Introduction 

 

The practice of Islamic banking has become a fast growing and widespread phenomenon, not only in the Muslim countries of the Middle East, but also in countries such as Indonesia, Bangladesh, Morocco, Switzerland, etc.(Karstan 1982, Iqbal and Mirakhor 1985, Wohlers-Scharf 1983, among others). Beginning with the first Islamic bank established in Cairo, Egypt, in 1971, the movement toward banking practices based on Islamic Laws (Shariah) has proceeded at a phenomenal rate. Today after two decades Islamic banks operate in over 45 countries, some of which (Iran and Pakistan) have completely changed their banking system to confirm with Islamic Laws. While currency and calendar differences make it difficult to estimate total assets of these banks, it has been roughly estimated that, by 1987, those assets totaled over $50 billion (Mangla et al. 1988) 

The transformation from a traditional or conventional form of banking to a banking system that corresponds with Islamic principles and codes has generated a great deal of interest on the part of the public, academicians, government officials, and bankers outside the countries involved. One reason for this great interest might be that the process of Islamization of banks and banking would directly affect the local operations of Western-based companies. A prime example of the impact, which this process might have arose in Saudi Arabia in 1987 when borrowers from traditional, foreign-owned banks and subsidiaries defaulted on their loans. In the ensuing litigation, the court acted according to Islamic principles and sided with the borrowers, finding them liable only for the principal of the loans. If this becomes the norm rather than the exception, it will become impossible to operate in those countries at all. If such occurs, it would have a significant long-term effect on Western economic and political influence in the "Islamic bloc" countries. 

In this study I attempt to explain the theoretical as well as operational issues and problems of Islamic banking. Although there is a scarcity of data pertaining to the Iranian Islamic banking experience, wherever possible, available Iranian data are provided.

Theoretical Background

The practice of collecting interest on loans (riba or reba; usury) is unambiguously condemned in the Qur'an (V:62; VI:161; 111:130-131; 11:275-75; 11:278-279). Unlike Judaism, where the practice of taking interest from non-Jews is allowed, Islam, like early Christianity, does not allow the practice of usury in any form. Of course, not all Moslem scholars agree in regard to the absolute prohibition of usury. There are those who believe that the prohibition of usury (interest) is not applicable to loans made for industrial, trade, or other productive investments (Karsten 1982, p. HO; Siddiqi 1983, p. 7). They argue that, since borrowers use capital resources to produce goods and services, which are sold for a profit, the providers of the capital resources must benefit from the profits earned. Likewise, there are those who believe that indexation of debts to protect the real value of the principal is not strictly forbidden either (Naqvi 1980). 

Acceptance of one or the other view with regard to collection of interest is less a result of theoretical and empirical analysis, and more a reflection of religious beliefs, and the desire to attain justice by abolishing exploitation of one class by another. The attitude and feelings of Islamic scholars and religious leaders toward interest taking (riba) are best enunciated by Seyyad Mahmmood Taleqani.

The greedy people, with the poison of money through usury, extracted the economic blood from the body of the producing classes, which are the active and progressive organs of society, and injected it into their fat bodies, which are the parasite of society...with all the complications, disorders, and injustices that usury and the concentration of money have brought about everywhere, it can accurately be said that they are the foundation and root of all or most social and economic problems (Taleqani 1983, p. 103).

If there is acceptance of the premise that usury is not in accordance with Islamic beliefs, then attention must be directed to the process of Islamization of the economy in general, and of banking in particular. The possible consequences of this new and relatively unexplored path must be considered. 

Islamization of banking practices requires two steps. Step one is the elimination of interest from banking practices; that is creating a "loan free" economy. The second step involves the adaptation of intermediation practices of the banking system to Islamic rules and principles. 

The elimination of interest from bank lending and borrowing is most definitely not an inconsequential undertaking in a country that has previously operated in accordance with the directions given by the rate of interest. There are several authors who argue that the elimination of interest from banking would lead to disorder in the economy because saving, and therefore investment and aggregate demand, would collapse (Pryor 1985). In other words, if interest, as a reward for saving, is eliminated, people would refrain from saving. Without saving, investment and development would be slowed. As a result, it is argued, Islamic banking would be injurious to the welfare of the country and should not be implemented. Although this argument is theoretically plausible, empirical support for the relationship between the rate of interest and saving (consumption) has not been established, even in an interest-based economy (Bisignano 1984). Establishing this relationship has eluded economists of all persuasions for many years.

