Islamic Financial System: A Brief Introduction

Briefly speaking, we are talking of a system with the following features:

1. There is no interest in the economy. Financial capital can cam income only by bearing and sharing risk of losses. All banks, commercial financial institution and development financial institutions will seek and provide finances which will always have some clement of risk-bearing. Though there can be several ways to substantially reduce risk-bearing by the financial institutions, yet all of them have to have some risk-bearing in some form by the finance supplier.
2. If financial capital is not willing to bear and share risk, it can then be advanced on qard-e-hasan basis. In this case, financial capital neither cams any income nor bears or shares any risk of loss. Commercial financial institutions, of course, will not indulge in such transactions on large scale. The system will develop special institutions for this type of financing, cither on cooperative basis or in public sector.
3. There is Zakah and charities in the system, the minimum obligatory levy being 2.5 percent on the ownership of financial capital. Besides, serving as a deterrent to keep the financial capital idle, it also serves as an obligation-free financial support to the low-income population.
4. Public borrowing is constrained by the absence of interest in the economy. Public borrowing will either come in the form of risk-bearing capital for commercially productive projects or it will come in the form of qard-e-hasan to the government. Government securities bearing return can be issued only for such borrowing that are linked to commercially productive activities.
5. In principle, this is for the government to print money if its benefits outweigh its cost.

Within this broad line, it will be instructive to go into a bit more detail about the modes of financial accommodation in the above-mentioned system where interest is absent and financial capital can cam income only by bearing risk of loss.

Modes of Financial Accommodation

From the Islamic teachings, we can identify two categories of permissible forms of financial accommodation. One, we may call direct financial accommodation and the other indirect financial accommodation.

Direct Financial Accommodation

The financial needs of someone are allowed to be met by the finance owner in one of the following two ways: One, qard- e-hasan system (QHS) and the other, profit-loss sharing system (PLS). Under QHS, a finance owner may provide a loan to someone who needs it. He will have a claim only on the principal amount. He cannot claim any return on it, small or large, nominal or real, directly or indirectly. The finance owner in this case is also obliged to reschedule or postpone the repayment of principal amount, if the borrower’s conditions are such that he docs not have the ability to pay. The postponement is required to be allowed until he becomes able to pay.

If a finance owner intends to benefit out of his financial accommodation, then he will have to enter a PLS arrangement with a user of finance in the context of a specific productive or commercial enterprise only. The PLS arrangement is not allowed if the financial accommodation is for consumption or for general purpose where the QHS is the only option.

The principle of PLS arrangement is the following: The finances will be provided for a specific project or productive activity. The finance provider and the finance user will agree to share the profit earned from the project according to a pre- agreed ratio. The profit-sharing ratio may be different from the ratio of the investments of the two parties in the project. In case of a loss, both parties will share the loss in exact proportion to their investments in the project. The loss cannot be shared in a ratio different from that of their investments.

There is no other option for direct financial accommodation

Indirect Financial Accommodation There are several permissible Islamic ways of indirectly providing financial accommodation. Some of these are or have been in practice and some more may be discovered or identified in future. Before explaining some major forms of indirect financial accommodation, let us first be clear of the fundamental principle underlying these forms. The underlying principle, which will always have to be adhered to whether it is direct financial accommodation or indirect financial accommodation is that there can be no return earned on one’s finances without subjecting these finances to bearing some part of the risk associated with the activity where finances are being used. The only difference between direct financial accommodation and indirect financial accommodation from the point of risk-bearing (if return is to be earned on financing) is that under direct financial accommodation, risk-bearing is in exact proportion to the investment of two parties and is for the entire period of the use of finances, whereas under indirect financial accommodation, the level of risk-bearing can be different from the risk-bearing involved in direct financial accommodation. Sometimes it may be possible for the finance provider to substantially reduce his part of the risk-bearing (but he is not allowed to eliminate it) and it may also be possible to substantially reduce the period of risk-bearing (though he cannot eradicate it).

