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Methods to Finance Alternative Mechanisms

Personal Loans

In addition to financing productive activities in various sectors of the economy, commercial banks at present also provide, on a relative limited scale, personal loans, e.g. for purchase of consumer durables, for financing higher studies of students within the country and abroad, for tiding over the needs of persons proceedings abroad for employment, for relief in calamity-stricken areas and for social ceremonies. Some of these loans are secured, e.g. “gold loans” provided against the security of gold ornaments, secured overdrafts allowed against “approved securities” and purchase of cheques granted against lien on the account of the customer. Clean overdrafts up to a limit of Rs. 25,000 are allowed against personal securities. Other loans, such as“student loans”, “rains/flood loans”, car, motor cycle and cycle loans and “overseas employment loans” are generally unsecured.


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At present, interest is paid on personal loans in the same manner as on loans provided by banks for productive purposes. As such, the demand for personal loans is restrained by the cost element. Under the new system, no built-in device would be available to restrain the demand for personal loans which are usually taken for unproductive purposes.

It may be stressed that in an ideal Islamic society the recourse to personal loans is not considered desirable except in cases where satisfaction of the basic human needs or redeeming financial obligations are involved. Borrowings for lavish expenditure, artificial standard of living or conspicuous consumption are considered highly undesirable. It may also be mentioned that under the Islamic system the needy may not be expected to have to borrow because it is the duty of state to provide them assistance without any charge. This is because it is a cardinal objective of an Islamic state to establish a welfare society and the system of Zakah and Sadaqat as a means to achieve this objective. If a state is too poor to meet this obligation, it may make it obligatory for banks to provide such loans to a limited extent. The Council, therefore, recommends that under the new system banks may generally not provide any personal loans. However, meritorious students may be provided loans to finance their studies without interest. Consumer durables may also be financed under Bai Muajjal or “hire-purchase” arrangements on a restricted scale. As regards personal loans in calamity-stricken areas, these may be provided by the Government from the Federal Zakat Fund.

Bank Deposits 

The Council is of the view that elimination of interest from the deposits side of bank operations should be handled with utmost care. Commercial banks are the largest intermediaries between savers and investors in the country. Over the years, they have successfully gained the confidence of the savers and mobilised large amounts of savings in the form of bank deposits. It is, therefore, of crucial importance that the switch-over to the new system should be effected in a carefully planned manner so as to avoid any adverse effect on depositors’ confidence and deposit mobilisation by banks. Keeping this objective in view, the Council feels that in the short transitional period needed for eliminating interest from the banks’ financing operations, deposits may continue to be accepted by banks on the existing basis.

Under the new system, payment of a fixed return on savings and time deposits will have to be done away with and replaced by a variable return*. The mechanism of determining the return to depositors under the new system should be as follows:

  1. Distributable profits/losses of banks would be computed by setting off the administrative expenses** payments due to the State Bank and other banks in respect of the accommodation provided by them, provision for taxes, and appropriation for reserves from the total earnings. The amount so arrived at would be distributed among capital and reserves and savings and fixed deposits while holders on current account deposits would share neither in the profit nor in the loss, if any. The calculation of the profit/loss would be made on the basis of daily product of the amounts. These daily products would be assigned different weights so as to ensure an edge for capital and reserves and longer-term deposits. The weights would be prescribed by the State Bank. The period of fixed deposits would be 6 months and its multiples. The various deposit schemes introduced by banks in recent years which are based on calculations of compound interest for attracting longer-term deposits would also be brought under the PLS system. Profits/losses would be computed and distributed at 6-monthly intervals.
  2. An illustration of profit/loss distribution among the equity holders and savings and fixed deposit holders is provided by the following hypothetical exercise:
  • Bank’s capital and reserves                                                                       200
  • Bank’s total earnings                                                                                1000
  • Administrative expenditure, payments due to State Bank and other banks, provision for taxes and appropriation for reserves                                    300
  • Distributable profit                                                                                     700

Particulars

 

Amount

Period of deployment

Product

ofI&

II

Weights

Weighted

Daily

Product

Share in Profits (Amount)

(I)

OD

(III)

(IV)

(V)

(VI)

1. Capital and reserves

200

180 days

36.000

1.00

36,000

119.7

2. Savings deposits

200

90 days

18.000

0.30

5,400

17.9

3. Fixed deposits

 

 

 

 

 

 

(0

3-6 months

200

180 days

36,000

0.30

10,800

35.9

(u)

6 months to 1 year

200

180 days

36,000

0.40

14,400

47.9

(iii)

1-2 years

200

180 days

36,000

0.60

21,600

71.8

(iv)

2-3 years

200

180 days

36,000

0.70

25,200

83.7

(v)

34 years

200

180 days

36,000

0.80

28,800

95.7

(vi)

4-5 years

200

180 days

36,000

0.90

32,400

107.7

(vii)

5 years and above

200

180 days

36,000

1.00

36,000

119.7

 

 

 

 

 

Total

210.600

700.0

In case

of loss the respective shares in

losses would work out

 

follows:

 

 

 

1.

