It is indeed gratifying to see that during last two decades or so about 175 Islamic banks and financial institutes have been established in Asia, Africa, Europe and USA. It is estimated that Islamic banks in some 54 countries are handling a portfolio of over US$ 85 billion. The funds portfolio of these Islamic banks & financial institutions is increasing at the rate of about 15 per cent per annum. It is therefore visualized that these funds may well cross the land mark of US$ 100 billion by turn of the century. There can, therefore, be no doubt that the growth in the number of these institutions as well as in the quantum of funds handled has simply been spectacular.

It is however important to appreciate that the profit and loss sharing system is the essence of Islamic banking but bulk of the financing under this mode is not being done by Islamic banks worldwide. Further, for all practical purposes profit and loss sharing system in it’s true spirit has also not been enforced by most Islamic banks for mobilization of savings and investments with the result that the objectives of the Shariah are not being met. The time has now come to pause for a moment to ponder as to what benefits, if any, have accrued to the society after the enforcement of the riba-free banking system.

It appears that many Islamic banks and financial institutions in various countries have, without much efforts, been securing sizeable funds and business from those Muslim traders, industrialists, investors and general public who want to deal with Islamic banks on the basis of mere faith. This gave these banks a false sense of success which apparently drove them away from designing innovative products and services conforming to Shariah. This task must now be taken in hand by Islamic banks immediately. These banks must also now clearly understand that they should have only those bankers among their ranks who are not only professionally competent but possess deep in-sight of the practical implications of the Islamic banking coupled with commitment to it’s cause.

It is unfortunately a fact that many Islamic banks have hired bankers from conventional banks notwithstanding the fact that some of these bankers had neither any special commitment to the cause of Islamic banking nor were aware of the practical implications of Islamic banking system. As the professional training to these bankers is also not being generally provided, they have mostly failed to make any significant contribution to the real cause of Islamic banking system.

The Islamic banks established in some 54 countries neither developed innovative products nor designed schemes for the common man, — both in respect of securing funds or for providing financing. The conventional banks, on the other hand, have designed the products even at the retail level which are now being offered at the Islamic windows of these banks as also in the subsidiaries established by them. Many western banks are also engaged in Research and Development in the field of Islamic banking and are even committing substantial funds for this purpose but Islamic banks established by Muslims are not doing enough in this direction.

Interest in all forms and manifestations is prohibited in Islam as it leads to injustices—both to depositors as well as to those who avail loans from these banks. It is, therefore, important that the operational results of individual Islamic banks in each country are compared with the operational results of the interest-based banks operating therein to ascertain if injustices are in fact being avoided in the banks supposed to be operating under Islamic banking system. In case a conventional bank has opened an Islamic banking window or has established an Islamic bank as it’s subsidiary, the rates of return paid on deposits and charged on financing by these institutions should also be compared This exercise should, therefore, be carried out with special reference to the following:

1. The comparative rates of return paid by the Islamic banks and the conventional banks in a market place for various categories of deposits.

2. The comparative average return on advances/ financing — rates of interest charged by conventional banks and the corresponding rates of Islamic banks on the same lines as at (1) above.

3. The comparative position of classification of outstanding advances/financing by size i.e. the total number and amount of advances/financing of (a) Upto $1 million (b) Above $1 million but below $5 million (c) Above $5 million but $10 million. (d) Above $10 million but below $50 million (e) Above $50 million.

In addition, the total number and amount of financing on profit and loss sharing basis should be assessed along with it’s share in the total number and amount of financing provided by Islamic banks. A comparative statement of last five years showing the percentage of financing on PLS basis to total financing of each Islamic banks would reflect whether these banks are moving towards the essence of the Islamic system.

An in-depth study of the comparative operational results of banks on the above lines as well as of the nature and purposes of financing provided by Islamic banks would also indicate whether Islamic system of banking has made any positive contribution to the achievement of socio-economic objectives in the society and whether any headway in eliminating injustices to depositors/borrowers has in fact been made by Islamic banks.