Let us briefly describe some major forms of indirect financial accommodation. These forms can be described under three major categories:

• Trading-based modes
• Leasing-based modes
• Service-based modes

Trading-Based Modes

There are two major forms. One may be referred to as deferred payment form and the other as deferred delivery form. To understand this concept, let us call the party needing the finance as A and the party providing the finance as B.

Under deferred payment form, the permissible financing would be as given below:

A needs financing to purchase certain goods. B is not interested in doing PLS arrangement with A. B can offer A that he can purchase the goods, needed by him from the market. A will then repurchase them from B at a predetermined profit (mark-up on cost- plus basis) and B will agree to receive the payment until some pre-agreed date. In this way, the financing needs of A have been met and B also ends up making profit on his financing. The risk that B is bearing is that during the period he is marketing the goods for A and all the goods are delivered to A, the entire loss or damage if any will be that of B. Furthermore, it is also possible that after B has made all the purchases for A, A may change his mind or may not like the goods marketed by B and hence B will end up with the responsibility of disposing of the goods purchased by him. This risk though can further be reduced if B appoints A himself as his (B’s) agent to purchase the needed goods. In this case, of course, A will purchase the goods that he needs and risk of rejection of goods is pre-empted. The risk of loss or damage of these goods, however, will remain with B until A finally makes a contract to repurchase them from B. Until A makes this contract, A also has the option to change his mind. Hence, some risk will still be there. Any attempt to eliminate the entire risk, for example, binding A to repurchase the goods from the beginning of entering into the deal will be against the spirit and fundamental principle of the financial accommodation in Islam.

Under the deferred delivery scheme, A approaches B to provide finances and B agrees to do so only by purchasing at a specific predetermined price certain specific goods that B will produce and/or deliver at specific date in future. The financing needs of A are met and B expects to cam a profit, because he must have contracted the price with some expected margin profit. The risk-bearing for B in this case is that he may not be able to realise the expected margin of profit that he had in mind while agreeing upon the price of the goods. The actual price at the time of the delivery of goods may turn out to be lower than what B paid for in advance. Also, B, after delivery of goods, has to store and market them and in this process he bears several risks.

Leasing-Based Financing

Leasing in itself is an alternate to financing. A needs an equipment or real estate, but he docs not have financing to purchase it. B uses his finances to purchase the equipment and leases it to A and charges a rent on it. The need of A is met. B makes a profit out of the rent.

It may apparently seem that B is making a fixed income without bearing any risk (and hence is similar to interest). It may be noted that rent docs not reflect a return on finance, at least in Islamic sense. Under Islamic arrangements, B will be bearing the following risks while leasing the equipment to A:

• During the entire lease period, the basic maintenance of the leased item remains the responsibility of B. The total cost of maintenance during the entire life of the item will always be uncertain.
• The leased item may be damaged or go out of order (without any fault of lessee) before completing its life that was supposed to repay the total investment made in it and a certain return on it. Even if insurance is made, the uncertainty of working life of the item will keep the gains from insurance uncertain.
• The lessor is not certain for how much of its active life the item will remain on lease at the rent he expected to repay him the investment and a certain return on it. All above keeps the profit of the lessor on his investment on the leased item uncertain until the item completes its working life.

Leasing, however, is not financing and is only an alternate to financing. As mentioned above, leasing only met for A the need for using the equipment or real estate needed. But if A wanted to own the equipment or real estate and needed financing for this purpose then the leasing did not meet the financing need.

We have leasing-based financing modes which are modes of indirect financial accommodation to meet financing needs in Islamic ways. The leasing-based modes work in the following way:

A approaches B to finance a certain purchase. If the purchase is of a rentable item then he will like to use the leasing-based mode. B makes the needed purchase and hands it over to A on lease. B also agrees to receive (in addition to rent) the payment of the price of the equipment, etc. in instalments. As the instalments of the price are paid, the rent of the equipment also declines proportionately. When all instalments are paid, the rent to be received by B becomes zero and the equipment comes under complete ownership of A. The financing need of A has been met as he ends up owning the equipment due to the financing from B. Also, B ends up receiving his investment along with some return on it in the form of rent that he had been receiving during the period.

