(Reproduced here for the benefit
of those students and others, especially in developing countries, who find it
difficult to obtain the book and who make frequent inquiries of the author if he
could send them more information about Islamic Banking.)
4.1.1 Interest-free banking as an idea 2
4.1.2 The coming into being of interest-free banks 2
4.2.2.1 Investment financing 4
4.2.4 Shortcomings in current practices 4
4.3 Problems in implementing the PLS scheme 4
Term Structure of Investment by 20 Islamic Banks, 1988 5
4.3.1.4 Government borrowing 6
4.3.3 Involvement in specialised non-bank activities 6
4.3.7 Uneasy questions of morality 7
4.4 Islamic banking in non-Muslim countries 8
4.4.1 Certainty of capital and return 9
4.4.2 Supervision and control 9
4.5 Discussion and suggestions 9
4.5.1 Savings accounts and capital guarantee 10
4.5.2 Loans with a service charge 10
4.5.3 Investment under PLS scheme 11
Modern banking system was
introduced into the Muslim countries at a time when they were politically and
economically at a low ebb, in the late 19th century. The main banks in the home
countries of the imperial powers established local branches in the capitals of
the subject countries and they catered mainly to the import export requirements
of the foreign businesses. The banks were generally confined to the capital
cities and the local population remained largely untouched by the banking
system. The local trading community avoided the “foreign” banks both for
nationalistic as well as religious reasons. However, as time went on it became
difficult to engage in trade and other activities without making use of
commercial banks. Even then many confined their involvement to transaction
activities such as current accounts and money transfers. Borrowing from the
banks and depositing their savings with the bank were strictly avoided in order
to keep away from dealing in interest which is prohibited by
religion.1
With the passage of time, however,
and other socio-economic forces demanding more involvement in national economic
and financial activities, avoiding the interaction with the banks became
impossible. Local banks were established on the same lines as the interest-based
foreign banks for want of another system and they began to expand within the
country bringing the banking system to more local people. As countries became
independent the need to engage in banking activities became unavoidable and
urgent. Governments, businesses and individuals began to transact business with
the banks, with or without liking it. This state of affairs drew the attention
and concern of Muslim intellectuals. The story of interest-free or Islamic
banking begins here. In the following paragraphs we will trace this story to
date and examine how far and how successfully their concerns have been
addressed.
It seems that the history of
interest-free banking could be divided into two parts. First, when it still
remained an idea; second, when it became a reality -- by private initiative in
some countries and by law in others. We will discuss the two periods separately.
The last decade has seen a marked decline in the establishment of new Islamic
banks and the established banks seem to have failed to live up to the
expectations. The literature of the period begins with evaluations and ends with
attempts at finding ways and means of correcting and overcoming the problems
encountered by the existing banks.
Interest-free banking seems to be
of very recent origin. The earliest references to the reorganisation of banking
on the basis of profit sharing rather than interest are found in Anwar Qureshi
(1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties,
followed by a more elaborate exposition by Mawdudi in 1950 (1961).2
Muhammad Hamidullah’s 1944, 1955, 1957 and 1962 writings too should be included
in this category. They have all recognised the need for commercial banks and the
evil of interest in that enterprise, and have proposed a banking system based on
the concept of Mudarabha - profit and loss sharing.
In the next two decades
interest-free banking attracted more attention, partly because of the political
interest it created in Pakistan and partly because of the emergence of young
Muslim economists. Works specifically devoted to this subject began to appear in
this period. The first such work is that of Muhammad Uzair (1955). Another set
of works emerged in the late sixties and early seventies. Abdullah al-Araby
(1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr
(1961, 1974) were the main contributors.3
Early seventies saw the
institutional involvement. Conference of the Finance Ministers of the Islamic
Countries held in Karachi in 1970, the Egyptian study in 1972, First
International Conference on Islamic Economics in Mecca in 1976, International
Economic Conference in London in 1977 were the result of such involvement. The
involvement of institutions and governments led to the application of theory to
practice and resulted in the establishment of the first interest-free banks. The
Islamic Development Bank, an inter-governmental bank established in 1975, was
born of this process.
The first private interest-free
bank, the Dubai Islamic Bank, was also set up in 1975 by a group of Muslim
businessmen from several countries. Two more private banks were founded in 1977
under the name of Faisal Islamic Bank in Egypt and the Sudan. In the same year
the Kuwaiti government set up the Kuwait Finance House.
However, small scale limited scope
interest-free banks have been tried before. One in Malaysia in the
mid-forties4 and another in Pakistan in the late-fifties.5
Neither survived. In 1962 the Malaysian government set up the “Pilgrim’s
Management Fund” to help prospective pilgrims to save and profit.6
The savings bank established in 1963 at Mit-Ghamr in Egypt was very popular and
prospered initially and then closed down for various reasons.7
However this experiment led to the creation of the Nasser Social Bank in 1972.
