Introduction One of the significant developments in the Muslim world during the last decade and a half is the emergence of Islamic banking, which has appeared as a powerful movement. Although some attempts to reorganize banking activities along Islamic lines go back to the early sixties, the concept of Islamic banking is even older. In fact, the strong disapproval of interest by Islam and the vital role of interest in the modern commercial banking system led Muslim thinkers to explore ways and means by which commercial banking could be organized on an interest-free basis. However, for a long time, the idea of Islamic banking remained a mere wish. Some papers were written and some professional economists even worked out theoretical models of Islamic banking. However, they were quickly dismissed by highbrow economists who described them as wishful thinking and attempts to put history into reverse gear. The establishment of the Islamic Development Bank (IDB) in 1975 gave momentum to the Islamic banking movement. The Islamic Development Bank was established as an international financial institution in pursuance of the declaration of intent issued by the Conference of Finance Ministers held in Jeddah in December 1973. According to Article 1 of the Articles of Agreement establishing the bank, the purpose of the IDB is to "foster the economic development and social progress of the member countries and Muslim communities, individually as well as jointly, in accordance with the principles of the Shariah". Its present membership consists of 45 countries. The authorized capital of the bank is two billion Islamic dinars. The value of an Islamic dinar, which has been adopted as the unit of account at the IDB, is equivalent to one special drawing right of the International Monetary Fund. It was the first time in modern Muslim history that an international financial institution committed itself to conduct its activities in conformity with the Shariah. According to Article 20(3), instead of working on the basis of interest, the bank was authorized to levy a service fee to cover its administrative expenses. One of the official publications of the IDB declares that, "the bank is clearly and unequivocally committed to the principles of the Shariah in the conduct of all its financing operations and the performance of its activities...the bank has made a constant endeavor to identify the modes of financing that conform to the Shariah." Since the establishment of the IDB, a number of Islamic banking institutions have been established all over the world. At present, more than 50 Islamic banking institutions are working in different parts of the world and two countries, viz., Iran and Pakistan, have taken the necessary steps to reorganize their entire banking system along Islamic lines. Islamic banking is no more a mere idea, just a blueprint or even wishful thinking. It is said to "have arrived". Even the "highbrow" West finds itself compelled to take notice of Islamic banking. This may be guessed from the fact that the International Monetary Fund has published a monograph on Islamic banking. It is also not uncommon to see various seminars being organized on Islamic banking in Western universities, as well as in other economic, business and banking circles. Many graduate students at American and British universities have written their Ph.D. dissertations on various aspects of Islamic banking. All this activity is bound to increase curiosity about Islamic banking. What is Islamic banking? How is it different from the usual type of commercial banking? How does it function? Is it really free from interest? These are some of the questions which are being asked not only by curious non-Muslims but also by concerned Muslims. This essay is an attempt to answer some of these questions. The paper is divided into six sections. Section Two discusses the meaning of prohibition of interest (riba) in Islam. Section Three examines the theoretical basis of Islamic banking. The next section is devoted to tracing the evolution of the concept and practice of Islamic banking. In Section Five, the current business practices of Islamic banks are discussed at some length. The last section endeavors to clear some common misconceptions about Islamic banking. Prohibition of Interest It is commonly known and acknowledged that Islam has strictly prohibited interest. It disapproves both the giving and charging of interest. The Arabic word used in the Quran for interest is riba, and it has been condemned in the strongest possible terms. Riba is often translated as usury but its literal meaning is an excess, addition or growth. Islamic jurists have classified usury into two types: 1. Usury of debts (riba al-diyun) 2. Usury of trade (riba al-buyu') The usury of debts was an established practice amongst Arabs during the pre-Islamic period. It is also known as usury of delay or usury of waiting (riba al-nasia). It may arise in two situations: first as an excess over and above the amount of the principal the repayment of which is incorporated as an obligatory condition of the giving of a loan. In the second situation, an excess amount is imposed over and above the amount of the principal if the borrower fails to repay the principal on the due date. Thus, more time is allowed for payment in return for an excess amount. If the borrower fails to pay again, a further excess amount over the principal (usually the double of the first excess) is imposed, and so on. The usury of trade (riba al-buyu') is also known as riba al-fadl. It is concerned with the buying and selling of a commodity in exchange for the same commodity. It was also practiced by the Arabs in the pre-Islamic period and was prohibited by the Prophet Muhammad, peace be upon him. The following Tradition of the Prophet (peace be upon him) is cited as evidence thereof: It is related that Abu Sa'id al-Khudri said: "The Prophet, peace be upon him, said: Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt for salt—like for like, hand to hand. Whoever pays more or takes more has indulged in riba. The taker and the giver are alike [in guilt]." It is the considered opinion of the experts on Islamic jurisprudence that interest charged by commercial banks "is identical with the excess stipulated as an obligatory condition in the contract, which is one of the two types of usury prohibited by the Islamic Shariah". This kind of usury has been prohibited because it admits the possibility of fraud in transactions. The Shariah requires that there should be no element of uncertainty (gharar) when people enter into contracts with each other, whether these contracts pertain to real transactions of commodities or to financial transactions. Keeping in line with the above age-old tradition, the Islamic Fiqh Academy established by the Organization of Islamic Conferences (OIC), in its second session held in Jeddah, Saudi Arabia, from 22-28 December 1985, declared that "any increase or profit on a loan which has matured, in