CONVERSION FROM INTEREST-BASED TO ISLAMIC BANKING
ZIAUDDIN AHMED
It is the cardinal belief of Muslims the world over that Islam provides a complete set of guidelines for organizing human activity in all spheres of life. The basic Islamic precepts for organizing the economic side of life, if put into practice, give rise to an economic system which has an individuality of its own with its main characteristics manifestly different from both the capitalist and socialist forms of economic organization.
One of these basic precepts is that all transactions based on the giving or taking of interest should be avoided. In fact, interest-based transactions are most severely condemned and those who engage in these transactions are warned of severe chastisement in the hereafter. Since the whole edifice of conventional banking is built on the institution of interest, the Muslim mind cannot obviously reconcile to it, and has to look for an alternative model of banking which may be compatible with Islamic teachings.
It is a fact of life that despite the severe condemnation of interest in Islam, Muslim societies were unable to keep away from interest-based transactions when modern banks appeared on the scene. The reason for this is to be found in the military and political subjugation of a large part of the Muslim world by the Western colonial powers who foisted alien financial practices on the Muslim people. The drift away from Islamic teachings, specially on the part of sizeable segments of the well-to-do and educated classes, under the Western influence, was also a factor in the passive reaction to the inroad of the institution of interest in Muslim societies.
With the attainment of freedom from the foreign yoke and the resurgence of Islam, there is a widespread yearning in Muslim countries to reorder their economic life in the light of the injunctions of Islam. Elimination of interest, which is prohibited in Islam, is one of the biggest challenges facing the Muslim world in this context.
In recent years a good deal of attention has been paid by Muslim experts in economics, banking and finance to finding ways and means of replacing interest. Muslim economists have developed theoretical models of an interest-free economic system and examined the implications of the abolition of interest on economic growth, allocation of resources and distribution of income. They have also provided a theoretical basis for organising modern banking functions on an interest-free basis. Practising bankers have also made valuable contributions to the literature on interest-free banking.
The concept of interest-free banking is no longer confined only to the realm of ideas. T h e last two decades have witnessed the emergence of a number of Islamic banks which are operating in different parts of the world on a non-interest basis. Three countries of the Muslim world, Pakistan, Iran and Sudan, have taken a bold initiative to abolish interest on an economy-wide basis, and considerable headway has already been made towards the achievement of this objective.
This paper deals with matters related to the conversion of an interest-based banking system to an Islamic interest-free banking system in the light of both the theoretical contributions on the subject and the operating experience of Islamic financial institutions working in different countries.
The paper is divided into four sections. The first section deals with the general approach to such a conversion. The second section deals with the mechanics of conversion on the liabilities side of the banking system. The third section is concerned with the conversion on the assets side. The fourth and final section discusses certain policy issues related in general to the Islamisation of the banking system.
The General Approach
The guidance for all institutional developments in an Islamic society is to be derived from the principles of the Sharia. The form and content of Islamic banking practices have therefore to be deduced from the teachings of Islam. There was no prototype of modern banks in the early history of Islam. Even in the Western countries, banking in the form in which it exists today is of comparatively recent origin.
The attitude of Islam to all known innovations is that nothing should stand in the way of their adoption if they are useful for human society and do not conflict with the fundamental principles as enunciated in the Holy Qur’an and the Sunnah. Banks are essentially a financial intermediary between savers and investors. Apart from that, banks also create credit.
However, this is not integral to banking business, as proposals of 100 per cent reserve requirement demonstrate. Since savings can perform a useful purpose for the society only if they are invested and all savers cannot be expected to possess the skill necessary for productive investment, there is no reason to doubt that banks as institutions may exist in an Islamic society. However, as far as the conduct of actual banking business is concerned, banks in an Islamic society cannot be patterned on the Western model as it has features repugnant to Islam.
The Western banking system is primarily based on interest. Prohibition of interest in Islam necessitates that in countries seeking to introduce an Islamic economic system, banking and financial practices be organised on a basis other than interest.
In determining what should be done to replace interest in the banking system, it is important to bear in mind the reasons underlying the prohibition of interest in Islam. Some are puzzled as to why Islam should prohibit interest when it appears to be innocuous, particularly in its modern manifestations.
It is pointed out, for example, that there appears to be nothing obnoxious in the practice of people getting some return by way of interest on the money they deposit with banks, as banks lend this money mostly for productive purposes on which they also get a return by way of interest.
Similarly, they wonder why any odium should be attached to the practice of banks charging interest from persons or business entities to whom they lend, because the loan extended to them enables them to earn a profit out of which they pay a part to the banks by way of interest. Yet, if one analyses the consequences of the practice of interest for the general welfare of a society, it is not difficult to decipher the reasons for its prohibition by Islam.
The delineation in the Holy Qur’an of the practice of interest as an act of “war with Allah and His messenger”, provides a clue to the philosophy behind the prohibition of interest in Islam. It is a clear pointer that the institution of interest is something which runs counter to the scheme of things which Islam stands for and which Allah wants to see established on earth.