Though the bank is still active, its objectives are more social than
commercial.8, 9
In the ten years since the
establishment of the first private commercial bank in Dubai, more than 50
interest-free banks have come into being. Though nearly all of them are in
Muslim countries, there are some in Western Europe as well: in Denmark,
Luxembourg , Switzerland and the UK. Many banks were established in 1983 (11)
and 1984 (13). The numbers have declined considerably in the following
years.10
In most countries the establishment
of interest-free banking had been by private initiative and were confined to
that bank. In Iran and Pakistan, however, it was by government initiative and
covered all banks in the country. The governments in both these countries took
steps in 1981 to introduce interest-free banking. In Pakistan, effective
1 January 1981 all domestic commercial banks were permitted to accept
deposits on the basis of profit-and-loss sharing (PLS). New steps were
introduced on 1 January 1985 to formally transform the banking system over
the next six months to one based on no interest. From 1 July 1985 no banks
could accept any interest bearing deposits, and all existing deposits became
subject to PLS rules. Yet some operations were still allowed to continue on the
old basis. In Iran, certain administrative steps were taken in February 1981 to
eliminate interest from banking operations. Interest on all assets was replaced
by a 4 percent maximum service charge and by a 4 to 8 percent ‘profit’ rate
depending on the type of economic activity. Interest on deposits was also
converted into a ‘guaranteed minimum profit.’ In August 1983 the Usury-free
Banking Law was introduced and a fourteen-month change over period began in
January 1984. The whole system was converted to an interest-free one in March
1985.11
The subject matter of writings and
conferences in the eighties have changed from the concepts and possibilities of
interest-free banking to the evaluation of their performance and their impact on
the rest of the economy and the world. Their very titles bear testimony to this
and the places indicate the world-wide interest in the subject. Conference on
Islamic Banking: Its impact on world financial and commercial practices held in
London in September 1984, Workshop on Industrial Financing Activities of Islamic
Banks held in Vienna in June 1986, International Conference on Islamic Banking
held in Tehran in June 1986, International Conference on Islamic Banking and
Finance: Current issues and future prospects held in Washington, D.C. in
September 1986, Islamic Banking Conference held in Geneva in October 1986, and
Conference ‘Into the 1990’s with Islamic Banking’ held in London in 1988 belong
to this category. The most recent one is the Workshop on the Elimination of
Riba from the Economy held in Islamabad in April 1992.
Several articles, books and PhD
theses have been written on Islamic Banking during this period. Special mention
must be made of the work by M. Akram Khan in preparing annotated bibliographies
of all published (and some unpublished) works on Islamic Economics (including
Islamic Banking) from 1940 and before. It is very useful to students of Islamic
Economics and Banking, especially since both English and Urdu works are included
(1983, 1991, 1992). M.N. Siddiqi’s bibliographies include early works in Arabic,
English and Urdu (1980, 1988). Turkish literature is found in Sabahuddin Zaim
(1980).
Generally speaking, all
interest-free banks agree on the basic principles. However, individual banks
differ in their application. These differences are due to several reasons
including the laws of the country, objectives of the different banks, individual
bank’s circumstances and experiences, the need to interact with other
interest-based banks, etc. In the following paragraphs, we will describe the
salient features common to all banks.
All the Islamic banks have three
kinds of deposit accounts: current, savings and investment.
Current or demand deposit accounts
are virtually the same as in all conventional banks. Deposit is guaranteed.
Savings deposit accounts operate in
different ways. In some banks, the depositors allow the banks to use their money
but they obtain a guarantee of getting the full amount back from the bank. Banks
adopt several methods of inducing their clients to deposit with them, but no
profit is promised. In others, savings accounts are treated as investment
accounts but with less stringent conditions as to withdrawals and minimum
balance. Capital is not guaranteed but the banks take care to invest money from
such accounts in relatively risk-free short-term projects. As such lower profit
rates are expected and that too only on a portion of the average minimum balance
on the ground that a high level of reserves needs to be kept at all times to
meet withdrawal demands.
Investment deposits are accepted
for a fixed or unlimited period of time and the investors agree in advance to
share the profit (or loss) in a given proportion with the bank. Capital is not
guaranteed.
Banks adopt several modes of
acquiring assets or financing projects. But they can be broadly categorised into
three areas: investment, trade and lending.
This is done in three main ways: a)
Musharaka where a bank may join another entity to set up a joint venture,
both parties participating in the various aspects of the project in varying
degrees. Profit and loss are shared in a pre-arranged fashion. This is not very
different from the joint venture concept. The venture is an independent legal
entity and the bank may withdraw gradually after an initial period. b)
Mudarabha where the bank contributes the finance and the client provides
the expertise, management and labour. Profits are shared by both the partners in
a pre-arranged proportion, but when a loss occurs the total loss is borne by the
bank. c) Financing on the basis of an estimated rate of return. Under
this scheme, the bank estimates the expected rate of return on the specific
project it is asked to finance and provides financing on the understanding that
at least that rate is payable to the bank. (Perhaps this rate is negotiable.) If
the project ends up in a profit more than the estimated rate the excess goes to
the client. If the profit is less than the estimate the bank will accept the
lower rate. In case a loss is suffered the bank will take a share in it.
This is also done in several ways.
The main ones are: a) Mark-up where the bank buys an item for a client
and the client agrees to repay the bank the price and an agreed profit later on.
b) Leasing where the bank buys an item for a client and leases it to
him for an agreed period and at the end of that period the lessee pays the
balance on the price agreed at the beginning an becomes the owner of the item.
c) Hire-purchase where the bank buys an item for the client and hires it
to him for an agreed rent and period, and at the end of that period the client
automatically becomes the owner of the item. d) Sell-and-buy-back where a
client sells one of his properties to the bank for an agreed price payable now
on condition that he will buy the property back after certain time for an agreed
price. e) Letters of credit where the bank guarantees the import of an
item using its own funds for a client, on the basis of sharing the profit from
the sale of this item or on a mark-up basis.
Main forms of Lending are: a)
Loans with a service charge where the bank lends money without interest
but they cover their expenses by levying a service charge. This charge may be
subject to a maximum set by the authorities. b) No-cost loans where each
bank is expected to set aside a part of their funds to grant no-cost loans to
needy persons such as small farmers, entrepreneurs, producers, etc. and to needy
consumers. c) Overdrafts also are to be provided, subject to a
certain maximum, free of charge.
Other banking services such as
money transfers, bill collections, trade in foreign currencies at spot rate etc.
where the bank’s own money is not involved are provided on a commission or
charges basis.
