(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
4.1.2 The coming into being of interest-free banks
4.2.4 Shortcomings in current practices
4.3 Problems in implementing the PLS scheme
Term Structure of Investment by 20 Islamic Banks, 1988
4.3.3 Involvement in specialised non-bank activities
4.3.7 Uneasy questions of morality
4.4 Islamic banking in non-Muslim countries 8
4.4.1 Certainty of capital and return
4.5 Discussion and suggestions
4.5.1 Savings accounts and capital guarantee 10
4.5.2 Loans with a service charge
4.5.3 Investment under PLS scheme
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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