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Theory & Practice of Interest-Free Banking

Prohibition of interest in Islam necessitates that in countries seeking to introduce Islamic economic system, banking and financial practices be organised on a basis other than interest. Research work on the subject has proceeded to suggest that the principle of profit- sharing offers the best alternative to interest in an Islamic system. The participants in the Seminar were familiar with the work of Muslim economists in this field. Apart from this background they had the opportunity of going through the Report of the Council of Islamic Ideology on the Elimination of Interest (hereinafter referred to as CII Report) which was submitted to the Government of Pakistan in June 1980. Among the papers presented at the Seminar, those by Al-Jarhi and Chapra contained material on the subject. Besides, the paper presented by Fahim Khan reviewed the working of Islamic banks which had already started functioning in some countries.

There was overwhelming support in the Seminar for the view expressed in the CII Report that the ideal alternatives to interest in an Islamic economic system are profit/loss-sharing and qard-hasanah. The view is rooted in the Islamic philosophy of justice between man and man. To charge interest from someone who is constrained to borrow to meet his essential consumption requirements is considered an exploitative practice in Islam. Charging of interest on loans taken for productive purposes is also prohibited because it is not an equitable form of transaction. When money is invested in a productive undertaking the quantum of profits that may accrue is not known before hand and there is also possibility of a loss. Charging of a fixed and pre-deter- mined rate of interest on loans for productive purposes cannot therefore be morally justified. Justice demands that provider of money capital should share the risk with the entrepreneur if he wishes to earn profit. Thus, there is a basic difference between Islam and capitalism in regard to the treatment of money capital as a factor of production. Whereas in the capitalistic system, money capital is treated at par with labour and land, each being entitled to a return irrespective of profit or loss, this is not so in Islam which treats money capital at par with enterprise.

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The CII Report contains a detailed blueprint for reorganisation of banking practices and procedures on the basis of the principles of profit/loss-sharing in consonance with the Islamic legal concepts of sharakah and mudarabah. Under this system, the amount of return on the funds invested is neither fixed nor pre-determined. The quantum of profits depends on the operational results of the economic undertaking. When capital is provided entirely by one party and enterprise and/or labour entirely by another party the profit is to be divided in proportions agreed at the time of the contract while loss is to be borne by the provider of capital, unless it is due to the negligence of the entrepreneur/worker. If there are more than one providers of capital, profit is to be distributed among them in agreed proportions, while loss is to be shared by them strictly in proportion to their capital contributions.

The CII Report does not suggest any change in the institutional structure of the monetary and banking system. The central bank, the commercial banks and the specialised financial institutions would continue to perform the same functions as previously but their operating procedures would be modified to replace interest-based transactions by a system of variable return. Commercial banks would provide funds to business enterprises and would be entitled to receive a part of the profits earned by the enterprise in accordance with the agreed propor- tions stipulated in the mudarabah contract. For the purpose of profit distribution, the respective capital contributions of 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 a daily product basis. As for deposits, the commitment on the part of the bank to pay a fixed return on savings and time deposits would be replaced by an agreement with the depositors to pay to them a part of the profits earned by the bank. Distributable profits would be computed by setting off the administrative expenses, payments due to the central bank and other banks in respect of finance provided by them, provision for taxes and appropriation for reserves from the total earnings. The amount of profit so arrived at would be divided between the shareholders of the banks and the holders of savings and time deposits, the basis of the calculation for apportionment of profits being the daily products of the amount of capital and reserves and the total amount of savings and time deposits. Commercial banks would also accept demand deposits but they would not share in the profit of the bank.

The methodology suggested in the CII Report for the elimination of interest from the transactions of the non-bank financial intermediaries and specialised financial institutions is modelled more or less on the same lines as in the case of commercial banks. A somewhat different procedure has been suggested for providing housing finance which is based on the sharing of the actual or imputed rent.