In the previous section we listed
the current practices under three categories: deposits, modes of financing (or
acquiring assets) and services. There seems to be no problems as far as banking
services are concerned. Islamic banks are able to provide nearly all the
services that are available in the conventional banks. The only exception seems
to be in the case of letters of credit where there is a possibility for interest
involvement. However some solutions have been found for this problem -- mainly
by having excess liquidity with the foreign bank. On the deposit side, judging
by the volume of deposits both in the countries where both systems are available
and in countries where law prohibits any dealing in interest, the non-payment of
interest on deposit accounts seems to be no serious problem. Customers still
seem to deposit their money with interest-free banks.
The main problem, both for the
banks and for the customers, seem to be in the area of financing. Bank lending
is still practised but that is limited to either no-cost loans (mainly consumer
loans) including overdrafts, or loans with service charges only. Both these
types of loans bring no income to the banks and therefore naturally they are not
that keen to engage in this activity much. That leaves us with investment
financing and trade financing. Islamic banks are expected to engage in these
activities only on a profit and loss sharing (PLS) basis. This is where the
banks’ main income is to come from and this is also from where the investment
account holders are expected to derive their profits from. And the latter is
supposed to be the incentive for people to deposit their money with the Islamic
banks. And it is precisely in this PLS scheme that the main problems of the
Islamic banks lie. Therefore we will look at this system more carefully in the
following section.
Several writers have attempted to
show, with varying degrees of success, that Islamic Banking based on the concept
of profit and loss sharing (PLS) is theoretically superior to conventional
banking from different angles. See, for example, Khan and Mirakhor (1987).
However from the practical point of view things do not seem that rosy. Our
concern here is this latter aspect. In the over half-a-decade of full-scale
experience in implementing the PLS scheme the problems have begun to show up. If
one goes by the experience of Pakistan as portrayed in the papers presented at
the conference held in Islamabad in 1992,12 the situation is very
serious and no satisfactory remedy seems to emerge.13 In the
following paragraphs we will try to set down some of the major difficulties.
There are four main areas where the
Islamic banks find it difficult to finance under the PLS scheme: a)
participating in long-term low-yield projects, b) financing the small
businessman, c) granting non-participating loans to running businesses, and
d) financing government borrowing. Let us examine them in turn.
Table 1 shows the term structure of
investment by 20 Islamic Banks in 1988. It is clear that less than 10 percent of
the total assets goes into medium- and long-term investment. Admittedly, the
banks are unable or unwilling to participate in long-term projects. This is a
very unsatisfactory situation.
Term Structure of Investment by 20
Islamic Banks, 1988 | ||
|
Type of
Investment |
Amount*
|
% of
Total |
|
Short-term |
4,909.8 |
68.4 |
|
Social
lending |
64.2 |
0.9 |
|
Real-estate
investment |
1,498.2 |
20.9 |
|
Medium- and
long-term investment |
707.7 |
9.8 |
The main
reason of course is the need to participate in the enterprise on a PLS basis
which involves time consuming complicated assessment procedures and
negotiations, requiring expertise and experience. The banks do not seem to have
developed the latter and they seem to be averse to the former. There are no
commonly accepted criteria for project evaluation based on PLS partnerships.
Each single case has to be treated separately with utmost care and each has to
be assessed and negotiated on its own merits. Other obvious reasons are: a) such
investments tie up capital for very long periods, unlike in conventional banking
where the capital is recovered in regular instalments almost right from the
beginning, and the uncertainty and risk are that much higher, b) the longer the
maturity of the project the longer it takes to realise the returns and the banks
therefore cannot pay a return to their depositors as quick as the conventional
banks can. Thus it is no wonder that the banks are averse to such investments.
Small
scale businesses form a major part of a country’s productive sector. Besides,
they form a greater number of the bank’s clientele. Yet it seems difficult to
provide them with the necessary financing under the PLS scheme, even though
there is excess liquidity in the banks. The observations of Iqbal and
Mirakhor14 is revealing:
Given the comprehensive
criteria to be followed in granting loans and monitoring their use by banks,
small-scale enterprises have, in general encountered greater difficulties in
obtaining financing than their large-scale counterparts in the Islamic Republic
of Iran. This has been particularly relevant for the construction and service
sectors, which have large share in the gross domestic product (GDP). The service
sector is made up of many small producers for whom the banking sector has not
been able to provide sufficient financing. Many of these small producers, who
traditionally were able to obtain interest-based credit facilities on the basis
of collateral, are now finding it difficult to raise funds for their operations.
Running
businesses frequently need short-term capital as well as working capital and
ready cash for miscellaneous on-the-spot purchases and sundry expenses. This is
the daily reality in the business world. Very little thought seems to have been
given to this important aspect of the business world’s requirement. The PLS
scheme is not geared to cater to this need. Even if there is complete trust and
exchange of information between the bank and the business it is nearly
impossible or prohibitively costly to estimate the contribution of such
short-term financing on the return of a given business. Neither is the much used
mark-up system suitable in this case. It looks unlikely to be able to arrive at
general rules to cover all the different situations.
Added to
this is the delays involved in authorising emergency loans. One staff member of
the Bank of Industry and Mines of Iran has commented:15
Often the clients need to
have quick access to fresh funds for the immediate needs to prevent possible
delays in the project’s implementation schedule. According to the set
regulations, it is not possible to bridge-finance such requirements and any
grant of financial assistance must be made on the basis of the project’s
appraisal to determine type and terms and conditions of the scheme of financing.
The
enormity of the damage or hindrance caused by the inability to provide financing
to this sector will become clear if we realise that running businesses and
enterprises are the mainstay of the country’s very economic survival.
In all
countries the Government accounts for a major component of the demand for credit
-- both short-term and long-term. Unlike business loans these borrowings are not
always for investment purposes, nor for investment in productive enterprises.
