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Practical Options for Central & Commercial Banking

The Federal Shari‘ah Court judgement does not directly impugn the functioning of the State Bank of Pakistan except for section 22 (1) of the State Bank of Pakistan Act, 1956. But this apparently minor repugnancy to Shari'ah involves the most important role of the central bank that governs interest rates chargeable by all the financial institutions in the country. In addition, because State Bank regulates, directs and monitors the financial institutions in the country, it cannot remain unconcerned with the judgement relating to:

  • Negotiable Instrument Act XXVI of 1981.
  • Agricultural Development Bank Rules, 1961.
  • Banking Companies Ordinance (LVII of 1962).
  • Banking Companies Rules, 1963.
  • Banks (Nationalisation) Payment of Compensation Rules, 1974.
  • Banking Company (Recovery of Loans) Ordinance (XIX of 1979).

The sections that have been declared by the court in the above laws or rules involve charging of interest or mark-up which, according to the court, resembles interest. Interest rate is governed by the bank rate. Mark-up is one of the modes of finance which the State Bank recommended to the banks. Thus, it is the State Bank that will have to find out a solution to the problems arising out of this judgement. Charging of in- tcrest or mark-up is not confined to the few cases that the court has assailed. The judgement has to be viewed in broader perspective. Hence arises the question of practical options for central banking in order to meet the challenge.

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The Prerequisites

Islamisation of banking in Pakistan was initiated in 1980 with introducing some changes in ICP, NIT and HBFC. This was a simple task because the first two institutions required minor portfolio changes while HBFC which used central bank funds also did not find it difficult to adopt a new mode of operation for its only long-term portfolio. This change, in principle, could decrease the returning but it was the headache of the central bank or of the institution itself. The problem arose when commercial banking was required to eliminate interest from its transactions. This process was to be pioneered by the central bank which had to choose one of the two alternatives. The substitute that was recommended by the Council of Islamic Ideology (ClI) and which comprised six modes of financing with emphasis on musharakah and mudarba or another substitute comprising 12 modes of financing including the council’s six modes without any special emphasis. The financial institutions were allowed to choose any of them that suited their interest. The council’s modes required the fulfilment of certain basic conditions to make the new experiment a success. These were as follows:

  1. Interest-free banking system can only, function successfully and prove to be fruitful subject to the condition that simultaneously with its introduction strenuous efforts are made on a wide front to inculcate in the society such basic virtues as fear of God, honesty, trustworthiness, sense of duly and patriotism, (p.3)
  2. With a view' to ensuring the success of the new system of banking it is of paramount importance that the government should carry out a thorough reappraisal of the tax system, focusing in particular on the need for greatly simplifying the system of income tax. A thoroughgoing reform of the income lax system is a sine qua non for the success of interest-free banking. This is because that under the new system, the in come of the bank would crucially depend upon the profits of the business firms which receive financial assistance from them. If the existing system of income tax remains as it is, the business firms would continue the malpractices of concealing their profits and maintaining multiple sets of accounts which would deprive the banks of their rightful share in the profits of these concerns and would thus adversely affect the earnings of the banks, (p.4)
  3. At present, two factors militate against a wide-ranging application of the principle of profit-and-loss sharing, widespread prevalence of unethical practices in the society and illiteracy... We have to, therefore, channelise all our energies and resources towards promoting honesty among the people and banishing illiteracy. (P-5)

The prerequisites laid down above assign the most basic role to the government. The success of the experiment depended upon successful campaign of moral reform. Changes in the mode of financing without fulfilling the basic conditions of success should have meant frustration in the new experiment leading to financial crisis. This also reflected the degree of sincerity with which the government was proceeding in this direction. The government’s lack of interest should have been sensed by the State Bank as also by the financial institutions. As a result the sensitive financial institutions, since the very beginning, took the programme of change in a similar mood.

Thus, on the one hand, the government claimed that lending by banks at interest has been eliminated since July 1, 1985, but on the other, some ministers claimed after the FSC judgement that interest was inevitable and that its elimination was a disastrous step. This self-contradiction has caught the central bank between the devil and the deep blue sea. Thanks to the appeal against the judgement which has granted some time to reformulate the strategy to meet the challenge. The strategy should be based on the assumption that the government, due to its own constraints, would not be able to fulfil the prerequisites as emphasised by the CII. This calls for a fresh thinking on the realities about the special position and importance of financial institutions, the constraints that keep them from adopting modes of finance warranting for risk exposure and a solution that satisfies the Shari‘ah requirements and is also acceptable to the financial institutions. An attempt to examine the anomalies in the existing theory and practice and propose new modus operandi for the financial institutions has been made below.

The proposals made in the annexure recognise the constraints and guarantee risk-free income for the banks and an active participation of the subsidiaries in modes like musharakah, mudarba, operating lease, hire-purchase, etc.

Bank-Rate Substitutes

After the modes of financing as set out in the annexure are adopted, the bank rate would become redundant. The central bank, in order to discharge the functions of bank rate, namely, rediscounting bills and commercial papers and lending to banks against eligible collaterals will have to rely upon the data regarding average return (AR) and overall return (OR). AR would be the average earning made by different units of the same industry or in the same trade during a given period. OR would represent average earning of all the industries or trades taken together by assigning weights according to their financial involvement during a given period.

Rediscounting bills and other commercial papers would be done by the central bank on the basis of a portion of AR. The same basis would be adopted in case of central bank financing of specialised financial institutions which finance a single sector of economy. OR would be adopted in case of financing commercial banks and those NBFIs that cater to financing requirements of various industries or trades. The same rates may be made the basis of prescribing profit-sharing ratio between the financial institution and the trader and between the financial institution and the depositor. It should be noted that AR and OR would be ex post facto rates and may be different from the actual in the future. A provision for adjustment between the two may be made only if the difference between actual and ex post facto rates is substantial. This need for change would be determined by the central bank.

In order to ensure that reliable AR and OR are available the central bank will have to set up a commercial intelligence unit enlisting informers who are skilled in all the trade techniques.

The rates thus obtained would replace the bank rate in the same way profit-sharing ratio is proposed in the CII report on the elimination of interest from the economy.

S M Hasanuz Zaman 


Source: Elimination of Riba, Khurshid Ahmad, Khalid Rahman and Zahed A. Valie. Republished with permission.