The words, “Allah has blighted riba and made Sadaqat fruitful” (II: 276) also point towards the fact that the practice of interest militates against the objectives of an Islamic society, while Sadaqat promotes these objectives. The call given in the same Surah “O ye who believe! Observe your duty to Allah and give up what remaineth (due to you) from riba if ye are (in truth) believers” (II: 278), shows that the practice of interest is incompatible with the spirit of Islam, and has no place in a society of true believers.
The rationale for the prohibition of interest on loans used for consumption purposes is clearly based on the ethical consideration that people living in an Islamic society should help each other in times of need by lending money without charging extra for it. Charging of interest on loans used for consumption purposes amounts to taking advantage of a man’s inferior economic position, and is repugnant to the spirit of Islam, whose underlying philosophy is one of al-‘adl wa’l ahsan.
In the modern age, it is credit for production purposes rather than for personal consumption that dominates the scene. The Western-type banks mobilise the savings of the people by undertaking to pay a predetermined return on savings and time deposits while guaranteeing the safety of the principal amount of the deposit. They lend resources to business enterprises and charge interest on the principal amount of the loan. On the face of it, this looks like an innocuous arrangement.
However, such an arrangement has many undesirable features that militate against the ethical norms of Islam and also stand in the way of achievement of the socio-economic objectives of an Islamic economy. An understanding of these undesirable features is necessary, not only for appreciating the rationale behind the prohibition of interest even in the case of loans for production purposes, but also for fashioning an alternative system which may be in consonance with the spirit of Islam. The undesirable features of an interest-based banking system, looked at in the context of the operative principles that currently underlie banking practice, may be listed as follows:
a) Transactions based on interest violate the equity aspect of an economic organisation. The borrower is obliged to pay a predetermined rate of interest on the sum borrowed even though he may have incurred a loss. Even when a profit is made, the fixed rate of interest can prove an onerous burden if the rate of profit earned is less than the rate of interest payable. When money is invested in a productive undertaking, the actual outcome in terms of profit or loss is not certain. To insist on “a pound of flesh” irrespective of the economic circumstances of the borrower of the money militates against the Islamic norm of justice.
b) The inflexibility of an interest-based system in a loss situation leads to a number of bankruptcies, resulting in loss of productive potential and unemployment. The dead weight of interest in terms of depressed economic activity characterised by low profitability makes industries “sick” and makes their “recovery” extremely problematic, which again has adverse consequences for the employment situation.
c) The interest-based system is security oriented rather than growth-oriented. Because of the commitment to pay a predetermined rate of interest to depositors, banks in their lending operations are most concerned about the safe return of the principal lent along with the stipulated interest. This leads them to confine their lending to the already well-established big business houses or such parties as are in a position to pledge sufficient security.
If they find that such avenues of lending are not sufficient to absorb all their investible resources, they prefer to invest in government securities with a guaranteed return. This exaggerated security orientation acts as a great impediment to growth because it does not allow any flow of bank resources to a large number of potential entrepreneurs who could add to the gross national product by their productive endeavour, but do not possess sufficient security to pledge with banks to satisfy their criteria of creditworthiness. Over-supply of credit to well-established parties and its denial to a large segment of the population also results in increasing inequalities of income and wealth.
d) The interest-based system discourages innovation, particularly on the part of small-scale enterprises. Big industrial firms and big landholders can afford to experiment with new techniques of production as they have reserves of their own to fall back upon in case the adoption of new practices does not yield a good dividend. Small-scale enterprises hesitate to go in for new methods of production with the help of money borrowed from banks, as the liability of the banks for the principal sum and interest has to be met irrespective of the results, while they have very little reserves of their own. In agriculture particularly, small farmers are deterred from adopting new cultivation practices on account of this factor. This not only acts as an impediment to the rate of growth but also aggravates income inequalities.
e) Under the interest-based system, banks are only interested in recovering their capital along with the interest. Their interest in the ventures they finance is therefore strictly limited to satisfying themselves about the viability and profitability of such ventures from the point of view of the safety of their capital and the ability of the venture to generate a cash flow which can meet the interest liability.
Since the return the banks get on the capital sum lent by them is fixed and does not vary with the actual profits of the ventures to whom they lend, there is no incentive on the part of the banks to give priority to ventures with the highest profit potential. Efficiency in resource allocation is most often judged by the profitability of a productive undertaking. Social considerations may necessitate judging the utility of certain projects with reference to criteria other than profitability. However, in the case of the bulk of private sector projects profitability is the main criterion of economic efficiency. Lack of sufficient attention to the profit potential of various projects and preference in lending to well-established parties leads to misallocation of resources in the interest-based system.
The operating procedures of Islamic banking have to be evolved keeping in view the injunctions of the Holy Qur’an and the Sunnah, the inequities and inefficiencies of an interest-based system and the ethos of the value system of Islam.