 In any case, whether or not one can show weak or strong causation between the interest rate and savings, elimination of the former should not cause alarm for numerous reasons. In an Islamic system one earns a share of the bank's profits (or losses, whichever the case might be) rather than a fixed interest. This potential for a share of the profits can be a potent motivation for saving. In addition to the profit potential, there are other reasons for positive savings, such as the desire to accumulate wealth in anticipation of future consumption, and/or future retirement needs, and the desire to bequeath money to one's children. In other words, as long as people plan their consumption-saving behavior on the basis of a forward-looking expectation formula, their savings will be positive, regardless of whether a positive rate of interest exists. One could use the example of positive savings during an inflationary period, when the return on savings is usually not positive. 

Another reason for positive savings, according to the Qur'an (Kahf 1982, p. 110), is that by nature, human beings desire to save. Saving will take place as long as there are risk-averse people. There will always be those who will save for rainy days. Keynes touches upon this basic need in his discussion of the multiplier:

The fundamental psychological law…is that men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in income (Keynes 1964, p. 96).

In addition to the possible effect, which an interest-free economy would have upon savings, is the broader issue pertaining to the effect of Islamic banking on the stability of the economy? In a loan-based economy instability can arise from two separate sources. One source of instability is the financing and refinancing of business investment. As long as markets are moving in the "right" direction loans are available on reasonable terms. But as soon as the market turns against expectations, especially against surplus spending units expectations, refinancing of the old debt and financing of new projects will prove to be difficult and such activities will have repercussions for the economy. This cannot happen in an equity based economy. Business investments are financed by investors and therefore refinancing is not needed for the most part.

 A second source of instability in a loan-based economy comes from the demand for real balances (Goldfeld 1976). The possible effects of these disturbances to a loan-based economy are well documented and analyzed as well (Thornton 1983). In an equity based, or interest free or loan free economy, the speculative demand for money does not exist. As a result, a major source of instability in the demand for real balances and therefore in the economy is eliminated. This is particularly evident when one considers the existence of a wealth tax on cash (zakat; zakah; zokat). This wealth tax will discourage holding and/or hoarding of real balances beyond what is necessary for transaction and precautionary needs.

 Besides the theoretical issues arising in regard to Islamization of banking practices, there are operational questions, which relate to consumer loans, government borrowing, and international financial relationships. For consumer loans, there are no profits to be shared with the bank. So profit sharing schemes are not applicable. One possible solution for purely personal loans is the use of zokat money (wealth tax) to provide interest free loans to those who need financial assistance. As for consumer durable goods, one could suggest that banks should finance (or engage in a partnership of sorts) with the producer and share the profits earned by the producers. This will provide some income for the bank as well as financing for the customers who would be buying on installment directly from the producer, as in the case of the purchase of tools, inventories, etc. 

With respect to international financial relations, there are several issues. One has to do with the feasibility and compatibility of free foreign exchange and free capital markets in a society that practices Islamic banking. There is a very plausible argument that in an interest-free environment, capital flight is inevitable. It is argued that capital will follow the highest return, wherever it might be. This issue can be addressed on two levels. 

On one level are factors pertaining to religion. In compliance with Islamic teachings, Moslems cannot accept interest from anyone or any institution, foreign or domestic. There is one exception, however. "Charging interest is permissible for financial transactions with Dar Al Harb," i.e., for transactions with non-Moslems living beyond the rule of Islam (Wohlers-Scharf 1983, p. 76). Therefore, based on religious beliefs, the lure of interest abroad should not be a significant problem in an Islamic society. On the other hand, investments in an Islamic bank will earn a share of the bank's profits. As a result, as long as the Islamic bank is profitable and competitive, there is no reason for an individual to shift his resources abroad. 

A second major aspect of international financial relations pertains to the dealings between Islamic and non-Islamic banks in the rest of the world. Various questions arise when one considers such dealings: Would an Islamic bank receive interest on its deposits in the Eurodollar market? Would an Islamic bank refuse to pay interest on its overdraft or borrowing from foreign banks? It seems that, in practice, as long as there are no international or multinational Islamic banks operating on Islamic principles, countries with Islamic banks must adhere to the laws, rules, regulations and Customs of the countries with which they are dealing if they want to be a part of the international community. Therefore, they must accept and pay whatever charges, including interest, may occur.