return for an extension of the maturity date, in case the borrower is unable to pay, and any increase or profit on the loan at the inception of the loan agreement, are both forms of usury (riba), which is prohibited under the Shariah." The Theoretical Basis of Islamic Banking In order to be justified Islamically, the banking system has to avoid riba (interest). Consequently, much of the literature of the theory of Islamic banking has grown out of a concern as to how the monetary and banking system would function if interest were abolished by law. In this section, the theoretical basis of Islamic banking will be briefly reviewed. Modern commercial banking activity is based on the creditor — debtor relationship between the depositors and the bank on the one hand and between the borrower and the bank on the other. Interest is viewed as the price of credit, reflecting the opportunity cost of money. The Islamic view about loans is that they should be given or taken, free of charge, to meet any contingency and that the creditor should not take any advantage of the borrower. When money is lent on the basis of interest, more often than not it leads to some kind of injustice. The Islamic principle in these kinds of transactions is "deal not unjustly, and ye shall not be dealt with unjustly" (Quran, II: 279). Hence, commercial banking in an Islamic framework may not be based on the creditor — debtor relationship. The other Islamic principle in matters of financial transactions is that there should be no reward without risk-bearing. This principle is applicable both to labor and capital. As no payment is allowed to labor unless it is applied to work, no reward for capital should be allowed unless it is exposed to business risks. Financial intermediation in an Islamic framework is based on these two principles. Consequently, Islamic financial relationships are participatory in nature. It has been suggested by several theorists that commercial banking in an interest-free system be organized on the principle of profit-sharing, which is referred to in Islamic jurisprudence as mudaraba. The principle of mudaraba can be explained by a simple illustration. Suppose there are two persons, one of whom has capital but no special skills in trade, while the other has been endowed with some special insight and dexterity in matters of trade but possess no capital. These two persons can cooperate in either of the following two ways: (a) The trader can borrow the money from the capital-owner and invest it in his trade. The capital-owner is to get back his principal and an additional amount worked out on the basis of a fixed rate, called the interest rate, as his compensation for parting with liquidity. This is debt financing. Usually, the loan will be granted for a fixed period. The claim of the creditor for repayment of the principal and the payment of the interest becomes viable only after the expiry of this period. This is irrespective of the fact of whether the trader has made a profit using the borrowed money or not. In the event of a loss, the borrower has to repay the principal amount of the loan as well as the accrued interest from his own resources. This is viewed by Islam as an unjust transaction. (b) The other possibility is that the two persons mentioned in the example cooperate with each other not on a creditor-debtor basis but on the basis of partnership and cooperation, in which the capital-owner provides his capital and the other party puts his skill and management into the trade. The capital-owner is not involved in the actual day-to-day operation of the business but is free to stipulate certain conditions which he may deem necessary to ensure the best use of his funds. After the expiry of the period, which may be the termination of the contract or such time that returns are obtained from the trade, the capital-owner gets back his principal amount together with a share of the profit. The ratio in which the total profits of the enterprise are distributed between the capital-owner and the manager of the enterprise is determined and mutually agreed at the time of the contract, before the beginning of the project. In the event of loss, the provider of the capital bears all the loss and the principal will be reduced by the amount of the loss. In a way, it is the possibility of the loss which makes the capital-owner entitled to a share in the profits of the enterprise. This is, in essence, the principle of mudaraba. The Islamic legality of mudaraba is based on the Sunnah, as it is reported that mudaraba was practiced in the city of Madinah and elsewhere during the time of the Prophet (peace be upon him) and that he did not disapprove of it. The creditor-debtor relationship shown in the earlier example is viewed as an unjust one because it gives more leverage to the creditor in contrast to the debtor. The interests of the creditor are protected at the cost of the debtor. In contrast, the mudaraba agreement is based on justice, as it grants an equal position to both parties in the agreement. There are at least three reasons for considering the mudaraba relationship to be more just than the creditor-debtor relationship: Firstly, both parties have an equal position in the determination of the ratio in which profits will be shared between them. Secondly, the treatment of both parties is uniform in the event of loss, in which, if the provider of the capital suffers a reduction of his principal amount, the worker or manager in the mudaraba contract is deprived of a reward for his labor, time and effort. Thirdly, both parties are treated equally if there is any violation of the agreement. If the worker/ manager violates any one of the stipulated conditions, or if he does not work hard, or is instrumental in causing loss to the business by negligence or bad management, he will have to bear the responsibility for the safe return of the whole amount in question. If, on the other hand, the provider of the capital violates any of the stipulated conditions, for example, by withdrawing his funds before the stipulated time, or by not providing part or full funds at the promised time, etc. he will have to pay the worker/manager a reward equivalent to what he would have earned in similar work. It has been suggested that mudaraba be the basis of reorganizing banking activity in an interest-free framework. This can be done by entering into a two-tier mudaraba agreement, which may be explained as follows: The first tier of a mudaraba agreement is between the bank and the depositors, who agree to put their money in the bank's investment account and to share profits with it. In this case, the depositors are the providers of the capital and the bank functions as the manager of funds. The second tier of a mudaraba agreement is between the bank and the entrepreneurs who seek finance from the bank on the condition that profits accruing from their businesses will be shared between them and the bank in a previously mutually agreed proportion, but