There seem to be two broad alternatives. The first is to decree that no return would be paid on any type of deposits in banks and all loans and advances will be provided on an interest-free basis. Under this scheme the banks would only be allowed to recover a service charge from their clientele sufficient to cover their operating expenses.
Since the banking business under this scheme would cease to be a profitable undertaking, the banking system would need to be a nationalised one and treated as a public service. However, this alternative cannot be commended because it would have adverse consequences for economic growth and allocative efficiency. Absence of any return on bank deposits would lead to a dramatic decline in the flow of resources to banks and would lead to the withering away of the banking system. This would not be to the advantage of the community, as banks perform a useful service as an intermediary between savers and investors.
Other institutions may, of course, come in, but economic growth can be adversely affected if the gap caused by the withering away of the banking system is not adequately filled. Allocative efficiency would be adversely affected because absence of any return on finance provided by banks would result in even less attention being paid to the profit potential of various projects than in the interest-based system.
Besides, this alternative would also militate against the objective of an equitable distribution of income and wealth, to which Islam attaches great importance. A large number of depositors in banks belong to lower income groups, while borrowers are mostly businessmen who belong to more affluent sections of the population.
Under the interest-free system with a sei-vice charge, businessmen would retain all the profits they earn with the help of resources provided by the less well-to-do sections of the population. This would aggravate the mal-distribution of incomes and wealth, and would certainly be contrary to what Islam stands for.
The other alternative is that banking should be conducted on the basis of profit/loss sharing. While any return on capital in the form of interest is completely prohibited in Islam, there is no objection to getting a return on capital if the provider of capital enters into a partnership with a worker or entrepreneur and is prepared to share in the risks of the business.
This points to the possibility of organising banking so that the depositors and shareholders of the bank get a return on their capital related to the actual results of the business undertakings. In other words, depositors of the bank might not be guaranteed a predetermined return on their savings, but they would be entitled to a share in the actual profits earned by the bank, similarly, the bank; would not be entitled to claim a predetermined return on the capital provided by it to the business undertaking but could enter into a profit/loss sharing arrangement with them.
Provision of financial resources to business undertakings for productive purposes on the basis of profit/loss sharing, fulfils the Islamic norms of justice, as Islam allows a return on capital, provided the provider of capital shares in the risks of the business.
Apart from fulfilling the criterion of equity, a banking system based on profit/loss sharing can assist greatly in achieving the socio-economic objectives of an Islamic society. Islam favours full utilisation of the productive resources of an economy and lays great stress on an equitable distribution of income and wealth. A banking system based on profit/loss sharing is likely to provide a tremendous boost to economic development by enlarging the supply of risk capital.
Besides, such a system may quicken the pace of technological development through greater encouragement to innovation and experimentation with new techniques of production. It will also promote greater allocative efficiency, as banks will join hands with business enterprises in maximising productivity, since the profit/loss sharing arrangement, unlike the lending arrangement, ties up the return on bank funds with the actual performances of an enterprise.
It is recognised that some difficulties may be encountered in the practical application of the principle of profit/loss sharing in certain spheres. To meet such situations, certain other methods of financing which are not prohibited in Islam can be used. These will be mentioned in the third section of this article.
Conversion on the Liabilities side
The main items on the liabilities side of an interest-based bank are its paid-in capital reserves, demand savings and time deposits of the general public, inter-bank deposits, inter-bank borrowings and borrowings from the central bank of the country.
The conversion of interest-based banking to interest-free banking does not require any modification in the structure of a bank’s liabilities in so far as paid-in capital and reserves are concerned. Payment or receipt of interest is not involved in these two components of a bank’s liabilities, and these can continue to appear in the same format in an Islamic bank’s balance sheet.
There will be a change, however, in the way the return on shareholders’ equity, consisting of paid-in capital and reserves, is determined. In the interest-based system, the return on shareholders’ equity is the residual amount of profit remaining after the contractual interest payments on various types of deposits and borrowings have been made. In the interest-free system, none of the items on the liabilities side is eligible to receive a pre-determined return, and hence the shareholders of the bank share in the actual profits earned by the bank, along with the other contributors to the resources of the bank.
It is generally agreed that there is nothing objectionable, from the Sharia point of view, in the deposits of an Islamic interest-free bank having different maturities. Thus, an Islamic bank can continue to accept both demand deposits and time deposits. An Islamic bank can also attract resources through savings deposits that occupy an intermediate place between demand deposits and time deposits.
However, there will be a basic change in the characteristics of both saving and time deposits. Demand deposits in the conventional banking system are fully repayable on demand. Banks usually do not pay anything on these deposits and some banks even levy a service charge on such deposits. Demand deposits in the Islamic banking system will continue to maintain their previous characteristics.
Resources flowing in the form of demand deposits entail the possibility of both profit and loss, yet full payment of the principal amount of such deposits is guaranteed at all times on demand. In fact, these deposits are treated as a loan from a client to the bank. For this reason, some Islamic banks have given these deposits the nomenclature of qard al-hasana deposits.