Service-Based Financing

A is a skillful person and can cam substantial income from his skill by producing certain goods, but needs financing to purchase raw material. The trade-based mode which allows for deferred payment is also not suitable, because A is not a trader and docs not know how to market his or her goods. Service-based financing mode can help meet financing need of such a person. The procedure is as follows:

B offers A all necessary materials to produce certain amount of goods for B and B offers to pay A on the basis of completed output. A’s financing needs have been met (and is also relieved of marketing problems). B expects to make profit by selling the goods, produced by A, in the market with some margin of profit.

Islamisation of Financial System in Pakistan in Retrospect

The first formal attempt in preparing a blueprint for an Islamic financial system for Pakistan was initiated by President Gen Muhammad Ziaul Haq who specifically asked the Council of Islamic Ideology on Sept 29, 1977, to prepare a blueprint of an interest-free economic system. The council submitted its report in June 1980. The report was a product of the combined efforts of the experts in economics and banking and those of the Shari‘ah.

The council recommended that a detailed blueprint for the switchover to the interest-free system should be drawn up by the government in the light of the recommendations of the council by the end of December 1980. It also recommended the setting up of study groups for effecting such changes in banking laws and other legislation as may be necessitated by the proposed switchover.

By virtue of its scope and technique, the report of the council is perhaps the first comprehensive document written in the contemporary Muslim world through joint efforts of experts on economics and banking who possessed both practical experience in the field as well as had deep insight into the theoretical aspects of the formidable task entrusted to them.

The council stressed that with a view to ensuring the success of the new system of banking, it was of paramount importance that the government carry out a thorough reappraisal of the tax system, focusing in particular on greatly simplifying the system of income tax. The need for this measure was earlier also underscored by the council while submitting its report on the introduction of Zakah and it was pointed out in that context that proper collection system was not simplified and made sufficiently easy for the asscssccs. The council expressed its deep concern in this regard once again, particularly in view of the fact that a thorough reform of the income tax system was a sine qua non for the success of an interest- free banking system. This was because that under the new system, the income 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 be inclined to maintain multiple sets of accounts which would deprive the banks of their rightful share in the profit of these concerns and would thus adversely affect the earnings of the banks.

In regard to the operative aspects of the interest-free banking system, the council considered it of vital importance to make it clear at the very outset that ideally the real alternatives to interest under an Islamic economic system are profit- loss sharing or qard-e-hasan. Although the recommendations contained in the report were based largely on the principle of profit-loss sharing, yet some of the recommendations referred to other methods such as leasing, hire-purchase, bai' mu'ajjal and investment auctioning in view of the difficulties faced, at least in an interim period, in the practical application of the system of profit-loss sharing in its pure form on account of the prevalent standards of morality in the society. The council had, of course, incorporated the necessary modifications into these alternative methods so as to rule out the possibility of any built-in element of interest in them. However, these alternative methods (i.e. those other than profit-loss sharing and qard-e-hasan), though free of the interest element in the form in which they were specifically laid down in the report, were declared no more than a second best solution from the viewpoint of an ideal Islamic economic system.

The report clearly warned that there was also a danger that these alternative methods such as mark-up, leasing, etc. could eventually be misused as a means for opening a back door for interest along with other evils. It was, therefore, strongly recommended that the use of these methods should be kept to the minimum extent that may be unavoidably necessary under the given conditions and that their use as general techniques of financing must never be allowed. The council, therefore, recommended that a basic policy decision should be taken to the effect that with the passage of lime the operational field of profit-loss sharing and qard-e-hasan would gradually be expanded while that of the other alternatives reduced.

