Issues Faced by Islamic Banks
The Islamic banking industry has grown rapidly over the last few years. However, an examination of Islamic banks and the wider industry, raises a number of issues.
Before going into the discussion of issues, following is a general overview which can cause some of the issues:
- All the banks are relatively recently established. The oldest commercial Islamic bank was established in 1973.
- They are located or doing business mostly in the finance-rich countries and they probably have not faced the real problem of raising deposits.
- In some markets, individual banks are working in isolation of the general banking system around them.
- The strategy of these banks generally seems to be to look for projects with quick returns. This has specifically been mentioned as “operational strategy’’ by one of the oldest Islamic Banks in its current annual report. This is also reflected by the facts that the real estate investment is generally one of the major investment activity of these banks.
With these features of the Islamic banks the following issues arise:—
1. Tools to Attract Depositors
The Islamic banks so far have undertaken extensive research in devising non-usurious procedures to utilize their funds. Very little research has been done in devising the tools to attract deposits. This may be so because they have not yet faced the shortage of deposits. But if they do not pay attention to devise the non-usurious tools to compete with the interest-bearing tools of raising deposits, then these banks are likely to face problem in their growth particularly when they are working side by side with the modern banks. So far Islamic banks have the following types of deposits which differ from the deposits in other banks:
- Savings Accounts
- Investment Accounts
On Savings Accounts they are not obliged to offer any reward because the amount of the savings is guaranteed and the holders of these accounts are not liable for any losses that the bank incurs. This account, therefore, can attract only those customers who have money to save but do not want to take a risk and also are not keen to earn profits on their savings. Though the investment account, has the attraction of getting a higher rate of return than the current rate of interest this account will attract only those people who have the money to save, want to earn money and are willing to take a risk.
For these two types of people, the Islamic banks have to compete with two institutions:
- Interest-based banks.
There is a third category of people i.e. those who have money and want to earn profit on their savings without taking any risk. This is a category of people not available to Islamic banks.
The deposit performance of some of the existing banks underlines the need of developing effective tools to attract deposits. Table 4 compares the current performance of Dubai Islamic Bank — one of the oldest Islamic banks — with an interest-based bank originating during the same period in the same area and of the same size.
Paid-up Capital 1978
Growth of Deposit 1979 Deposits as % of
Capital Employed 1978
This is despite the fact that the Islamic bank is paying 6 per cent irofit on the savings accounts which will generally not be entitled to any share in the profits of the bank. This slow growth in deposits may not necessarily be reflecting the failure of Islamic banks to attract deposits but the fact remains that in a society where interest-based banks are also allowed to exist, Islamic banks stand at a disadvantage. How they are going to successfully compete the interest-based banks is not clear from their current programmes. There has been a lot of theoretical discussion on the literature on Islamic banking as to how to save the depositors of investment accounts from the risk of the losses that the bank might incur. Islamic economists, in search, of a viable alternative to interest-based banking, have suggested a number of schemes such as building reserves by the bank out of their good time earnings to compensate losses in bad time or launch deposit insurance with the backing of the central bank and the cooperation of all commercial banks and their depositors.
None of these schemes are so far operating and the depositors in the investment account stand liable to loss, should such possibility arise, though none of the banks so far have undergone such a possibility.
An effort on a large scale is needed to devise non-usurious tools (going beyond conventional devices) of banking that can raise the deposits for Islamic banks. The existing Islamic banks will have to do this research not only in their own interest but also in the greater interest of the Islamic countries who are Islamizing their societies.
Source: Money and Banking in Islam, Ziauddin Ahmed; Munawar Iqabal; M. Fahim Khan. Republished with permission.
2. Extra Management Burden of the Islamic Banks
Another factor that puts the Islamic banks at a disadvantageous position vis-a-vis the interest-based banks is that the Islamic banks have to supervise and in some cases manage the operation of the project that they are financing.
This problem is serious in developing countries where the business enterprises, generally, do not maintain proper accounts or keep different sets of account for different purposes.
The presence of such malpractices will raise the cost of Islamic banking. Unless such fool-proof devices are developed that do not entail these extra costs for Islamic bankers, the growth of Islamic banking activities are likely to be constrained considerably. The Islamic banks have devised certain strict rules and regulations so that they select only sound parties but these procedures not only discriminate them unfavourably against the other banks but also do not guarantee that their customers will be obliged to declare actual profits of their enterprise. None of the banks so far seem to have faced the problem perhaps, because either the Islamic banks have not expanded their business to the extent where they could feel this problem or because so far these banks have been dealing only in real-estate and trade business where such management problems may not be significant. This is, however, a problem that cannot be ignored.
