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Islamic Bank as Finance House

What we expect from Islamic banking is not only to remove ‘the evil’ of interest, but also to provide an environment where there are stable prices, full employment, equitable distribution of income and wealth, sustained growth and no business cycle – something the capitalist system has not been able to achieve in the last two centuries. There are special features of an Islamic bank which make it fundamentally different from a conventional bank:

Depositors are no longer lenders to the bank… they are shareholders in any activity in which the bank becomes involved;

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The Islamic bank is an advocate for depositors in that it takes their interests and those of society in general into consideration in all of its decision-making;

The customers are potential investors through having a Profit-Loss Sharing (PLS) contract. They are no longer borrowers. They have to have an investment project proposal whose justification – economic, technical, and financial – will have already been approved by the bank. This means that every dollar going out of the bank has to be project- specific. This is the way projects are financed. Through its engagement in PLS contracts, the bank becomes the partner of investors and unlike its conventional counterpart, provides equity capital rather than debt capital. The Islamic banking institution as the financier channels funds to specific projects proposed by the firm applying for partnership, the financee. The bank then becomes a shareholder on behalf of its depositors and thus, unlike the conventional bank, has the right to monitor the way the finance is being used. This makes the money supply for conversion into actual capital an endogenous variable and the supply of money is thus synchronized with production in a way that is not reliant on the required reserve ration for purposes of alignment. In fact, this could be safely lowered down to zero. Further, as long as there are justifiable investment projects, the supply of money could be increased, without a limit, with no fear of inflationary pressure. [During the gestation period of certain projects, however, there might be occasions where the prices of some commodities in short supply go up. However, as soon as investors and consumers satisfy themselves that such shortages are merely temporary, there is no reason for consumers to panic.]

All in all, our Islamic bank is neither a loan house nor an intermediary funding institution, rather, it is a finance house directly involved and integrated into the economic system.

There is no guarantee of a predetermined rate of return to the depositors. However, the expected rate of return (profit) is what makes the Islamic bank a strong financial institution in that its general and active performance in the economy attracts depositors. This means that the cost of capital is zero (a more detailed explanation will follow in coming chapters). In this sense, the tasks and commitments of the bank management rate are similar to those of any Islamic firm, which pursues not only the interests of its shareholders, but also those of society in general. This clearly differentiates it from privately-owned firms in the capitalist system. To better understand and distinguish the differences between the activities of an Islamic bank and their impact on the economy from those of the conventional bank, one need only compare the nominal value of stocks in the absence of speculation with the par value of bonds resulting from speculation. Where the former exactly exhibits the performance of the economy, the latter often reflects something quite different. More importantly, the dividend paid to stockholders will not represent part of the cost of the issuing firm but the interest on bonds, unquestionably, is part of the cost of the issuing firm. Again, stockholders are not promised a predetermined return and thus the cost of obtaining equity-capital is zero. Bond-holders definitely accept a return from the outset, which counts as a cost of debt-capital. Further elaboration and the logic underlying this argument might seem a challenging issue for some scholars.

There is no need for banking authorities to intervene in the market, as the Islamic bank is expected to play an active role in a capital market free of any speculation. Determining the ratio of profit shares to capital is not undertaken through intervention in the market. Surprisingly enough, investment projects, which are long-run in nature cannot and ought not to respond to very short-term changes of interest rates. Moreover, there is always an urgent need for potential investors to make decisions in a stable environment; something which everyday changes in the rate of interest and expectations on its future changes do not allow. Such changes are the products of speculative activities, which benefit a few at the expense of the majority. These activities can be avoided by allowing the system to take its natural course while monitoring the outcome. The conventional system has proven over the past several decades that it is unable to stand up on its own. My criticism of the capitalist system and its inevitable collapse is more fundamental than that of Marx. Where his main concern was with the exploitation of labor, ours here is much broader in that it incorporates every individual exploited by Riba. Exploitation, here, does not refer to underpayment to individuals to the benefit of capitalists, but being exploited with the invisible hand of interest in unemployment, inflation, inequitable distribution of income and wealth, business cycles, and irregular growth in the zero-sum game called capitalism.

