I

Since 1980, Iran and Pakistan in the process of Islami7 of their societies, directed their banks to transform their operations on the basis of Islamic principles. Unlike conventional commercial banks, the banks in Islamic tradition neither pay interest on deposits accepted nor charge interest on credit given. The rationales for prohibiting interest in banking in the Shariah is given by many Muslim writers.¹ The concept of predetermined interest rate is replaced by profit and loss sharing principle in Islamic banking. And it is also theoretically argued that such banking is more stable than interest-based banking because an Islamic financial system can adjust relatively faster to shocks than would the traditional system.² This argument is difficult to examine empirically in view of data constraints on complete Islamic mode of banking for the reason that Islamic banking in Iran and Pakistan each has completed only less than five years in operation; the transformation in Pakistan was partial and gradual. The detail data even for these years in both cases are not available. However, Islamic banking as an alternative mode of banking offers a wide scope for debate on issue involved. The paper is addressed to the issues of banking competition and stability at micro level in second section, growth of financial system in third section and monetary policy implications of interest free banking in fourth Section. The last section concludes the discussion.

II

Banking Competition and Stability

At the outset, one must note that in profit and loss sharing principle, the bank deregulation and disclosure of banks’ assets and profits are obvious necessities. Full disclosure regarding the quality of banks’ assets and true pro fits is a very sensitive issue from the point of view of public confidence in the financial system of a country. This is an important information for the public at large and obviously for the depositors. Variation in rate of return on deposits and in degree of uncertainty regarding nominal value of investment deposits can not be eliminated altogether at bank level as these are dependent on quality of banks’ assets. Because banks deploy these deposits in a wide range of assets backed by projects/activities with varying risk and yield. Historically, each bank has selected industries in its portfolio on the basis its expertise, experience and operational advantage. Each bank can not become a bank of all sessions for all industries. Though the profits of certain investments are difficult to maintain persistently due to the constraints imposed by market forces, but the projects with a yield above than average in the industry or sector become attractive acquisitions for banks. Bank competition in a deregulated environment is unavoidable at least in case of such investments. For this reason banks are likely to differ in respect of structure and quality of assets, as a consequence of the criterion of rate of return payable on deposits. In the absence of uniform principle, the disclosure of difference in rate of return is enough for bank deposits to switch over to banks with assets of high quality and higher ratio of profits to assets. Such behaviour of depositors is shaped as a result of bank competition for quality assets. In sum, full banks disclosure of quality of assets and profits, therefore, may create instability in the Islamic banking system at micro-level though at macro it may he stable.

III

Growth of Financial System

Does the financial system in Islamic banking tend to improve its growth? This question needs a comparative analysis either with reference to growth before and after such transformation took place or by observation of relative growth of interest-based financial instruments and non-interest-based instruments irrespective of mode of banking exists. In view of scanty information on Iran’s financial sector, the former approach of analysis of growth of banking before and after transformation is restricted to Pakistan, where profit and loss sharing deposits accounted for 61.6 per cent of total deposits in 1985. The latter approach of analysis of relative growth of interest linked instruments and non-interest linked ones can be suggested with reference to India for data conveniency. Moreover, the Indian financtal system has both types of instruments each with substantial market share and with competitive return combined with attractive characteristics. It needs a little elaboration. Though India has interest-based financial system, but different institutions offer a variety of instruments to tap the saving of public; some of them are interest-based and other are not. Regarding the availability of these instruments to the common savers for investment, Muslim countries are not different from their neighbouring countries like India. For such an analysis, one can look at the relative performance of these instruments in a diversified financial market where both options of interest related instruments and non-interest related instruments are available. One may examine the features of financial instruments for this purpose classified into three broad categories. The first type includes bank deposits and corporate debentures exclusively interest based. Bank deposits have attractive features of liquidity, fixed income and safety of nominal value. Debentures of private sector companies offer higher fixed income to compensate for partials of nominal value and loss of liquidity. The second type exclusively based on profit and loss sharing principle are equity shares of companies, in case of shares of public limited companies, savers are separated from the control of productive use of assets financed and remain passive receivers of return on their investment. But in case of shares of private limited companies, savers are in command of productive use of investment. In both cases, there is a complete absence of fixed income and guarantee of nominal value of investment. Third type of instruments which include life insurance prcrna and units of Unit Trust of India, fall in between the first and the second types having features of both. Life. insurance premium and UTI’s units receive declared bonds and dividends respectively which have been revised from time to time depending on profits earned on total assets. In these cases income from investment and its nominal value are known to investors in broad range.

