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Alternative Mechanisms to Replace Riba

The financing operations of the commercial banks have been dealt with in the following paragraphs in respect of the various sectors of the economy viz., industry, agriculture, commerce, construction, transport and “other sectors” and personal loans.

Industry


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Commercial banks provide credit to industries both for fixed investment and working capital requirements. Finance for fixed investment is provided by way of term loans or purchase of debentures or participation in underwriting and “bridge financing” arrangements. Working capital requirements are financed through grant of demand loans, cash credit, overdraft, opening of import L/Cs and bill discounting. Only commission is charged on the opening of L/Cs, while in all other cases finance is provided at fixed interest rates.

(a) Fixed Investment Financing

Each project submitted to the bank for fixed investment financing would be thoroughly scrutinised and the bank would provide financing facility only for projects considered viable. Projects submitted by parties which maintain accounts that are audited by Chartered Accountants may be financed under profit/loss-sharing arrangements. Parties which maintain accounts but do not get them audited by Chartered Accountants may be accommodated under “hire- purchase”, Bai Muajjal or “leasing” arrangements and they may be induced to submit their accounts for proper auditing. Smaller parties who may not be in a position to maintain accounts may be financed under “normal rate of return”, “hire-purchase” or Bai Muajjal arrangements and they may be induced to introduce at least some sort of accounting.

It is not necessary that banks should confine their financing activities only to projects received from other parties. Banks may themselves formulate new projects, singly or in collaboration with non-bank financial intermediaries. In such cases, the method of “investment-auctioning” may be used.

The financing agreements under the new system would have to provide specifically for monitoring by the banks of the actual performance of the concern financed by them so as to safeguard their interests. For this purpose, they should be free to inspect the projects and to call for any information and books of accounts of the concerns. The financing agreements may also empower the banks to appoint, if deemed necessary, a director on the Board of the concern, to demand security against such finance and to impose any conditions in regard to incurring of additional liabilities by the concern.

Provision of finance for fixed industrial investment on profit/ loss-sharing basis would necessitate the replacement of some of the existing techniques by new ones. At present financial assistance is provided to projects during the gestation period under “bridge-financing” arrangements whereby the underwriters give an interim loan equivalent to the underwriting commitment at a fixed rate of interest. Although underwriting business as such is not repugnant to SharVah, the arrangement of bridge-financing, which is a basic ingredient of the “stand-by” technique of underwriting that is in vogue in Pakistan, makes this type of underwriting incompatible with SharVah. The Council recommends that the “stand-by” technique may be substituted by “firm commitment” underwriting under which the underwriters, instead of providing a bridge loan, actually take up a part of equity at the very inception of the project at a negotiated price which can be below the face value of the shares. The Council understands that “firm commitment” underwriting is not permissible at present under the Companies Act. It recommends that necessary changes may be made in the Companies Act to permit this form of underwriting.

Debenture financing, which at present is a very common method of financing fixed investment, specially for balancing, modernisation and expansion of the existing industrial units, may be replaced by the issuance of a new corporate security to be called the Participation Term Certificate (PTC). PTC would entitle its holders to share in the profits of the concern issuing it instead of receiving a fixed interest. The main features of PTC may be as follows:

  1. The issue of PTCs beyond certain limits should be subject to the approval of the Controller of Capital Issues.
  2. Any changes in terms of the issue of the PTC, including pre-payment, should be subject to the mutual agreement of the issuers and the holders.
  3. In order to provide protection to the purchasers of the PTCs, a Trustee borne on the approved list of the Controller of Capital Issues, may be appointed. The Trustee shall be responsible, among other things, for the appraisal of the projects, necessary legal documentation and end-use supervision. The Controller of Capital Issues may maintain a list of approved Trustees for the purpose. Issuers of the PTCs or their associates may not be appointed as Trustees.
  4. PTC finance may be secured by a mortgage on the fixed assets of the company ranking pari passu with the charges created in favour of other providers of outside funds. There may also be a floating charge on the current assets.