For remodelling the banking system on Islamic lines, the report also recognised that it was indispensable to make the necessary changes in respect of all such matters as have a bearing on the operations of banks. Accordingly, the existing laws relating to sale of goods, mortgage, hire, lease, agency, loans, trust, partnership, etc. were also recommended to be amended to make them conform with the Shari‘ah and conducive to the promotion of a financial system based on the principle of profit-loss sharing and qard-e-hasan.

The report was required to be followed up by more rigorous exercise by a select group of experts from relevant fields to translate the recommendations into specific and elaborate action and policy measures. Such exercise was not carried out in a true spirit.

Instead, some internal exercises were conducted within the finance ministry and central bank resulting into actions quite different from what was recommended by the CII.

State Bank of Pakistan started the process of conversion in January 1981 (and claimed to have completed it in July 1985). The process was planned to be completed in two main phases. In the first phase, Islamic banking was introduced partially in the sense that both Islamic banking and in- interest based banking were allowed to be operative in the country. In the second phase, the interest-based banking was claimed to have been eliminated and non-interest-based banking was claimed to have been introduced throughout the banking system. It may be instructive to review the approach adopted by State Bank in order to make recommendations for future action.

Phase I

This phase was introduced from January 1, 1981, through a State Bank circular 1. According to this circular, interest- based banking was allowed to continue side by side with interest-free banking. Necessary amendments were introduced in banking laws. Banks were asked to establish PLS counters where the depositors who did not like to earn interest on their deposits could deposit their savings on the basis of a share in the profits and losses that the bank may make on these deposits. Banks were required to maintain separate accounts in respect of PLS deposits as also of investment and financing provided out of the amounts collected in the PLS deposits as well as all income and expenditure relating thereto. Investment or deployment of the funds received in these deposits was placed at the sole discretion of the bank. They were, however, restricted to use these funds only in such avenues where the return did not accrue to the bank by way of interest. Necessary amendments were made in all relevant laws, rules and regulations. Banks were asked to periodically pay to the PLS depositors a share of its profits made on the PLS deposits. In the event of incurring loss, the depositors were made liable to bear the loss proportionately. All these provisions were made in the circular mentioned above. Later on, circulars were issued to gradually eliminate interest from financial dealings of the scheduled banks with the State Bank of Pakistan. Mark-up was, however, introduced as the alternative to interest in such dealings.

From July 1, 1982, the area of interest-free operations was further widened by allowing the banks to use more freely the Islamic modes of financing other than the mark-up mode. They were allowed to finance working capital needs of their selected customers in trade and industry on PLS basis (the option of interest, however, was still allowed to continue). In this ease, a certain proportion of profit in a venture was made payable to client as a good management fee (before claiming a share in the profit of the client); the remaining profit distributable between bank and client on the basis of their respective funds employed in the venture. Complete flexibility was granted by the State Bank to the banks for negotiating the management fee and profit-sharing ratio. Profit-sharing ratio once determined, however, was made unalterable. In case of loss, the loss was required to be borne strictly by the bank and the client in the ratio of their respective funds employed in the venture calculated on daily product basis. Financing of fixed capital investment needs were allowed to be financed on the basis of leasing along with complete flexibility in mutually determining the terms and conditions. The financing in trade and industry on hire-purchase basis was also allowed with full flexibility to mutually determine the terms and conditions of such contract.

Phase II

The State Bank launched a programme of complete shifting over of the entire interest-based banking system to a non-interest-based system. A circular was issued by the State Bank, announcing this shift. This circular made the following provision:

• No banking company would accept any interest bearing deposits and all deposits would be on the basis of participation in profit and loss of the banking company except deposits received on current account on which no interest or profit would be given by the banking company (these instructions did not apply to foreign loans and foreign currency deposits).
• All finances provided by a banking company to any entity including the individuals would be only in the 12 modes specified in the circular.

