ISLAMIC BANKING – WHERE ARE WE GOING WRONG?
ANWAR AHMED MEENAI
Islamic banks have now been around for slightly more than two decades. During this period, the pace of their progress in various countries has been different. Sentiments about Islamic banking also differ from country to country.
While apathy in varying degrees is quite noticeable in some Muslim countries, probably due to a lack of conviction about whether banking can be organised differently, a fair degree of excitement and inquisitiveness is also noticeable in some parts of the Western World, where the economists and policy-makers are awakening to the problems caused by banking which is exclusively credit-based.
The end of the first half of this century saw many Muslim countries gain independence from the colonial rules of Western powers. During such colonial rules, the Islamic code of law became confined to Muslim personal law – as practised by two major sects – in almost all these countries.
Upon gaining independence, the Muslim masses in these countries realised that changes brought about by their colonial masters in various spheres of life were not in line with their beliefs and the rules of conduct given to them by the Islamic Sharia. This realisation compelled Muslim bankers, economists and thinkers to review critically the present set-up, and think of ways and means to replace it with a system in line with the tenets of Sharia.
What is Islamic Banking?
Islamic banking may perhaps be best understood in comparison to conventional banking.
Conventional banking has been defined as “accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise”.
Conventional banking is credit-based. It relies on the ability of the borrower to repay the principal, together with interest. To ensure the borrower’s willingness, the bank relies on security obtained.
Islamic banking, on the other hand, is participatory in nature. The Islamic bank will usually assume all the normal risks of business that the entrepreneur assumes. Profit or loss, irrespective of its quantum, is shared by the bank and the entrepreneur. Return on the bank’s investment is not a function of time. Even when it is pre-determined (as in the case of Murabaha), it is predetermined in absolute terms and not affected by any delay or prepayment.
How is it Different?
A major point of difference, of course, is the way Islamic banks earn their incomes and offer returns to their depositors.
Islamic banks cannot participate in businesses prohibited by the Sharia (such as the manufacture or trading of liquors etc). Socio-economic dimensions also play a significant role in the evaluation of financing proposals in the Islamic system. Businesses that add more to social welfare are likely to get a higher priority.
The structure of production in an Islamic society should be different from that in other societies. This structure must cater to the requirements of lower income groups. It should be noted that the philosophy of Islamic banking places a heavy burden on Islamic banks in selecting business proposals to finance. The philosophy compels the Islamic banks to be content with whatever profits they earn through legitimate means and not aspire to compete with conventional banks.
This latter part needs some elaboration. In conventional banking, the concept of “liquidity” plays a significant role in its philosophy. This aspect is a direct result of the mis-match between tenures for which deposits are mobilised and for which funds are invested. Depositors require that their deposits should earn profits (by way of interest, of course) and at the same time remain at their disposal.
Deposits in current accounts are usually not entitled to any returns, but conventional banks usually employ funds in these accounts for lending purposes. Since businesses are not usually in a position to repay on demand or at short notice, and some of the investments are relatively illiquid, conventional banks resort to inter-bank borrowings among themselves. These may be clean or in the shape of repos of government securities. Rates of such borrowing are determined by the demand and supply situation.
Businesses are normally allowed overdraft facilities whereby they can borrow or repay at will, or at short notice. In the case of borrowings for fixed tenures, some banks put a restriction on the borrower’s ability to prepay without notice or at short notice.
Short-term borrowing/lending or development of secondary markets presumes a predetermined rate of return. They cannot function without such a rate being in place.
Strategy Adopted in Pakistan
Islamisation of banking in Pakistan started in the early 80s and changes were introduced gradually. From the view-point of commercial banking, the significant changes were:
a. acceptance of all local currency deposits on a PLS basis;
b. providing of financing on the basis of mark-up, on sale purchase of goods; and
c. prohibition on charging any mark-up on mark-up in case of default.
However, the process of Islamisation started without any regard to the Islamic philosophy of life in general, and business in particular, without any efforts to improve the moral standards in the society, and without making the necessary changes in the laws affecting the banks.
These deficiencies are now telling on the implementation of the new scheme. The next section addresses the particular problems that Islamic banks are facing because of these deficiencies.
Problems Facing Islamic Banks in Pakistan
Starting with the liability side, a major problem is the way deposits are being mobilised. By the nature of their business on the asset side. Islamic banks need a stable deposit base where the depositors are willing to commit their funds for specific periods. Also, it is important that Islamic banks should not commit any fixed return to their depositors, because they are themselves not sure of their earnings on the assets side.
Owing to competition with conventional banks (who have now adopted the mark-up and PLS system, at least on paper) Islamic banks are also offering cheque accounts with returns thereon, accepting deposits (especially where amounts are substantial) at pre-agreed rates of profit, and offering returns to all their depositors in line with the market, to be able to compete, regardless of their actual earnings.
To provide liquidity to depositors as well as those who come to avail themselves of financing facilities, at short notice, Islamic banks must also borrow from other banks in the money market. Such borrowing/lending is on the basis of interest. Similarly, a portion of all time and demand liabilities of Islamic banks must be surrendered to the central bank. This portion is also lying-in interest-bearing deposits (even though they are called PLS) or invested in interest-bearing securities. If Islamic banks need to borrow from the central bank as lender of last resort, such borrowing must also be on the basis of interest.