 A final debate has to do with the question of government debt and deficits in an Islamic system. Can a government borrow from the private sector to finance its deficits? The answer seems to depend on the use of funds. If the borrowed funds are to be used for a profit making government project, then there is no problem. The government enterprise is treated as any other private business. Therefore, if a government-owned and operated project is efficient and profitable, it can be financed by banks. If not, there is no financing available. As for not-for-profit government projects and expenditures such as justice and defense, borrowing from the private sector to finance the deficit is not feasible. In regard to government borrowing from the state-owned banking system (i.e., state-owned commercial banks and the central bank) any charges, interest and/or fee are of no consequence. This position is a direct result of the attitude of the Islamic scholars about usury, and is particularly true in Iran. The argument against usury is that people, particularly poor people, negotiate with the usurers (banks) from a weak position. They have no choice but to agree to pay a part of their production (income) to those people who have hoarded part of their income in the past. This is not just. However, if one organ of the government pays interest or a fee for borrowing from another organ of the same government, no injustice has taken place. Money is taken from one pocket and is put in another pocket. As a result, it is argued that government can borrow from state-owned banks, including the Central Bank, and pay whatever is needed for that purpose. 

Practice of Islamic Banking in Iran

In Iran, after the revolution of 1979, the banking system was nationalized. Shortly thereafter, in 1983, the Law of Usury-Free Banking was passed, and on March 21, 1984, interest free banks started to implement Islamic banking based on the 1983 law.

 There arc several questions regarding the feasibility of the practice of Islamic banking which involve, among other things, bank activities, the process of money (deposit) creation, international banking relations, government lending and borrowing from financial institutions, the monetary policy of the Central Bank, etc. 

In an Islamic banking environment, commercial banks are allowed to accept demand deposits the same way that their counterparts in the United States were permitted to do under "Regulation Q." That is, they accept deposits without paying any interest on them. Using Islamic terminology, this is called Qard al-Hasanah (Qarz ol-Hasaneh). However, banks are not prohibited from offering prizes or other incentives of various forms to attract funds to the bank. For example, in its routine banking practice, the bank might give priority to those who have a deposit account, e.g., those depositors might be given priority over others in their loan applications. Besides the interest-free demand deposits, people could choose to deposit their money in interest-free savings deposits as well. These are also classified as Qarz ol-Hasaneh.

 For those people, however, who wish to earn some form of compensation for their deposits, other types of savings accounts are available. These alternative accounts may set minimum limits on the amount of deposit and the length of time required for the deposit. There are short-term investment deposits which require depositors to leave their resources in the bank for a minimum of three months and which require a minimum deposit of Rls. 2,000. For those people who have a greater amount of money available for deposit, at least Rls. 50,000, and who are willing to part with their money for at least one year, there are long-term investment accounts. Depositors of these accounts are not compensated on the basis of a predetermined interest rate. They are paid, however, a share of the bank's profits, whatever those profits might be.

 On the asset side of their balance sheet, commercial banks or other specialized financial institutions can have interest free loans (Qarz ol-Hasaneh), or income-earning assets. Every bank is required to provide a portion of its deposits, almost free of charge to the industrious and the needy. Most of these loans go toward productive small businesses and toward personal expenditures such as weddings, medical, needs, etc. There is a 1.5 percent per year handling fee charge for "industrial" or a 1 percent per year handling fee charge for personal Qarz Ol-Hasaneh. Industrial Qarz Ol-Hasaneh must be paid back in no more than five years and personal ones in no more than one year. Other types of assets that banks can acquire can be divided into several categories: (Mudarabah, or Qirad), Mosharekat, Installment Sale, Lease=Purchase contracts, Mozareh, Mosaqat, Jo'aleh, and Direct Investment.