Table 1 suggests that the growth rate in Pakistan’s Islamic banking tappers off after 1980-81. After transformation, mean growth rate declined by 7.6 percentage points in total deposits contributed by a fail of 5.3 percentage points in term deposits and of 9.5 percentage points in saving deposits between 1975-76 to 1979-80 (prior to Islamic banking) and 1980-81 to 1984-85 (Post Islamic banking). This disintermediation trend is shaped by the fact that the bank depositors are not high risk searching class of savers and thus, they avoid the high risk profit and loss sharing deposits. Therefore, the transformation of banking into Islamic type is likely to affect adversely the financial growth of the economy.³

Table 2 shows relative growth of selected interest linked and non- interest linked instruments in Indian financial system for two periods, i.e. 1971- 1981 and 1981-1990. Bank deposits and debentures of private sector companies both exclusively interest-linked instruments showed higher growth than the equity shares of corporate sector for the years 1971-1990. Bank deposits increased at about 19 per cent per annum and debentures at 42.0 per cent. Investment in equity shares of public limited companies registered a growth rate of about 14 per cent per annum whereas that of private limited companies about 16 per cent annum. The substantial difference in last two growth rates reflect degree of risk in two types of investments, though made on the basis of profit and loss sharing principle. Life insurance premium grew at about 14 per cent per annum and units of the Unit Trust of India (UTI) at 24 per cent per annum between 1971-1990 and 19.2 per cent for the entire period. The banks deposits registered a growth of 21 per cent per annum in 1971-1981 and 17 per cent in 1981-1990. As against this, the equities of public limited companies increased at 9 per cent during the former period and 22 per cent during the latter period and that of the private limited companies at 17 per cent and 15 per cent respectively. The life insurance prema and units of the UTI each recorded a growth of 15 per cent per annum for 1971-1981. However, the growth of the former was 12 per cent and that of the latter 34 per cent for 1981-1990. Apart from their other advantages, the investments in life policies and UTI’s units offer the fiscal incentive of income-tax exemptions. Therefore, the investment in this category is made by either salaried class or income tax-payers, and thus, do not constitute a direct competition with other investment instruments.

How growth rate differential can be explained, given a variety of options of risk, yield and safety of nominal value in the financial market? The higher growth of interest linked investments than that of non-interest linked ones suggests the risk-aversion behaviour of investors in India. The substantial difference between growth of debenture investment and equity investment in private sector companies indicates the same behaviour trend. Debenture investment offers highest interest rate with good deal of safety of principal and, therefore, carries less risk as compared to the equity investment in private sector companies.

These findings, as indicative of risk aversion behaviour in developing countries, suggest that financial intermediation based on profit and loss sharing principle is likely to receive a setback in growth unless the risk inherent in such investment assets reduced.

IV

Monetary Policy Implications

In conventional banking, interest rate on deposits is fixed with reference to inflation rate in order to keep a real positive yield on fixed deposits and at least safeguard the nominal value of short-term deposits. The landing rate is determined keeping in view, apart from cost of saving mobilization, the demand for credit and us interest elasticity. Thus, the link between lending rate and productivity of capital is sought by assuming the former as a scale in financial market against which borrowers compare potential or probable rate of return on their investment with a view to select only viable projects. The changes in interest rates have important implications for saving mobilizations and efficient allocations of surplus financial resources among competing borrowers. In other words, interest rate structure provides an elastic mechanism in financial market to guide the flow of resources in different uses.

Besides, monetary policy is conducted through variety of instruments to affect changes in cost, volume and direction of bank credit. Since cost and volume of credit are inversely related and as a result, change in one quantity leads to change in other in opposite direction. Therefore, the eventual impact of monetary poi icy is transmitted to the economy through interest rate mechanism; increase (decrease) in volume of available credit forces a decline (increase) in interest rates in informal and other sector even if the administered interest rates exists.