3. Problems of the Borrowers of Pure Loan
The “Loan” (borrowing) has gained a prominent role in the present- day economic activities. Apart from the loans for commercial or productive needs, the loans are required for the personal consumption or non-productive needs. The Islamic banks with very limited funds for such loans will thus be ignoring the needs of quite a large class of population. Institutions will have to be developed to meet the society’s demand for loan particularly for genuine consumption purposes. The following possibilities are worth considering:
- Integrating Zakah & Sadaqat with the Banking System so as to give support to such vulnerable depositors of the bank as widow, old people etc. who would be supported on the basis of charities/or interest-free loans whenever the bank is running a loss or is not making a substantial profit. Islamic Economists have already discussed this possibility but it did not find favour with most writers. According to them it should be the responsibility of state. Though some of the Islamic banks do have a Zakah Fund it is not yet clear, how far they can be successful in meeting such needs of the society. Thus launching of an Islamic banking system will need to be synchronized with the development of an effective Zakah Fund by the state or the central bank.
Financing the Interest-Free Commercial Loan from pure savings accounts. All the Islamic banks have savings accounts which are meant for such depositors who do not want to stand liable for the losses and rather require their full amount to be guaranteed. These types of depositors, however, give the banks their consent to use their money. The banks use their money but are not obliged to pay them a share in the profit to the same extent to which they give to the depositors of the investment account. The amount for these deposits should obligatorily be used to provide the interest-free loans for consumption needs. Since the banks earn profits on the use of such deposits, therefore, the same should be used to finance the subsidy involved in interest-free loans. As the bank guarantees the full amount of saving to the depositors, the same can be compensated by the guarantee to be provided by the borrowers. The attraction of the provision of interest-free, loan to depositors in the savings account will raise the Islamic banks’ customers of savings accounts,
- Developing a system of local community funds operated by local communities themselves. Such institution will support the loan requirements of the members of the community. These institutions will work on the principle of cooperation rather than on commercial basis. The potential for such a community cooperative exists very much in countries like Pakistan. A recent public opinion survey in Pakistan showed that majority of the population would be willing to lend money to friends and relations without any compensation.* Efforts by the state can organize such institutions where people’s cooperation can be obtained as a part of a compre- hesive social security programme.
Apart from these, the need (particularly in Pakistan where the whole system is to be switched-over to interest-free banking) is for an intensive research into the behaviour of the population of savers in general and of Muslim savers in particular to investigate:
The ways and means by which their behaviour could be modified to become consistent with the norms of Islamic economy and the alternative institutional framework that can supplement the Islamic banking system to meet all the needs of borrowers/savers.
4. Problems of Investment in Long Gestation Projects
The Islamic banks have been found to be investing generally in the projects with quick returns. This is perhaps because the banks have to pay a sizeable profit every year on the deposit and they cannot afford to have no profit for some time if they are competing with the interest-based banks. This means that the long gestation projects are not likely to be picked up by these banks. If this is true then this is not only reducing the long run efficiency of the Islamic banks vis-a-vis other banks but will also affect the growth in developing countries if there are no banks to finance such projects.
To shift to an interest-free system, therefore, one of the crucial requirement will be to develop an institutional framework that can provide adequate financing for long gestation and infra-structural pro- jects. Establishment of Islamic Development Banks alongwith Commercial Islamic Banks will, therefore, become essential when switching-over to an interest-free economy.
5. Need for Theoretical Research
It is generally believed that all theoretical issues relating to riba- free banking are settled and that now it is only a matter of practice. This view, generally held by all the practising Islamic banks (with the exception of Islamic Development Bank) is a little over optimistic particularly when there is a question of changing the system in a country. Most of the Islamic banks are privately owned and are working along with the interest-based banking system. There is little chance that the Islamic banking tools devised by these banks can be challenged. But when the question is of running a system under a government advice, there is likely to come up a number of questions that need to be clarified by Muslaim Fuqaha and Muftis. Some of the issues for example are:
- Can a service charge be levied on pure loans. If the answer is in the affirmative, how this is to be calculated. What direct and indirect costs need be included in the calculation of this charge? How to envisage the costs in future without involving the interest element? This is a problem which both the Islamic Development Banks and the Islamic Commercial Banks will have to face when they advance pure loans.
- How to decide a margin of profit in trading, i.e. if a bank is supplying money to buy some merchandise should it or should not it charge any profit on it and if the answer is in the affirmative, what should be the rate of profit? In many cases such purchases may be a risk loss. If this is true then can the mark-up charged by the bank be considered as profit and not riba?
- How should the rent of physical capital be calculated so that it does not include the interest element?
These concepts, may theoretically not seem to have any practical problem, but as mentioned earlier, where it is a question of changing the whole system, these issues have to be settled in advance.
6. Use of Media
Another important issue that the Islamic banking, in general, has so far ignored is the use of media. Even the Muslims are not very much aware of the fact that the Islamic banking is being practised in the world. The banks have not ever used an effective media to publicise their activities. Some reports did appear in American newspapers about Islamic banking but they are not enough for a proper publicity of the Islamic system in this sphere.
Source: Edited version of: Money and Banking in Islam, Ziauddin Ahmed; Munawar Iqabal; M. Fahim Khan. Republished with permission.