that loss shall be borne by the financier only. In this case, the bank functions as the provider of capital and the entrepreneur works as the manager. In case there is more than one financier of the same project, i.e., one project is jointly financed by several banks, profits are to be shared in a mutually agreed proportion previously determined, but loss is to be shared in the proportion in which the different financiers have invested their capital. There could also be a partnership (sharika) agreement between the bank and the entrepreneur in which loss would be shared by the contracting parties in the proportion in which they had invested their capital, but profits would be shared in the agreed ratio determined beforehand. The principle of mudaraba as a basis of financial intermediation in the Islamic economy is offered as a viable basis for an interest-free banking system. The creditor does not earn interest on a fixed rate in this system, but participates in the business risks and earns a share of the profit. Thus, under an Islamic banking system, the cost of capital is not zero, i.e., analogous to a zero interest rate, as some people wrongly assume it to be. The only difference between Islamic banking and interest banking in this respect is that the cost of capital in interest-based banking is expressed in terms of a predetermined fixed rate, while in Islamic banking; it is expressed as an absolute amount which may also be expressed as a ratio of profit. Some writers have even suggested that the profit-sharing ratio in an Islamic economy could discharge the same functions as are performed by the interest rate in a capitalist economy. Thus the profit-sharing ratio could work as an allocative device as well as a control variable. The Evolution of the Concept and Practice of Islamic Banking Considering the facts that the Islamic injunction against riba is fourteen hundred years old and that Islamic banks have emerged only in the last fifteen years, a question which may legitimately be asked by any observer of Islamic banking is why the Islamic world took so long to come up with an alternative to interest-based banking. The answer to this question is necessarily based on historical factors. In order fully to appreciate the emergence of Islamic banks, one has to comprehend the historical evolution of interest-based banking and its role in the Muslim countries, because the significance of Islamic banking can be understood and appreciated only within the context of the over-all development of commercial banking. The history of commercial banks in the western world itself is not very old. The development of commercial banking in the West has synchronized with the emergence of industrial civilization in the last two and a quarter centuries. With the Industrial Revolution, there was a tremendous expansion in the number of traders, manufacturers, industrialists and other entrepreneurs who wanted to expand their businesses and set up various kinds of firms but whose own financial resources were not enough for them to do so. Hence, a method had to be found which would give finance users access to the finances of others. Thus, the needs of financial intermediation gave birth to commercial banking, which, very soon, became the backbone of the modern industrial and financial system. An efficient and smoothly functioning banking system is today one of the most basic prerequisites for having efficient economic organization. However, all this happened against the backdrop of western cultural tradition, which had shrugged off the moral and ethical considerations of Christianity from economic and business relations in its very early stages of development. When the Muslim world came into contact with industrialization and other associated institutions of capitalism, including the commercial banking system, Muslims had one of two choices: (1) to accept the institution of commercial banking as it was and argue that interest charged by the commercial banks did not contain the elements of riba prohibited by Islam. Hence, commercial banking would become permissible and Muslims would have no reservations about it. (2) to accept the verdict that interest charged by commercial banks was riba and, in view of the indispensability of commercial banking, make an attempt to develop an alternative system of banking which would not violate any tenets of the Islamic Shariah. It should be kept in mind that these two choices were not as clear at first as they appear to be now. There were certain factors blurring the distinction between them. First of all, the economies of most of the Muslim countries were managed by the colonial powers and the population of those countries had little say, if any, in choosing their own political and economic systems. The institutions which had existed in the Muslim countries for centuries, such as the Shariah courts, were made either ineffective or defunct or destroyed. The new institutions were imposed on them. Under these circumstances, Muslims had no practical alternative but to work with them, even though they had serious reservations about some of them on moral and ethical grounds. This was the case with commercial banking. Nevertheless, it must be conceded that during the middle of the nineteenth century, several religious scholars in certain Muslim countries, such as Egypt, the Indian subcontinent and Indonesia, made an attempt to reconcile the Islamic prohibition of riba and the existence of commercial banking. They did so by arguing that the Islamic prohibition of riba was mainly applicable to usurious loans and not to commercial banking operations. It was also argued that the riba condemned and prohibited by the Quran is really usury and not the interest which is the basis of functioning of modern banks. Some others argued that the prohibition is mainly aimed at eliminating the excesses and exploitation involved in consumption loans when given on interest and that since commercial banks gave loans mostly for productive purposes, the prohibition of riba may not cover bank loans. The advocates of these views neglected the fact that the Quran categorically declares any surplus (or excess) over the principal amount to be riba and clearly mentions that creditors are entitled only to their principal amounts. It was also forgotten that Islam does not make any distinction between consumption and production loans. The prohibition of riba has to apply irrespective of the purpose for which loans have been raised. However, it is also a historical fact that these views were held only by a miniscule minority in the Muslim countries. The majority of Muslim scholars or believers who had serious reservations about the correctness of these positions and the permissibility of bank interest did not accept these views. As a consequence, modern commercial banking could not make much headway in the Muslim countries as it did in the western world and even in some Asian countries. This is corroborated by the fact