In this connection, it is also important to keep in mind that Islam has prohibited interest as it amounts to injustice and exploitation. The Holy Qur’an says “And give up what remains of your demand for riba” (2:278) and verse (2:279) says “Deal not unjustly and you shall not be dealt with unjustly”. In case, the system remains exploitative, it can obviously not be termed as Islamic system of banking. This in fact is a litmus test for the Islamic banking. If it is found that the objective of socio-economic justice is not being achieved then the obvious conclusion is that Islamic system in real sense has not been implemented. It must however be clearly understood that the fault lies with us and not with the system.

Presently many Islamic banks and financial institutions are investing the funds, collected by them from their clients, with interest-based banks instructing them to invest the amount through Islamic modes of financing. It is due to this sad state of affairs that it has all along been advocated that Islamic banks must develop innovative and competitive products for utilization of funds which should not only conform to Shariah but should also be tailored according to local requirements. It is therefore of utmost importance that Islamic banks should also take initiative and pain in locating trustworthy parties having feasible projects and proposals for financing judiciously and skillfully on profit & loss sharing system of Islamic banking.

It is indeed an irony of fate that Islamic banks who were the pioneers of Islamic banking are not only approaching the conventional banks for investment of their funds on Islamic principles but continue to make tall claim of progress and achievements. The logical position should have been the approaching of conventional banks to Islamic banks to find avenues for investments of funds on Islamic principles.

As the funds are placed with the Islamic banks by their customers on profit and loss sharing basis, it is important that their customers are kept duly informed as to how these funds are being invested. There should therefore be more transparency in the operations of Islamic banks and format of their balance sheets should be revised so that more meaningful information are provided therein for the benefit of the public as well as for scrutiny by their major clients/other interested parties. It is also important that the revised format of balance sheet should be uniform for all the Islamic banks world-wide but additional information may be given for compliance with the local legal requirements.

Some Islamic banks are also facing the problem of liquidity and non-availability of sufficient funds for providing long term financing as some sort of Islamic financial market does not exist. Further many rich Muslims as well as many major Muslim businessmen and industrialists etc. are not really patronizing the Islamic banks. There is, therefore, an urgent need of providing them education and persuasion so that a definite change is reflected in their attitudes. It is also felt that if Islamic banks start operating according to the spirit of Shariah, this in itself would be a great motivation to the Muslims world wide to deposit their funds with these banks as many Muslims are not interested in dealing with Islamic banks as they feel that only the name has been changed and interest in real sense has not been eliminated from the operations of Islamic banks.

The fact that Islamic banking has not been introduced in the right earnest even in the banks established in the Muslim countries should not give any comfort to Islamic banks which are providing financing through instruments which do not fulfill either the requirements or objectives of Shariah.

It is seriously apprehended that if remedial measures are not immediately taken by the Islamic banks, they will fall behind the living age and Islamic banking would then be controlled by the non-Muslims in their own style under the cover of Islamic system of banking This is too serious a threat to be ignored or taken lightly as funds of over dollars eighty five billion are presently being handled by Islamic banks world-wide.

Muslim countries should therefore not only make efforts for transforming the existing banking system in their countries into a true Islamic banking system but should also take initiatives to counter threats, challenges and pitfalls of Islamic banking system at global level.

Islamization of Banking System in Pakistan

Prime Minister Nawaz Sharif in his first address to the nation on February 23, 1997 has committed to enforce Islamic Banking System in the country. He has also announced the decision of formation of a committee comprising legal, religious and financial experts to prepare recommendations for introducing Islamic banking in Pakistan.

In my opinion, no useful purpose is likely to be served by the formation of the proposed committee. There is instead an urgent need of re-constituting the Commission for Islamization of the Economy and The Council of Islamic Ideology (CII) to make these institutions more vibrant and dynamic. In this connection it may be pointed out that some time back, the present Chairman of the CII had proposed the formation of a commission for resolving the issue of equating riba with bank interest, as he felt that experts have divergent views about whether interest was similar to riba. It is surprising that although the CII was established for recommending ways and means for Islamization of various systems in Pakistan but it’s Chairman had chosen to dispute the very prohibition of interest by Shariah.