The maximum and the minimum rates of return to be derived by the banks for these modes of financing are required to be detained by the State Bank from time to time. With respect to investment type modes of financing, the State Bank circular specifically mentioned that the losses will be proportionately shared by all financiers including the banking company. The circular also specified which modes of financ- ing could be used in what transactions. In case of lending on the basis of service-charge, the State Bank specified an explicit formula with all necessary details. (This formula can be seen in Annexure I.) It was also announced by the State Bank that in case of lending on mark-up basis, no banking company will charge a mark-up over mark-up if the client of the banking company happens to be defaulting in payment.

The commercial banks and development finance institutions, however, were left free to shape their own procedures and contracts of financing to conform to the above requirements and no Shari4ah guidance procedure was laid down in the above rules.

On the liability side, State Bank required all banking companies and DFIs to declare profits on half-yearly basis. (The institutions are, however, required to take clearance from the Slate Bank before declaring the profits.) The distribution of profits among PLS depositors, creditors and the shareholders of the banking company is done by using the following weights:

A. Deposits

Type and Maturity                                                     Weightage to be given

1. Special Notice Deposit

• Withdrawal at 7-29 days notice                   0.65
• Withdrawal at notice of 30 days and over     0.75

1. Saving Account                                           1.00
2. PLS Call Deposits from Other Banks

• For term up to and inclusive of 6 months
• For terms in excess of 6 months

1.00+0.05 for each month on the basis of the deposits. 1.30 for the first 6 months plus 0.01 for each subsequent month of the term of the deposit subject to maximum of 2.08.

B. PLS Borrowing

Borrowing of various maturities will be given weightage as for term deposits of corresponding maturities.

C. Equity

Not exceeding five as may be determined by the concerned bank.

Due credit must go to the State Bank and hence to the Government of Pakistan for making enough provision in the law and legal framework to allow anyone to practise banking in true Islamic spirit. Barring a few minor provisions, which too, of course, can be easily corrected, there is no room to say that the legal framework of the country did not allow establishment of a true Islamic bank. If anyone was committed to establishing a true Islamic bank, then there was nothing in his way as far as the State Bank control is concerned. This was certainly not the situation before 1984.

The main point, however, is that it was not merely the question of allowing the establishment of an Islamic bank in the country but in fact the question of moulding the existing banking structure on an Islamic structure. State Bank did not address itself to the question of conversion when issuing the circular to introduce Islamic banking system.

On the face of it, the approach of State Bank was quite rational. A transition to an entirely new system required time and flexibility. State Bank circulars provided both. It did not force the banks to convert overnight. It allowed them to continue to operate interest-based operations while trying to develop the interest-free systems and procedures. It also did not force any particular procedural setup and instead provided them full flexibility to design their own ways and means to meet the challenge of replacing interest by Islamic alternatives.

No doubt State Bank circular provided full support to true conversion but the banks did not show any enthusiasm to shape their system in line with the spirit of Islamic principles. No safeguards were provided in these circulars to ensure that this flexibility provided by the State Bank may not be used to find out ways and means which may look Islamic in appearance but in spirit they may not be very different from or be rather exactly same as interest. Since there was no compulsion from the State Bank to find true Islamic altematives, the conversion, therefore, solely depended on the commitment and sincerity of the bankers to the cause of Islamic banking. State Bank did not even force the banks to have their own religious board to gel religious sanction for the Islamic alternatives to interest that they would develop.

The State Bank’s approach to allow interest-based deposits along with PLS deposits for some years was meant to provide time to the banks to develop Islamic financing techniques to deploy their funds. No concrete steps were taken by the State Bank to help the banks in developing a true alternative Islamic structure. State Bank rather assumed too much of the commitment on the part of the bankers to Islamise their banking operations.

The fact that State Bank assumed loo much in this respect is reflected from the fact that soon after the introduction of PLS counters in 1981, the influx of deposits in PLS accounts put the banks in serious problem of how to deploy these funds in an Islamic way and the State Bank started receiving inquiries from the banks about what to do with their surplus PLS funds. The State Bank in response to these inquiries, issued a circular (No 36) on October 12, 1982, which says that:

“A bank having surplus funds would be free to place the same with another bank (receiving deposits on the basis of participation in profit or loss) on call-on PLS basis. The latter shall invest such funds in avenues...”