In Iran, for example, consequent to the passing of the Law for Interest-free Banking in 1983, demand deposits of banks were renamed as qard-al-hasana deposits. It has been the opinion of certain scholars that demand deposits are of the nature of an amanah, because they are handed over to a bank for safe custody. Banks, therefore, are expected to hold these deposits in trust. However, even scholars agree that banks can use these resources in their operations with the specific permission of the owners of these funds.
The conventional banking system has another category of deposits, known as savings deposits. These are differentiated from demand deposits, as they are subjected to certain restrictions with respect to the amounts that can be withdrawn from such accounts at any one time and the periodicity of such withdrawals. The savings deposits usually bear a fixed return by way of interest in the conventional banking system.
When an interest-based banking system is converted to an interest-free banking system, the saving deposits can continue to maintain their separate identity, but they will cease to earn a pre-determined return. According to the principles of the Sharia, holders of saving deposits can be enabled to get a return which is not contractually fixed and fluctuates with the profits of the banks, provided they undertake to share in the loss also, in the event of the bank making a net loss in its operations.
Most of the Islamic banks conform to this principle in their operating procedures. However, there are cases where holders of savings deposits are given some benefits, though not in the form of a contractually fixed pre-determined return, even though the nominal value of such deposits is fully guaranteed.
In the case of Bank Islam Malaysia Berhad, for example, the Bank is allowed, at its absolute discretion, to reward the holders of saving deposits by “returning a portion of the profit generated from the use of their funds from time to time”. In Iran, saving deposits are included in the category of qard al-hasana deposits, and they earn no return. The law on banking requires the full nominal value of such deposits to be guaranteed by the banks.
However, the banks are allowed to offer incentives to attract saving deposits which can include one or all of the following: non-fixed prizes and bonuses in cash or kind; an exemption from, or a discount in, the payment of commission and fees; and priority in use of banking facilities.
Time deposits in the conventional banking system carry a guarantee of their nominal value and earn a pre-determined return. When converting to an interest-free banking system, these have to be replaced by deposits that do not earn a fixed return. If the bank makes profits, holders of time deposits will be entitled to receive a certain proportion of these profits. On the other hand, if the bank incurs losses, the depositors will have to share in these as well. Because of the change in the nature of these deposits, which make them akin to shares in a business firm, many Islamic banks have given them the name of “Investment Accounts” or “Investment Deposits”.
The investment deposits of an Islamic bank can have different maturity periods. In Pakistan, for example, the profit/loss sharing deposits (PLS deposits) have maturity periods of three months, six months, one year, two years, three years, four years and five years or over. In Iran, banks are authorised to accept two types of investment deposits, short-term and long-term.
The deposits differ with respect to the minimum required time limits, three months for short-term and one year for long-term deposits. Apart from limited-period deposits, some Islamic banks also accept unlimited period investment deposits. In this case, the period of deposits is not specified, and the deposits are automatically renewed unless a notice of termination of deposits is given of a mutually agreed time interval. This interval is usually of three months, as is the case, for example, at the Bahrain Islamic Bank and the Kuwait Finance House.
The resources flowing into the investment accounts, along with the demand deposits, are pooled together and form the principal source of Islamic banks’ financing activities on the assets side. However, Islamic banks can also have specific investment accounts in which deposits are made for investment in particular projects.
The return to the depositors in these accounts depends on the outcome of these particular projects and the ratio of profit sharing agreed between the bank and the depositors. Specific investment accounts of this type are being operated by a number of Islamic banks, such as, for instance, the Kuwait Finance House and Jordan Islamic Bank.
The conversion of interest-based banking to Islamic interest-free banking would necessitate suitable modification in operating procedures, not only with respect to deposits from the general public, but also in respect of inter-bank deposits, inter-bank borrowings and borrowings from the central bank of the country. In the conventional banking system, all these transactions take place on the basis of interest.
In the Islamic system, these transactions will have to take place either on the basis of qard-al-hasana or profit-sharing. There should be no difficulty in doing this in domestic banking transactions when an economy-wide switchover from interest-based banking to interest-free banking takes place. However, some problems may be encountered in respect of transactions with banks abroad. Foreign banks may be reluctant to offer correspondent banking services except on the basis of interest.
This problem was fairly acute in the initial period of Islamic banking. However, with the increased familiarity of the non-Muslim world with the concept of Islamic banking and the operating procedures of Islamic banks, this problem has greatly eased in recent years. Islamic banks have succeeded in securing the correspondent banking services of conventional banks on mutually agreed terms which do not involve the payment or receipt of interest. The main elements of such mutually agreed terms are reported to be as follows:
a) The Islamic banks will keep a reasonable amount of cash in their current account with the correspondent banks.
b) The Islamic banks will endeavour to correct a debit balance in their accounts with correspondent banks as soon as possible.
c) The correspondent bank will not charge any interest on the temporary debit balances of Islamic banks in lieu of its freedom to use the credit balances of Islamic banks profitably without paying any compensation to the Islamic banks.
d) As partial security, the correspondent bank, while adding its confirmation to import letters of credit, will debit the Islamic banks only with a certain “cash margin”, so that Islamic banks need to keep only such credit balances with correspondent banks as are likely to cover the cash margins of the letters of credit and not the whole value of these letters.
