Special Loans Facility

A special loans facility, that is interest-free loans may be provided by banks and other financial institutions in such cases in which neither PLS nor any of the other alternative methods is feasible, provided that the projects/purposes for which finance is given are meant for general welfare of the community such as procurement of foodgrains by the Government to ensure stability in supplies and prices. However, in order to minimise the impact of such loaning on the profitability of the financial institutions, it should be ensured that it remains restricted to a scale considered absolutely necessary. The State Bank may provide the necessary guidelines or issue instructions in this regard to the financial institutions. It may also provide refinance facility to them. The Council also considered a proposal envisaging levy of a service charge by banks on such loans so as to cover the related cost incurred by them. It, however, came to the conclusion that in order to conform to the Shari'ah, the service charge will have to be on the basis of the actual cost incurred but the determination of the actual cost attributable to each loan would be difficult. The Council, therefore, recommends that in order to cover a part of the actual costs incurred by banks, they may fix a charge by way of an application fee, which should be uniform irrespective of the amount of the loan and its duration. Any other arrangement shall either be practically too difficult or would not conform to the Shari'ah. The Council considered another proposal stipulating that those financial institutions which do not avail of the refinance facility may be provided subsidy by the Government on the basis of the average rate of profit of the commercial banks in the relevant accounting period. The Council, however, felt that although the payment of subsidy to banks for their financing of special loans does not constitute interest in a strict sense, the provision of this subsidy would act as an incentive for the banks in providing such loans which makes this arrangement undesirable. In the opinion of the Council a more preferable course would be that banks provide the interest-free loans under the special loans facility against such deposits on which they do not have to pay any return to the depositors. However, should the resources available from such deposits with banks be found to be inadequate, provision of the subsidy could be resorted to if considered unavoidable.

While evolving a workable mechanism for financing on profit/ loss-sharing basis suited to our conditions, the Council has kept in view the Fiqh literature on the subject of Sharakah and Mudarabah. The stipulations pertaining to Sharakah provide that the partners are free to agree on any profit-sharing ratios irrespective of their capital contributions but losses are to be shared strictly in proportion to their respective capital contributions. It is felt that under the proposed profit/loss-sharing system, the division of profits between the financial institutions and business and industrial enterprises should not be left to be decided by the two parties but should be regulated by the central bank of the country. This will reduce unhealthy competition among the financial institutions and also enable the central bank to influence the allocation of resources among competing uses in accordance with national priorities and monetary policy considerations*. Under the new system, the respective capital contributions of the parties would continue to form the basis of profit/loss-sharing but banks and financial institutions would not, as a rule, be entitled to the full amount of profi,t that corresponds to their capital contribution, their actual share being governed by the ratios to be prescribed by the central bank. For instance, if the profit assignable to a bank’s capital contribution in a particular business on the basis of strict proportionality is Rs. 100 and the ratio prescribed by the regulating agency is 50:50, the profit accruing to the bank would be Rs. 50. The loss would, however, be shared strictly proportionately to the respective capital contributions.

For the purpose of profit/loss distribution, the respective capital contributions of the parties, utilised for varying periods, would be brought to a common denominator by multiplying the amounts with the number of days during which each particular item such as equity capital of the firm, its current cash surpluses, suppliers’ credit as well as the finance provided by the bank were actually deployed in the business. In other words, the calculation of the respective capital contributions of the parties would be made on daily product basis. However, in no case the highest multiple to be used for calculating the daily product can exceed the total number of days covered by the accounting period. This is because it is in this period that the funds will have effectively contributed to the operating results of the firm. In making financing agreements with firms, the banks may insist on a clause to empower them to appoint a director of their own to look after their interest as financing partners. They may also be empowered to inspect the books of the firms and to call for any information relating to the business for which the banks have provided finance. In the case of banks’ transactions with limited companies, the liability of banks would be limited to the amount of the financial assistance provided by them. However, in the case of their financing of individuals, partnership and other entities with unlimited liability, the banks’ liability would also be unlimited. Nevertheless, in such cases they may impose a restriction to the effect that during the period of financing by the banks, the other party would not accept any additional financial liability, and in case such a liability is accepted without the banks’ consent, then the banks would not share any responsibility for the same4.

The viability of a financial institution crucially depends on smooth and unhindered return flow of funds provided by it to its clients. Under the present system the banks often make use of penal interest rates in cases of delay in repayments. With the abolition of interest they would be deprived of this instrument for bringing pressure to bear on the delinquent borrowers. The Council recommends that the penal rates of interest should be replaced by fmes in cases of delay in repayment, except when it is caused by a genuine loss situation. However, the amount of the fine should not accrue to the banks, as this would tantamount to interest under the SharVah, but should be deposited in the Government treasury. Since delays and defaults without genuine reasons would not only be a breach of trust but also jeopardise the success of the new system the Council recommends that deterrent punishments should be provided to defaulters, which may include confiscation of property. Such delinquents should also be blacklisted and debarred from any future financial assistance by banks.

