Islamic Instruments for Secondary Reserves

Under section 29 (1) of the Banking Companies Ordinance 1962, every banking company is required to maintain in Pakistan in cash, gold or unencumbered approved securities not less than 35 percent of the total of its demand and time liabilities. Since banks are required to maintain cash reserves equal to five percent of the total of their demand and time liabilities in Pakistan in terms of section 36 (1) of State Bank of Pakistan Act 1956, the question that arises is: in which approved securities should the banks maintain the remaining liquidity requirements of 30 percent?

At present, these reserves are maintained by banks in such securities on which interest is paid by the government and this interest is included in the profit paid to banks’ PLS depositors.

One over-simple solution is that the entire liquidity reserve be maintained in cash which will not involve any interest. This will no doubt reduce the rate of profit on PLS deposits. Another possible alternative is that banks may be allowed to keep this reserve in the form of profit-and-loss sharing in-, vestment like the shares of joint stock companies but this will be a very risky form of investment for secondary or liquidity reserves of the banks. It has also been suggested that since PLS deposits are a form of risk capital, there should be no reserve requirements for PLS deposits and the reserve requirements may only apply to current deposits.

Extreme solutions should be avoided and PLS depositors should not be exposed to unnecessary risk. Secondary or liquidity reserves should be kept in interest-free securities which should be easily encashable with no risk of capital loss. For this purpose, government should create a special category of interest-free treasury bills. The banks and through them the PLS depositors should be compensated as under:

• The present limit of 30 percent reserves against PLS deposits be reduced suitably.
• Some concessions be allowed to the PLS depositors by exempting the PLS profits from payment of certain forms of taxes.
• Banks should be entitled to interest-free discounting or financing facilities from State Bank of Pakistan to the extent of banks’ holdings of interest-free treasury bills. This will not be an encashment of these interest-free treasury bills. What will be discounted interest-free by SBP will be interest-free promissory notes or bills of exchange held by other banks. In effect, it will be a case of mutual qard-e-hasan.

Dr Ziauddin Ahmad

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