156 AN INTRODUCTION TO ISLAMIC FINANCE
through special investment accounts. For longer - term maturity investments,
an Islamic bank can engage in venture capital or private equity activities in
the form of musharakah.
An Islamic bank can attract depositors/investors either by inviting them
to share profi ts and losses on a general pool of assets maintained by the
fi nancial intermediary itself, or by acting as a dealer/broker for third - party
products. The general pool could be in the form of various funds special-
izing in specifi c sectors or geographical regions. In this case, the investor/
depositor will be placing funds with the bank in a fund of funds, which
would be a collection of diversifi ed portfolios of fi nancial assets. The rela-
tionship between the bank and the depositors/investors could be on the
basis of either a mudarabah, where the bank manages assets for a fee, or a
musharakah (equity partnership), where the bank shares profi ts and losses
with the depositors/investors. In either case, there is risk sharing between
the fi nancial intermediary and the depositor/investors.
On the other hand, the Islamic bank can simply act as dealer/broker and
help the investor in selecting and placing funds in portfolios of independent
fund managers who specialize in specifi c asset classes, investment styles,
sectors, and maturity terms. In this case, the bank facilitates the purchase/
sale of third - party products and has no liability regarding the outcome or
the performance of those products. However, the bank may perform due
diligence on the fund and its managers before making any recommendations
to its customers.
Table 8.3 shows broad and detailed classifi cations of the assets side of
a typical Islamic bank for fi nancial reporting purposes. Typically, the assets
are divided into banking and trading books. The banking book consists of
old - fashioned investments and fi nancing of real sector activities, whereas
the trading book contains fi nancial securities such as bonds.
SOURCES AND USES OF FUNDS
Table 8.4 shows how an Islamic bank raises funds (the sources) and how
these funds are utilized (applied) through investments. The sources of funds
are also the liabilities of the bank. When compared to a conventional bank,
Islamic banks do not use debt as the source of funding, which prevents
them from indulging in or creating leverage. With the exception of demand
deposits, all the sources of funds are directly linked to the fi nancing of assets
and there is no disconnect between the sources and the application of funds.
Whereas conventional banks tend to use the funds by investing heavily in
debt securities (treasury bills and notes), Islamic banks use the funds to
provide direct funding of real economic activities — an important function
which has been fading from modern conventional banks.
As described in Chapter 6, the Islamic fi nancial system proposes a capi-
tal market consisting of equity markets and securitized asset - linked securi-
ties. Islamic banks and fi nancial intermediaries can serve three functions in