The company would be required to apply PTC proceeds exclusively for implementing the project. It would alsomaintain books of accounts and other records so as to reflect truly the financial position of the company and the results of its operations in conformity with generally accepted accounting principles.

  1. On behalf of the PTC holders the Trustee would have the right to call for information from time to time from the company, to visit the premises where the plant and machinery of the company are located and the business of the company is conducted and to have access to records.
  2. During the period PTCs remain outstanding, short-term financing from banks by the company shall be regulated in accordance with mutual agreement.
  3. The losses, if any, will be certified by Chartered Accountants and the Trustees would have a say in the appointment of Chartered Accountants.
  4. The statutory obligations of Chartered Accountants shall have to be enlarged.
  5. In the case of dispute, profits/losses may be determined by Arbitration. For this purpose a panel of arbitrators shall have to be maintained by the Controller of Capital Issues.

(b) Financing of Working Capital Requirements

Working capital requirements of industry are at present being met by banks through grant of cash credit, overdraft facility, demand loans and through discounting of bills of exchange. All thesetransactions involve interest. Under the new system banks could continue providing all these facilities under interest-free arrangements. In the case of firms maintaining proper accounts with which banks have regular dealings, working capital needs may be met under cash credit, overdraft and demand loan facilities through profit/loss-sharing on daily product basis. However, in regard to bills of exchange, the Council recommends as follows: Since the bank accepts the responsibility of realising the amount due to the drawer from the drawee, it is permissible under the SharVah that the bank may realise a commission for rendering this service. This commission will be variable according to the amount of the bill, but not according to the period of payment. The drawer will have to enter into two separate agreements with the banks, 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 in the amount equal to the value of bill. The bank’s commission will be payable in advance and the loan will be free of interest. 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 amount to the bank5. In the case of parties not maintaining proper accounts, finance may be provided under “normal rate of return” arrangements or Bai Muajjal. They may also be induced to adopt at least some sort of accounting.

Industrial concerns are often indebted to commercial banks as well as specialised industrial finance institutions at the same time. Finance for fixed investment is obtained from both commercial banks and specialised financial institutions while working capital is mostly obtained from commercial banks. It will be possible under the profit/loss-sharing arrangements to apportion profit/loss among the various providers of funds by taking into account the amount of the capital and the period during which it is employed*. A hypothetical example of profit/loss-sharing in respect of finance provided by a bank to an industrial unit is given below:

Let us assume that a textile Mill ‘X’ has been given the following facilities by Bank *Y\

  1. For Fixed Investment:
  1. Long-term rupee finance for renovation against second mortagage of its fixed assets:                       Rs.  2 million.
  2. Finance provided under underwriting commitment in respect of additional share floatation, the duration being a period of 100 days in the particular accounting year: Rs. 2 million.
  3. Payment against guarantee under PAYE scheme for import of additional spindles from abroad, the period for which the amount remained outstanding being 100 days: Rs. 2 million.

 

  1. For Working Capital:
  1. Cash credit limit of Rs. 35 million against raw material/ finished goods. The limit is assumed to have been fully utilised for 180 days.
  2. Demand loan limit of Rs. 5 million. The limit is assumed to have been fully utilised for 150 days.
  3. Occasional overdraft in its current account. The amount of overdraft is assumed at Rs. 1 million and used for 100 days.

Inland L/C limit of Rs. 5 million for purchase of cotton. The limit is assumed to have been fully utilised for 30 days.

Import L/C limit of Rs. 2.5 million for import of man-made fibre etc. The limit is assumed to have been fully utilised for 52 days.