 Modarabah  is one way that a bank can provide financial resources to an individual or a firm for a particular project. In this type of transaction, the bank and an agent (customer) agree to engage in some commercial activity and earn, hopefully, a profit, which will be shared between the bank and the agent (customer). The expected rate of profit is not known in advance. However, the Central Bank (Bank Markazi Iran) sets the minimum expected rate of profits for policy and resource allocation purposes. This type of agreement is used for any short term commercial activity except importation which is currently prohibited. The expected rates of profit set by the Bank Markazi Iran for such activities are 12 percent for domestic commerce and imports (when legal), and 8 percent for export agreements. Setting the expected profit rates for imports and exports allows the use of Modarabah agreements for imports and exports activities in the future, whenever the government decides to relax the prohibition mentioned before. The maximum amount for a contract between a bank and an individual engaging in commercial activities is Rls. 50 million; for a banking contract with an incorporated the maximum is Rls. 500 million.

 Musharakah (Mosharekat) is a partnership arrangement between the bank and an individual or a firm to start a new line of business. In this case, assets of the business entity belong  to all partners and profits will be shared according  to each Mosharekat agreement.  Bank Markazi Iran sets the minimum expected profit rates for Mosharekat. Currently the rates are 6 percent for agricultural projects; 8 percent for mining and industrial projects; 10 percent for housing and construction; 12 percent for commerce and services. Besides the minimum required profit rates that can be manipulated by the Central Bank for policy purposes (setting the country's priorities), the maximum amount of the bank's share in a project can also be used as a policy variable. Currently, the maximum share for a bank entering into a civil Mosharekat agreement in agriculture is 90 percent; in mining and industry it is 85 percent; in housing, commerce, and services the rate is 80 percent. Even though the bank is providing a given share of the capital, this does not necessarily mean that the profits are to be shared in the same proportions. That is, the ability to manipulate how the profits are to be shared is another tool available to the policy makers for setting the economic priorities of the country.  It is very possible that, for instance, in an agricultural project, 90 percent of the capital may be provided by the bank, yet only 50 percent of the profits are agreed to be paid to the bank. This is another way of encouraging expansion of investment in agriculture. The maximum amounts that a bank can invest in a Mosharekat agreement are set by the Bank Markazi Iran. Currently, the maximum amounts are one billion rials for agriculture, one billion rials for mining, 500 million rials for services, and 500 million rials for commerce.

 

Installment sales constitute another type of service that a bank can provide its customers. On an installment basis, a bank can buy and resell tools, raw materials, machinery, houses, or any business inventory, thus earning a profit. Currently, banks are not allowed to finance consumer durable goods on installment. 

The sale price of goods sold on an installment basis will be based on a cost-plus scheme. In the case of raw materials and spare parts, the sale price must be paid back in one year. In special cases the repayment period can be postponed one additional year. In the case of machinery, the repayment period cannot be more than the useful life of the machine. Currently, the rate of profit on installment sale of tools and spare parts is 4 percent and the rate of profits on machinery is 8 percent in agriculture and mining and industry, respectively. The maximum amount of installment loans are Rls. 50 million and Rls. 3 billion, for individuals and corporations, respectively. The rate of profits for machinery bought on an installment basis in the service sector is 10 percent. The maximum amount of an installment loan made to an individual for machinery is Rls. 100 million, while the maximum amount loaned to a corporation is Rls. 3 billion, the bank may require a down payment from a corporation. Currently, Iranian banks require a 10 percent down payment for agricultural machinery, 15 percent for mining and industrial machinery, and 20 percent down payment for machinery used in the service sector. 

Home financing is more involved than other types of installment sales. In regard to housing construction, the applicant can borrow up to 80 percent of the project's cost to complete a construction project. After the completion of the project, which should not be more than one year after the time the contract was signed, the bank will add a maximum of 10 percent profit, on an annual basis, to the money borrowed during the construction period. At that time the builder can pay the entire amount and the bank would release the mortgaged project. If the borrower should decide to repay over a long period of time, i.e., on an installment basis, the bank will add 6 or 10 percent profit per year (6 percent for those with a savings account and 10 percent for others) to the borrowed money, and the property will remain mortgaged until all the debt is completely repaid.

 The Lease-Purchase (Hire Purchase) contract is a device that allows a bank to buy and lease buildings, machinery, and equipment. At the end of the lease period, the lessor (the bank) transfers the property (movable or immovable property) to the lessee. Currently, the profit rate is in the range of 6-8 percent for agriculture, 8-10 percent for mining and industry, and 10-12 percent in the service sector. The maximum amount of a contract in industry is Rls. 100 million and Rls. 50 million for the service sector. The maximum contracted amounts are Rls. 500 million for the service sector and Rls. 3 billion for the industrial sector. There is a 20 percent down payment requirement for these contracts.