Even when invested in productive enterprises they are generally of a longer-term
type and of low yield. This latter only multiplies the difficulties in
estimating a rate of return on these loans if they are granted under the PLS
scheme. In Iran,16
...... it has been decreed
that financial transactions between and among the elements of the public sector,
including Bank Markazi [the central bank] and commercial banks that are wholly
nationalised, can take place on the basis of a fixed rate of return; such a
fixed rate is not viewed as interest. Therefore the Government can borrow from
the nationalised banking system without violating the Law.
While the
last claim may be subject to question, there is another serious
consequence:17
Continued borrowing on a
fixed rate basis by the Government would inevitably index bank charges to this
rate than to the actual profits of borrowing entities.
Existing
banking laws do not permit banks to engage directly in business enterprises
using depositors’ funds. But this is the basic asset acquiring method of Islamic
banks. Therefore new legislation and/or government authorisation are necessary
to establish such banks. In Iran a comprehensive legislation was passed to
establish Islamic banks. In Pakistan the Central Bank was authorised to take the
necessary steps. In other countries either the banks found ways of using
existing regulations or were given special accommodation. In all cases
government intervention or active support was necessary to establish Islamic
banks working under the PLS scheme.
In spite
of this, there is still need for further auxiliary legislation in order to fully
realise the goals of Islamic banking. For example, in Pakistan,18
... the new law has been
introduced without fundamental changes in the existing laws governing contracts,
mortgages, and pledges. Similarly no law has been introduced to define modes of
participatory financing, that is Musharakah19 and PTCs. It is presumed
that whenever there is a conflict between the Islamic banking framework and the
existing law, the latter will prevail. In essence, therefore, the relationship
between the bank and the client, that of creditor and debtor is left unchanged
as specified by the existing law. .... The existing banking law was developed to
protect mainly the credit transactions; its application to other modes of
financing results in the treatment of those modes as credit transactions also.
Banks doubt whether some contracts, though consistent with the Islamic banking
framework, would be acceptable in the courts. Hence, incentives exist for
default and abuse.
In Iran,
although the law establishing interest-free banking20
... is comprehensive, the
lack of proper definitions of property rights may have constrained bank lending.
Thus far there has been no precise legislative and legal expression of what is
viewed as “lawful and conditional” private property rights. This may also have
militated against investment lending in agricultural and industrial sectors and
thus encouraged increased concentration of assets in short-term trade financing
instruments.
Iran and
Pakistan are countries committed to ridding their economies of riba and
have made immense strides in towards achieving it. Yet there are many legal
difficulties still to be solved as we have seen above. In other Muslim countries
the authorities actively or passively participate in the establishment of
Islamic banks on account of their religious persuasion. Such is not the case in
non-Muslim countries. Here establishing Islamic banks involves conformation to
the existing laws of the concerned country which generally are not conducive to
PLS type of financing in the banking sector. We will see some of these problems
below in section 4.4.
Dr
Hasanuz-Zaman, lists the traditional tasks of the bank and then questions its
ability to take on the additional functions it is called upon to perform under
the PLS scheme:21
It is due to historical
reasons that banks have evolved purely as a financial institution. They are
suited to attract money, keep it in safe custody, lend it under safety, invest
it profitably and enjoy the capacity to create the means of payment. A bank has
to maintain a balance between income, liquidity and flexibility. While
allocating its funds it has to be meticulously sensitive about the factors like
capital position and rate of profitability of various types of loans, stability
of deposit, economic conditions, influence of monetary and fiscal policy,
ability and experience of bank’s personnel and credit needs of the area. So far
these banks thrive on a fixed rate of return a portion of which is passed on by
them to the depositor. Thus the entire effort of a bank is directed towards
money management and it is not geared to act as an entrepreneur, trader,
industrialist, contractor or caterer.
The question arises: with
all these limitations can a bank claim any competence in trading or
entrepreneurship which is necessary for musharakah or
mudarba22 contract, or can it act as
an owner of a large variety of heavy machinery, transport vehicles or real
estate to take the position of a lessor or, can it act as a stockist to buy and
resell the entire stock of imports and exports that are needed by genuine
traders?
Then he
raises the even more serious question:
In case the bank is
historically and practically not competent to do all these jobs its claim to
share a portion of profits as a working partner, trader or lessor becomes
questionable.
Traditional banks do perform a certain
amount of project evaluation when granting large medium- and long-term loans.
But doing such detailed evaluation as would be required to embark on a PLS
scheme, such as determining the rates of return and their time schedule, is
beyond the scope of conventional banks. So is the detailed accounting and
monitoring necessary to determine the actual performance.
Under
Islamic banking these exercises are not limited to relatively few large loans
but need to be carried out on nearly all the advances made by the bank. Yet,
widely acceptable and reliable techniques are yet to be devised. This is
confounded by the fact that no consensus has yet been reached on the principles.
Both the unprecedented nature of the task as well as the huge amount of work
that need be done and the trained and experienced personnel needed to carry them
out seems a daunting prospect.
As was
seen in the previous section, the bank staff will have to acquire many new
skills and learn new procedures to operate the Islamic banking system. This is a
time consuming process which is aggravated by two other factors. One, the sheer
number of persons that need to be re-trained and, two, the additional staff that
need to be recruited and trained to carry out the increased work.
Principles are still to be laid down and
techniques and procedures evolved to carry them out. It is only after the
satisfactory achievement of these that proper training can begin. This delay and
the resulting confusion appears to be among the main reasons for the banks to
stick to modes of financing that are close to the familiar interest-based modes.
Among the
other disincentives from the borrower’s point of view are the need to disclose
his accounts to the bank if he were to borrow on the PLS basis, and the fear
that eventually the tax authorities will become wise to the extent of his
business and the profits. Several writers have lashed out at the lack of
business ethics among the business community, but that is a fact of life at
least for the foreseeable future. There is a paucity of survey or case studies
of clients to see their reaction to current modes of financing. As such we are
not aware of further disincentives that might be there.
