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Riba-Free Alternatives in Commercial Banking

There are some basic Islamic principles of doing business. First, one has to be honest in dealings. Second, the economic activity to be undertaken or goods to be traded should be halal, i.e. socially desirable. Third, the methods and forms of raising finance and investing it in business should be in accordance with the established precepts of Islam.

Very recently a question was put to me as to why a certain bank had gone into liquidation? My reply was that the said bank failed as it did not operate according to Islamic principles. The failures of finance companies, investment companies and cooperative credit societies in Pakistan was also due to non-compliance with the basic principles of Islamic finance. Besides honesty in dealings, another basic principle of Islamic finance is that the return paid on capital raised for business has to be directly linked with what is to be actually earned in business. And this is the essence of musharakah and mudarba methods of financing.

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If the above principle of Islamic finance is followed, then the return on capital paid to a financier can in no case be higher than what the capital has actually earned. This principle is not strictly followed under the interest-based system which leads to failure of many financial institutions. We have seen that this Islamic principle was not followed by the finance companies, investment companies and the cooperative credit societies. These institutions went into liquidation as they had committed themselves to pay to their depositors such high rates of return which they were not in a position to earn. They were destined to fail for this reason alone even if cases of dishonesty are ignored.

It might be rightly asked here as to why most of the traditional banks and financial institutions which operate on the un-Islamic basis of interest do not always fail. The answer may be that these financial institutions follow the Islamic principles to some extent. First, they usually operate honestly and do not start with the intention of running away; besides, the governing legal framework also makes such running away difficult. Second, they manage their operations in a way that the promised return to their depositors is usually less than what they are able to cam. But wherever this principle is flouted, either intentionally or through compulsion of circumstances, the institution runs into financial difficulties sometimes leading to bankruptcy.

This ever-present risk in interest-based financial institutions is referred to as the “interest-rate risk” and is the major cause of their failures. The recent widespread failure of savings and loan associations in United States was an outcome of the interest-rate risk. The deposits with the financial institutions are basically for short term even if these are for a long term on paper as the depositors demanding premature withdrawal of their deposits are usually not refused. When interest rates rise, the depositors usually withdraw their deposits for redepositing the same at higher rates of interest. On the contrary, the borrowers are reluctant to repay their loans when interest rates are rising. The margin available to banks between rates of interest payable on deposits and receivable on loans narrow down leading to a financial crunch. A risk of this nature is non-existent in financial institutions which operate on Islamic principle as there is no contracted rate of return with depositors.

In addition to the cost factor, changes in interest rates ere ate their shock waves in many other ways. In the specific context of banking, heavy withdrawals by depositors cause additional problems relating to their liquidity and if financial institutions are unable to meet their commitments due to liquidity constraint, the consequences are obvious.

It is evident that in a riba-free financial system there is no room for interest-rate changes as there is neither a benchmark discount rate nor a bank rate to be periodically announced by the central banking authority. When interest rate ceases to exist, the problems connected with interest-rate risk and of liquidity constraint resulting from interest-rate changes will also become irrelevant.


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