The concept of Islamic banking

Islam does not view money as a commodity which produces interest or profit. ‘Riba’

(interest) is prohibited in Islam. The basic principle of Islamic banking lies in the belief that interest does not influence in any way the volume of saving. The relation of an Islamic bank with its client is seen as that of a partner, investor and trader. Islamic banking is based upon the universally recognized principles of ‘Shirakah’ (partnership): a whole system of banking in which the shareholders, the depositors, the investors and the borrowers participate on a partnership basis. This system works through the application of another principle, Mudarabah, where labour and capital can be combined as working partners. This is not merely a partnership, it is rather a code of economic ethics combining the material and spiritual values for the conduct of its economic system. Mudarabah functions as a contract under which banks provide the capital and the clients their expertise, and the profits are shared according to an agreed ratio. Within the framework of Murabaha operations, the clients ask the banks to purchase a certain commodity according to certain specifications and require the bank to deliver them on the basis of a certain mark-up according to the initial agreement between the two parties. Under Musharakah, both the banks and the clients enter into a partnership by contributing capital in various proportions for a limited period of time and agree upon a share of profit in advance.

The whole mechanism of Islamic banking is supposed to be interest free. This banking scheme has two types of depositors. Those belonging to the first type may withdraw their deposits without any notice. This type of depositor favours safe deposit only, not investment in any productive activity where risk is involved. The bank may recover

‘Zakat’ and service charges from such deposits.This taxation on idle funds is justified, because it checks the tendency to hoard cash in idle form and provides a stimulus for investing in productive activities. The second type of depositors cannot draw their surplus without notice; their surplus may be invested on short term basis. The bank will not deduct any charges from them, they will rather be eligible to share the profits of the bank proportionately, in the form of dividends which may be worked out at the end of the financial year.The Islamic banks may raise funds by inviting investment for a period of one year to five years or more. „As regards a bank’s relations with depositors and entrepreneurs it may be said that a bank in relation to depositors has been considered the operator or business manager and the depositors deemed capitalists. In relation to the entrepreneurs, however, the bank may be taken to be the capitalist and the entrepreneurs,

52 The concept of Islamic banking mainly draws upon the views of AHMED (1983); AL-NAGAR (1978);

HUQ (1982); IMAMUDDIN (1961); MANNAN (1980); QURESHI (1979, 1974); UZAIR (1978).

the operators. In this, the conditions governing a capitalist’s rights and an operator’s obligations shall apply. Any profits realized by the entrepreneur, the operator in this case, shall be shared with the bank as the capitalist in the agreed proportions“ (MANNAN 1986:179).

Furthermore, MANNAN (1986:179) presents a comparative account of Islamic and modern banking systems. According to him, the superiority of the Islamic concept of banking over modern banking lies in the fact that Islam has eliminated the tyranny of interest. Islam has prohibited interest because it has no influence on saving, and mainly because it encourages the unequal distribution of wealth.

Interest and its influence on saving has been a conflicting factor in classical economics as well. MARSHALL (1905, cf. MANNAN 1986:162) and other leading classical economists view saving and interest as interlinked. Since the rate of interest is one of the most important factors which govern the volume of savings, the higher the rate of interest, the larger the reward for saving, the higher the propensity to save and vice versa. Thus, according to them an increase in the volume of saving means an increase in investment.

These classical analyses are refuted later by KEYNES, who casts serious doubts on the efficacy of the rate of interest in influencing the volume of saving. According to him, the volume of saving depends upon the volume of investment. A higher rate of interest will damp down the volume of investment; as a result, development will be adversely affected and the aggregate money income will shrink. Since savings depend upon the money income of the people, the volume of savings will automatically be reduced.

Similarly, Islamic banking believes that the rate of investment determines the rate of saving. As Islam prohibits interest and encourages investment, one may argue that if no interest is paid on deposits, then the people may be tempted to keep their deposits idle and hoard them. It is here that Zakat plays a very significant role in penalizing those who keep their money idle. MANNAN (1986:172) concludes that Islamic banks are superior in comparison to the capitalist concept of banking on the basis of the following two circles of economic activity.

Diagram 1: A comparative description of the Islamic and modern banking

( I = Investment; Y = Total Income; C = Consumption; S = Saving) Source: MANNAN (1986:172)

Inducement by Zakat

(Y-C)

More saving (relatively)

Inducement by Zakat

(Y-C)

Less saving (relatively)

Islamic Banking 0% interest Social justice

Modern Banking say 3% interest Social injustice

Full exploitation of resources

Partnership beween bank and businessmen

Resources not exploited to the

extent of 6%

businessmen only More income

(relatively)

Less income (relatively)

Depression (less possibility because of healthy investment)

Depression (greater possibility) Loan at 0%

interest rate

Loan at say 6%

interest rate Full exploitation

of resources

Here also resources not exploited.

i.e.

Part of

state planning

Independent of state planning

The practical application of the phenomenon of the Islamization of banking, however, fails to depict such an optimistic theoretical picture. A recent example from Pakistan, where a mix of both Islamic and modern banking was introduced in 1985, distinguishes between three groups and twelve modes of financing (STOCKHAUSEN 1987:60f):⁵³

(A) Financing by lending

1) Loans not carrying any interest on which the banks may recover a service charge not exceeding the proportionate cost of the operation, excluding the cost of funds and provision for bad and doubtful debts. The maximum service charge permissible to each bank is determined by the State Bank from time to time.

2) ‘Quard-e-Hasan’ interest free loans given on compassionate grounds and repayable if and when the borrower is able to pay.

(B) Trade-related modes of financing including the following:

1) Purchase of goods by banks and their sale to clients at an appropriate mark-up in price on a deferred-payment basis.

2) Purchase of trade bills.

3) Purchase of movable or immovable property by the banks from their clients with Buy-Back Agreement or otherwise.

4) Leasing 5) Hire-purchase

6) Financing for the development of property on the basis of a development charge.

(C) Modes of financing investment include the following:

1) Musharika

2) Equity participation and purchase of shares.

3) Purchase of participation term certificate and Modaraba certificates.

4) Rent-sharing.

„These modes of financing are by no means Islamic by definition. They contain aspects which can easily turn them into usurious transactions“ (ZAIDI 1985:37).

STOCKHAUSEN (1987:61) elaborates further that, „a bank may participate in a project through hire purchase agreement with collateral securities for performance of the contract by way of promissory notes provided by the partners of share-holders. Both transactions, considered separately, would appear to be valid, but taken together the contract may be designed to ensure that, in case of default, the bank receives its full investment via the promissory notes and mulcts the client with all the losses. To make hire-purchase Islamic, some sort of protection of the shareholders is necessary.“

The development of a viable and stable banking structure which is conducive to the Islamic economic structure is a challenge for Pakistan’s economy. No blue-print of an Islamic economic structure has been worked out in Pakistan so far.The Naqui Report on Islamization published in May 1980 states that nothing more than a mere smattering of vague ideas of Zakat and Ribah (interest) have been formulated. Purely Islamic banking is not seen to be sufficient, firstly, because people are more concerned with their material well-being than with moral values, and secondly, because of the moral hazards or because of the problems of dishonesty on the part of the entrepreneurs borrowing funds from the financial institutions (ZAIDI 1985:34). Since Islamic and modern banking systems are two independent concepts opposing each other in many respects, a mix of both systems is difficult, if not impossible.

53 See also ZAIDI (1985:27-28); HABIB (1984:21-23); STATE BANK OF PAKISTAN (1984:3).