Before concluding this section, it is necessary to dwell briefly on the principles governing the allocation of profits accruing to a bank among its remunerable liabilities. The basic principle of the Sharia, which has to serve as a guideline in this respect, is that if there is more than one provider of capital to a business undertaking, profits can be distributed among them in proportions mutually agreed upon, but losses, if any, have to be borne by them strictly in proportion to the capital provided by each party.
In most of the earliest theoretical models of Islamic banking, shareholders’ equity and investment deposits were deemed to be the only two remunerable liabilities of an Islamic bank, and holders of investment deposits were treated as one homogeneous group. The profit-sharing arrangements between these two broad groups of providers of capital were envisaged along the following lines:
a) The aggregate profit earned by the bank on the total capital will be divided over it. After such a division, an agreed proportion of the profit will be kept by the bank and the rest will be given to the holders of investment deposits. Th e proportion of profit division will be determined with the mutual consent of the two parties concerned.
b) If the bank suffers a loss, the loss will be shared between the two parties in strict proportion to the capital supplied by each party.
c) The maximum incidence of loss to an investment account holder in a loss situation will be limited to the amount of his deposit.
In later contributions to the literature on Islamic banking, it was recognised that profit-sharing arrangements among the remunerable liabilities of an Islamic bank could take more complex forms while still remaining within the Sharia parameters. It was felt that there was a strong case for some flexibility in profit-sharing ratios depending upon the degree of risk to which various types of remunerable liabilities were exposed. The investment deposits of a longer maturity could be given an edge over deposits of shorter maturity in the profit-sharing arrangements. Similarly, a distinction could be made between the providers of redeemable capital and non-redeemable capital, with provision of a larger return to providers of non-redeemable capital.
It will be interesting to note here that the Council of Islamic Ideology in Pakistan, in its Report on the Elimination of Interest from the Economy, approved in principle the idea of introducing a system of weights for apportioning profits to various providers of capital based on whether the capital is redeemable or non-redeemable and, within redeemable capital, between capital which is redeemed in a short period and that which is redeemed after a longer period.
The idea has already been put into practice, and net profits of banks in Pakistan are allocated to the remunerable liabilities in different proportions keeping in view their relative maturities. The smallest weight is accorded to special-notice deposits from other banks. The same principle of differentiation is followed within the category of time deposits, where highest weightage is accorded to deposits of five years or more and smallest to deposits of three months.
The highest weightage among all remunerable liabilities is assigned to equity. The logical consequence of the weightage system adopted in Pakistan has been that, owing to the differences in the composition of liabilities and net profits, different banks offer different rates of return on various categories of deposits, even if the average maturity structure is the same.
Conversion on the Assets side
The main items on the assets side of an interest-based bank are cash, balances with the central bank of the country, balances with other banks, bills purchased and discounted, loans and advances, and investment in various types of securities and shares. Cash and balances with the central bank of the country are non-interest-earning assets. They retain their place when a switchover from interest-based banking to interest-free banking takes place.
Balances with other banks do not earn any interest if they can be withdrawn on demand, but they earn interest in the conventional banking system if they are kept in the form of time deposits. While there would be no change in the status of inter-bank demand deposits after the switch to interest-free banking, inter-bank time deposits within the country will cease to earn interest and the depositor bank will instead be given a share in the profit of the recipient bank. The change-over to Islamic banking would also mark the end of keeping balances with banks abroad in the form of interest-bearing time deposits.
Bills purchased and discounted are an important component of the assets of interest-based banks. Islamic teachings do not preclude the use of bills of exchange, but discounting of bills is not allowed because exchange before their dates of maturity is a genuine need of the business community, which must continue to be met after the conversion of interest-based banking to interest-free banking. The alternative to bill discounting in the interest-free system which has found wide support among Sharia experts is as follows:
The drawer of the bill of exchange enters into two separate agreements with the bank, one pertaining to the appointment of the bank as his agent for the collection of the amount from the drawee on the due date, and the other for receiving a loan from the bank in an amount due to the drawer from the drawee, while the loan extended to the drawer of the bill, will be free of interest. The commission to be charged by the bank can vary according to the amount of the bill but not according to the period of payment. On collection of the bill, the bank will adjust the loan account of the drawer. In case the bill is dishonoured, the drawer will be liable for payment of the loan amounts to the bank.
