Interest-Free Banking: A Proposal
Each of the three constitutions of Pakistan (1956, 1962, 1973), adopted so far, contains a clause making the elimi nation of riba (interest) an objective of the state. However, the first serious initiative in this direction was taken when the late General Ziaul Haq assumed power in 1977 and the Council of Islamic Ideology, on his directive, constituted a panel of economists and bankers to suggest ways and means for eliminating riba from country’s economy. In the light of the recommendations of the panel, as approved by the council, the State Bank prescribed 12 different non-interest-based modes of financing which the banks could use for extending finances with effect from April 1, 1985. Similarly, on the liabilities side, all bank deposits, with the exception of foreign currency deposits, were to be on the basis of participation in profit and loss of the banks effective from July 1, 1985.
Two of the modes of financing prescribed by the State Bank, namely financing through the purchase of client’s property with a buy-back agreement and sale of goods to clients on a mark-up, involved the least risk and were closest to the old interest-based operations. Hence, the banks confined their operations mostly to these modes, particularly the former, after changing the simple buy-back agreement (prescribed by the State Bank) to buy-baek agreement with a mark-up, as otherwise there was no incentive for them to extend any finances. The banks also reduced their mark-up- based financing, whether through the purchase of client’s property or through the sale of goods to clients, to mere paper work, instead of actual buying of goods (property), taking their possession and then selling (back) to the client. As a result, there was no difference between the mark-up as practiced by banks and the conventional interest rate, and hence, it was judged as repugnant to Islam in the recent decision of the Federal Shari‘ah Court.
As banks are essentially financial institutions and not trading houses, requiring them to undertake trading in the form of buy-back arrangements and sale on mark-up amounts to imposing on them a function for which they are not well equipped. Therefore, banks in Pakistan made such modifications in the prescribed modes which defeated the very purpose of interest-free financing. Furthermore, as these two minimum-risk modes of financing were kept open to banks, they never tried to devise innovative and imaginative modes of financing within the framework of musharakah and mudarba.
Fixation with Certain Modes of Financing
Besides, problems inherent in the menu of financial assets allowed to banks in 1985, there has been one fundamental problem with our approach to the Islamisation of the financial sector in the past. We seem to have a fixation with certain types of musharakah and mudarba and do not seem to be willing to go beyond these modes of financing. The fact is that these modes of financing were in vogue in Hijaz even before the advent of Islam and the Prophet (pbuh) approved them. In the present era, if Muslim experts in finance devise some other modes of financing based on profit-and-loss sharing and religious scholars judge them as not repugnant to Islam, these should be as Islamic as various forms of musharakah and mudarba in vogue at the lime of the Prophet (pbuh). The same creativity of the Muslim mind, which invented calligraphy as an alternative expression in the field of creative arts because of the prohibition of painting of human figure, should be at work in this area. We should come up with a wide menu of financial instruments suiting the preferences of different groups of savers and investors with regard to the mix of risk and return.
In the following paragraphs, an attempt has been made to briefly describe the existing relationship between depositors, banks and borrowers and then propose alternative framework in which the nature of the relationship will be quite different from the present one. Some measures should also be suggested for ensuring the disclosure of actual profits and losses of the units being financed by the bank.
A commercial bank in the present age serves as a financial intermediary between those economic units who have more funds than they want to use, i.e. surplus units and those units who have plans to spend more than what their own financial resources would allow, i.e. deficit units. Surplus units deposit their surplus funds with banks which, in turn, lend these funds to deficit units for meeting their working capital requirements, for financing their investment expenditure and even for consumption expenditure. Some economic units also keep their transaction balances with banks in the form of current deposits and draw upon them as and when the need for spending them arises.
In addition to deposits, which are the main source of financing bank operations, equity of shareholders also contributes to the total pool of funds available to banks for their operations. The two items, deposits and equity, appear as liabilities in the balance-sheet of the bank. On the assets side, the major item is the loans made by the bank besides the physical assets like buildings, furniture and office equipment. Both lending and deposit-taking by banks is done on the basis of fixed interest rate. The banks charge a fixed rate of interest on the funds lent by them irrespective of the actual magnitude of profit earned or loss incurred by the borrowing entity, except in the case of the bankruptcy of the borrower when the bank may lose even a part of the principal amount. Similarly, depositors receive a fixed rate of interest on their deposits which is known at the time of making the deposit.