When a
business is financed under the PLS scheme it is necessary that the actual
profit/loss made using that money be calculated. Though no satisfactory methods
have yet been devised, the first requirement for any such activity is to have
the necessary accounts. On the borrowers’ side there are two difficulties: one,
many small-time businessmen do not keep any accounts, leave alone proper
accounts. The time and money costs will cut into his profits. Larger businesses
do not like to disclose their real accounts to anybody. On the banks’ side the
effort and expense involved in checking the accounts of many small accounts is
prohibitive and will again cut into their own share of the profits. Thus both
sides would prefer to avoid having to calculate the actually realised
profit/loss. To quote Iqbal and Mirakhor:23
.... the commercial banks
do face an element of moral hazard owing to the non-existence of systematic
book-keeping in this sector. Additionally the reluctance of small producers to
submit their operations to bank audits and the perceived enormous cost of
auditing and monitoring relative to the small size of the potential credits
makes banks unwilling to extend credit on the basis of new modes of financing to
these small producers. These reduced lending to small producers may also explain
the existence of excess liquidity in the banking system.
The bank
is a big business and it has to declare its profit and loss and is legally
required to present an audited account of its operations. Once the bank’s
accounts are known it doesn’t take much for the tax collectors to figure out the
share of the businesses financed by the bank under the PLS scheme. Thus it’s no
surprise that businesses are not too very happy about the situation. The fact
that suggestions have been made to use the banks to collect taxes due has not
helped the matter either.
Presence
of excess liquidity is reported in nearly all Islamic banks. This is not due to
reduced demand for credit but the due to the inability of the banks to find
clients willing to be funded under the new modes of financing. Some of these
difficulties are mentioned under section 4.3.1 Financing. Here we have a
situation where there is money available on the one hand and there is need for
it on the other but the new rules stand in the way of bringing them together!
This is a very strange situation -- specially in the developing Muslim countries
where money is at a premium even for ordinary economic activities, leave alone
development efforts. Removal of riba was expected to ease such difficulties, not
to aggravate the already existing ones!
The
practices in use by the Islamic banks have evoked questions of morality. Do the
practices adopted to avoid interest really do their job or is it simply a change
of name? It suffices to quote a few authors.24
The
Economist writes:25
..... Muslim theoreticians
and bankers have between them devised ingenious ways of coping with the interest
problem. One is murabaha. The Koran says you cannot borrow $100m from the
bank for a year, at 5% interest, to buy the new machinery your factory needs?
Fine. You get the bank to buy the machinery for you -- cost, $100m -- and then
you buy the stuff from the bank, paying it $105m a year from now. The difference
is that the extra $5m is not interest on loan, which the Koran (perhaps)
forbids, but your thanks to the bank for the risk it takes of losing money while
it is the owner of the machinery: this is honest trading, okay with the Koran.
Since with modern communications the bank’s ownership may last about half a
second, its risk is not great, but the transaction is pure. It is not surprising
that some Muslims uneasily sniff logic-chopping here.
Dr Ghulam
Qadir says of practices in Pakistan:26
Two of the modes of
financing prescribed by the State Bank, namely financing through the purchase of
client’s property with a buy-back agreement and sale of goods to clients on a
mark-up, involved the least risk and were closest to the old interest-based
operations. Hence the banks confined their operations mostly to these modes,
particularly the former, after changing the simple buy-back agreement
(prescribed by the State Bank) to buy-back agreement with a mark-up, as
otherwise there was no incentive for them to extend any finances. The banks also
reduced their mark-up-based financing, whether through the purchase of client’s
property or through the sale of goods to clients, to mere paper work, instead of
actual buying of goods (property), taking their possession and then selling
(back) to the client. As a result, there was no difference between the mark-up
as practised by the banks and the conventional interest rate, and hence it was
judged repugnant to Islam in the recent decision of the Federal Shari’ah court.
As banks are essentially
financial institutions and not trading houses, requiring them to undertake
trading in the form of buy-back arrangements and sale on mark-up amounts to
imposing on them a function for which they are not well equipped. Therefore,
banks in Pakistan made such modifications in the prescribed modes which
defeated the very purpose of interest-free financing. Furthermore, as these
two minimum-risk modes of financing were kept open to banks, they never tried to
devise innovative and imaginative modes of financing within the framework of
musharakah and mudarba.
Prof.
Khurshid Ahmad says:27
Murabaha (cost-plus financing) and
bai’ mu’ajjal (sale with deferred payment) are permitted in the Shari’ah
under certain conditions. Technically, it is not a form of financial mediation
but a kind of business participation. The Shari’ah assumes that the financier
actually buys the goods and then sells them to the client. Unfortunately, the
current practice of “buy-back on mark-up” is not in keeping with the conditions
on which murabaha or bai’ mu’ajjal are permitted. What is being
done is a fictitious deal which ensures a predetermined profit to the bank
without actually dealing in goods or sharing any real risk. This is against the
letter and spirit of Shari’ah injunctions.
While I would not venture a
fatwa, as I do not qualify for that function, yet as a student of
economics and Shari’ah I regard this practice of “buy-back on mark-up” very
similar to riba and would suggest its discontinuation. I understand that
the Council of Islamic Ideology has also expressed a similar opinion.
Dr
Hasanuz Zaman is more scathing in his condemnation:28
It emerges that practically
it is impossible for large banks or the banking system to practise the modes
like mark-up, bai’ salam, buy-back, murabaha, etc. in a way that
fulfils the Shari’ah conditions. But in order to make themselves eligible to a
return on their operations, the banks are compelled to play tricks with the
letters of the law. They actually do not buy, do not posses, do not actually
sell and deliver the goods; but the transition is assumed to have taken place.
By signing a number of documents of purchase, sale and transfer they might
fulfil a legal requirement but it is by violating the spirit of
prohibition.