Banks in the interest-based system hold government securities as well as debentures of business concerns as part of their earning assets. In a country that undertakes the conversion of an interest-based banking system to an Islamic interest-free banking system, it is expected that measures will be taken to develop new financial instruments to replace interest-bearing financial instruments. Possibilities exist for developing a wide variety of financial instruments that are compatible with Sharia.
Instead of resorting to debt finance through issuance of interest-bearing government securities, the government can issue variable dividend share certificates to mobilise resources for a particular project or a group of projects with good profit potential on the basis of Sharia-approved principles of profit-sharing. Debentures of business firms can be replaced by issuance of a new type of corporate security with a fixed maturity which entitles its holders to share in the profits of the concern issuing it instead of receiving a guaranteed return. The conventional banks usually avoid investment in the ordinary shares of business concerns, and in many countries, they are even prohibited from investing in shares. Islamic banks, on the other hand, can hold shares of business concerns in their investment portfolio without any inhibition.
The most remarkable aspect of the conversion of an interest-based banking system to an Islamic interest-free banking system is the relegation of loans and advances to a very minor role, whereas they play a dominant role in the assets structure of the interest-based system.
This is for the simple reason that no return is allowed on loans and advances in the Islamic system, whereas in the conventional system they are high-return assets. However, Islamic teachings allow the use of a wide variety of techniques by banks to meet the financial requirements of productive sectors of the economy. The use of lending is confined mainly to helping to meet the needs of those who are unable to secure financing facilities in any other way.
The direct or indirect financial accommodation that can be provided by Islamic banks falls broadly into three groups:
a) Participative finance provided under profit-sharing arrangements,
b) Facilities provided through sales and rental contracts, and
c) Lending without any return, that is, Qard-Al-Hasana.
The salient features of various techniques, as categorised into these three broad groups, are discussed below.
A. Participative finance
Mudaraba: This is a participative arrangement in which one party (known as rab al-maal) provides capital and the other (known as mudarib) utilises it for business purposes under an agreement that profit from the business will be shared according to a specified proportion; but loss, if any, unless caused by negligence or violation of contract by the mudarib, will be borne by the rah al-maal.
This is an essential feature of a mudaraba contract on which there is complete agreement among jurists of all schools of thought. The jurists in the early Islamic period were concerned with the fact that the system oi mudaraba, though allowed in Islam, could possibly be used to derive unfair advantage by one of the two parties. They, therefore, set out a number of conditions for the validity of a mudaraba contract to safeguard the interests of both the rah al-maal and the mudarib. The views of the jurists differ in respect of some of these conditions.
In designing, operating procedures of interest-free banking, modern scholars have tried to follow as closely as possible the precepts of the highly respected jurists of the early Islamic period. However, in matters on which the Qur’an and the Sunnah contain no specific injunction, they have, where necessary, departed from some of the earlier opinions, particularly in matters of detail, to suit modern-day conditions. This is in consonance with the objectives of the Sharia and aids the growth of Islamic jurisprudence to meet the challenges of the modern age.
There is widespread agreement among scholars that, in applying the concept of mudaraba to the financing operations of banks in modern times, the following would be reasonable stipulations:
a) The bank as the rab al-maal will not interfere in the routine transactions of the business of the mudarib. The mudarib, however, will furnish regular periodical reports to the bank on the state of the business.
b) The mudarib can employ his own capital also in the mudaraba business, but this requires the specific permission of the rab al-maal. With the same condition, the mudarib can procure further capital from others on the principles of mudaraba.
c) The mudarib is not allowed to lend to another party out of the funds collected under a mudaraba agreement without the specific permission of the rab al-maal. Similar restriction applies to borrowing by the mudarib from other persons for use in business.
d) The financial liability of the bank as rab al-maal is limited to the amount provided by it, except where it has increased its own liability by permitting the mudarib, on its behalf, to borrow from another party.
e) Profit earned from mudaraba business will be distributed between the rab al-maal and the mudarib on the basis of proportions settled in advance. No fixed amount can be settled for any party.
f) In the event of a loss, except in case of the loss having been caused by the negligence of the mudarib or violation of the terms of the contract by the mudarib, the entire loss has to be borne by the rah al-maal.
g) In a running business, losses will be made good by profit till the business comes to a close and accounts are settled finally.
Musharaka: This is a participative arrangement in which two or more parties enter into a contract of business partnership with well-defined amounts of capital and mutual sharing of profits and losses. The salient features of a musharaka contract, which are widely agreed among jurists to be in consonance with Islamic teachings and are also suitable for adoption in modern times in the context of Islamic banking, can be stated as follows:
a) Musharaka agreements can be entered into amongst the partners for a specific transaction or for the whole business for an agreed duration and may be renewed by mutual consent.
b) In medium- and long-term operations, a “self-liquidating” form of partnership can be agreed upon, whereby one of the partners (usually the bank) retrieves its entire capital over an agreed period of time while sharing in the profits and losses realised during that period.
c) All providers of capital are entitled to participate in the management of the business but are not necessarily required to do so.