Suppose that, apart from finance provided by Bank ‘Y\ capital deployed by Mill ‘X’ during that particular accounting year consisted of the follows:

 

(Rs. in

million)

(1)

Paid-up capital:

20.00

(2)

Reserves and unappropriated profit and loss:

2.00

 

(a) Reserves:

3.10

 

(b) Accumulated loss:

-1.10

(3)

Foreign currency finance obtained from

 

 

a non-bank financial institution:

2.70

(4)

Participation Term Certificates issued:

6-40

(b) Short-ternv

 

0)

Current maturity of foreign currency

 

 

finance and PTCs: (90 days)

3.70

(2)

Creditors, provisions & accrued

 

 

charges: (30 days)

21.50

(3)

Other liabilities: (90 days)

1.60

(4)

Provision for taxation: (90 days)

0.80

3. The daily products of the respective capital contributions of Bank

‘Y’ and Mill ‘X’ and other providers of funds besides bank ‘Y’ would be

as follows:

 

 

Daily Mill ‘X’ and other pro-

Daily

Bank Y

Products viders of funds besides

Products

 

Bank ‘Y’

 

(0

Long-term finance (2x365)

730

(0

Capital (20x365)

7,300

 

(ii)

Finance provided against underwriting (2x100)

200

(ii)

Reserves (2x365)

730

 

(iii)

Payments made according to

 

(iii)

Foreign currency

 

 

 

guarantee issued under PAYE

 

 

finance (2.7x365)

986

 

 

Scheme (2x100)

200

(iv)

PTCs (6.4x365)

2,336

 

 

Sub-Total (A)

1,130

 

Sub-Total (A)

11,352

 

(i)

Cash Credit (35x180)

6,300

(i)

Overdues in respect of foreign currency finance and PTCs (3.7x90)

333

 

(ii)

Demand loans (5x150)

750

(ii)

Creditors, provisions and accrued charges (21.5x30)

645

 

(iii)

Overdrafts (1 xlOO)

100

(iii)

Other liabilities (1.6x90)

144

 

(iv)

Inland L/C (5x30)

150

(iv)

Provision for taxation (0.8x90)

72

 

(v)

Import L/C (2.5x52)

130

 

 

 

 

 

Sub-Total (B)

7.430

 

Sub-Total (B)

1.194

 

 

GRAND TOTAL (Y)

8,560

 

GRAND TOTAL (X)

12,546

 

                 

 

  1. Assumed distributable profit of the Mill:    Rs. 7 million
  2. Profit/loss distribution would be as follows:
  1. Profit attributable to long-term capital:      Rs. 4.14 million
  1. On Mill’s and other providers’ capital contribution: Rs. 3.77 million

 

  1. On        Bank’s capital contribution:                      Rs. 0.37 million
  1. Profit attributable to short-term capital:                Rs. 2.86 million
  1. On Mill’s and other providers’ contribution:          Rs. 0.40 million

 

  1. On  Bank’s contribution:                                        Rs. 2.46 million
  1. Supposing the maximum profit-sharing ratios fixed by the State Bank for banks in regard to fixed investment financing and working capital financing are 50% and 65% respectively, then the share of Bank ‘Y’ in the profit of Mill ‘X’ would be as follows:
  1. On  fixed investment financing:                        Rs. 0.19 million
  2. On  working capital financing:                          Rs. 1.60 million

TOTAL:            Rs. 1.79 million

  1. The share of Mill ‘X’ and other providers of funds besides Bank ‘Y’ would be Rs. 5.21 million, which would be divided between the Mill and the other providers of funds in accordance with the terms agreed between them.

Assuming that the Mill ‘X’ incurs a loss of Rs. 7 million, its distribution would be as follows:

(a) Daily products of capital contributions:

  1. Bank                                                8,560
  2. Mill and other providers of funds    12,546

(b) Distribution of loss:

  1. Bank:                                                                                     Rs. 2.83 million
  2. Mill ‘X’ and other providersof funds:                                      Rs. 4.17 million

Agriculture

Till early Seventies, commercial banks’ involvement in agricultural finance was minimal. In 1972-73 it was decided to induct commercial banks actively in the field of agricultural finance. To expand the flow of bank credit to agriculture, the State Bank fixes every year mandatory targets for commercial banks in respect of small loans for agricultural production and loans for fixed investment. It also operates a credit guarantee scheme under which the State Bank shares with the commercial banks on 50:50 basis any bonafide losses incurred by them in respect of their small loans for agricultural production. The definition of small loans has varied from time to time, the present definition being loans given for agricultural production to farmers cultivating holdings up to subsistence level. Till recently, all loans given by the commercial banks to agriculturists were interest-bearing. However, in June, 1979 the Government decided that loans for agricultural production to farmers cultivating holdings up to 12xfi acres be provided free of interest. The major portion of commercial banks’ financial operations in agricultural sector relates to input-financing.