Again,29
It seems that in large
number of cases the ghost of interest is haunting them to calculate a
fixed rate percent per annum even in musharakah, mudarba, leasing,
hire-purchase, rent sharing, murabaha, (bai’ mu’ajjal, mark-up),
PTC, TFC, 30etc. The spirit behind all
these contracts seems to make a sure earning comparable with the prevalent rate
of interest and, as far as possible, avoid losses which otherwise could occur.
To sum
up, in Dr Hasanuz Zaman’s words:31
... many techniques that
the interest-free banks are practising are not either in full conformity with
the spirit of Shari’ah or practicable in the case of large banks or the entire
banking system. Moreover, they have failed to do away with undesirable
aspects of interest. Thus, they have retained what an Islamic bank should
eliminate.
The
modern commercial banking system in nearly all countries of the world is mainly
evolved from and modelled on the practices in Europe, especially that in the
United Kingdom. The philosophical roots of this system revolves around the basic
principles of capital certainty for depositors and certainty as to the rate of
return on deposits. In order to enforce these principles for the sake of the
depositors and to ensure the smooth functioning of the banking system Central
Banks have been vested with powers of supervision and control. All banks have to
submit to the Central Bank rules. Islamic banks which wish to operate in
non-Muslim countries have some difficulties in complying with these rules. We
will examine below the salient features.32
While the
conventional banks guarantee the capital and rate of return, the Islamic banking
system, working on the principle of profit and loss sharing, cannot, by
definition, guarantee any fixed rate of return on deposits. Many Islamic banks
do not guarantee the capital either, because if there is a loss it has to be
deducted from the capital. Thus the basic difference lies in the very roots of
the two systems. Consequently countries working under conventional laws are
unable to grant permission to institutions which wish to operate under the PLS
scheme to functions as commercial banks. Two official comments, one from the UK
an the other from the USA suffice to illustrate this.
Sir Leigh
Pemberton, the Governor of the Bank of England, told the Arab Bankers’
Association in London that:33
In the
United States, Mr Charles Schotte, the US Treasury Department specialist in
regulatory issues has remarked:34
There has never been an
application for an Islamic establishment to set up either as a bank or as
anything else. So there is no precedent to guide us. Any institution that wishes
to use the word ‘bank’ in its title has to guarantee at least a zero rate of
interest -- and even that might contravene Islamic laws.
Besides
these, there are other concerns as well. One is the Central Bank supervision and
control. This mainly relates to liquidity requirements and adequacy of capital.
These in turn depend on an assessment of the value of assets of the Islamic
banks. A financial advisor has this to say:35
The bank of England, under
the 1979 Act, would have great difficulty in putting a value on the assets of an
Islamic institution which wanted to operate as a bank in the UK. The traditional
banking system has much of its assets in fixed interest instruments and it is
comparatively easy to value that. For example, if they are British Government
instruments they will have a quoted market value; and there are recognised
methods for valuing traditional banking assets when they become non-productive.
But it is very difficult indeed to value an Islamic asset such as a share in a
joint venture; and the Bank of England would have to send a team of experienced
accountants into every Islamic bank operating in the UK as a bank under the 1979
Act, to try to put a proper and cautious value on its assets.
Another
financial analyst states:36
Even if a method could be
found for assessing the risks to calculate the capital necessary, little comfort
could be taken from the profitability which is usually relied upon to cover
day-to-day losses arising from the bank’s business, because a substantial part
of an Islamic bank’s portfolio is venture capital without any guaranteed return.
It is
evident then that even if there is a desire to accommodate the Islamic system,
the new procedures that need be developed and the modifications that need be
made to existing procedures are so large that the chances of such accommodation
in a cautious sector such as banking is very remote indeed. Any relaxation of
strict supervision is precluded because should an Islamic bank fail it would
undermine the confidence in the whole financial system, with which it is
inevitably identified. As Suratgar puts it:37
There could be potential
dangers for the international system, where the failure of such an institution
could bring with it the failure of other associated institutions, or of all the
Western banking institutions which come closely tied to with such an operation.
The
question has engaged the attention of Central Banks in Muslim countries as well.
But reliable satisfactory methods are still to developed.
Another
important consideration is the tax procedures in non-Muslim countries. While
interest is a ‘passive’ income, profit is an earned income which is treated
differently. In addition, in trade financing there are title transfers twice --
once from seller to bank and then from bank to buyer -- and therefore twice
taxed on this account decreasing the profitability of the venture. The Director
of the International Islamic Bank of Denmark says:38
Tax laws are against the
Islamic philosophy and pose the greatest difficulty. In most OECD countries
Mudarabha is constrained by fiscal acts which define profits as an after tax
item for the profit creator and a fully taxable item for the profit receiver.
People
have needs -- food, clothes, houses, machinery, services; the list is endless.
Entrepreneurs perceive these needs and develop ways and means of catering to
them. They advertise their products and services, peoples expectations are
raised and people become customers of the entrepreneur. If the customers’ needs
are fulfilled according to their expectations they continue to patronise the
entrepreneur and his enterprise flourishes. Otherwise his enterprise fails and
people take to other entrepreneurs.
Banks too
are enterprises; they cater to peoples’ needs connected with money --
safe-keeping, acquiring capital, transferring funds etc. The fact that they
existed for centuries and continue to exist and prosper is proof that their
methods are good and they fulfil the customers’ needs and expectations.
Conventional commercial banking system as it operates today is accepted in all
countries except the Islamic world where it is received with some reservation.
The reservation is on account of the fact that the banking operations involve
dealing in interest which is prohibited in Islam. Conventional banks have
ignored this concern on the part of their Muslim clientele. Muslims patronised
the conventional banks out of necessity and, when another entrepreneur -- the
Islamic banker -- offered to address their concern many Muslims turned to him.