d) All the partners will be provided with information about the operations of the business and its financial situation at regular intervals.
e) Prior permission of the co-partners will be necessary before entering into a new musharaka or mudaraba agreement with other parties.
f) The profits of musharaka business will be distributed according to agreed ratios which need not be the same as the capital proportions but loss will have to be borne strictly in proportion to the capital invested by each partner.
g) For the purpose of profit/loss sharing, the respective capital contributions of the parties, utilised for varying periods, would be brought to a common denomination by multiplying the amounts with the number of days during which each particular item such as the equity capital of a firm, its current cash surpluses, suppliers’ credit and the finance provided by the bank were actually deployed in the business. In other words, the calculation of the respective capital contribution of the parties would be made on a daily product basis.
h) other conditions of a musharaka agreement will be more or less the same as mentioned in the context of mudaraba business.
B. Sales and rental contracts
Murabaha and Bai Muajjal. Murabaha is one of the various kinds of sale-purchase transactions permitted in the Sharia. Supply of goods by the seller to the buyer with a specified profit margin mutually agreed between them is called murabaha. The mode of payment in a murabaha transaction can be either cash or deferred. Bai Muajjal is defined as a sale against deferred payment, either in a lump sum or in instalments. Unlike murabaha, the sale of a commodity under bai muajjal takes place without the seller declaring his profit margin.
Islamic banks can engage in murabaha and bai muajjal transactions because, unlike in the case of conventional banks, trading is not a prohibited field of activity for them. Goods can be purchased by a bank from a third party at the request of its client and sold to the client at cost plus a profit margin. The jurists have emphasised that in such transactions, all risks attendant on the purchase-sale of goods should be borne by the bank until the possession of goods has been passed on to the client.
Bai Salam: This signifies a sale/purchase deal in which the buyer pays the agreed price of a commodity in advance and the commodity is delivered by the seller to the buyer on a specified future date. The salient features of a bai salam contract, which are widely agreed among jurists, are as follows:
a) The contract must specify clearly the kind, description, quality and quantity of goods to be delivered.
b) There should be a definite fixed time in the future for the delivery of the goods.
c) The agreed price for the goods to be delivered should be paid in full at the time of the contract.
Ijara and Ijara wa Iqtina: Ijara is a contract under which one party obtains the right of usufruct of an article owned by another party on the basis of an agreed rent. It is emphasised by jurists that the contract of ijara should clearly spell out the period of the usufruct and the rent agreed between the parties to avoid any dispute in the future. During the entire period of the contract, the basic maintenance of the article remains the responsibility of the owner of the article.
A variant of ijara is ijara wa Iqtina, in which the owner of the article given on rent agrees to the transfer of the ownership of the article to the person making use of it at the end of a specified period on having received all the payments due under the contract. This arrangement is also subject to the same conditions as stipulated in respect of simple ijara.
Islamic banks provide indirect financial accommodation to their clients through these two types of contracts. They acquire certain assets such as machines, buildings or equipment and allow the clients to use them under a standardised ijara contract. Under the system of ijara wa Iqtina, the client undertakes to deposit agreed capital payments instalments over a definite time period. The contract is terminated when the full price has been paid and the ownership has been transferred.
C. Qard-AI-Hasana
Islamic teachings encourage the well-to-do sections of society to extend qard-al-hasana to persons who are in need of temporary financial accommodation to meet their urgent consumption requirements or for economic rehabilitation. Islamic banks cannot afford to tie up a significant part of their resources for extending qard-al-hasana as they have to maintain good profitability in order to be able to compete with other institutions for mobilising the savings of the community.
There is a clear rationale, however, for earmarking a certain portion of their resources for lending without interest, as they do not pay any return on resources mobilised by them through demand deposits. In Iran, banks are required to set aside a portion of their resources in order to extend interest-free loans to (i) small producers, entrepreneurs and farmers who would otherwise be unable to find alternative sources of financing investment and working capital and (ii) needy consumers.
The jurists have taken account of the fact that the administration of interest-free loans involves some costs for the banks. They do not object, therefore, to banks levying a service charge to defray such costs. While deliberating on this matter, the Council of Islamic Ideology in Pakistan came to the conclusion that in order to conform to the Sharia, the service charge would have to be on the basis of the actual cost incurred but that the determination of the actual cost attributable to each loan would be difficult.
The Council, therefore, recommended that in order to overcome this problem, banks may fix a charge by way of an application fee, which should be uniform, irrespective of the amount of the loan and its duration. In actual practice, however, the service charge being currently levied by banks in Pakistan is determined on the basis of a formula laid down by the central bank of the country.
The directive on this subject states that the maximum rate of service charge which a bank may recover on such loans during an accounting year is to be calculated by dividing the total of its expenses, excluding the cost of funds and provisions relating to bad assets and income taxation, by the mean of its total assets at the beginning and the end of the year, and rounding off the result to the nearest decimal point for a percentage.