As against these, Islamic banking lacks a guarantee of the nominal value of investment deposits in an inflationary situation and it also lacks an alternative scale against which viability of projects/investments can be compared, particularly when rate of return available varies in a wide range. The elasticity of monetary policy significantly gets reduced in view of absence of interest rate (cost of credit). The change in direction and volume of credit is only possible either by stipulation of credit targets and ceiling, etc. consistent with policy objectives. Such changes are made on discretion with no regard to demand and supply factors in the financial market.

Inview of the fact that deposits in the form of mutual funds with Islamic banks are subject to monetary policy regulation, it imposes its own cost. The cost of monetary regulation is due to stipulation of cash reserve ratio and statutory liquidity ratio specifying a portion of bank liabilities to be kept in designated assets which earn either no income or very low return. As a result, the income foregone on such bank funds is the cost of monetary policy. This, in turn, adversely affects the average yield on bank assets, higher these ratios are, more income loss is born by banks on their funds.

Islamic banks organised on profit and loss sharing principle dilute the concepts of banking and commerce, in which performance of banks and clients consisting of industrial/trading firms are interlocked. This type of banking, with which this world has already experimented in beginning of this century, involves high risk as compared to present day modern banking. Since like direct investment in corporate shares, the bank deposits carry the risk of uncertain income and nominal value of principal amount, it is quite likely that the savers may prefer direct investment in corporate stocks to the bank deposits to avoid the cost of monetary policy on deposits. In that case, monetary policy is reduced to minor importance leaving entire burden of economic management on fiscal policy.

V

Summary and Conclusion

This study discusses the issues of banking competition and stability, financial growth and monetary policy implication of interest free banking. The competition among banks operating on profit and loss sharing requires full disclosure of quality of banks’ assets and profits which may create instability in the Islamic banking system at micro-level. The empirical evidences suggest that the financial system in Islamic type tends to record lower growth in both ways of analysis; (a) comparative growth of Pakistan banking after transformation was lower than that of the pretransformation banking and (b) the growth of interest linked financial instruments was higher than that of non-interest linked ones, in Indian financial systems during 1971-1990. The monetary policy also loses its significance and fiscal policy becomes the only available instrument of credit and economic management.

Bank competition can be partially regulated either through establishment of regional/sectoral banks and restricting their operation to a particular geographical area or fixing some minimum as well as maximum rate of return on banks’ assets of varying maturities and qualities. In turn, such minimum and maximum rates also need to be applied to deposits.

The risk in investment can be reduced by either institutional support direct intervention, insurance—or creating information revolution—data bank on industry profile/project performance, vast network of media and institutions to update, improve and make available information to investors at affordable price. Besides, a secondary market for instruments liquidity is essential.

FOOTNOTES

1. See a brief survey in Islamic Banking, Zubair Iqbal and Abbas Mirakhor, Occasional Paper 49, International Monetary Fund, Washington, March, 1987, pp 1-3.

2. Khan, Mohsin S., ‘‘Islamic Interest-free Banking”, IMF Staff Papers, Vol. 33, March, 1986, p4.

3. Bishnoi, T.R. ,“Banking Regulation and Islamic Finance”, Economic and Political Weekly, December 1-8, (1990) p 2687.

TABLE 1

Mean Growth Rate of Bank Deposits in Pakistan, 1975-76 to 1984-85

                                                                                                                                                (per cent, per annum)          

Bishnoi, T.R. , “Banking Regulation and Islamic Finance” EPW, Dec. 1-8, 1990, p. 2687.

Source: Based on Khan, S.R., Profit and Loss Sharing - An Islamic Experiment in Finance and Banking, Oxford University Press, Karachi, (1967) Table 8.2, p. 141.

TABLE-2

Growth of Interest Linked Financial Instruments and Non-Interest Instruments in India, 1971 to 1990

Source: Worked out from the Appendix.

APPENDIX

Changes in Interest Linked Financial Instruments and Non Interest Linked Instruments in India, 1971, 1981 and 1990

* and  **; Data relates to 1988 and 1989 respectively.