Following the Friedman Rule, it seems that the necessary condition for achieving full employment is through elimination of interest – that is, a zero nominal interest rate, to be specific. If speculation as the first and immediate derivative of interest is completely abolished then full employment can be guaranteed. This important target can be maintained in an Islamic setting and Islamic banks would bring about the necessary savings and investment conditions through providing equity-capital and monitoring measures, but the rest of the system would take responsibility for maintaining those sufficient conditions

Under such a system, the bank’s balance sheets on the asset side would show the various equity positions they hold in different firms under PLS contracts, the values of which would vary with the general economic conditions. On the liabilities side, deposits would work more like shares in a mutual fund. The returns to depositors would vary with those of the firms whose projects have been financed by the banks. There the hundreds of different projects financed by the Islamic banks which encompass the whole economy. If the economy does well, the profits would be distributed proportionately to the shareholders. Similarly, if the economy does not do well, losses would be shared proportionately. This has the advantage of bringing the aligning the interests of all concerned and strengthening the sense of cooperation among laborers, consumers, and the firms. The stronger the ties, the higher the social welfare of the system and the fewer the potential conflicts. With such an arrangement, there would be no need, as Professor Akacem puts it, for:

Deposit insurance and no likelihood of financial panics, since both sides of the balance sheet would move in tandem … It is tempting to conclude that an Islamic financial structure would not be conducive to risk-taking, and might stifle the entrepreneurial 68 spirit for which America is prized. Perhaps. But it could also be argued that such a system would eliminate the financing of the marginal projects from the start, and thus remove the likelihood of a major bailout. (Akacem, 1991)

Among the advantages offered by PLS Contracts are the following:

From the late 1930’s, economists have been growing increasingly skeptical of the value of monetary policy for moderating the swings of the business cycle or for controlling inflation. The main source of this skepticism lies, with regard to conditions other than deep depression, in the evidence provided by a number of empirical investigations showing that the interest elasticity of demand for investment is extremely small. In conclusion, he remarks: In view of all their defects, no definite conclusion can be drawn from the surveys of business attitudes toward capital costs. The surveys do indicate that investment is to some degree less interest-elastic than thought by the proponents of interest-rate policy. (Ibid: 113) Given the continuing doubt about the impact of interest rates on investment, it remains to be seen what role interest plays other than to inflict irreparable harm on the majority of households to the benefit of the very few.

Money creation in the conventional system is based on lending, which makes it prone to an oversupply of money (that is, inflation), as there is no direct linkage between additional production and additional money supply. Debt- financing based on fixed and predetermined rates of return (namely, interest) on money produces ways for money to go astray, mostly, for speculative purposes, from the production process in which it was once supposed to make saving (S) identical with investment (I). In the Islamic system, 69 on the other hand, the abolition of interest and the prohibition of speculation on any durable commodity would necessarily bring these two into equality (following the Friedman Rule).

Public sector borrowing based on virtual wealth rather than backed by tangible assets adds to the burden for future generations. Islamic asset-backed financing does not carry a debt-burden; and in the rare and unlikely event of inflation, its value goes up and assets are available which can be liquidated to repay the shareholders.

Except for current accounts (the liabilities of the Islamic bank) all other deposits are accepted on a fiduciary basis and are invested on behalf of depositors who enjoy the major portion of the profits and bear any losses, unlikely though they are. While profit is important for Islamic banks, it is not their main objective. The emphasis is on achieving the community’s socio economic objectives in line with the injunctions of Shari’ah. Giving depositors a share in the profits of firms financed by the banks, in which the rate has been shown to be much higher than the rate of interest, brings about a more equitable distribution of income. It also creates a greater incentive for others to save more, which, in the absence of Riba and speculation, brings the system into full employment equilibrium. The role of the Islamic bank is that of an advocate who manages to legally transfer the money deposits (potential capital) into actual capital on behalf of depositors. This system ensures that the assets and liabilities of the Islamic Bank are always in balance. The stability of the system is increased by the close linkages between financier and financee. It is not hard to demonstrate that a sharing system is more conducive to growth, as it affords greater initiative and drive to the entrepreneurs.