 The Muzara'a (Mozare'a) contract is a device that allows a bank to lease agricultural land. The bank may provide a piece of land, for a specified period of time, to a farmer for agricultural purposes and share the profits earned. In addition, the bank may provide seed, fertilizer, water, pesticide, transportation, etc. Currently, banks have the authority to set the terms of Mozare'a contracts, which are usually for one year.

 Musaqat (Mosaqat) is the same as Mozare'a except the contract is for trees. The bank may provide an orchard to a farmer for a period of time (one year or until its fruits are harvested) for a share of the profits.

Jo'aleh is a service contract according to which one party (Ja'el) purchases another party's (Amel or contractor) services for a specified commission (Jo'al). The bank may function as either Ja'el or Amel depending on the situation and the need of the customer.

 Direct Investment is another way that a bank can engage in whatever activities it deems desirable for the purpose of economic development, or in response to a social concern. Direct investment, however, occurs only as long as the project is not designed to produce luxury and/or unnecessary goods and services. Obviously the definition of socially and economically desirable goods and services is subject to the discretion of the authorities. The minimum profit rate required to justify direct investment is set by the Currency and Credit Council of Iran.

 Because Islam is not just a religion but a total way of life, the resurgence of Islamic fundamentalism has had far-reaching effects, even to the point of influencing economic systems. One of the most recent manifestations of the Islamic way of life has been in banking. In many countries, business persons, in cooperation with governments, have established Islamic Banks either to compete with an existing interest-based banking system or to completely replace it. This has happened despite misgivings and uncertainty that exist on theoretical as well as theological grounds.

 Iran, in contrast to all other countries that have some degree of Islamic banking, has completely transformed its banking activities to comply with the accepted Islamic principles. Some of the transformation of the liabilities of the banking system is evident in Table 1. Interest-oriented savings accounts were discontinued in 1362 (1983). Starting in 1363 (1984), new types of deposit accounts, e.g., qarz ol-Hassaneh; short and long-term investment deposits were created.

 As far as the feasibility of Islamic banking, the banking system has been operating over the last few years in Iran without many publicized problems. There are a variety of methods for providing financial resources to individuals and businesses (Table 2) to promote flexibility within the system. For example, one could use Hire Purchase agreements for industrial projects, commercial, or housing projects.

 As far as monetary policy is concerned, the Bank Markazi Iran is not any less able to manage the monetary policy now than before the implementation of Islamic banking. As was discussed before, there are several new tools available to the central bank to manage the monetary policy. These new tools include the establishment of maximum and minimum amounts of loans that the bank can provide for a particular project; the expected rate of profit from a project; and the bank's share of the profit. Each of these could be changed to achieve an economic objective and/or direct the scarce resources toward a particular sector of the economy.

Table 1. Private Sector

 Deposits During 1362-64

	Outstanding 1362* (1983)	Outstanding 1363* (1984)	Outstanding 1364* (1985)
Sight Deposits	2,013,504	2,509,005	2,747,325
Non-Sght Deposits	3,586,556	3,409,332	3,958,480
Total sight & non-sight deposits	5,600,060	5,918,337	6,705,805
Time Deposits	8,492,280	---	---
Long-Term Investment Deposits	---	998,413	1,191,536
Savings(Interest)	2,737,276	---	---
Savings (Qarz-ol-Hasanah)	---	1,496,744	903,504
Short-term Investment Deposits	---	938,275	1,863,440

*End of the year.

SOURCE: Bank Markazi Iran, "Mobilization of Resources and Granting of Activities," 1986.

The spread of Islamic, banking has several possible implications for the world financial community. Non-Islamic foreign-owned banks in Moslem countries might join the system and operate in accordance with Islamic law, or take their chances of being forced out of the market by Islamic banks. Furthermore, conventional banks located in Moslem countries run the risk of a considerable loss if borrowers default on their loans. It is very possible, as happened in Saudi Arabia in 1987, that Islamic legal systems will side with the borrowers and find them liable only for the principal of the loan. If this becomes the norm, it will become impossible for conventional banks to operate in those countries at all.