that are subject to personal juristic interpretation, (b) juristic position of an authoritative school of Shari’a or (c) the opinion of some eminent and knowledgeable scholars.
  • If the bank is has rights to prohibited non-monetary assets; it may receive them with the intent to destroy them. If the bank is entitled to receive consideration for supplying non-permissible assets or services, the bank may receive the consideration with the intent to donate it to charity. The same rule applies to any income that has been acquired from non-permissible assets during the period in which the bank decides to convert. In both these cases, the customer should not be allowed to avoid paying the amount receivable or the consideration, otherwise such a customer would end up being entitled to two counter-values of the same transaction: the good or service supplied and the price payable for it.
  • If the bank is converted and it has, among its tangible assets, impermissible commodities, the bank is obliged to destroy them. If the bank has sold some of these commodities and is yet to receive the price thereof, the price must be received and be donated to charity.
  • If the property assets of the bank are locations designated for non-permissible activities, they should be changed to locations designated for permissible operations and services

8. Treatment of non-permissible liabilities before the decision to convert, whether the conversion is internal or external

a. Internal Conversion

If the liabilities are in the form of payment of interest, the bank should employ all lawful means to avoid paying such interest. This rule does not apply to the principal amounts of debts or loans. The bank should not pay interest except on the basis of dire need.

b. External conversion through acquisition of the bank by parties interested in converting it

If the purchaser is capable of negotiating a deal that could exclude all non-permissible receivables (e.g. interest and non-permissible assets) from the acquisition deal in a way that will make the seller solely liable for non-permissible liabilities, then the Shari’a requires that the purchaser do so. However, if the acquisition cannot be concluded unless all assets of the bank including the non-permissible assets and receivables are acquired, then there is no objection to the acquisition on this basis on condition that the purchaser act as quickly as possible to dispose of non-permissible liabilities even if the purchaser has to suggest to the creditors of the bank an earlier repayment for a discount.

c. Treatments for impermissible pledges

The shareholders must accelerate the redemption of all impermissible pledges attached to the assets of the bank. In the case of external conversion, the buyer must stipulate that the seller replaces impermissible pledges with permissible ones.

9. Disposal of impermissible earnings

All impermissible earnings acquired by the bank before conversion that need to be disposed of as per the rules in this standard must without delay be paid to charity, unless it is difficult to do so, for example, where complete disposal promptly will lead to the collapse of the bank or bankruptcy. In this case, the implementation of conversion can reasonably take place gradually.

10. The Zakah Obligation on the Bank before the decision to convert

When the conversion is initiated by outsiders who acquired the conventional bank for the purpose of converting it, then they are not obliged to make zakah payment for the past financial periods because the zakah for previous periods is the liability of the previous owners. The zakah liability will start to exist for the new owners from the date of the decision to convert. For the purpose of discharging the responsibility to pay zakah, the owners may apply the accounting standard No. 9 on Zakah issued by Accounting and Auditing Organisation for Islamic Financial Institutions. However, if the decision to convert was made by the shareholders and the zakah was not paid for the previous financial periods, the shareholders are obliged to pay zakah for these periods. They must take into account that they are obliged to pay zakah even if the revenues and the money earned are impermissible because the shareholders are obliged in the first place to dispose of all accrued interest and impermissible earnings. So, the payment of zakah is part of the obligation to dispose of impermissible earnings and interest.