It will be recalled that to fulfill the obligations of the 1973 Constitution of the Islamic Republic of Pakistan as contained in Articles 31, 37 and 277, General Zia had earlier specifically asked the CII on September 29, 1977 to prepare a blue print of an interest-free economic system. The CII headed by Justice Dr. Tanzil-Ur-Rehman adopted a final report in it’s meeting on June 15, 1980 which was submitted to the then President of Pakistan on June 25, 1980.

The recommendations submitted by the CII in 1980 for elimination of interest from the banking system of Pakistan clearly laid down that the ideal alternatives to interest are profit & loss sharing (PLS) and Qard-Hasanah. It was however, recognized that large-scale financing on PLS system of Islamic banking could pose serious risks and hazards due to prevalent standard of morality and host of other reasons including lack of proper legal frame-work to support the new system. The CII therefore, recommended that some other modes of financing including the following should also be adopted by banks in Pakistan for a transitory period along with financing on PLS basis.

a. Leasing

b. Investment Auctioning

c. Bai Muajjal

d. Hire-purchase

e. Financing on the basis of normal rate of return

f. Time multiple counter-loans

g. Special Loans Facility

The CII had however, hoped that these methods will not be used for opening a back door for continuation of interest-based transactions and had accordingly desired to ensure that PLS system should be gradually expanded while other modes should be reduced and kept at minimum level. The CII had also emphasized upon the government to initiate reformatory measures for moral building and eradication of false values of life which would pave way for transforming the entire economic system in accordance with the Islamic vision.

The Government generally, ignored these recommendations in their future policy decisions. The then Federal Finance Minister however, announced in his budget speech on June 14, 1984 that interest would be completely eliminated from fresh domestic operations by July 1, 1985. In pursuance of this announcement, State Bank issued necessary circular to all banks in Pakistan on. June 20, 1984 under the caption “Elimination of Riba from the Banking System”. It laid-down that from April 1, 1985, all financing provided by banks shall be on the basis of any of the 12 permissible modes of financing which were duly specified. State Bank termed this as “shift over to Islamic Modes of Financing”.

The following were the permissible mode of financing specified by State Bank:

Modes of Financing

i) Financing by lending which include:

                a)    Loans with service charge.

b)   Qard Hasan.

ii) Trade-related modes of financing which include:

a)      Purchase and sale of goods on mark-up basis.

b)      Purchase of trade bills.

c)      Purchase of property with buy-back agreement or otherwise.

d)   Leasing.

e)   Hire-purchase.

f)   Financing for development of property on the basis of a development charges.

iii) Investment type modes of financing which include:

a)  Musharaka or Profit and Loss Sharing. (PLS).

b)  Equity participation and purchase of shares.

c)  Purchase of PTC’s or Modaraba certificates.

d)  Rent-sharing.

Since then, many changes have been made in the technicalities of these modes, obviously in an attempt to make them more practicable as well as to bring them close to Shariah, wherever possible. The fact, however, remains that in the Islamic system, there are mainly two alternatives to lending: one is Qard Hasan and the other is profit loss sharing.

In connection with the mode of financing under Islamic banking system, it is important to appreciate that any mode of financing developed and adopted under Islamic banking system must conform the following criteria:

a) Eliminating of interest in the sense, as per the objectives of Shariah, thereby meaning that profit should be shared in agreed ratio but the losses should be borne in the ratio of funds employed in the business.

b) Harmonization with the goals of Islamic economic system and conduciveness to it’s structure.

c) Practicability, stability and perpetuity.

If we carefully examine the modus operandi of the modes referred to above, we will find that some of these resemble interest while others, though can be termed as riba-free, cannot be expected to contribute to the achievement of socio-economic objectives of Shariah. The fact however, remains that in most of these modes, risks are practically not shared by the banks in the ratio of funds employed in the business. While some of these modes could have been permitted as a transitory measure it appears that the banks have sheltered themselves in comfort zone by persisting with the modes of financing against which genuine reservations exist as regards permissibility by Shariah. The element of interest has therefore, been crept into the new system also and has been allowed to be perpetuated.

It will therefore, be seen that by enforcing compromised modes of financing, State Bank and Government of Pakistan have not only deviated from the recommendations of the CII but have also subordinated Shariah to men-made laws. The result is that the new system adopted under the banner of Islamic banking has become even more exploitative than the interest-based system. Under the interest-based system in 1980s, the saving bank account holders in Pakistan were being paid interest of about 8% P.A. whereas the normal interest rate charged by banks on advances was 14% P.A. leaving a spread of 6% to banks.