The question is: has the new entrepreneur successfully met their concerns, needs
and expectations? If not he may have to put up his shutters!
Broadly
speaking, banks have three types of different customers: depositors, borrowers
and seekers of bank’s other services such as money transfer. Since services do
not generally involve dealing in interest Muslims have no problem transacting
such businesses with conventional banks; neither do Islamic banks experience any
problems in providing these services. Among the depositors there are current
account holders who too, similarly, have no problems. It is the savings account
holders and the borrowers who have reservations in dealing with the conventional
banks. In the following paragraphs we will see how well the Islamic banks have
succeeded in addressing their customers’ special concern.
As
pointed out earlier, our concern here is the savings account holders. As the
name itself indicates the primary aim of the saving account depositor is the
safe-keeping of his savings. It is correctly perceived by the conventional
banker and he guarantees the return of the deposit in toto. The
banker also assumes that the depositor will prefer to keep his money with him in
preference to another who might also provide the same guarantee if the depositor
is provided an incentive. This incentive is called interest, and this interest
is made proportional to the amount and length of time it is left with the bank
in order to encourage more money brought into the bank and left there for longer
periods of time. In addition, the interest rate is fixed in advance so that the
depositor and the banker are fully aware of their respective rights and
obligations from the beginning. And laws have been enacted to guarantee their
enforcement. In Economic theory the interest is often taken to be the
“compensation” the depositors demand and receive for parting with their savings.
The fact that the depositors accept the paid interest and that, given other
things being equal, they prefer the bank or the scheme which offers the highest
interest proves the banker’s assumption correct.
The
scheme is simple, transparent and seems to have satisfied the requirements of
all types of savers -- from teenagers to old-age pensioners, from individuals to
large institutions, pension funds and endowments, from small amounts to
millions, and from a few weeks or months to years -- that it has survived over
centuries and operates across national, cultural and religious borders.
The
situation is very different in the Islamic banks. Here too the depositor’s first
aim is to keep his savings in safe custody. Islamic bankers divide the
conventional savings account into two categories (alternatively, create a new
kind of account): savings account and investment account. The investment
accounts operate fully under the PLS scheme -- capital is not guaranteed,
neither is there any pre-fixed return. Under the savings account the nominal
value of the deposit is guaranteed, but they receive no further guaranteed
returns.39 Banks may consider funds under the savings accounts too as
part of their resources and use it to create assets. This is theory. In
practice, however, the banks prefer, encourage and emphasise the investment
accounts. This is because since their assets operate under the PLS scheme they
might incur losses on these assets which losses they cannot pass onto the
savings accounts depositors on account of the capital guarantee on these
accounts. In the process the first aim of the depositor is pushed aside and the
basic rule of commercial banking --capital guarantee-- is broken.40
It is
suggested that all Islamic banks guarantee the capital under their savings
accounts. This will satisfy the primary need and expectation of an important
section of the depositors and, in Muslim countries where both Islamic and
conventional banks co-exist, will induce more depositors to bank with the
Islamic banks. At the same time, it will remove the major objection to
establishing Islamic banks in non-Muslim countries.
But the
question is how does the bank make an income from these deposits? We will
examine this in the next section.
We have
already seen that all the problems of the Islamic banks arise from their need to
acquire their assets under the PLS scheme. A simple solution does, in fact,
already exist in the current theories of Islamic banking. It need only be
pointed out and acted upon. We will examine the provisions in the Iranian,
Pakistani and the Siddiqi models.41
All three
models provide for loans with a service charge. Though the specific rules are
not identical, the principle is the same. We suggest that the funds in the
deposit accounts (current and savings) be used to grant loans (short- and
long-term) with a service charge. By doing this the Islamic banks will be able
to provide all the loan facilities that conventional banks provide while giving
capital guarantee for depositors and earning an income for themselves.
Furthermore, and it is important, they can avoid all the problems discussed in
section 4.3. This would also remove the rest of the obstacles in opening and
operating Islamic banks in non-Muslim countries.
The bonus
for the borrowers is that the service charge levied by the Islamic banks will
necessarily be less than the interest charged by conventional banks.
Let us
now look at the existing relevant rules in the three models. The Iranian model
provides for Gharz-al hasaneh whose definition, purpose and operation are
given in Articles 15, 16 and 17 of Regulations relating to the granting of
banking facilities:42
Article 15
Gharz-al-hasaneh is a
contract in which one (the lender) of the two parties relinquishes a specific
portion of his possessions to the other party (the borrower) which the borrower
is obliged to return to the lender in kind or, where not possible, its cash
value.
Article 16
... the banks ... shall set
aside a part of their resources and provide Gharz-al-hasaneh for the following
purposes:
(a) to provide equipment,
tools and other necessary resources so as to enable the creation of employment,
in the form of co-operative bodies, for those who lack the necessary means;
(b) to enable expansion in
production, with particular emphasis on agricultural, livestock and industrial
products;
(c) to meet essential
needs.
Article 17
The expenses incurred in
the provision of Gharz-al-hasaneh shall be, in each case, calculated on the
basis of the directives issued by Bank Markazi Jomhouri Islami
Iran43 and collected from the
borrower.
In
Pakistan, permissible modes of financing include:44
Financing
by lending:
(i) Loans not carrying any
interest on which the banks may recover a service charge not exceeding the
proportionate cost of the operation, excluding the cost of funds and provisions
for bad and doubtful debts. The maximum service charge permissible to each bank
will be determined by the State Bank from time to time.
(ii) Qard-e-hasana loans
given on compassionate grounds free of any interest or service charge and
repayable if and when the borrower is able to pay.
