A. Concept

The banking system that deals with the transactions of credit without any predetermined excess over capital i.e. interest can be called Islamic banking system.

The element of interest defined as any predetermined excess over the borrowed capital for a fixed time period, as such, is the fundamental distinguishing point between the modern and the Islamic banking systems. The word 'interest' is taken as synonymous for the Arabic word 'Riba'. Some critics intend to use 'Riba' as synonymous for the word 'usury' meaning exhorbitant rate of interest paid by the borrower to the lender for the use of capital for a fixed time period. According to them any clement of interest that is not exhorbitant should not be treated as usury and as such be justifiable. The distinction between what is exhorbitant and what is not is not one of kind rather than degree only. What seems to be reasonable rate now considering the need and time coupled with many other determinants of investment may appear unreasonable or exhorbitant at another time. The historical records on the rate of interest of western economies since the beginning of the eighteenth century lend support to this view. Since Islam lays emphasis on fundamental or humanitarian issues more than the external or material ones it cannot allow anything that is likely to have damaging impact on the society and individual either now or in future. In Islam, therefore, anything whose excess is harmful for the society regardless of any time period is from the similar logic forbidden, too, even if it lies much below the limit of excess.

B. Historical Background of Interest-free Banking

Before the advent of Islam in the land of Arabia, money lenders used to charge highly exhorbitant rate of interest. Like many other vices prevailing in those days, the system of charging excess over the capital, not only helped in maximizing the volume of wealth or idle wealth, but also hindered the overall growth of the economy that is likely to be achieved through free investment. While at the individual level the poorer section was turned into pauper as they were required to dispose off either part or whole of their belongings to get rid of the cumulative burdens of debt, at the national level the projects which were socially profitable yet economically not feasible because of higher Interest rate had not been undertaken. Furthermore, at the micro level, this discouraged the people to undertake any economic activity capable of augmenting output, at the macro level, the higher rate of interest or in other words, limited investment frustrated the efforts to increase aggregate output and hence welfare of the society. It is from this background that Islam, fourteen hundred years ago, had successfully identified any excess charged for the use of capital as usury and once for all forbidden it for the interest of individual as well as social welfare of the entire humanity.

C. Objectives Behind Interest-free Banking System

Firstly, Payment or acceptance of interest should be understood in the light of all other innumerable injunctions of Islam. To refrain from paying or accepting interest is as important as the payment of Zakat to enjoy purified wealth. So, like the five pillars of Islam, the divine order for not accepting or paying interest is to obtain satisfaction of Allah, Almighty through the use of Allah's wealth given to man only to make proper use and derive satisfaction out of it.

Secondly, it is stated in the Quran that the poorer section of the community has got the right on the wealth of those who have got excess over their own need. So, it is not a question of asking the poor borrower to pay excess over that lent out rather than helping them in their distress.

Thirdly, the reason behind forbidding interest is to help set up an exploitation-free society, There is no denying the fact that interest is one of the most important and powerful mechanisms by which more fortunate exploit the less fortunate.

Fourthly, to help an economy to attain maximum growth. This can be attained by taking concerted efforts to invest in all possible undertakings or projects regardless of any positive net return obtained after deducting the utilization cost of capital. Unlike modern theory of interest, Islamic economic system does not apprehend that investors will invest only up to the point where the rate of return over the additional capital invested (marginal efficiency of capital) equalizes the cost required for using the given capital (rate of interest) for a given time period. But in Islamic economic system investments are made in the form of 'Shirkate Inan' and 'Mudarabah'. Under both the systems, investment will continue so long as there exists an element of profit calculated on the basis of all the costs of running an enterprise other than the cost of using the capital i.e. predetermined excess over the capital used.

Fifthly, the reason why interest is forbidden is to create opportunities for the savers or capital owners to apply their own physical and mental capabilities in multiplying their wealth. By this, Islam has not only discouraged those who despite having Allah's mercy in the form of wealth do not like to work but also encouraged the dignity of labor for all. Islam hates those who prefer to lend their money for interests and destroy their physical and intellectual capabilities. These are the people who are likely to spend time most extravagantly and squander away their ill-got wealth for all sorts of evil deeds.

Sixthly, the objective behind the profit-sharing system as opposed to fixed interest is to discourage the profiteering leading to income concentration. If business partner knows that he will have to share with his absentee partner any amount of profit on fifty-fifty basis, he will be less enthusiastic to maximize his profit through illegal or more risky methods.