The stipulations suggested above in regard to banks would also be applied in the case of specialised financial institutions.

For the success of the new system it will be imperative that banks enjoy free and unfettered discretion in respect of acceptance or rejection of financing proposals received by them on the basis of sound banking principles and criteria. In this connection, the Council considers it pertinent to draw attention to an important problem which the banks have been facing during the past several years. It is a well-known fact that a number of public sector enterprises are not operating efficiently. They are also subject to administrative controls in respect of pricing of their products. As a result, they have been incurring losses or showing nominal profits. Yet, the banks under official instructions are often obliged to meet their financing needs and have in the process been saddled with heavy over dues. Under the present system, this situation has only affected the profit margins of the banks. However, under the new system it would also affect the rate of return available to the depositors as it would be related to actual profits of the banks. The Council, therefore, strongly recommends that when the new system is adopted such public sector enterprises as do not meet the criteria of sound banking may either be financed by a separate public agency or the banks should be guaranteed the repayment of the capital and provided with a subsidy by the government equivalent to the average rate of profit of the banks in the relevant accounting period.

A thoroughly-going reform of the auditing system, which presently suffers from a number of weaknesses, will also be necessary for ensuring the success of the new system. There is need for a comprehensive re-appraisal of the existing laws and practices governing th role of auditors and for evolving a really independent auditing system. Towards this end the following measures deserve consideration:

1. The financial institutions should be empowered to appoint auditors for auditing the accounts of the enterprises receiving financial assistance from them. This would afford a greater sense of security to the auditors and would be conducive to greater independence in the exercise of their functions.
2. Enterprises seeking financial assistance should also be required to introduce costing system which should be subjected to audit. At present most of the companies do not have a well designed costing system which could provide necessary information to auditors for checking the various costs incurred in the process of production.
3. The financial institutions should have well-organised audit departments in order to exercise a double check and carry out verification tests. This would help exert pressure on.the enterprises to keep their records systematic, clean and straight. It would also help assessment of profitability forecasts on quarterly or half-yearly basis.
4. The Institute of Chartered Accountants should organise training courses for in-service auditors to equip them with necessary expertise to detect accounting subterfuges designed to conceal the true profit position.
5. The Institute of Chartered Accountants would also organise research in order to evolve a new system of auditing suited to the requirements of an interest-free economy. The cost of such research work should be borne jointly by the Government and the financial institutions.
6. A committee of experts should be constituted by the Government to examine the existing Company Laws, Chartered Accountants Ordinance, Income Tax Law, Securities and Exchange Ordinance and other relevant laws and suggest suitable changes and new measures required to reform the present auditing system to bring these in line with the requirements of an interest-free economy. The committee should also make recommendations for the necessary changes in the mode and form of judicial action in cases of wilful concealment of profits.

The Council is conscious of the fact that the remodelling of the commercial banks’ operations on the basis suggested in this Report would represent a radical departure from the traditional British pattern of banking on which the commercial banks in this part of the world nave, for historical reasons, been operating. It must, however, be emphasised that in the broader international context, some features of the proposed system have already been in existence in the banking system of other countries. For instance, the German banks have from the very beginning been engaged in equity Financing on a considerable scale and have aptly been termed as “all-purpose” banks. In Japan before the Second World War, commercial banks actively participated in underwriting of shares and in the post-war period also the under-writing business continues to be strongly influenced by them. In France the Banques d’ Affaires, which represent an important part of the banking system, undertake investment financing on participation basis. In recent years, commercial banks in a number of countries have increasingly adopted new financing technique such as leasing, hire-purchase and the exercise of “convertibility options” which shift loans into equity.

The Council realises that the new system proposed by it would involve a certain amount of intervention by banks and other financial institutions in the management decisions of the firms to whom they provide financial assistance. However, such intervention is becoming a common practice even in the case of banks and other financial institutions which provide loan finance on a fixed interest basis. For example, a number of stringent conditions are being incorporated in loan agreements, such as conceding the right to the credit institutions to appoint one director on the Board of the borrowing concern, seeking permission of the financial institution concerned before issue of new share capital or obtaining of additional long-term loans or declaration of dividends. Loan agreements in many cases also give powers to the financial institutions to appoint auditors and to take over borrower company’s management at any time of its choosing. While undertaking the under-writing operations the financial institutions also insist on “buyback” agreement, and in addition to collateral they insist on guarantees of particular amounts of dividends and commissions.

The significant fact is that the character of banks and their operating procedures and practices are largely determined by the national priorities and the particular situation obtaining in the country in which they operate. For instance, in spite of the long-enduring political association as well as ethnic and racial links between the United States and Britain, the development of banking in the United States has proceeded on a radically different pattern, reflecting deep imprints of the local conditions and the social attitudes and behaviour.