Source: Tata Services Ltd., Statistical Outline of India, for the years 1987, 1988-89 and 1989-90 and RBI, Report on Currency and Finance, Vol. II, Statistical Statements, Various years.

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COMMENT

Islamic Banking: Some unsettled issues of stability and growth

The basic idea behind Islamic banking is that equity participating contracts are more efficient than based on ex-ante fixed interest. In fact, there is ample evidence regarding this issue in the literature on the Equity Premium Puzzle. Western researchers, such as Mehra and Prescott (1985) and others, have been perplexed by the fact that stocks, inspite of their risk and adjustment for it, offer much higher returns than bonds. Abel (1991) summarizes the work of prominent economists and assails the inability of sophisticated techniques such as the Consumption Capital Asset Pricing Model (CCAPM) in an attempt to explain this puzzling phenomenon. He suggests overhauling the CCAPM and calls for a new strand of the real business cycle theory. Siegel (1992) concludes that “Equities, however, still appear to be the best route to long-term wealth accumulation.”¹

In the light of the international debt crisis, the U. S. savings and loan crisis and the current problems confronting the U.S. banking industry,² Khan (1986) and Akacem (1991) have advocated a banking system based on similar grounds to that of the Islamic Profit-Loss-Sharing (PLS) arrangement. Even prominent western economists like Simon (1948) and Kindleberger (1985) proposed abandoning fixed interest rates from western banking practices in order to protect the banking industry from rampant failure. Moreover, Weitzman (1984) has also demonstrated the superiority of the profit-loss sharing scheme over the pre-determined wage rates as a solution to the stagflation problem.

Bishnoi’s (1992) recent paper lacks any rigorous theoretical and/or empirical analysis to substantiate his bold claim that Islamic banking is highly risky and lacks merit. Insinuating causal observations from the experience of one country (Pakistan) and then generalizing it to the entire Islamic Banking System is simply erroneous. The problems of Islamic Banking in Pakistan are unique and are described in Mirakhor (1988) as follows:

(1) The government of Pakistan borrows from the public at a fixed rate of interest higher than that paid by Islamic banks in their PLS accounts. Since this loan is less risky than that of the PLS accounts, it results in attracting deposits away from Islamic banks in the country. It, thus, leads to disintermediation, threatening the proper functioning of these banks. Mirakhor argues that such government policy is harmful to the process of Islamization of the Pakistan’s economy.

(2) The banking community allocates a high percentage of assets on short-term trade related modes of financing, i.e., Murabaha (mark-up) rather than on long-term project financing modes of Musharaka and Mudaraba. This causes capital starvation for industrial projects, and

(3) The banking industry in Pakistan also feels that as long as the entire business community in the country does not adopt Islamic ethical norms, the monitoring costs of profit-sharing projects will remain high as they are subject to higher moral hazard.

Bishnoi (1992) laments on the lack of empirical evidence demonstrating the success of Islamic banking and argues otherwise through a simple, perhaps naive, look at the data from India. Contrary to Bishnoi’s claim, there exists some empirical (regression-based) evidence on the merit of Islamic banking reported, for example, in Darrat (1988), Bashir and Darrat (1992), and Bashir, Darrat and Suliman (1993), to name just a few. In particular, Darrat (1988) used time series data (1960-1984) from a Muslim country (Tunisia) and tested empirically the hypothesis that the financial (banking) System in the country may become more efficient if interest transactions were eliminated within the banking sector. Efficiency was defined in terms of four criteria: (i) the stability of the velocity of money (equal to the ratio of national income to money supply), (ii) the stability of the public demand for cash balance, (iii) policy controllability of alternative monetary aggregates, and (iv) the monetary aggregates/ultimate policy goal linkages. The empirical evidence was astounding. First, in contrast to the fixed interest based financial system, an interest-free financial system was found to exhibit a well-behaving and smoother velocity of money. Second, only the interest-free system has a structurally stable demand for money function. Third, only the interest-free monetary aggregates can be usefully utilized by the monetary authorities as an appropriate intermediate policy target. This inference was based on the finding that only the interest-free monetary assets can be effectively under the control of policy-makers and that only such assets have a reliable link with the ultimate policy objectives.