that commercial banking in the Muslim world is mainly confined, even today, to large urban centers where western culture and civilization has made deep inroads. Even in the cities, significant numbers of people stay away from the commercial banks for religious and moral reasons, respecting the Quranic injunction against riba. Even among those who have to deal with the banks, under the force of circumstance or due to the non-availability of any Islamically permissible banking facility, there are a large number of people who believe it to be a violation of faith. Consequently, they do not make any use of the interest earned by their funds. Either they leave it at the bank unclaimed or give it to someone else. The other approach, to evolve a banking system consistent with the requirements of the Shariah, has become more important recently, although the idea of establishing an interest-free bank goes back to as early as the 1940s. However, the conditions then were not ripe for the actual establishment of an Islamic bank, since thought had not been given to the technical details and actual operation of an interest-free bank. In fact, in the absence of any breakthrough in the theory of interest-free banking, the idea of Islamic banking remained a mere desire, not even a blueprint, for a long time. An Early Experiment A pioneering experiment putting the principles of Islamic banking into practice was conducted in Mit-Ghamr in Egypt from 1963 to 1967. The experiment combined the idea of German savings banks with the principles of rural banking within the general framework of Islamic values. Mit-Ghamr was essentially a rural area and the people in general, as elsewhere in the Islamic world, were quite religious. They did not place their savings into any bank, because interest is forbidden in Islam. Moreover, hardly any financial institution was available to them. Under these circumstances, the task was not only to respect Islamic values regarding interest but also to educate the people about the use of banking. A Western observer describes the significance of the Mit-Ghamr experiment in the following way: "The majority of the population had never dealt with financial institutions. Because of this, capital formation had been impaired. Basically rural and religious, they tended to distrust the bankers operating in the western style and, what is more, there were few local branches-they could patronize. Since a substantial part of their income was not spent immediately, but put aside for social events, emergencies and the like, this idle capital could not be used for productive investment. A precondition, however, of any change of behavior from hoarding and "real asset saving" to "financial saving" was the creation of a financial institution which would not violate the religious principles of large segments of the population. Only then could the majority of the population be integrated into the process of capital formation." Thus an attempt was made to integrate the rural population into the financial system and the "developmental nature of this early experiment made it very prominent". In the Mit- Ghamr project, the following types of accounts was accepted:
(i) savings accounts; (ii) investment accounts; and (iii) zakat accounts. No interest was payable to depositors in the saving accounts but they were allowed to make withdrawals on demand. They were also eligible for small, short-term, interest-free loans for productive purposes. The funds deposited in the investment accounts were subjected to restricted withdrawals and were invested on the basis of profit-sharing. The zakat account attracted the stipulated amount of zakat for redistribution amongst the poor. The Mit-Ghamr project of Islamic banking had an unexpected success, as savings deposits increased from 25,000 Egyptian pounds to 125,000 Egyptian pounds during 1963-66. During the same period, investment deposits increased from 35,000 to 75,000 Egyptian pounds. It is also reported that "the bank functioned on a cautious basis, rejecting, on the average, 60 per cent of loan applications in the first three years. The default ratio was zero in economically good times." Although the Mit-Ghamr project made a good start, it was abandoned owing to certain political factors. Its importance is only historical now. Nevertheless, it was the first experiment which showed that commercial banking activity could be organized on the basis of Islamic principles respecting the prohibition against riba and not indulging in interest. A Unique Financial Institution In terms of the historical evolution of Islamic banking, mention should also be made of a unique financial institution which is generally not mentioned in discussions on Islamic banking but whose significance, importance and uniqueness demands it. This financial institution is The Pilgrims' Management and Fund Board of Malaysia, which is popularly known as Tabling Haji. The reason for the establishment of this institution was the desire of Malaysian Muslims that "money spent on pilgrimage must be clean and untainted with riba". Since this was not possible by depositing the money with ordinary commercial banks, this desire necessitated the establishment of a special financial institution. Consequently, the Pilgrims' Savings Corporation was established in Malaysia in 1963 and was later incorporated into the Pilgrims' Management and Fund Board (Tabling Haji) in 1969. The objectives of the Tabling Haji are” (i) to enable Muslims to save in order to provide their expenses for performing the Pilgrimage (Hajj) or for other expenses beneficial to them; (ii) to enable Muslims, through their savings, to participate in investment in industry, commerce and plantations, as well as in real estate, according to Islamic principles; and (iii) to provide for the protection, control and welfare of Muslims on pilgrimage through the various facilities and services of Tabling Haji". To achieve these goals, the institution is assigned to collect savings through its branch offices and other agencies, such as post offices, and to invest the depositors' saving in "accordance with the investment principles and tenets of Islam". In 1963, Tabling Haji started with 1281 depositors and a total of Malaysian 46,600 dollars in deposits. By the end of 1985, it had 65 branches all over the country and the number of its depositors had reached 867,220, with total deposits exceeding one billion Malaysian dollars. The activities of Tabling Haji are managed by a Department of Finance and Investment which has six divisions, viz., finance, savings and withdrawals, securities, land and buildings, property management and computers. It has also established five subsidiary companies dealing with plantations, pilgrims' transportation, construction and housing and property management. As far as the management of funds is concerned, Tabling Haji operates as a savings and investment institution. Basically, it operates on the principle of Al-wakala al-mutlaqa (absolute power of attorney), through which the depositors give their consent to Tabling Haji to manage their deposits for the purposes of investment. It has several schemes to attract deposits, e.g., direct deposits, deposits through branches and post offices, salary deduction schemes, children's savings schemes, etc. Withdrawals are allowed up to 100 per cent of the cash balance with the fund. However, normally only one withdrawal is allowed within six months. Persons who are registered to perform the Hajj during a given year are not normally allowed to withdraw in that particular year. For making investments in accordance with Islamic principles, Tabling Haji utilizes mudaraba, musharaka and ijara as modes of investment. In order to ensure that it does not violate any Islamic principle, it used to consult The National Fatwah Committee of Malaysia. However, following the establishment of the Bank of Islam Malaysia, it utilizes the services of the Shariah Supervisory Board attached to this Islamic bank. The investments of Tabling Haji have taken four different forms: investment in shares, in subsidiary companies, in land and buildings and short-term investments. After subtracting the operating expenses and the payment of zakat, profits are distributed among the deposit-holders. Generally, the rate of dividend declared by Tabling Haji has ranged between 8 and 8.5 per cent. Although, strictly speaking, Tabling Haji is not a bank, it operates very much in a similar way to an Islamic bank. It performs two important banking functions, i.e., accepting deposits and making investments. In fact, Tabling Haji is a good example of how a specialized financial institution can work successfully in accordance with Islamic principles. The Emergence of Islamic Banks The first Islamic bank in an urban setting was established in Cairo in 1971 with the incorporation of the Nasser Social Bank, which started its operations in 1972. The bank is a public authority with an autonomous status. Its objectives are mainly social, such as the granting of interest-free loans for small projects on a profit-sharing basis, assistance to the poor and needy and loans to students for university and other higher education. Because of these social functions, the Nasser Social Bank was granted exemption from the Banking and Credit Law of 1957 in its initial stages of operation. The Bank was originally under the Ministry of Treasury, but is now functioning under the Ministry of Social Affairs and Insurance. Its capital has been provided out of the funds allocated by the President from extra-budgetary resources, appropriation from the state budget and contributions from the Ministry of Awkaf. After the Nasser Social Bank, the next to be established was the Dubai Islamic Bank in 1975. The Dubai Islamic Bank is a public limited company having its head office at Dubai, with a capital of 50 million dirhams. The governments of Dubai and Kuwait have respectively contributed 20 per cent and 10 per cent of the bank's capital. Since 1975, a number of other Islamic banks have been established in Muslim countries and in other parts of the world and are functioning successfully. Two major international Islamic holding companies, namely, the Dar al-Mal al-Islami (DMI) Trust and the Al-Baraka group control a number of Islamic banks. The DMI is a holding company registered under the laws of the Bahamas. It was established in 1981 with an authorized capital of one billion U.S. dollars divided into 10 million shares of equal value. Today the DMI is operating in a number of Islamic countries' international financial centers through a network of Islamic financial institutions which include Islamic investment companies, Islamic banks and Islamic insurance companies. The Al-Baraka group was established in 1982. It has 12 affiliates and financial interests in a number of sister institutions. There are certain Islamic banks in the Gulf region, such as the Dubai Islamic Bank, the Kuwait Finance House and the Qatar Islamic Bank, which do not belong to any one of these holding companies. There are also Islamic banks in some other Islamic countries, such as Malaysia and Bangladesh, which have been established with the active support of the governments of these countries. A number of Islamic banks are also functioning in non-Muslim countries, such as the Philippine Amanah Bank, the Islamic Bank International in Denmark and the Islamic Finance House Universal Holding in Luxemburg. In addition, a few conventional institutions are operating so-called "Islamic windows", through which they offer to their clients certain services using various Islamic financing techniques. Among them, the National Commercial Bank of Saudi Arabia, and the Bank Misr of Egypt deserve special mention. Business Practices of Islamic Banks Islamic banks, like other banks, attract financial resources from individuals and institutions and direct them towards business firms which need external finance to support their productive activities. Thus, Islamic banks perform the same function of financial intermediation as is performed by the traditional banks. The basic difference between Islamic banks and interest-based banks lies in how these functions are performed, i.e., how they raise financial funds and how they use them. For the sake of analytical convenience, let us distinguish between the sources and uses of funds. 1. Sources of Funds of Islamic Banks It is well known that interest-based banks accept deposits of different maturities, paying different rates of interest on each kind. Islamic banks do not pay interest on deposits. How Islamic banks operate different kinds of deposits is described below. (a) Current Accounts
All Islamic banks operate current accounts for their customers, just as traditional banks do. These accounts govern what is known as "demand deposits" i.e., the deposits are payable on demand, without notice being given to the bank. The bank guarantees a full return of these deposits on demand. The bank may use these funds in its business operations at its own risk. Since all risk is borne by the bank, the depositors are not entitled to any share in the profits earned by the bank. (b) Savings Accounts
Islamic banks also accept savings deposits from individuals. Four different methods of operating savings accounts by Islamic banks have emerged: (i) accepting savings deposits on the principle of al-wadi'a (trust), requesting the depositors to give the bank permission to use the funds at its own risk, but guaranteeing full return of the deposits and sharing any profits voluntarily, (ii) accepting savings deposits with an authorization to invest them and sharing profits in an agreed manner for the period in which a required minimum balance is maintained, (iii) treating savings deposits as qard hasan (a benevolent loan) from the depositors to the bank and granting them pecuniary or non-pecuniary benefits, (iv) accepting savings deposits into an investment pool and treating them as investment deposits, as explained below. Generally speaking, the depositors are given a right of withdrawal without notice in savings accounts, but they are not entitled to a share in the profit for the period in which the withdrawal is made. (c) Investment Accounts