No change is contemplated in the functions and responsibilities of the central bank. However, its operating procedures and the contents and substance of some of its monetary policy instruments would undergo significant changes consequent to elimination of interest. These are discussed in detail in CII Report. The Bank Rate weapon is proposed to be replaced by an alternative instrument of control to influence the total availability of bank finance as well as the allocation of bank finance among competing uses. This consists of empowering the central bank to vary the profit-sharing ratio on the basis of which it would provide financial assistance to banks. It can also be empowered to prescribe profit-sharing ratios for banks in respect of finance provided by them to business firms and, as observed in the CII Report as well as by Nejatullah Siddiqi, variations in such profit-sharing ratios can powerfully influence investment decisions in the desired direction. The central bank’s, power to require the commercial banks to maintain minimum cash reserves with it against their demand and time liabilities and to vary this ratio from time to time will remain unaffected by the elimination of interest. It will be possible to retain liquidity ratio requirement as an instrument of monetary policy with the only change that the interest-bearing securities held in the portfolio of the banks will have to be replaced by such financial instruments as are permissible under the Shari'ah. ' The central bank’s role as “lender of the last resort” as well as the provision of refinance by it to commercial banks and other financial institutions would not be affected by the abolition of interest. However, under the new system such assistance would in general be provided under profit-sharing arrangements or other alternative methods permissible under the Shari‘ah.

The CII Report recognizes that there are certain spheres where it will not be possible to use the system of profit/loss-sharing so that use will have to be made of alternative devices to replace interest. The most prominent case of this type relates to government borrowings from the banking system as well as the non-banking sector. The CII Report suggests that the banking system should provide loans to government on interest-free basis within the safe limits of monetary and credit expansion. Some participants in the Seminar pointed to the possibility of indexation of government loans and small savings schemes and felt that by preserving the real value of qard-hasanah, indexation fulfilled the Islamic imperative of socio-economic justice and should therefore be permissible. Others pointed out that under the Shari'ah currency transactions are not treated differently from commodity transactions in as far as lending and borrowing are concerned. The basic principle in this respect, they pointed out, is that the same quantity should be returned as was borrowed even though the price of the commodity may have changed in the meantime. The possibility of the use of indexation in the dealings of the banks with private clients, particularly in respect of mobilisation of deposits, was also discussed in the Seminar but, in view of the lack of unanimity of views on this issue, it was considered a suitable subject for further research and study.

Another area where interest cannot be replaced by profit-sharing relates to government borrowing from external sources. The Council of Islamic Ideology recognised the difficulties in the elimination of interest from transactions relating to international loans and aid and has therefore acquiesced in government borrowing from abroad on the basis of interest for the time being. The CII Report, however, express- es the hope that if Muslim countries work jointly, reduce reliance on outside assistance and promote movement of capital among themselves on the basis of profit/loss-sharing or some other non-interest basis, it is not unlikely that, with the passage of time, non-Muslim aid-giving countries and international financial institutions may also begin to deal with Muslim countries on a basis compatible with Shari'ah.

The CII Report gives due recognition to difficulties that may arise in changing, the whole system to profit/loss-sharing in one step. It has therefore given qualified approval to certain other methods being used in conjunction with profit/loss-sharing like leasing, hire-purchase, Bai Muajjal, investment auctioning and financing on the basis of normal rate of return. However, cautioning against the danger that such methods could open a back-door for interest, it emphasises that their use should be kept to the minimum extent that may be unavoidably necessary under given conditions and that their use as general techniques of financing must never be allowed. The participants in the Seminar were even more emphatic in sounding such a note of caution. They were strongly of the view that, keeping in view the rationale for the condemnation and prohibition of interest in Islam, no mechanism other than profit/loss-sharing really conformed to the spirit of Islam.

It was recognised, however, that the concept of profit-sharing cannot be applied in the case of personal loans taken for meeting consumption requirements. It was felt that in a truly Islamic society, the need for such loans should be minimal as Islam emphasises austerity and exhorts people to live within their means. Moreover, the Zakah system is expected to assist persons who find it difficult to meet their essential consumption requirements from their own earnings. Still some arrangements would need to be made to meet loan requirements of an emergent nature arising from temporary causes. Some participants in the Seminar were of the view that such requirements should be met by stipulating that each bank should devote a small percentage of its resources for interest-free lending. Others were of the view that banks should not be burdened with this responsibility and separate consumer loan institutions should be organised for the purpose with resources contributed by the Government or derived from Zakah proceeds.