Seventhly, by abolishing interest, distributive justice is taken care of under Islamic economic system better than any other existing economic systems. Under the present system it is found that in institutional sources of credits the substantial amount of total deposits comes from the lower and middle income classes. But the investors from the said two income groups have limited access as well as opportunity to provide supplementary fund required to start any enterprise. They are constrained to furnish required security to get loans from the banks. On the other hand, the investors mainly coming from the higher income groups having the double advantage of providing security as well as additional capital are more preferred by the bankers. In the presence of market imperfections accompanied by the absence of Government or any other control over prof- its and prices, the investors can make a substantial amount of profit under the existing system even after paying off the bank interest. Thus, income concentrates from relatively poorer section (i.e., the depositors) to the relatively affluent section (i.e., the borrowers) of the community in existing system. But under profit sharing or Mudarabah the share holders and the entrepreneurs are equally benefited by higher profits. On the other hand in case of non-institutional or private source of credit income concentrates in the hands of lenders who are more affluent than the borrowers with, of course, a few exceptions. Because of exhorbitantly high interest rate of non-institutional credit which most often varies from above zero to 10/12 times as high as the original capital, it is the lenders class whose incomes get multiplied at the cost of the borrower or the poorer class. So, we find that in both the situations mentioned above interest rates are equally contributing to the concentration of income in the hands of the affluent. This answers why any predetermined excess over capital despite not being exhorbitant or unreasonable is treated as 'Riba' and as such 'usury' in Islam.

Eighthly, the abolition of interest will help an economy to get rid of the most disastrous effect of business fluctuation resulting either from over or under production. This has been explained below in section D, No. (7).

D. Preconditions for the Success of an Interest-free Banking System

From the various objectives as stated above, it appears that the whole super-structure of an interest less banking system is dependent on some fundamental assumptions without which this system and more particularly the Mudarabah will crumble down. These assumptions are:

(1) The partners who are involved in the business must be very honest and have confidence of all those who provide capital.

(2) There must exist good understanding and whole-hearted cooperation among the partners of a business or shareholders of an enterprise.

(3) Those partners who, in addition to the capital borrowed from others under Shirkate-Inan, also make some investment of their own must not charge the lenders for the losses suffered due to his own capital.

(4) There must be a devoted and well-trained cadre of bank workers who understand the detailed workings of an interest-free banking system based on Mudarabah and Shirkate Inan.

(5) Interest-free banking being one of the important institutions of Islamic way of life can only be effectively implemented if the state responsible to administer it is an Islamic one. This implies a sort of state where administrative set-up including the legislative as well as executive rules and regulations is run by Islamic Shariah as enjoined in the Quran and the Hadith. A state partly adopting Islamic values and partly western or non-Islamic values as in the case with most of the Muslim majority nations of the world cannot implement such a policy of Islamization.

(6) People's readiness to accept a system quite deviated from the existing one is also a very important determining factor for the successful working of an interest-free banking system.

(7) The successful working of such a system is very much dependent on how Zakat and Sadaqat coupled with many other income and wealth purifying mechanisms are practiced. We know that an economy must maintain effective demand to attain full employment of its available resources. Zakat and Sadaqat along with all other prohibitive measures regarding eating, drinking and utilization of one's time and wealth can fully take care of sustaining such a balanced effective demand. On the one hand, these measures will prevent the wealthier section from creating excess demand for currently produced non-essential goods and services and enhance the purchasing power of those who lack of it through the said income distributive mechanisms (Zakat and Sadaqat) as well as increased creased investment demand made possible by zero interest rate, on the other. Thus, the demand for available goods and services in the economy will be matched by the supply of it. If these mechanisms are allowed to work properly all the disastrous effects of industrial glut or under production can be effectively controlled.

E. What is the reality

It is quite clear that although the pre-conditions seem quite straight forward these are hard to attain. There are two reasons behind this. Firstly, this is not untrue to say that in Muslim countries which are, by historical reasons, poor too, most of the essential preconditions are very much lacking. In fact they are at the bottom of the social as well as moral degradation. For this, of course, the Muslims cannot be held entirely responsible. The colonial rules and complicated administrative procedures accompanied by deliberate policy of economic, social and cultural exploitation of the periphery by the centre in past few centuries - lie at the root of most of the evils we now inherit.

Secondly with the tremendous technical and scientific advancement, the geographical boundaries of a nation based on say, faith, customs or traditions have become immaterial. The very survival of a nation be it rich or poor now depends on its relation with outside world. What I mean to say is that a single nation for its own interest or for the interest of its people, must seek cooperation of other countries; regardless of their faith and moral values. Assuming this inter-dependence among nations we have to work out how are we going to implement an interest-free banking system particularly when we have financial involvement with other countries having different values.