Investment deposits are the Islamic banks' counterpart of term 'deposits' in the conventional system. They are also called 'profit-and-loss-sharing' (PLS) or 'participatory' accounts. These accounts may be opened either by individuals or companies for any specified period, such as six months, one year or even longer. The depositors do not receive any interest. Instead, they are entitled to a share in the actual profit accruing from the investment operations of the bank. The profits are shared by the depositors in an agreed proportion according to the amounts of their deposits and the period they are held by the bank. As an accounting practice, the amount held in the account is multiplied by the period for which it has been employed. The profits are distributed on a pro rata basis on this product. Usually withdrawals are not allowed from these investment accounts except under special circumstances, for which some notice is required. The depositor foregoes his share of the profit on the amount withdrawn. (d) Joint/General Investment Accounts Some Islamic banks establish an investment pool in lieu of fixed-term deposits. The investment pool takes the form of a general investment account in which investment deposits of different maturities are pooled together. They are not tied to any specific investment project but are utilized in the different financing operations of the bank. The profits are accounted for and distributed at the end of the period on a pro rata basis. (e) Limited Period Investment Deposits Some Islamic banks also accept investment deposits for a specified period determined by mutual consent between the depositor and the bank. The contract may terminate at the end of the period, but profits are distributed and accounted for at the end of the financial year. (f) Unlimited Period Investment Deposits These investment deposits are automatically renewable without specifying the period. They can be terminated by giving a specified period of notice to the bank, usually three months. No withdrawals or increases in the amount of the deposit are permitted during this period. Profits are calculated and distributed at the end of the financial year. (g) Specified Investment Deposits Some Islamic banks have evolved an investment deposit scheme with specific authorization to invest in a particular scheme or a specific trade. The profits of the specific activity are distributed between the depositor and the bank. In such case, the bank works as an agent of the investor. It may agree to perform this function against an agreed fee or may opt to have a share in the profit. 2. Uses of Funds by Islamic Banks Islamic financing techniques mark a significant departure from traditional banking. This is mainly because of the prohibition of interest. Most traditional banks use lending on interest as their major financing tool, which is modified with respect to interest rate charged, period of loan, conditions of repayments, etc., to suit the requirements of various clients and different sectors. Since Islamic banks cannot use lending on interest as a financing device, they have to find innovative ways of financing which do not involve interest. Consequently, Islamic banks have drawn upon the rich treasures of the Islamic theory of contracts for financing techniques which conform to various requirements of the Islamic Shariah. These contracts were originally devised for commodity trade and deal with the contracts between two individuals. The application of these contracts at the institutional level and in the financial sector is a new phenomenon. In the course of these applications, some of the contracts have been slightly modified from the point of view of Islamic jurisprudence. However, this is not the place to discuss the judicial nature of these contracts. Instead, the present discussion will be confined to the application of these contracts to the financial sector, as actually put into practice by contemporary Islamic banks. Financing techniques used by Islamic banks may be summarized as follows: (a) Murabaha (mark-up or cost-plus-based financing)
This is the most popular technique of financing among Islamic banks. It has been estimated that 80 to 90 per cent of the financial operations of some Islamic banks belong to this category. It works in the following way: The client approaches the Islamic bank to finance the purchase of a specified commodity. The bank, either itself or through an agent (who could be the client himself), collects all the required information about the nature and specification of the commodity, its price, names of dealers, etc. The bank informs the client of these details as well as of the margin it would like to charge on the original price. If these conditions are acceptable to the client, a murabaha contract will be signed between the bank and the client. The bank will purchase the specified commodity from a seller of its choice, paying the price of the commodity in cash. If a sale deed is required (e.g., in the case of a car or a house), the registration is done in the name of the bank. Once the ownership of the commodity is transferred to the bank, it sells the commodity to the client on a deferred payment basis against an agreed price. The new price at which the bank sells the commodity to the client is the original price (which is the cost to the bank) plus the markup the bank is charging (which is its profit margin). The client pays this price, either in installments or in a lump sum, at an agreed later date. It should be noted that there are certain requirements for the murabaha contract to be valid. It is necessary for the profit margin (the mark-up) the bank is charging to be determined by mutual agreement between the parties concerned. Similarly, the goods in question should be in the physical possession of the bank before being sold to the client. Thirdly, the transaction between the bank and the seller should be separate from the transaction between the bank and the purchaser. There should be two distinct transactions. That is why certain Islamic banks effect a murabaha transaction in two stages, using two separate contract forms. The first form is a request to the bank through which the client informs the bank of his intention to carry out the murabaha. In this contract, the client promises to buy the goods from the bank. It should be noted that a promise is not legally enforceable. Hence, the client can change his mind and the bank runs the risk of losing the money it has invested in this particular murabaha. The second contract deals with the sale of the goods by the bank to the client on a deferred payment basis, the terms and conditions of which are clearly spelt out in the contract form. The murabaha form of financing is being widely utilized by Islamic banks to satisfy various kinds of financing requirements. It is used to provide finance in various and diverse sectors, e.g., in consumer finance for the purchase of consumer durables, such as cars and household appliances, in real estate to provide housing finance and in the production sector to finance the purchase of machinery, equipment, raw materials, etc. However, the most common use of murabaha techniques is to finance short-term trade. Murabaha contracts are also used to issue letters of credit and to finance import trade. (b) Musharaka (Partnership)
