Book Review by De Economist, vol. 146, no.1 (April 1998)
(Quarterly Review
of the Royal Netherlands Economic Association)
A.L.M.
Abdul Gafoor, Interest-free Commercial Banking, Apptec
Publications, Groningen, 1995. pp.86.
and
A.L.M. Abdul Gafoor, Participatory Financing
through Investment Banks and Commercial Banks, Apptec Publications,
Groningen, 1996. pp.97.
Interest plays a central role in
the Western monetary system. This role is firmly embedded in classical
economic theory (Fisher, 1930).[I. fisher, The Theory of Interest, New
York, Macmillan, 1930.] But what are the consequences for a monetary
system, if interest in the classical sense (that is, the compensation for
individuals who are willing to exchange current consumption for future
consumption) is prohibited by religion, as in the case of Islam? This is
the subject matter of the two books reviewed here. The first volume
shows, using a general model of the commercial bank lending process, that
interest can be eliminated from modern commercial banking (assuming that the
clientele wishes to avoid dealing in interest, which is a sin as far as Muslims
are concerned). In the resulting banking system depositors entrust their
money to the bank for safe-keeping and permit the bank to use their funds to
grant loans. Capital is guaranteed but no interest is paid.
Borrowers obtain their loans through the bank and they pay a fee for the
services provided the bank. The bank is an agent of the borrower (it
finds counterparts for the borrower who are willing to advance to the borrower
funds) and not a lender. Banks in this system are service providers,
whose main income is the fees they charge for the service they provide.
In the above mentioned system there
is no mechanism by which income is generated for the depositors. But
Islam has nothing against profit (the Koran assumes a system based on
individual enterprises and individual reward), and the second volume discusses
the possibilities Islamic banks have to use depositors' funds to earn an income
for themselves as well as for depositors. To this end, Islamic banks have
invented the concept of participatory financing. In this concept, the
bank, using the money entrusted to it by depositors, participates in an
enterprise. It is a partnership between entrepreneur, bank and depositor,
in which all risks are shared. The bank is the intermediary between
entrepreneur and depositor. The funds used to finance these participations
come from so-called 'investment accounts.' These are time deposits which
bear no interest, and the deposited capital is not guaranteed (nor is there any
profit guarantee). This system of participatory financing has features
that are attractive, at least in theory. For one thing, it gives the
provider of money a strong incentive to be sure that he is doing something
sensible with it. Moreover, the system stresses the sharing of
responsibilities by all users of funds, and this accountability helps to make
the system more open. But, as the author extensively discusses, the
system of participatory financing also has its drawbacks. The
intermediary role played by the banks implies that these institutions need to
have considerable expertise and experience in project selection and evaluation
and assumes that the bank knows as much about the business in question as the
entrepreneur does. If not, there is asymmetry in information which could
make the banks averse to such participations. Moreover, participatory
financing seems applicable only to certain types of projects, i.e.
entrepreneurs investing in new enterprises. The failure to recognise the
later drawback is, according to the author, the main reason for the problems
currently faced by the Islamic banks. The latter applied the concept of
participatory financing to projects for which conventional financing through
lending from their deposit accounts would be appropriate. Also, they used
funds from other accounts than the investment account for financing the
participations. This caused problems as the guarantee of capital is (in
the absence of interest) the sole reason for holding these other accounts (i.e.
time and savings deposits), and capital is not guaranteed under participatory
financing.
All in all, these two volumes
present an interesting analysis of a banking system without interest.
Knowledge of such a system is useful, because a large part of the world
population adheres to a religion which prohibits interest but still is in need
of the economic functions performed by a "Western-style,"
interest-bearing, banking system. Moreover, rethinking a banking system
without interest requires one to understand the precise role interest plays in
the conventional interest-bearing system. This understanding is useful by
itself.
Jan Marc Berk