Under the Islamic banking system, major banks in Pakistan are presently paying an average return of 8% P.A. to saving bank depositors whereas banks are normally charging mark-up of over 19% P.A. from borrowers. The spread of banks has therefore increased from 6% P.A. under interest-based system to over 11% P.A., under Islamic banking system. This spread is higher than the spread of banks in most countries of the world.

On the other hand, depositors who used to get a positive real rate of interest on their deposits, (interest rate adjusted for inflation, then prevalent) are now getting negative average real rate of return of about 9% P.A. (After adjusting for inflation of 18% and deduction of 10% withholding tax on the amount of return). It is also interesting to note that while the depositors continue to get negative real rates of return, the borrowers are practically paying an average rea1 rate of mark-up of mere 2% P.A. to banks. It will therefore, be appreciated that all this is nothing but injustice which is strictly prohibited in Islam. The worst part of this is that all these injustices are continuing un-checked under the cover of Islamic system of banking.

The position now is that bulk of financing by banks in Pakistan is being done on mark-up basis which is nothing but interest. Further, there seems to be no possibility that banks will be allowing any significant financing on PLS basis in foreseeable future. The depositors, on the other hand are not being paid profit on an equitable and just basis. Under approval of State Bank, banks in Pakistan have also designed schemes wherein pre-announced higher rates of return are offered to big depositors even for deposits of shorter tenure. The privileged class is therefore being favoured whereas majority of 31 m depositors continue to be exploited by banks under the so called “PLS system of Islamic banking”, by paying comparatively lower rates of return.

The Commission for Islamisation of Economy practically exists for name it is not playing any significant role in fulfilling it’s responsibility. The Federal Shariat Court and Shariat Appellate Bench of Supreme Court of Pakistan have practically not been functioning for the last many years. The Judgement given by Federal Shariat Court on November 14, 1991 was a milestone in the history of Islamic banking in Pakistan but petitions have been filed against this verdict which are lying in cold-storage for the last many years. This has halted the process of Islamisation of banking system in Pakistan.

It is therefore, my belief that if the present sad state of affairs is allowed to continue, even many innocent Muslims may develop doubts about the feasibility, practicability and usefulness of the Islamic system of banking. During the last few years, a number of western bankers and journalists have posed a question to me as to what is the real difference between interest-based system and Islamic banking system, as being practised in some of the Muslim countries including Pakistan. They however, concede that PLS system of Islamic banking, if practiced in the right earnest, could ensure socio-economic justice in the society.

As mentioned earlier, the CII had recommended some modes of financing as replacement of interest for an interim period. It had opposed opening of separate interest-free counters in banks as such measures were likely to entail perpetuation of the interest-based system. It has now become clear that the modes of financing enforced by State Bank of Pakistan have in fact perpetuated the interest-based system in Pakistan with a change of name only. I am now constrained to believe that the opening of separate interest-free counters at interest-based banks would have been a better option than to enforce and persist with the interest-based system from the back door. This at least would not have brought bad name to the “Islamic system of banking”.

In view of the policies of the successive governments, the banks in Pakistan have also generally lost interest in the Islamic system of banking and the process stands frozen. There is therefore, an urgent need to take some effective steps to remedy the situation as it is apprehended that irreparable damage will be inflicted to the cause of Islamic system of banking, if present State of Affairs is allowed to continue for an indefinite period.