Musharaka (partnership) is another type of financing utilized by Islamic banks. In this form of financing, two or more financiers provide the finance for a project. All the partners are entitled to a share in the total profits of the project according to a ratio which has been mutually agreed upon. However, any losses are to be shared exactly in proportion to the capital contributed. All the partners have a right to participate in the management of the project. However, they may also waive this right in favor of any specific partner. There are two main types of musharaka: permanent musharaka and diminishing musharaka. In the first case, the bank participates in the equity and receives an annual share of the profit on a pro rata basis. The period of termination of the contract is not specified, so it can continue as long as the parties concerned wish it to continue. The technique of diminishing partnership is getting quite popular with Islamic banks because of its potentialities. In permanent musharaka, funds may be committed for a long period, but this is not so in the case of diminishing musharaka. Diminishing Musharaka allows equity participation in the first place and a share of the profit on a pro rata basis. The contract also provides for the payment of a further sum of money over and above the bank's share in the profits as a repayment of part of the equity held by the bank. In this manner, the equity held by the bank is reduced progressively over time. After a certain period of time, the bank will have zero equity and will cease to be a partner. Islamic banks have found this approach quite suitable for financing commercial buildings. Islamic banks in Sudan have evolved yet another application of musharaka which has tremendous potential for rural and agricultural development in the Islamic countries. The Sudanese Islamic Bank has been experimenting in providing finance to farmers under musharaka arrangements. This works in the following manner: The SIB and the farmer enter into a musharaka contract under which the bank provides the farmer with fixed assets such as ploughs, tractors, irrigation pumps, sprayers, etc., and working capital in the form of fuel, oil, seeds, pesticides, fertilizers, etc. The farmer's equity is confined to the provision of land, labor and management. Since it is a partnership contract, there is no need for collaterals or other guarantees other than personal guarantees. Initially, the farmer is paid thirty per cent of the net profit as a compensation for his management. The rest of the net profit is shared between the bank and the farmer on a pro rata basis for each side's respective share in the equity. The musharaka technique of financing is also utilized to finance domestic trade and imports and to issue letters of credit. (c) Mudaraba (Profit-Sharing) Several theorists of Islamic banking have postulated that mudaraba should be a dominant mode of financing in the scheme of Islamic banking. However, this technique, because of various conceptual, practical and legal hindrances, has not found wide application by the Islamic banks. The Jordan Islamic Bank (JIB) is one of the few banks which use mudaraba as a financing technique. The JIB utilized two types of mudaraba: individual and joint. In the case of individual mudaraba, the JIB provides finance to a commercial venture run by an individual or by a company on the basis of profit-sharing. The joint mudaraba may be between the investors and the bank on a continuous basis. The investors keep their money in a special fund, which is operated by the bank in continuous joint financing. The investors receive a proportionate share of the net profit realized even, without the liquidation of those financing operations which have not reached the stage of final settlement. (d) Ijara (Leasing)
Leasing is also one of the approved methods of earning income according to Islamic law. In this method, a real asset such as a machine, a car, a ship, a house, etc., can be leased by the lessor to the lessee for a specified period against a specified price. The benefit and cost relating to each party should be clearly spelt out in the contract so as to avoid any element of uncertainty (gharar) with respect to the responsibility of each party. Leasing is emerging as a popular technique of financing among Islamic banks. Some of the important Islamic banks which use leasing as a technique of financing include the Islamic Development Bank, the Bank Islam Malaysia and the commercial banks in Pakistan. Under this scheme of financing, the bank purchases a real asset (the bank may even purchase the asset as per the specifications provided by the prospective client) and leases it to the client. The period of lease may be determined by mutual agreement according to the nature of the assets. In general, it may be anywhere between three months and five years or more. During the period of the lease, the asset remains in the ownership of the bank, but the physical possession of the asset and the right to use it are transferred to the lessee. After the expiry of the lease agreement, the ownership of these assets may be passed to the lessee. At present, Islamic banks are experimenting with various forms of leasing, one of which is the lease-purchase agreement. In this scheme, the lessee can purchase the equipment at the end of the lease period at an agreed price. In certain cases, the rental paid during the period of the lease may constitute part of the price. (e) Loans with a Service Charge
Some Islamic banks give loans with a service charge. The Council of the Islamic Fiqh Academy, established by the Organization of the Islamic Conference, in its third session held in Amman from 11-16 October 1986, in response to a question from the Islamic Development Bank, resolved that it is permitted for a bank to charge a fee for loan-related services. However, this fee should relate to actual expenses and any fee in addition to the actual service-related expenses is forbidden because it is considered to be usurious. Hence the amount of the service charge should be carefully calculated. According to this ruling, it may be calculated in the following manner: Actual administrative Service expenditure x 100 charge (%) = Average Assets during the period
Al + A2 Average assets = 2
where Al = Total assets at the beginning of the period A2 = Total assets at the end of the period.