In addition, there have been developments in Japan and in the U.S.A. which also point towards the growth of financial system/instruments based on the concept of equity participation. Japanese authorities have recently enacted certain reforms in their banking sector and expanded its participation nature.³ Even in the United States, there has been an explosion of financial instruments involving some form of equity participation. The growth of the mutual fund industry (half of which comprises equity funds) attests to this fact.⁴ The emergence of participating mortgages or shared appreciation mortgages in the area of real estate financing also bears witness to this phenomenon. Finally, the recent innovation of a Stock Index Certificate of Deposit by some financial institutions in the U.S. is yet another observation supporting, at least indirectly, the merit of the Islamic PLS principle.

The preceding analysis clearly suggests that Islamic banking is a rational meritorious economic scheme, both from the theoretical and empirical standpoints. Further support for the rationality and effectiveness of Islamic banking comes from real world experience among several Muslim as well as many non-Muslim countries, and backed by an increasing body of empirical evidence. Serious financial analysts are invited to study closely the Islamic banking scheme and subject its rather short experience to a fair and objective assessment.

M.S. Ibrahim

A.H.M. Bashir

A. F. Darrat

REFERENCES

Abdel, A., “The equity Premium Puzzle,” Federal Reserve Bank of Philadelphia Business Review (Sept-Oct 1991), pp. 3-13.

Akacem, M., “Islam and the U.S. Banking Crisis,” Wall Street Journal (May 9, 1991).

Bashir, A.H.M., and Darrat, A.F.. “Equity Participation Contracts and Investment”, American Journal of Islamic Social Science, 9 (1992), pp.219-232

Bashir, A.H.M., Darrat, A.F., and Suliman M.O., “Equity Capital, Profit-Sharing Contracts, and Investment: Theory and Evidence,” Journal of Business Finance and Accounting              (1993, forthcoming).

Bernstein P., “Who Needs Bonds?” Forbes (February 1, 1993), p. 113.

Bishoni T.R., “Islamic Banking: Some Unsettled Issues of Stability and Growth”, Journal

of Objective Studies, (July 1992), p.. 142-151.

Darrat A.F, “The Islamic Interest-Free Banking System: Some Empirical Evidence”, Applied Economics, 20(1988), p. 417-425.

Japan Economic Institute Report (Washington, D.C., January 29, 1993).

Khan, M.S., “Islamic Interest-Free Banking: A Theoretical Analysis”, International Monetary Fund-Staff Papers, 33 (March 1986), pp. 1-27.

Kindleberger, C.P., “Bank Failures: The 1930s and the 1980s”, Paper presented at the Conference on The Search for Financial Stability: The Past 50 Years (San Francisco, 1985).

Lynch, P., Beating the Street, New York, Simon and Schuster, (1993).

Mehra, R., and Prescott, E.C., “The Equity Premium: A Puzzle,” Journal of Monetary Economics (15 March 1985), p. 145-161.

Mirakhor, A., “The Progress of Islamic Banking: The Case of Iran and Pakistan,” in Chibli Mallat, ed., Islamic Law and Finance Boston:Grabam & Trotman, 1988, pp.91-115

Siegel, J., “The Equity Premium: Stock and Bond Return Since 1802” Financial Analyst Journal. (January-February 1992), pp. 28-46.

Simon, H.C., Economic Policy for a Free Society, Chicago: The University of Chicago Press, (1948).

Weitzman, M., The Share Economy Cambridge: Harvard University Press, (1984).

KEYNOTES

1. Practitioners like Bernstein(1993), and the legendary mutual manager Lynch (1993) also bold a similar veiw.

2. According to the Federal Deposit Insurance Corporation’s Annual Report(1991), (Table 122), no less than 2,031 banks failed in the United States due to financial difficulties in the period 1934-1991. Two thirds of that number, i.e., 1,329 closed during the period 1980-87, and 209 banks collapsed in 1989 alone.

3. See, for example, Japan Economic Institute Report (1993).

4. There are, for instance, more mutual funds in the U.S. than stocks on the New York Stock Exchange.