Bank’s total earnings

100

 

2.

Administrative expenditure

300

 

3.

Total loss

200

 

                     

 

Particulars

Amount

Period of deployment

Product of I & 11

Share in Loss

 

(•)

00

(HI)

(IV)

1. Capital and reserves

200

180 days

36,000

23.53

2. Savings deposits

200

90 days

18,000

11.76

3. Fixed deposits:

(i) 3—6 months

200

180 days

36,000

23.53

(ii) 6 months to 1 year

200

180 days

36,000

23.53

(iii) 1-2 years

200

180 days

36,000

23.53

(iv) 2-3 years

200

180 days

36,000

23.53

(v) 34 years

200

180 days

36,000

23.53

(vi) 4-5 years

200

180 days

36,000

23.53

(vii) 5 years and above

200

180 days

36,000

23.53

 

 

Total

306,000

200.00

The Council feels that under the new system, the nomenclature of deposits as well as the rules and procedures governing the operation of deposit accounts should for the time being remain unchanged in order to avoid the possibility of confusion. In this connection, the Council would like to stress that all the banking terms that are in vogue in the interest-based system cannot be continued under the new system. This is because the banking and financial terms are of two kinds: (i) Those evolved in the context of the interest-based system but would not suit the new system. For instance, finance provided on the basis of. Bai Muajjal cannot be termed as loan, (ii) Those which can continue,to be used under the new system as well. The Council is of the view that some changes in the banking terminology could be helpful in creating a feeling among the people that the country’s economic system is undergoing a radical change and the old system is being replaced by a system which conforms to the teachings and injunctions of Islam.

The banks should continue to enjoy full discretion in regard to the deployment of the deposit resources. It also appears advisable that after the switch-over of deposits to the new system, the government may continue the guarantee at present provided to deposits of nationalised commercial banks for a transitional period of, say, two years. However, this guarantee would be in the nature of a moral obligation on the part of the Government but it cannot be enforced legally. In this connection it is pertinent to note that the underlying spirit of the Islamic system in so far as it pertains to investment is that any one who wishes to earn a profit in business should also accept the risk of loss. Therefore, this guarantee should be for a short period as recommended and should not be allowed to continue indefinitely6

The Council noted that at present the rates of return on deposits are uniform for all the commercial banks. However, since under the new system the rates of return on deposits would depend on the profits of the banks and would vary considerably, there may occur 'frequent shifts of deposits from banks with lower profitability to banks with higher profitability, thereby causing dislocation. In order to avoid such a situation the Council recommends that there should be uniformity in the rates of return available on deposits held with nationalised commercial banks. This can be achieved by pooling their profits for distribution among deposit holders.

Miscellanteous Transactions 

Inter-Bank Transactions

  • Commercial banks usually keep deposits with each other and, when needed, also avail of financial assistance mutually. At present these transactions are interest-bearing. After the elimination of interest, such transactions may be carried out under PLS arrangements on the basis of daily products of the amounts.

Financial Assistance from the State Bank

  • The State Bank provides financial assistance to commercial banks under its various refinance schemes as also to enable them to tide over temporary liquidity shortages. Under the new system, such assistance may normally be provided by the State Bank under PLS arrangements. A detailed discussion of the proposed arrangements in this regard will be found in Section IV of this Report.

Foreign Transactions of Banks Involving Interest

  • Foreign branches of Pakistani banks would have to conduct their operations on the basis of interest. Similarly, the foreign currency deposits held with commercial banks in Pakistan as well as certain other transactions of banks with banks abroad would also have to continue on the basis of interest. The Council recommends that in order to avoid merger of interest and non-interest income, the administration of foreign branches of Pakistani commercial banks may be entrusted to a separate Corporation. The foreign currency deposits held with commercial banks should also be transferred to this Corporation. This Corporation should not accept any local deposits.

The above position may continue until alternative arrangements conforming with the Shari'ah are evolved in regard to these transactions.

 

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