It may be noted that the service charge can be calculated only at the end of the period, because it is only then that- the actual expenditure on administration will be known. Under the circumstances, it is possible to levy an approximate service charge on the clients, then reimburse or reclaim, the difference at the end of the period when the actual expenses on administration are known. (f) Qard hasan (Interest-Free Loans)
Most Islamic banks also provide interest-free loans (qard hasan) to their customers. However, practices differ in this respect. Some banks provide the privilege of interest-free loans to the holders of investment accounts at the bank. Other banks provide interest-free loans to needy students and other economically weaker sections of society. Yet others provide interest-free loans to small producers, farmers and entrepreneurs who are not qualified to receive financing from other sources. The purpose of these interest-free loans is to help them to become independent or to raise their incomes and standard of living. In Pakistan, a distinction is made between ordinary loans, which are granted with a service charge and qard hasan loans, which are granted without any service charge. Some Misconceptions about Islamic Banking It should be clearly understood that Islamic banking is one of several institutions in the Islamic economy. However, it is neither a necessary nor a sufficient condition for the existence of an Islamic economy. In certain quarters, there is a misconception leading to the naive belief that advocates of an Islamic economy want to establish an Islamic economic system just by establishing a few Islamic banks here and there. For example, a German observer of the Islamic banks scene remarks: "The hope is that the Islamic banks will turn out so successful in economic terms, i.e., so profitable for capital owners as well as depositors and without any adverse, but a number of beneficial, effects for the funds demanding entrepreneurial partners of the bank that (in the long run) everybody will turn away from interest banks and towards Islamic banks. The result would be an evolutionary instead of a revolutionary transformation of the economic order, basically caused by individual decisions and market forces and not by political decisions and government intervention." One should keep in mind that banking activity is required only when the economy has achieved a certain level of development, resulting in the separation of savers and investors. Hence, it would be possible to have an Islamic economy in which savers and investors were the same people. In such an economy, banking, which is necessarily a form of financial intermediation, would become redundant. Thus, theoretically, an Islamic economy may exist without Islamic banking. However, in practice, it remains one of its important ingredients. We may say, then, that Islamic banking is neither a necessary nor a sufficient condition of an Islamic economy. This assertion should not, however, be confused with the prohibition of riba, which is a necessary condition for the existence of an Islamic economy. The significance of an Islamic banking institution is that it aspires to perform the same functions as those of modern commercial banks without indulging in riba. To this extent, Islamic banks provide an alternative to interest-based banking for religious reasons. If there are certain other economic advantages accruing from their functioning on a basis other than interest, they only add to the usefulness of Islamic banks as an institution. Similarly, nothing forbids Islamic banks to carry out, in addition to their normal banking functions, other functions, which would contribute towards establishing the Islamic economic order and propagating the most cherished Islamic values in the field of economic and business activities. But it would be presumptuous to think that the mere establishment of a few Islamic banks would automatically lead, through market forces or otherwise, to the establishment of an Islamic economy. Concluding Remarks The Islamic banking system, which has emerged during the past decade and a half, is still in its early stages of development. It has succeeded in establishing the feasibility of banking on a basis other than the interest rate. However, it has a long way to go. Even the western commercial banking system was not created instantaneously. It was evolved over a long period of time necessitating learning from past mistakes and continually improving banking and financing techniques. Similarly, the techniques of Islamic banking cannot be created in a short span of time. They will have to be evolved. It is heartening to note that there is evidence suggesting that Islamic banks are not only willing to discuss various issues facing their development, but are also taking the necessary action. For example, one difficulty facing the healthy growth of Islamic banking is the dissimilarity of accounting practices among different Islamic banks. It should be noted that existing Islamic banks have to function under different types of social environments and heterogeneous economic milieux. They have to put up with different types of official requirements regarding accounting practices. This results in a dissimilarity of accounting practices among different Islamic banks to the extent that any meaningful comparison between the balance sheets or profit-and-loss accounts of two different Islamic banks becomes very difficult, if not impossible. The concepts used in the balance sheets or income statements are not rigorously defined. In order to rectify this situation, various Islamic banks, under the guidance of the Islamic Development Bank, have taken the necessary steps to establish a juridical organization which will be called, "The Financial Accounting Organization of Islamic Banks and Financial Institutions". This organization will be composed of a Supervisory Committee and a Financial Accounting Standards Board and will be responsible for preparing, issuing and amending the accounting standards of those Islamic banks and Islamic financial institutions which have agreed to apply the standards set up by the Board. The Board, along with some technical subcommittees, will also have a Shariah Committee, which will review the proposals for financial accounting standards and practices in respect of their conformity to the Islamic Shariah. It is hoped that the establishment of a financial accounting organization for Islamic banks and financial institutions will improve the technical capabilities of the Islamic banks as financial institutions and will lead to the development of sound financial practice. The establishment of this organization certainly augurs well for the future development of Islamic banking. |