The proposed system follows Lord Keynes in his belief that:

It is much preferable to speak of capital as having a yield over the course of its life in excess of its original cost, than as being productive. For the only reason an asset offers a prospect of yielding during its life services having an aggregate value greater than its initial supply price is because it is scarce; and it is kept scarce because of the competition of interest on money. (Keynes 1936: 213; original italics)

I am convinced that the scarcity of capital in the capitalist system arises from the misconception that money is a private good in which price is interest. As demonstrated in previous chapters, money is an impure public good and if it is given into the hands of the private sector, it will produce a less-than-optimum performance which results in unemployment. This assertion goes one step further than Keynes, for whom the only remedy for unemployment was to bring the central bank under public control (Ibid: 235). With the rate of interest changing every day, many projects become justified while others are rejected. This is not incompatible with interest inelasticity of investment expenditure, as cited earlier. Expectations of future changes in the rate of interest create uncertainty for investors as far as the price elasticities of the 70 commodities they produce are concerned. This, in turn, has a negative effect on investment decision-making, which makes this variable the most volatile components of GNP. In a reversal of the Friedman Rule, Keynes asserted that ‘the rates of interest will only reach equilibrium when there is full employment.’ (Ibid). The abolition of interest rates and the consequent removal of speculation in any commodity market will guarantee full employment in an Islamic setting. Keynes had more to say on this:

The only alternative position of equilibrium would be given by a situation in which a stock of capital sufficiently great to have a marginal efficiency of zero also represents an amount of wealth sufficiently great to satiate to the full the aggregate desire on part of the public to make provision for the future, even with full employment, in circumstances where no bonus is obtainable in the form of interest. (Ibid: 218)

The Islamic financial institution system honors the rights of ownership by individuals and institutions. It favors just rewards for hard work, skill and initiative, and makes the relationship between the individual and the community one of cooperation, integration, and duty.’ (IIBI 2000: 5)

In an efficient and well-organized cooperative system, inflation arising from the mismanagement and mistakes of the economic agents will be minimal, if not zero, as the supply of money is fully synchronized and directly linked with economic activity.

Before we conclude this section, it is worth noting that while the Islamic bank is value oriented and the conventional bank is value-neutral; and that: Islamic banks are multipurpose banks, as they play the role of commercial banks and investment banks, as well as development banks. They operate in the short- term like conventional banks [such as handling current accounts, opening of letters of credit based on Qard ul Hassan, collection, remittances, safe deposits, and so on, on which the bank earns fees, commission and exchange and in the medium and long term investment development banks like non-bank financial institutions … depending upon the structure of their resources.

All of the above-mentioned advantages of an Islamic finance system have to be put at the forefront of the research agenda. While much has been undertaken in this regard, much remains to be done.

But the central question has yet to be answered. Why, despite their strong social capital, their hi-tech developments, increased efficiency and other advantages, do developed countries still experience inflation and high unemployment. As should be clear by now, I firmly believe that interest has proved to be the Achilles heel of the capitalist system.

If a community has committed itself to Islamic Banking Practice and yet has failed to realize the full advantages it holds out over the conventional banking system, then it is clear that the Islamic banking system has not yet been properly launched. There are increasing numbers of countries, Islamic and non-Islamic, which have started to operate on Islamic principles, yet almost all continue to suffer from the same problems encountered by the capitalist system. In my observation, this arises from the fact that they are mostly organized along political rather than banking principles and are designed to absorb billions of dollars from Muslim countries, irrespective of the consequences. The mere surface of Shari’ah principles has been used as a cover for conventional-system practice, especially among Islamic banks located in non-Muslim countries. There is no logical reason why the real advantages cannot be realized to the benefit of all. As has been demonstrated in earlier chapters, the conflicts of interest that are the hallmark of the capitalist system make it very unlikely that the system will ever reach equilibrium and students of the system have to be taught economics on the basis of disequilibrium. The Islamic economic system, on the other hand, starts from equilibrium and moves along the upward trend of inter-temporal equilibrium. Where labor, money, and capital are given due respect, conflicts between economic agents are removed. This can only be achieved via Justice within the regulatory framework of an Islamic Grand Cooperative System. Justice (equity) has dual characteristics. Equity puts everything in its proper place and guarantees equilibrium. Justice, however hard to launch, removes hatred, jealousy, conflict and brings about love, cooperation, and prosperity.


Source: Prof. Iraj Toutounchian, Thoughts from Iraj Toutounchian’s Islamic Money & Banking: Narrated by Camille Paldi. Republished with permission.