All banks, however, were in the same boat. In such a case, banks could have no option but to find some easy solution. State Bank was required to play much more positive role during the transition period in order to help the banks convert on correct lines. State Bank did not choose to play this role.

The Islamic spirit of mark-up-based financing required that financing institution must bear some productive risk in order to justify the mark-up profit. This spirit is not prevailing in the mark-up-based financing now in vogue in Pakistan. State Bank circular docs not provide any compulsion to ensure that the modes selected by the banks meet Shari‘ah requirements in letter and spirit and the bankers lack motivation to do so on their own. The result is that the banks are now getting mark-up in the same fashion as interest is obtained. This fact can very clearly be ascertained by seeing the documentation being currently used by the banks in connection with the so- called Islamic financing techniques. All banks have to use modes and related documentation that is approved by a committee constituted by Pakistan Banking Council. The procedures and documentation of all banks are, therefore, almost identical. These procedures have serious Shari'ah objections.

Guidelines for An Action Plan

 At the State Level

The efforts done by Council of Islamic Ideology at theoretical level and by the State Bank of Pakistan at applied level leave little room for any further effort as far as a blueprint for the application of Shari‘ah in the financial system is concerned. What is needed to be done further is only to fill in the gaps in the way of proper adaptation and implementation of the blueprint by the commercial banks to build a strong edifice of Islamic banking. Hence, we try to identify some basic gaps in the blueprint that are not allowing the desired building to come up in the form of the right structure.

1. The most fundamental lacunae perhaps is the lack of Shari'ah counselling, supervision and control. A Shari'ah control board at State Bank level would have prevented such operations as buy-back arrangements and mark-down arrangements to be introduced as Islamic operations and hence spoiling the whole spirit of Islamising the financial system.

2. State Bank will also have to play a leading role to help the commercial banks develop Islamically valid modes of operation. Mark-up-based financing is something that has gained a considerably long record of successful operation in various Islamic banks around the world. State Bank should collect information about this mode of operation and with the help of Shari'ah board should select (or devise) best module and circulate it to all the commercial banks in the same way as State Bank has done for service-charge-based operations. These modules should replace the existing buy-back-based and so-called mark-up-based operations.

3. Though overwhelming dependence on mark-up-based operations is not desirable yet as an immediate corrective measure the mark-up-based operations (developed on the lines mentioned above) have to be widely introduced throughout commercial banking institutions. This immediate action is required to quickly convert the haram income of deposit holders and equity holders to halal income. This measure, however, will not bring a change into the economy that the Islamisation of financial system is expected to bring. Simultaneous policies will have to be introduced to motivate and help commercial banks shift away from overwhelming dependence on mark-up-based operations and make substantial operations on the basis of profit-loss sharing based operations. In this respect, State Bank may adopt following specific policies:

• Give commercial banks every year a specific target to be achieved with respect to the proportion of PLS-based operations.
• Provide some sort of an insurance scheme to commercial banks to cover part of their losses that they may incur in running PLS-based operations. State Bank may select specific sectors to be covered by the insurance scheme. The sectors may be selected keeping in view the national priorities, c.g. agriculture, small business, housing, industries in underdeveloped regions, etc.

4. The motivation at the level of commercial banks to shift away from mark-up-based financing to profit-loss sharing will perhaps be totally eroded by the lower and upper limits imposed by the State Bank on the rates of returns from various modes of financing. State Bank is justified on its own right to impose these limits in order to control the motivation towards extracting excessive profiteering (by exploiting the clients) or indulging into cut-throat competitions through offering lower costs on financing. Yet the State Bank has to realise that by imposing such limits, it leaves no choice for the commercial banks but to opt for mark-up-based financing only because it involves less efforts in terms of evaluating fi nancing-worthiness of the clients and involves lesser riskbearing costs for the banks (compared to the PLS-based modes of financing). The banks can be motivated towards using more and more PLS-based financing only if they are allowed to make higher returns through the application of PLS-based modes of financing.