It is important to keep in mind that Islamic banking system in totality cannot be enforced in isolation. The three pre-requisites for successful implementation of Islamic banking system are (a) reformation of society (b) restructuring the economic system and (c) re-framing the laws according to dictates of Islam. This obviously will take a long time, even if meaningful efforts are now initiated in this direction. In the meantime, the following strategy is suggested for Pakistan.

i) The Appeals filed against the judgement of Federal Shariat Court be withdrawn and time sought for the implementation of Islam banking system with the following provisions:

a) More and more financing will be made strictly on PLS basis and reliance on other modes would be gradually reduced.

b) Sectors would be specified to which financing would be made only on PLS basis.

c) There would be gradual expansion in these sectors and it would also be laid-down that the total outstanding financing under PLS basis would be not less than say, 35% of the total advances of each bank by the end of 1997. This percentage would be increased by 30% each year so that by the turn of century, the total financing under PLS basis is at least 60% of the total advances/financing of each bank.

d) As from July 1, 1997 rupee deposits will be accepted and returns paid strictly according to PLS system as laid-down by Shariah. The account opening and other forms/documents would be amended accordingly.

ii) The CII and the Commission for Islamization of the Economy should be reconstituted and strengthened. The Commission for Islamization should however also be given revised guidelines and a target date for submission of final recommendations for the Islamization of banking system in Pakistan on the lines suggested hereinabove.

iii) A Model Islamic Bank should be established by the government on priority basis which should transact business both as regards deposits mobilization and utilization of funds by allowing financing to trade, industry and agriculture strictly on profit and loss sharing system of Islamic banking.

The Proposed Bank should be a scheduled commercial bank which will accept deposits/investments on PLS basis only and would allow financing on PLS basis strictly according to Shariah. While the objective of the bank would be to earn profit but the bank would identify itself with the Shariah as regards objectives, principles, practices and operations. The Proposed Bank would undertake all normal banking business as is done by interest-based banks but the Provisions of Shariah would be kept in view at all times. The depositors/investors of the banks would, while assuming responsibility for sharing in losses, if any, reasonably hope to get comparatively higher rate of returns as compared to returns offered by other banks in the country.

iv) Prime Minister Nawaz Sharif while unfolding the agricultural package has recently said that; financial institutions will be established for meeting the credit requirements of framers. In this connection it is stated that over two years ago, in January 1995 we had emphasised upon the need of establishing a ‘Kisan Bank’ in Pakistan which should operate on Islamic principles. We had mentioned that 70 per cent of the population of Pakistan is engaged in agriculture. The establishment of Kisan Bank to provide finances to farmers on Islamic principles will make Pakistan the only country in the world whose 70 per cent population is conducting banking operations according to Shariah.

It is now the time that government should seriously consider establishing a Kisan Bank for providing credit to small farmers purely on profit and loss sharing system of Islamic banking.

General Recommendations

The following are some other recommendations for the growth and success of Islamic Banking:

i) There should be adequate research and Development (R&D) activities in banks for Islamic banking. Risk bearing but competitive products should be designed for deposits mobilization as also for providing finance which should not only conform to Shariah but should also cater to the needs of traders, industrialists and even common man.

ii) The format system of the Annual Accounts of the banks should be revised so that it contains more information for the investors and other interested parties.

iii) The audit system in the banks should be strengthened and the banks’ auditor should be provided special training. The role of external auditors should also be re-defined and their responsibilities re-fixed.

iv) The task of designing Uniform Accounting System and standardization of charge forms and other documents for handling various banking transactions should be taken in hand.

v) The Islamic banking department of major banks and DFIs should be upgraded. The personal posted in these departments should not only have commitment to the cause of Islamic banking but should be well-versed with the implications of the system.

vi) All the relevant laws should be reviewed so as to bring them in conformity with Shariah.

vii) A taxation system based on Islamic principles should be enforced. The tax laws should be amended wherever necessary reforms must also be introduced in the administration of taxation department. Steps should be taken to reduce the quantum of black money in the country and for documentation of the economy.

viii) The syllabi for colleges and universities should be revised so as to bring them in harmony with Islamic Ideology. The subject of Islamic banking should also be included as a separate subject at the post-graduate level. Universities should consider inviting academicians as visiting Professors.

ix) Central banks should prepare themselves for a new and enhanced role under the new system.

x) Religious boards should be constituted who should vet all products, documents, charge forms and proforma agreements for various transactions.

It is sincerely hoped that these submissions and recommendations will be given serious consideration for implementation. It is apprehended that if revolutionary decisions are not taken and present strategy and state of affairs is allowed to continue, the dream of Islamization of banking system is not likely to be fulfilled.

*****

*Author is a Director-General Institute of Islamic Banking and Insurance.