In a financial market, where the forces of demand for and supply of loanable funds are allowed to operate freely, there could be a link between what the users of funds (borrowers) earn and what the providers of funds (depositors) receive. Increase in the earnings of borrowers will lead to an increased demand for funds, rise in the rate of interest paid by them to banks, which will eventually be passed on to depositors. But even in the most free enterprise economies, interest rates are manipulated or at least influenced by the central bank through its open market operations and discount rate policy, even when it is targeting monetary aggregates rather than the rate of interest as such. The interest rate is as much a reflection of the state of the economy in terms of the profitability of business as it is a policy instrument for influencing the level of economic activity and for the allocation of funds. Even McKinnon and Shaw, the two leading advocates for freeing of interest rates in formal credit markets from government control in developing countries, advocate an increase in interest rates for improving the allocation of resources and for channelising more funds through financial intermediaries. They do not argue for market-determined interest rates as such.
One of the possible frameworks for the working of the Islamic banking system could be as follows:
An Islamic bank like a western bank will mobilise funds for its operations through both equity and deposits. However, unlike a western bank, depositors in an Islamic bank will also be shareholders, but of a somewhat different category than equity holders. This distinction is justified by the difference in the nature of their relationship with the bank. Whereas a shareholder’s relationship with the bank is of a permanent nature, a depositor relates to the bank temporarily and hence his or her stake in the institution is much less than that of a conventional shareholder. The implications of this distinction will come out clearly when the allocation of profits or losses of the bank between depositors and equity holders is discussed below.
The primary distinction between a western bank and an Islamic bank is on the asset side and any deviation from the western practices on the liabilities side is a derived one. Therefore, there is a need to concentrate on the management of assets of banks and make it compatible with the injunctions of Islam. The major flaw in on-the-ground efforts at Islamisation of the banking system so far has been the absence of any fundamental change in this area as all the energy being spent on devising ways for allocating the so-called profits earned by the bank among equity holders and various types of depositors. An Islamic bank could acquire four major categories of financial assets arising out of: 1) equity participation in other business concerns; 2) long-term financing of investment; 3) medium-term financing of investment; and 4) financing of the working capital requirements of commercial enterprises. Commercial banks, raising their own funds mainly by issuing short-term liabilities, will concentrate their financing operations in meeting the working capital requirements and some fixed-term financing of investment. Their involvement in equity participation may be only marginal and major part of that should be coming through stock markets and investment banks which raise long-term funds.
Assuming that these are the only means of financing for business houses, whether funds come through commercial banks, stock markets or investment banks, the total profit or loss of the business concern could be allocated among these categories with weights assigned to each category in accordance with the risk and maturity period (where relevant) of each asset. These weights may be negotiated between the bank and business enterprises availing finances and could vary across firms and over time, reflecting market conditions as well as the circumstances of each individual recipient of bank funds. For instance, a firm with low current profit but expecting a sharp increase in profits in the medium-term will be able to secure bank finances only by offering relatively higher weights for the allocation of profit and lower weights for the allocation of losses to such finances. (The only condition, imposed by Islam, may be that no category of finance can be assigned a weight equal to zero for the allocation of profit or loss.) Firms currently enjoying high rate of profit will be able to negotiate relatively lower weights for bank finances to be used for the allocation of profits.
The allocation of profit or loss discussed above will be for the pre-tax profit. After that allocation, corporate income tax (if it is to be continued) may be deducted from the part being assigned to the individual shareholders, but no such deduction should be made from the share assigned to the bank. Just like the interest expense of business concerns, this part may be treated as cost for the purpose of taxation, because otherwise these profits will get taxed thrice, which will be regressive considering the bulk of deposits in Pakistan as well as in other countries come from people of small means. Moreover, the taxation of this part of profits at the level of the user of bank funds will mean starting the new system with a disadvantage for the depositors compared to the old system. Besides, no part of profits assigned to the bank should be allocated to reserves of the enterprise, as depositors who are real owners of the funds do not have any long-term stake in the enterprise.
The central bank could still serve as the financier of the last resort for commercial banks. However, its finances will be provided on the basis of sharing in the profits and losses of the banks. It could influence the weights assigned to each category of finance provided by banks to business concerns by changing the weights it requires for its own financing for banks in sharing profit or loss with the latter. For instance, if the central bank wants to pursue an expansionary monetary policy, it could lower the weights for its financing. It will encourage the banks to avail themselves of the financing facility from the central bank. With increase in the funds available with banks, they will be inclined to negotiate lower weights for various types of financing provided by them to business concerns. With larger share of profits remaining with the private businesses, economic activity will pick up.
This way the weights assigned (rather negotiated and therefore determined by market forces) to bank finances for sharing profit and loss with businesses could be used for influencing the level of economic activity. The role of the profit-and-loss sharing in the allocation of resources is obviously there, as the banks being profit-maximising institutions will finance only economically viable projects. Hence, funds will flow to the most productive uses.