Moreover, with the changing requirements of the time even the British banks have departed from the traditional practice of confining themselves to short-term lending and have increasingly engaged in medium-term fmancing after World War II. It is also noteworthy that in recent years private savings institutions such as pension funds, investment institutions and insurance companies in Britain have assumed a role in equity and other long-term financing which closely approximates the role of commercial banks in Germany. Institutions of this type are exercising a powerful influence on corporate decisions in U.K. and a number of other industrially advanced countries.

Considering the variety of the practices of banks and other financial institutions and their roles in the economies of different countries, reorientation of bank fmancing in Pakistan on the lines suggested cannot be regarded as entering a field that is completely untried. At the same time, however, it cannot be denied that elimination of interest from the banking and financial system as a whole is a bold enterprise and, like any new system, it may initially be faced with problems and difficulties. The Council, however, feels that once the new arrangements proposed by it are put into practice and worked in right earnest, a process of evolution would be set in motion and practical solutions to the emerging problems would be found.

The Council gave consideration to the action plan that may be adopted for the elimination of interest from the economy. In this respect it considered three different options. The first was that a beginning may be made by setting up a model bank which may start operations on interest-free basis and, on the basis of experience gained from its working, the operations of the commercial banks and other financial institutions may be reorganised on interest-free basis subsequently. The second option was to prepare a comprehensive scheme for a complete switch-over to the interest-free economic system and then decide on the timing of such a switch-over. The third alternative was to eliminate interest from the economic system in a phased manner. The implications of each of these alternatives are discussed below.

The idea of setting up a model bank, though appealing at first sight, suffers from serious drawbacks. To undertake operations on a scale that may really contribute to the needed experience, the model bank would require large deposit resources which it would not be easy to mobilise for a new institution commencing operations on a radically different pattern. More importantly, if the borrowers have the choice between borrowing from other commercial banks at fixed rates of interest and securing resources from the model bank on the basis of profit-and-loss-sharing and other devices permissible under SharVah, the sponsors of highly profitable projects would most likely prefer to borrow from other commercial banks, while financing of less profitable and risky projects would fall to the lot of the model bank. If under the circumstances the model bank becomes highly circumspect and selective so as to avoid too much risk, its operations may remain confined to just a few lines of activity which could hardly blaze the trail for others. In case it is not deterred by this consideration, it would be saddled with high overhead costs and a low profit yielding investment portfolio which would not allow it to pay adequate profit to its depositors. This would pose even bigger problems for its deposit mobilisation efforts and in turn further affect its scale of operations. The model bank would, therefore, find itself caught in a vicious circle and the chances of its success would be slim indeed.

In this connection, the Council also considered a suggestion mooted in some quarters that initially only interest-free counters may be opened in the existing commercial banks which may operate simultaneously with interest-based banking. The suggestion also envisages that the depositors may be given option to keep their money with banks on PLS basis or on interest basis. The Council strongly opposes such a course of action because it is not only inappropriate but also extremely dangerous, as it is likely to entail a perpetuation of the interest-based system and to undermine the efforts at introducing the interest-free system in the country.

The second option did not commend itself to the Council as the elimination of an institution as deep-seated and pervasive as interest at one stroke at any future date and replacing it by a new system could give rise to a number of intractable problems of adjustment. The Council feels that problems of adjustment can best be handled if a sufficient period of transition is allowed.

The third option, that is, elimination of interest from the economy under a phased programme was considered by the Council to be the most practical and reasonable. It was in this perspective that the Council had earlier recommended the elimination of interest from the operations of the National Investment (Unit) Trust and the Investment Corporation of Pakistan as well as from housing finance provided by the House Building Finance Corporation and the commercial banks in the initial phase. The specification of the areas from which interest may be eliminated, to begin with, was governed,by a number of considerations. In recommending the elimination of interest from the operations of N.I.T., the Council was mainly guided by the consideration that in the very beginning of gradual elimination of interest, people should be provided with an investment medium in which they could invest their savings without any religious inhibition. Among other financial institutions, I.C.P. was selected because a good part of its operations was even then free of interest so that complete elimination of interest from its operations could be effected with the least possible delay. Moreover, by the very nature of its functions, I.C.P. was an institution which would have been called upon to shoulder greater responsibilities in an interest-free system, and it was therefore appropriate that it should begin to be equipped for the purpose with utmost expedition. In recommending abolition of interest from housing finance, the Council sought to meet a basic need of the people on interest-free basis and to rid a major sector of the economy from interest.

The Council is happy to note that a beginning towards the elimination of interest has already been made with the implementation of the Presidential announcement of 12th Rabiul Awwal, 1399 A.H. that the N.I.T., H.B.F.C. and I.C.P. Mutual Funds would operate on interest-free basis as from July 1, 1979 and the decision announced in the last Budget that no interest will be charged by banks on production loans given to farmers cultivating holdings up to 12te acres. The Council recommends that rest of the measures for the elimination of interest from domestic transactions should be taken in three clearly defined phases with specific time schedules as indicated in the following lines.

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