Siddiqi
has suggested that 50 percent of the funds in the ‘loan’ (i.e. current and
savings) accounts be used to grant short-term loans.45 A fee is to be
charged for providing these loans:46
An appropriate way of
levying such a fee would be to require prospective borrowers to pay a fixed
amount on each application, regardless of the amount required, the term of the
loan or whether the application is granted or rejected. Then the applicants to
whom a loan is granted may be required to pay an additional prescribed fee for
all the entries made in the banks registers. The criterion for fixing the fees
must be the actual expenditure which the banks have incurred in scrutinising the
applications and making decisions, and in maintaining accounts until loans are
repaid. These fees should not be made a source of income for the banks, but
regarded solely as a means of maintaining and managing the interest-free loans.
It is
clear from the above that all three models agree on the need for having cash
loans as one mode of financing, and that this service should be paid for by the
borrower. Though the details may vary, all seem to suggest that the charge
should be the absolute cost only. We suggest that a percentage of this absolute
cost be added to the charge as a payment to the bank for providing this service.
This should enable an Islamic bank to exist and function independently of its
performance in its PLS operations.
The idea
of participatory financing introduced by the Islamic banking movement is a
unique and positive contribution to modern banking. However, as we saw earlier,
by making the PLS mode of financing the main (often almost the only) mode of
financing the Islamic banks have run into several difficulties. If, as suggested
in the previous section, the Islamic banks would provide all the conventional
financing through lending from their deposit accounts (current and savings), it
will leave their hands free to engage in this responsible form of financing
innovatively, using the funds in their investment accounts. They could then
engage in genuine Mudaraba financing. Being partners in an enterprise
they will have access to its accounts, and the problems associated with the
non-availability of accounts will not arise.
Commenting on Mudaraba financing,
The Economist says:47
.... some people in the
West have begun to find the idea attractive. It gives the provider of money a
strong incentive to be sure he is doing something sensible with it. What a pity
the West’s banks did not have that incentive in so many of their lending
decisions in the 1970s and 1980s. It also emphasises the sharing of
responsibility, by all the users of money. That helps to make the free-market
system more open; you might say more democratic.
Islamic
banking is a very young concept. Yet it has already been implemented as the only
system in two Muslim countries; there are Islamic banks in many Muslim
countries, and a few in non-Muslim countries as well. Despite the successful
acceptance there are problems. These problems are mainly in the area of
financing.
With only
minor changes in their practices, Islamic banks can get rid of all their
cumbersome, burdensome and sometimes doubtful forms of financing and offer a
clean and efficient interest-free banking. All the necessary ingredients are
already there. The modified system will make use of only two forms of financing
-- loans with a service charge and Mudaraba participatory financing --
both of which are fully accepted by all Muslim writers on the subject.
Such a
system will offer an effective banking system where Islamic banking is
obligatory and a powerful alternative to conventional banking where both
co-exist. Additionally, such a system will have no problem in obtaining
authorisation to operate in non-Muslim countries.
Participatory financing is a unique feature
of Islamic banking, and can offer responsible financing to socially and
economically relevant development projects. This is an additional service
Islamic banks offer over and above the traditional services provided by
conventional commercial banks.
1 Rad (1991), pp.3-4.
2 Siddiqi (1980), pp.219-20.
3 ibid. p.222.
4 Arabia, April 1982, No.8;
p.46
5 Wilson (1984)
6 Arabia, April 1982, No.8;
p.46
7 Wilson (1984)
8 ibid.
9 All quoted in Rad (1991).
p.13-14.
10 Ausaf Ahmed (1994). p.373.
11 Iqbal and Mirakhor (1987).
12 Elimination of Riba from
the Economy. Islamabad: IPS, 1994.
13 At present the author has
no information as to the recent situation in Iran.
14 ibid. p.24.
15 Quoted in: Rad (1991).
p.56.
16 Iqbal and Mirakhor (1987).
p.24.
17 ibid. p.24.
18 ibid. p.25.
19 Musharakah and Musharaka
are different English spellings of the same Arabic word.
20 ibid. p.25.
21 Zaman (1994). p.204.
22 Mudarba, Mudarabha and
Mudaraba are different English spellings of the same Arabic word.
23 ibid. p.25.
24 Italics are mine
25 The
Economist
(1994). p.9.
26 Qadir (1994). p.105.
27 Ahmad (1994). p.46-47.
28 Zaman (1994). p.208.
29 ibid. p.203.
30 PTC (participation term
certificate) and TFC (term finance certificate) are the two Pakistani
instruments to provide long-, medium- and short-term finace.
31 ibid. p.212.
32 All quotations in this
section appear in Rad (1991).
33
Pemberton
(1984)
34
Schotta
(1985)
35
Steele
(1984)
36 Suratgar (1984)
37 ibid. p.30.
38 Karsten (1982) p.120.
39 It should be noted that
early writers such as Mawdudi (1961) and Siddiqi (1968) conceived of savings
accounts with capital guarantee. In the Iranian model too capital is guaranteed.
The Law for Usury- (Interest) free Banking (August 1983), Chapter II, article 4.
In Pakistan, however, “... all deposits accepted by a banking company shall be
on the basis of participation in profit and loss of the banking company, except
deposits received in Current Account ...” State Bank of Pakistan, BCD Circular
No 13, 20 June 1984. See Appendix in Iqbal and Mirakhor (1987), pp.36-37.
40 We are at present not aware
of any survey or case studies of depositors which would enable us to assess
their reaction to this state of affairs.
41 Laws and regulations
relating to interest-free banking in Iran and Pakistan are reproduced in Iqbal
and Mirakhor (1987), pp.31-58. Siddiqi (1988).
42 Iqbal and Mirakhor (1987),
pp.36-37.
43 Central Bank of the Islamic
Republic of Iran.
44 Iqbal and Mirakhor (1987),
p.45.
45 the other 10 and 40 percent
respectively are to be used for cash reserve and mudaraba investment.
46 Siddiqi (1988), p.69.
47 op cit. p.9-10.
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