For determining an appropriate strategy for eliminating interest from commercial banks’ financing of agriculture, the Council took into consideration the special characteristics of the agricultural sector. It noted that small farmers constitute the majority of the farming community. According to the 1972 Census of Agriculture, there were in all 3.8 million private farms in the country. Of these 89 per cent were of the size of less than 25 acres, covering 63 per cent of the total cultivated area. Moreover, a large number of farms were smaller in size than the subsistence holding. Farms of sizes below 12.5 acres constituted 68 per cent of the total private farms and covered 34 per cent of the total cultivated area. Recent data are not available. However, in view of the operation of the law of inheritance and the land reforms of 1972, it can be presumed that the number of small and below subsistence farms must have increased over the period at least in some regions. Thus, a vast number of the farmers in the country, specially those cultivating foodgrains, do not have much of a marketable surplus, and agriculture is a way of life for them rather than a business. The borrowing requirements of small farmers are normally for small amounts but their number runs in millions. Moreover, since most of the farmers are illiterate, even those who produce marketable surpluses are not in a position to maintain accounts of any description. On the other hand, there is a substantial number of farmers who cultivate larger farms and are engaged in farming as a business proposition. They are generally literate, more responsive to modern technological advances in farming practices and capable of adopting proper accounting practices.

Keeping; in view the above perspective, the Council recommends that for meeting the short-term and medium- and long-term financing needs of the agricultural sector the following methods may be adopted under the new system.

Short-term Finance

Short-term finance is required by farmers mainly for purchase of inputs viz., seeds, fertilizers and pesticides. The Council feels that in providing seasonal finance to farmers, the commercial banks should make a distinction between farmers cultivating holdings up to the subsistence level and those cultivating holdings above the subsistence level. The former may be provided assistance in cash or kind under the proposed “Special Loans Facility” which means that farmers falhng in this category will be expected to repay only the principal. Ordinarily such loans without costs should be provided out of funds raised by banks on interest-free basis. However, if such funds are not adequate, the banks may be provided a subsidy by the Government in respect of such loans on the basis of the average rate of profit of commercial banks during the relevant period. This method offers a number of advantages. It would not impose any financial burden on a poor section of the population and would help greatly in raising their standard of living. It would expedite the disposal of loan applications as banks would not have to carry out a detailed investigation of the production prospects of a myriad of farmers. The over-head costs of the banks in administering the scheme would also be lower compared to those that they would have to incur in case they provided these funds on PLS or some other profit-earning basis.

In the case of farmers cultivating holdings exceeding the subsistence level, banks may provide finance for purchase of inputs under Bai Muajjal or Bai Salam The stipulations of Bai Muajjal have already been described. Under the Bai Salam arrangement, banks may enter into an agreement with the farmer for advance purchase of agricultural produce, specifying complete details of the commodity, its quality, price and the place and time of delivery and make the payment of the agreed amount at the time of the entering into the agreement When the commodity is produced and supplied to the bank, on the appointed date, the bank is free to sell the commodity as it wishes. It must be emphasised, however, that Bai Salam is a special type of trading arrangement which is subject to strict stipulations and conditions as laid down in the Holy Quran and Ahadith. It will, therefore, be necessary to enact a law that may ensure the fulfilment of these conditions in all respects. It may also be pointed out that since there can be a danger of misuse of price fixation in advance as an exploitation device, an independent agency may have to be set up which should be responsible for exercising proper control on the price fixation in respect of Bai Salam