The above is not an exhaustive list of the techniques which can be used to replace interest-based transactions when switching over from the interest-based system to an Islamic interest-free system. In Iran, for example, some financing has been provided by banks on the basis of joaalah contracts, under which one party undertakes to pay a specified sum of money to another party for rendering a specified service in accordance with terms mutually agreed between the two parties.
Another possibility is to provide finance on the basis of a reference or normal rate of return, subject to final adjustment on the basis of the actual profitability of an operation. A lot of thinking is currently going on to develop new financial instruments that can be of use in the further growth and development of Islamic banking. As these efforts bear fruit. Islamic banking will gain further in maturity and strength.
Related Policy Issues
The preceding two sections of this paper have been largely concerned with the mechanics of the conversion of interest-based banking to interest-free banking. This section focuses on certain policy issues related to such conversion which have normative connotations.
The conventional interest-based banking system has evolved on a secular basis and is not conditioned in its operations by any religious commandments. Islamic banking, on the other hand, has to derive its inspiration from the religious edicts of Islam and has to mould its operations within the framework of the teachings of Islam. There has been a good deal of discussion in recent literature on whether Islamisation of banking means only abstinence from interest or something more. Most writers on the subject are in agreement that to deserve the name. Islamic banking should fulfil the following two basic criteria:
1. It should be conducted without transgressing any religious commandments.
2. It should help in achieving the Islamic socio-economic objectives.
The monetary and banking system of a country does not operate in an ideological vacuum. It is an integral part of its parent ideology. Its operating procedures have to be fashioned in accordance with the requirements of a particular ideology. Judged in this perspective, the task of the replacement of conventional banking by Islamic banking does not consist of a mere mechanical replacement of interest by non-interest modes of financing.
These modes of financing have to be chosen keeping in view the religious prescriptions as well as the ideological orientation of an Islamic society. Further, the financing activities of Islamic banks have to be directed towards achieving the Islamic socio-economic objectives. These objectives, briefly, are promotion of a pattern of growth best suited for eradication of poverty, equitable distribution of income and wealth and sufficient opportunities for gainful employment.
In the above context, the first concern of policy-makers in a country which proposes to switch over from interest-based banking to Islamic interest-free banking should be to ensure that the operating procedures adopted by banks fully conform to the requirements of the Sharia.
The best way to ensure the compatibility of all the banking operations with the requirements of the Sharia is to have an institutional mechanism whereby the managers of banks have easy and continuing access to religious scholars reputed for their piety and knowledge of Islam for consultations in evolving the operating procedures, and where in turn these scholars have full opportunity of scrutinising the actual operating procedures of the banks. In the absence of any institutionalised arrangement of such a nature, there is a risk that some of the practices adopted by the banks may not be in harmony with the requirements of the Sharia.
Another important policy issue is whether keeping in view the Islamic socio-economic objectives, the banks should have a preference pattern with respect to the various modes of financing which are permissible in the Sharia. For reasons already stated, the financing techniques based on the principle of profit/loss sharing are regarded by Islamic scholars and economists as the ideal substitute for interest and most suited to the achievement of Islamic socio-economic objectives.
The other techniques, such as murabaha, bai muajjal, bai salam, ijara and ijara wa iqtina, are recommended to be used only in cases where there are genuine difficulties in implementing the profit/loss principles as enshrined in the concepts of mudaraba and musharaka.
The main argument against their widespread adoption is that, being fixed-return techniques, they suffer from some of the same deficiencies as the interest mechanism and cannot, therefore, be of any significant help in achieving Islamic socio-economic objectives. It has also been pointed out by these scholars that, in the absence of any conscious policy measures to promote the financing techniques based on profit/loss sharing, the banking system may come to rely too heavily on fixed-return techniques, such as murabaha and bai muajjal, because of their relative simplicity and minimal risk.
It is recognised that the application of the profit/loss sharing principle in the conduct of banks’ financing operations is more complex, as it requires greater expertise. There is also the problem of “moral hazard” or the possible cheating by banks of their clients by not disclosing the true profit. However, a number of writings on the subject have shown that these problems are not insurmountable. The need really is for a firm resolve to overcome these problems, so that the changeover to Islamic banking really lives up to its promise.
It is also important to bear in mind that a system based on profit/loss sharing may also fail to achieve the socio-economic objectives of Islam if it is not attuned to the realisation of those objectives. It is a fact that the working of conventional banks in many countries has served to increase rather than decrease inequalities of income and wealth, as banks have usually provided credit facilities mostly to the well-to-do sections of society.
Islamic banks are expected to deploy the resources mobilised by them in such a manner that the egalitarian objectives of the Islamic society are duly achieved. In this connection, they have to ensure that all sections of the society which can make productive and effective use of bank finance have access to the banking system and receive their due share in the financial assistance provided by banks.
The central bank of the country will have a crucial role to play in bringing about the needed reorientation in the policies of banks to achieve this purpose.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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