Problems on the asset side are of a more serious nature:
1. No efforts having been made by the government or the Islamic banks themselves to improve the moral standards of the society and persuade people to deal honestly, it is nigh impossible to consider Musharaka financing. Even though some banks are now contemplating it on a limited scale, and with water-tight securities, the true spirit of Musharaka will be lacking in such deals.
2. The same problem is affecting the introduction of Mudarabas. The banks are not sure if the accounts of the enterprise will be honestly maintained and reflect the true state of affairs of the business.
3. In the case of Murabahas, the problem is compounded by a lack of financial discipline. Buyers, (the customers of the bank) seldom make any efforts to pay the purchase price on the due dates. In the case of such defaults, the Islamic bank cannot increase the purchase price and is thus deprived of income it could otherwise have earned. Religious scholars allow the imposition of heavy penalties in such cases but the penalty amount is not a part of the bank’s income.
4. Even if the lack of honesty was not a consideration, the existing tax laws, especially in Pakistan, are such that even the most honest and pious entrepreneurs are not willing to reveal the true profitability of their businesses.
This factor affects both Mudarabas and Musharakas. In the case of Murabahas, the party from whom commodities are being purchased is seldom willing to issue an invoice/cash memo/receipt for the full amount. Even if he is (a very remote chance) the buyer (i.e., the bank’s customer) is not willing to accept the proposition for the fear that he will have to account for that much stock in his production records and for the purposes of excise duty.
5. Neither the concerned staff of Islamic banks (who have been trained in conventional banking techniques) nor the customers (who are mostly dealing with conventional banks) realise the fact that a commodity must actually exist and be bought from a third party for such transactions to be valid.
As with conventional banking the customers consider it their right to do anything whatsoever with the funds obtained. Similarly, the bankers’ primary consideration is the customer’s ability to repay the sum disbursed. Indeed, in some cases, commodities already purchased by the customer have been sold to the bank and re-purchased (and that too on paper only). Some commodities have thus been the subject of several sales and repurchases with different banks.
6. Statutory liquidity requirements of central banks, in Muslim countries, fail to take cognisance of the fact that Islamic banks are not debtors vis-a-vis the depositors, as the conventional banks are, but that they are Mudaribs, or fund managers. As such. Islamic banks’ funds lying with the central banks to satisfy SLRS not only deprive Islamic Banks of earnings on such funds through Mudarabas, Murabahas and Musharakas, but also introduce an element of interest-income into the Islamic banks’ total earnings.
7. Finally, a very significant hurdle is the perception of Islamic banks that they should deal in money only. Therefore, they do not wish to develop any expertise in dealing in commodities or machinery and equipment or real estate. Also, they are reluctant to participate in the management affairs of businesses in which they invest as partners (Musharaka transactions).
Conclusion
It will be clear from the foregoing that the present half-hearted attempts to “convert” conventional banking into Islamic banking by mere changes in semantics and procedures will not, and do not, take us anywhere.
In fact, such attempts are causing more harm to the cause of Islamic banking than any benefit. It is time for us to make a serious attempt to reconstruct banking thought in Islam. This is not an easy task, but it is not impossible either.
Today we find a general apathy on the part of all parties interested in Islamic banking. This applies to customers (who do not want to introduce any financial discipline into their operations and demand complete, unbridled freedom to use the funds made available to them in any manner whatsoever, for the consideration of a fixed [meatier] return that they offer to the financiers); or depositors (who are more interested in the security and liquidity of their funds than the use to which these are put); or shareholders (whose objective is maximisation of profits through whatever means).
It must be realised that as with conventional banks, the objective of Islamic banks ought to be the pooling of monetary resources and talent within a society for its betterment. In order to achieve this, Islamic banking environment would have to be radically different.
Conventional banking is credit-based. Islamic banking will have to be equity-based. For this purpose, business laws in Muslim countries will have to change. Stringent financial discipline will have to be inculcated. Concepts such as liquidity (of investments), premiums for (credit) risk and the time value of money must be reconsidered.
It should be realised that in some areas. Islamic banks should not even aspire to compete with conventional banks (bill discounting is one such area) and in other areas Islamic banks should operate in a different manner (e.g., issuance of guarantees and the establishment or opening of letters of credit, where, in conventional banks, commission is related to both amount and time, to account for the “risk” factor).
Taxation laws would need to be revamped. These and banking laws should be such that they facilitate honest operations, and compel the users of financial resources to abide by their commitments. Auditing standards must improve to ensure that all parties get their legitimate due returns.
In a true Islamic banking environment, the banks would not be taking any “credit risk”. They would, however, have to assume all the normal business risks. It must be recognised that Islam does not see capital as a separate factor of production but considers it part of the enterprise. Use of better capital resources results in higher profitability through higher production or better quality (resulting in better prices) or both.
As mentioned earlier, such an all-round change in the environment would be a time, consuming process. In the existing environment, true Islamic banking may result only in very modest profits. The shareholders must willingly accept this and realise that an Islamic bank may have to curtail the scale and variety of its operations for the sake of Sharia compliance. Profit-maximization should only be a secondary consideration. The primary consideration should be adhering to the guiding moral principals of Islam.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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