F. What is the alternative

From the grim pictures as indicated above it seems as if we should give up all hopes for an interest-free banking system. This is not true. If we are intelligent enough to adopt suitable measures, that will only prepare a better ground for our future generation to lead a more pious, honest and Godly life. In this connection I have some specific suggestions which should be taken up right now.

1) As a first and foremost step, the present educational system should be redesigned thoroughly so as to inculcate in young minds the Islamic values side by side with modern education and research.

2) Steps may be taken to constitute immediately high powered body with intellectuals from various disciplines (such as Ulama economists, politicians, etc.) to make laws and devise working procedures for Zakat and Sadaqat fund. These money should finance the project which will primarily benefit the economically, socially, physically and mentally handicapped in the society.

3) As a part of the experiments, all commercial banks be it in the private or public sector should be instructed to operate a part of their fixed deposits made available on voluntary basis for investment on the principle of Mudarabah. The successful operation of such voluntary deposits without incurring losses for a few years will create confidence among other depositors and hence attract more depositors to go for such system of sharing profits or losses.

4) A training institute be set-up to create a cadre of devoted bank employees on the detailed working procedures, rules and regulation of Mudarabah system.

5) Efforts should be made to encourage research on problems related to Islamic ideologies, values and principles, etc.

6) The proposed Islamic Monetary Fund to be run without interest with the similar function and objectives of International Monetary Fund among the Muslim majority countries of the world can be a step in the right direction to help solve their balance of payment problems. The ultimate aim of forming similar other funds such as Islamic Development Bank with the contribution of Muslim majority countries and with the sole emphasis on financing development activities should be to reduce the dependence on interest-based financial transactions with western countries.

7) In rural-oriented economy like Bangladesh where substantial proportion of non-institutional credit is being transacted with highly exhorbitant rate of interest efforts be made to replace the non-institutional by institutional credit based on Mudarabah system.

Economic Feasibility of Interest-free Banking System

We all know that according to classical economists, rate of interest is the single most important determinant of savings. This has been modified by Keynes with the addition of income to the rate of interest in determining the volume of savings. The neoclassical economist also added another factor i.e. the real value of cash balances among the determinants. The fact that saving may not always be sensitive to the rate of interest is accepted both by Keynes as well as classical economists. The critics of classical school are also of the opinion that negative rate of interest may prevail for a society with a very high cost of storing money. In a rural based-economy as that of Bangladesh with poor banking facilities, the cost of storing money is really high in the sense of more time required to get the banking services, or the fear of theft, burglary, accident, insecurity of life and property, etc. All we intend to infer from these arguments is why should we assume that without interest, no body will save. This becomes apparent from the following complex savings function:

S=f (r,Yd,   Y   Ytr,  M  Ss, Uf. Ic, Ph, Ue, 0)
                  YO          P

Where S for savings;

r for rate of interest (classical determinant);

Yd for personal disposable income in real terms (Keynesian determinant);

Y
Y~ for relative position in the society-current income;

Yo previous peak income (Duesenberry's determinant);

Ytr for transitory component of income implying wind-fall gains (Friedman's determinant);

P for real value of cash balances i.e. M for money value of wealth and p for price level (Haberler and Pigou's determinant);

Ss for Government Social security scheme;                       

Uf for future uncertainty related to income;

Ic for Investment climate implying Government's favorable investment as well commercial policy;

Ph for personal habit;

Ue for unexpected events such as wars, natural calamities, etc.;

O for all other quantifiable and non-quantifiable factors not considered here.

The volume or rate of saving is either directly or indirectly related to each one of these eleven determinants of savings under considerations. The first six come under quantifiable and the rest under non-quantifiable or subjective factors. It appears from this complex saving function that the desire to save without any positive rate of interest or even at a cost (say, loss arising from profit sharing system) is possible because savings are not made solely for increasing future income through positive rate of interest. Rather, the desire for possession of wealth or more income as such, also depends on traditions, customs, conventions all incorporated within Ph, favorable investment climate (Ic), relative position in the society ( y-J), the wind-fall gains implying transitory part of the income (Ytr), absence or inadequate coverage of Government's social security schemes such as pension, benefits due to sickness, unemployment, accident, etc. (Sc), unexpected factors such as natural calamities, wars, etc. having positive impact on savings (Ue) and a whole lot of other less important quantifiable factors (0). Most of the researches so far made in advanced countries to establish the hypothesis of interest sensitivity of saving assumed all other determinants except rate of interest as given. So, the argument in favor of interest sensitivity of saving is rather a very crude one without much empirical supports. Hence, the future prospect of interest-free banking system is constrained more by non-economic or moral factors as has been indicated under the preconditions in section D, than by-the pure economic reasons usually put forward by the critics.