The Seminar also devoted attention to the evolution of new financial instruments to suit an interest-free system. In this context, the recommendation made in the CII Report to replace debentures with a new type of corporate security to be called the Participation Term Certificate based on the principle of profit-sharing was noted with interest. Al-Jarhi in his paper has mooted the idea of banks offering various types of certificates to mobilise investible resources which he has named as Specific Investment Certificates, General Investment Certificates, Profit-sharing Certificates and Leasing Certificates. Al- Jarhi also suggests the issuance of Central Deposit Certificates by the central bank of the country to attract the savings of the people on a profit-sharing basis. The idea is that savings thus mobilised should be placed by the central bank in the investment accounts of different commercial banks and profits realised from such investment should be distributed among the holders of Central Deposit Certificates. This seems to be a promising idea because, as Al-Jarhi states, such Certificates would give a more stable yield on account of diversified investment and would therefore make a useful addition to the variety of financial instruments that would be available for investment in an interest-free economy.

The Islamabad Seminar did not confine itself only to theoretical aspects of interest-free banking. It had an occasion to review the actual field experience in the conduct of interest-free banking operations in the Muslim World. The paper presented by Fahim Khan gives a good deal of information about the actual operating procedures of a number of Islamic banks some of which were personally visited by him. The participants in the Seminar also had the opportunity to hear the executives of some of the Islamic banks who expounded the methods of their working.

It was apparent from the paper presented by Fahim Khan that interest-free banking, which still recently existed only in the realm of theory, has now a lot of practical experience to offer. At the time the paper was written, interest-free banks were already functioning in Sudan, United Arab Emirates, Kuwait, Bahrain, Jordan and Egypt. Two other interest-free institutions were located in European countries. Besides, the Islamic Development Bank, which is a multilateral financing institution of the Muslim World, had been in the field for some years. In Pakistan, interest had been eliminated from the operations of a number of specialised financial institutions and more than 6500 branches of Pakistani banks had just embarked on interest-free banking by opening separate counters where people could deposit their savings which banks undertook to invest in profitable but interest-free avenues.

The review of the working of the interest-free banks in Fahim Khan’s paper shows that these banks have successfully devised banking practices which are in conformity with Shari'ah. They accept both current deposits and deposits committed for investment which are called Investment Accounts. The Investment Accounts are usually of two types, namely, accounts with authorisation and accounts without authorisation. In the accounts*with authorisation, the account holder authorises the banks to invest the money in any project. In the other type, the account holder may choose any particular project for investment of his deposited money. On the assets side, these banks were found to be operating on the basis of musharikah and mudarabah which are essentially profit-sharing arrangements. Besides, business is conducted on the basis of murabaha under which the bank buys a specified item for the client who agrees to pay the bank later, in lump sum or instalments, a price including an agreed percentage of profit.

The performance of the banks in respect of profits earned appeared to have been quite encouraging. The profit rate on capital in the case of Islamic banks included in Fahim Khan’s study is reported to have been in the range of 9 to 20 per cent. This was not much different from the profitability of interest-based banks in the same areas. Persons holding investment accounts in these interest-free banks are reported to have received a return ranging from 8 to 15 per cent which is again comparable to rates of return available in interest-based banks.

It appears that the banks included in Fahim Khan’s study showed a preference for financing trade and investment in real estate. They generally seemed to have looked for projects with quick returns. This is not difficult to understand because most of these banks had been only recently established, and to face competition from well established interest-based banks they must have been anxious to show good profitability even in the initial years of their operation. Moreover, appraisal of long gestation investment projects requires technical expertise of a high order which it takes time to assemble. One ought to remember also that these banks are operating in a scenario which is dominated by interest-based banks which have close inter-bank relationship and can also get financial support from the central bank of the country in time of need. The interest-free banks, on the other hand, have no support of this type as they cannot borrow from interest-based institutions. Viewed in the context of the handicaps they face their performance appears to be commendable. The real value of their contribution lies in the fact that they have blazed the trail for others and prepared the ground for further advancement in this field.


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