Evaluation and Further Suggestions
The arrangement suggested above has all the essentials of sharing profit and loss, but is still different from the conventional musharakah and mudarba where the ratios in which the profit or loss is to be shared have to be negotiated by parties to the financial transaction or could be specified by the central bank in the case of the banking system. Nevertheless, the idea of ratios for the allocation of profit or loss is embedded in weights assigned to various categories of finance. The arrangement suggested above is essentially a type of shirakat (partnership). The better known types of musharakah and mudarba have been deliberately kept out as these may not be suitable to the bulk of financing undertaken by banks, where assignment of profit or loss to individual credit lines, availed by modem corporate bodies, on the basis of specified or negotiated ratios is extremely difficult.
Because of these considerations, allocation of profit or loss to only broad categories of finances provided by banks and equity holders according to some negotiated weights has been recommended. However, banks could enter into conventional musharakah or mudarba arrangements with sole proprietorships, the simplest form of business organisation, where the assignment of profit or loss is easier. Besides, the development of venture-capital institutions could be facilitated through proper legislation and these institutions will be most suited to undertaking musharakah and mudarba. Other modes of financing like leasing, hire-purchase and murahaha (trading on deferred payment basis), allowed by the State Bank for commercial banks in 1985, do not seem appropriate to bank financing. Given in their hands, these will get distorted and will degenerate into essentially interest-based arrangements. There are a number of specialised financial institutions which can better handle these modes and the same have been set up in large numbers in Pakistan after the introduction of the process of Islamisation. Provision of qard-e- hasan and loans on the basis of service charges is also not the function of a commercial institution like a bank which exists with the sole objective of making profit. Welfare institutions like the Baitul Maal should perform such functions. However, because of the widespread network of branches, banks could be used for the disbursement of such assistance for a specified fee to be paid by Baitul Maal.
Once the profit or loss has been received by the bank, it can then be assigned to various liabilities of the bank in accordance with appropriate weights assigned to each type of liability. This arrangement for assigning profit-and-loss of the bank to various liabilities has already been there since 1985. Needless to say that the same weights should be used for assigning any loss incurred by the bank as for assigning the profit. Again, reserve building by the bank should have no claim on the part of profits allocated to depositors who have a temporary relationship with the bank unlike equity holders.
Generally a concern is voiced about the viability of the financial system based on profit-and-loss sharing in a society where concealment of corporate profits and siphoning of funds from corporate accounts to personal accounts are rampant. It is argued that in such an environment, banks providing finances on the basis of profit-and-loss sharing will end up in sharing losses only and will not be able to survive. Agreed that malpractices exist in Pakistan’s business sector, but the problem is there in all societies, though its seriousness may vary. And everywhere there are laws to address it. Because of the gravity of the problem in Pakistan and also because of the special demands of the alternate banking system being considered for introduction, we may consider some additional measures, both positive and negative, for handling the problem. Some of these measures are listed below:
- One very radical measure that has been proposed is the replacement of income tax by tax on the net worth of corporate bodies as well as individuals. That will take away a major disincentive for disclosing the amount of profit. If the measure is taken, our earlier submission regarding the exemption of profit assigned to the bank from income tax will become irrelevant.
- The State Bank may issue some additional prudential regulations prohibiting the exposure of banks to business concerns which have shown losses or earned no profit during three consecutive years after coming into full production. After all, none of us is willing to put his money on a losing horse. Why should banks be allowed or required to advance public money to losing concerns?
- If a business concern, being financed by a bank, starts showing losses, an objective and professional inquiry should be immediately initiated to establish the cause of the loss. All the banks may collectively fund the establishment of a professional body to undertake such inquiries on their behalf.
- For upcoming enterprises without any track record, moral as well as professional qualifications of sponsors and the viability of the project in the light of market conditions should be thoroughly scrutinised. For this, banks will have to recruit better qualified professionals specialising in different areas like finance, marketing, engineering and economics to constitute project appraisal committees within each bank.
- Stringent legal measures may be administered against the connivance of auditors with business concerns for the under reporting of their profits, overestimation of costs and other malpractices. On the extreme, an erring auditor could even lose his or her license to practice the profession.
- To exert moral pressure, members of the board of directors and the CEO of the firm being financed should be required to take an oath on the Holy Qur’an at the time of signing a financing agreement with the bank that they will neither deliberately conceal any profit earned nor exaggerate losses incurred by their firm. Similar oath should be administered to the individual owners of sole proprietorships or partnerships. Every bank official having an input in the process of approval of application for finance should also be required to take an oath at the time of his induction to the office that no consideration other than the economic and financial viability of the venture will guide him in recommending or approving the application.
Below is an illustration of the proposed allocation of profit of a typical business concern where total amount of annual profit is Rs 20 million:
Proposed Allocation of Profit of a Typical Business Concern
Type of Finances
Period (in years)
Ratios Share of Profit (Rs in million)
Dr Ghulam Qadir
Source: Elimination of Riba, Khurshid Ahmad, Khalid Rahman and Zahed A. Valie. Republished with permission.