Medium- and Long-term Agricultural Finance

Medium-term finance is provided by financial institutions for purchase of plough cattle and for poultry farming, dairy farming and repair of tubewells, tractors and attachments etc., while long-term finance is provided for purchase of tractors, sinking of wells, installation of tubewells, development and improvement of land and construction of storage etc. Replacement of interest in all these cases by a single substitute conforming to Shari'ah is not possible. The alternative methods that may be used to replace interest in bank financing for medium- and long-term in the agricultural sector are set out below:

(a) Plough Cattle

Borrowings for purchase of plough cattle are generally resorted to by small farmers. Profit/loss-sharing or hire-purchase do not appear to be feasible in their case. The Council feels that banks may provide loans for purchase of plough cattle to farmers cultivating holdings up to subsistence level free of any charge. Such loans should be provided by banks out of funds raised by them on interest-free basis. In case these are not adequate, the Government may provide subsidy to banks against these loans on the basis of the average rate of profit of commercial banks during the relevant accounting period. In other cases, finance for plough cattle may be provided under Bai Muajjal arrangements.

(b) Dairy and Poultry Farming

Small dairy and poultry farmers may be provided finance up to Rs. 10,000 free of interest while finance to medium and large dairy and poultry farmers may be provided under PLS or “normal rate of return” methods. The definitions of small, medium and large dairy and poultry farms would need to be formulated after due consideration. Banks may induce the farmers seeking finance from them to adopt proper accounting practices.

(c) Land Improvement and Development

In the case of farmers cultivating holdings up to subsistence level, finance may ,be provided free of charge out of funds raised on interest-free basis. Should these not be adequate, banks may be provided a subsidy by the Government on the amount of such loans on the basis of average rate of profit of the commercial banks in the relevant period. In other cases, PLS or “normal rate of return” methods may be adopted. Banks may induce the farmers seeking finance from them to adopt proper accounting practices.

(d) Purchase of Tractors, Installation of Tuhewells, Digging of “Karezes” and Construction of Storage Facilities

Finance for purchase of tractors and installation of tube- wells may be provided under PLS, Bai Muajjal or hire-purchase arrangements. Banks should induce the farmers, seeking finance from them to adopt proper accounting practices. The finance of “Karezes” may be provided under the special loans facility while construction of storages may be financed on the basis recommended by the Council for the construction of houses.

HI. Commerce Sector

The commerce sector comprises of retail and wholesale business as well as export and import business. At present, these activities are being financed by banks through grant of demand loans, cash credit, over-draft facility, opening of import L/Cs on behalf of clients and discounting of bills. The Council recommends that under the new system, in the case of small retailers who are not in a position to maintain accounts, the banks may provide finance either under Bai Muajjal arrangements or under Special Loans Facility out of resources raised by them on interest-free basis. In case these are inadequate, the government may provide a subsidy to the banks on the amount of such loans on the basis of average rate of profit of the commercial banks in the relevant period. Banks may induce those seeking finance from them to maintain accounts.

In regard to bank financing under cash credit, over-draft, demand loans and discounting of bills, the same arrangements may be adopted as recommended in respect of financing of working capital requirements of industry. In the case of opening of letters of credit, the banks .nay charge a commission for the service rendered by them and they may not necessarily share in the profit/loss.

Construction

For financing house construction by individuals, commercial banks may adopt the same system as was recommended by the Council in its Interim Report and has been put into practice by the House Building Finance Corporation. Financing of construction companies both for fixed investment and working capital may be strictly on PLS basis.

Transport

Banks may finance purchase of trucks, buses, taxis, vans, rickshaws and private cars under “hire-purchase” or Bai Muajjal arrangements.

Other Sectors

These include mining and quarrying, electricity, gas, water and “services”. Bank financing of these sectors has so far been of relatively lesser magnitude. With the exception of services sector, in which case banks may use any of the alternative methods of financing considered suitable, PLS seems to be the only practical basis for financing of other sectors. However, where finance is required for purchase of capital goods and machinery, such as generators or heavy drilling machines, techniques of Bai Muajjal or “Investment Auctioning” may also be used.

 

Source: Money and Banking in Islam, Ziauddin Ahmed; Munawar Iqabal; M. Fahim Khan. Republished with permission.