It is not difficult to reconcile the motivational needs of the commercial banks with the economic policies of the State Bank. It is only a matter of devising viable policy package. Some suggestions for such a policy package are as under:

In the sectors where State Bank does not want the commercial banks to go into profiteering, it will fix:

• An upper limit on rate of return.
• A lower limit on the bank financing in the sector on profit-loss sharing basis.

For other sectors, the State Bank will fix:

• A lower limit on the rate of return.
• An upper limit on the financing through mark-up-based operations.

At the Level of Commercial Banks

Since the procedure and operations of commercial banks are almost totally regulated by the central bank and the finance ministry, not much can be done at the level of individual commercial banks in connection with developing any distinct Islamic procedures for their own operations. The procedures will have to come from the central bank.

The banks, however, can have their own policies and strategies to make maximum benefit out of the new system within the regulatory framework of the central bank.

On the liabilities side of commercial banks, no major change perhaps is needed urgently. The State Bank of Pakistan formula for commercial banks to share their income with depositors at least helps depositors not to indulge into a riba contract with their banks. They share income of the bank which is a legitimate way of earning income on one’s dc- posits. But if the bank’s income that they are sharing is a prohibited (haram) income, mere legitimising form of contract or the method of sharing income will not suffice. An urgent action is, therefore, needed to reform the assets side of the bank to legitimise their sources of income.

An immediate action is to replace the buy-back arrangements of financing by the Shari’ah approved mark-up-based financing. In this respect, though we expect that State Bank will take the initiative and provide all commercial banks with the appropriate schemes and modules, yet this is an area where commercial banks should take an initiative as well. The relevant regulations are already in force to cover their action. They simply have to have their Shari’ah advisory board to help them adopt mark-up financing models of existing renowned Islamic banks in order to suit local conditions. This is something that can be done without pains and costs.

As mark-up-based banking operations have already gained a lot of experience and acceptance in various Islamic banks around the world, it is extremely easy to acquire the operational models of these banks.

Next step would be to get prepared for use of other modes of financing, particularly the profit-loss sharing based modes which may come either as a mandatory requirement for the central bank or banks may themselves get motivated to augment their profits through the use of these modes which promise a higher return, though with more risk-bearing.

Building New Institutions

One thing that must be recognised at all levels of the economy in general and at the level of policymakers in particular is that Islamic banking is not merely a change in legal provisions; it is a change in concept and philosophy. It is a new approach towards financial system and requires a totally different attitude from the financial institutions. The financial institutions may have to attract a new clientele, develop new accounting and documentation procedures and will have to train their staff to meet the demands of the new system. Besides, there may be need to change even the institutional structure of the financial system. Some immediate changes are suggested on the following lines;

Separation of Banking and Investment Activities

In Islamic framework, loan cannot be the basis of banking operations. Investments will have to replace loans. Contemporary structure of banking institutions is not geared to making investments in a way to match them with the deposit maturities and hence cam profit to periodically distribute over the deposits. The mismatch of maturities of liabilities and assets is in fact a serious problem for the interest-based banks also. This problem is multiplied when the banks are barred from advancing loans. The problem of mismatch of assets and liabilities in the conventional banking system is being proposed to be solved by separating the banking from the investment activities. Prof Maurice Alais, a Noble Laureate in Economics, has proposed two types of banks:

1. Deposit banks
2. Investment banks

This proposal would be even more suitable to Islamic financial system. State Bank should consider declaring the existing banks as deposit banks only. These banks will receive demand on very short-term deposits and will perform other banking activities such as transfer of money, exchange of currency, safe deposits, etc. and charge fees for providing these services. For those interested in making income on their savings, investment banks should be established which would receive deposits of varying maturities and invest them in projects of corresponding maturities.

Dr M Fahim Khan

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