Commercial Banking

The Section suggests alternative mechanisms for replacing interest in domestic banking transactions. Complete elimination of interest from international trade transactions cannot be achieved by the lone efforts of a single country. However, measures should be taken to minimise the element of interest even in international trade transactions. 

Under the new system, banks may provide finance on PLS basis for fixed investment in industry to parties maintaining accounts audited by Chartered Accountants. Parties whose accounts are not audited by Chartered Accountants may be accommodated under “hire-purchase”, Bai Muajjal or “leasing” arrangements. Smaller parties who may not be in a position to maintain proper accounts may be financed under “normal rate of return”, “hire-purchase” or Bai Muajjal arrangements.

Banks may also formulate new projects themselves singly or in collaboration with non-bank financial intermediaries, and the plant and machinery required for these projects may be financed by them on the basis of “Investment Auctioning”.

Under the new system the financing agreements would provide for monitoring by the banks of the actual performance of the projects financed by them so as to safeguard their interests.

Finance provided for fixed industrial investment under bridge financing arrangements based on “stand-by” technique of underwriting, currently in vogue, is not compatible with Shari'ah and needs to be substituted by “firm commitment” underwriting technique. Since the firm commitment underwriting is not permissible under the Companies Act, necessary changes in the Act may be made to permit the use of this technique.

Debenture financing may be replaced by the issuance of a new corporate security to be called the Participation Term Certificate (PTC).

Working Capital requirements of industry are at present being met through grant of cash credit, overdrafts, demand loans and bill discounting arrangements. These facilities, with the exception of bills discounting, may be provided on PLS basis in the case of firms maintaining proper accounts and having regular dealings with the financing bank. In other cases, finance may be provided under “normal rate of return” arrangements or Bai Muajjal. In the case of bill discounting, the Council has recommended a procedure designed to bring this type of financing in conformity with the SharVah. 

In providing short-term finance to farmers, the commercial banks should distinguish between farmers cultivating holdings up to the subsistence level and those cultivating holdings above the subsistence level. Farmers with subsistence holdings may be provided assistance in cash or kind without any charge under the “Special Loans Facility” Ordinarily such loans should be provided out of funds raised by banks on interest-free basis. However, if such funds are inadequate banks may be provided a subsidy by the Government in respect of such loans on the basis of the average rate of profit of commercial banks during the relevant period.

Short-term finance to farmers with holdings above the subsistence level may be provided by banks under Bai Muajjal or Bai Salam arrangements. 

Medium- and long-term finance is required for pruchase and maintenance of agricultural machinery and implements, sinking of wells, installation of tubewells, land development, construction of storage, poultry and dairy farming etc. Replacement of interest in medium- and long-term financing in the agricultural sector by a single substitute conforming to Shari‘ah is not possible. Therefore, the various alternative methods will have to be used for different purposes.

Under the new system, small retailers, who are not in a position to maintain accounts may be provided finance either under Bai Muajjal arrangements or under “Special Loans Facility” out of resources raised by them on interest-free basis. In case these are inadequate, the Government may provide a subsidy to the banks on the amount of such loans on the basis of average rate of profit of the commercial banks in the relevant period. In regard to bank financing of the commerce sector under cash credit, overdraft, demand loans and discounting of bills, the above arrangements as those recommended in respect of financing of working capital requirements of industry may be applied. In the case of opening of letters of credit, the banks may charge a commission for the service rendered by them and they may not necessarily share in the profit/loss. 

For financing house construction by individuals, commercial banks may adopt the same system as was recommended by the Council in its earlier Report and has been put into practice by the House Building Finance Corporation. Financing of construction companies both for fixed investment and working capital may be strictly on PLS basis.

Banks may finance purchase of trucks, buses, taxis, vans, rickshaws and private cars under “hire-purchase” or Bai Muajjal arrangements. 

With the exception of services sector, in which case banks may use any of the alternative methods of financing considered permissible under the Shari‘ah, PLS seems to be the only practical basis for financing of other sectors. In case of finance required for purchase of capital goods and machinery, techniques of Bai Muajjal or “Investment Auctioning” may also be used.

Banks may generally not provide any personal loans. Loans to finance educational expenses of meritorious students may, however, be provided without interest. Purchase of consumer durables under economically justifiable conditions may be financed under Bai Muajjal or “hire-purchase” arrangements on a restricted scale. Personal loans in calamity-stricken areas may be provided by the Government from the Federal Zakat Fund.

In order to avoid any adverse effect on depositor’s confidence and deposit mobilisation by banks, deposits in the short transitional period may continue to be accepted by banks on the existing basis.

Under the new system, variable return would be payable on savings and time deposits on the basis of banks profits/losses.

The nomenclature of deposits as well as the rules and procedures governing the operation of deposit accounts should remain unchanged for the time-being in order to avoid the possibility of confusion. However, some changes in the banking terminology could be helpful in creating a sense of the radical change in the system. The banks should also continue to enjoy full discretion in regard to the deployment of the deposits resources. The Government may also continue the guarantee provided to deposits of nationalised commercial banks for a short transitional period after the switch-over of deposits to the new system.

In order to avoid frequent shifts of deposits from banks with lower profitability to banks with higher profitability, the rates of return on deposits held with nationalised commercial banks should be made uniform by pooling their profits for distribution among depositors.

Inter-bank transactions may be carried out under PLS arrangements. 

The State Bank’s financial assistance to commercial banks under its various refinance schemes as well as those for meeting temporary liquidity shortages may normally be provided under PLS arrangements. 

The operations of foreign branches of Pakistani banks, foreign currency deposits held with commercial banks in Pakistan and certain other transactions of banks with banks abroad would have to continue on the basis of interest. In order to avoid merger of interest and noninterest income, however, the administration of foreign branches of Pakistani commercial banks may be entrusted to a separate Corporation to which foreign currency deposits held with commercial banks should also be transferred. This Corporation should not accept local deposits.

Commercial banks’ loans to their employees may be on the lines suggested in the case of the employees of the State Bank.

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