INTRODUCTION

The money and banking system should, like other aspects of the Islamic way of life, not only contribute to the achievement of the major socio-economic goals of Islam² but also perform the functions that relate to its own special field. The principal goals and functions are as follows:

(i) Broad-based economic well-being with full employment and optimum rate of economic growth.

It may be asked at this point whether the goals of Islam as stated above, are not the same as those of capitalism. On the surface they may appear to be the same but in essence there is a fundamental difference arising from the differences in the roots of the two systems -the Islamic economic system is morally-based while capitalism is secularist and moral Iv-neutral. The ensuing discussion should help to make this point clearer.

(i) Economic well-being with full employment and optimum rate of growth. Islam is not an ascetic religion. It takes a positive view of life, based on the belief that human beings are the vicegerents of God. Man must therefore lead a life that befits his status and the Divine Guidance embodied in Islamic teaching is intended to help him in the realization of this objective. It is designed to make life richer and worth the living, and not poorer, full of hardships. Hence, Muslim jurists have unanimously held the view that the welfare of the people and the relief of their hardships are the basic objectives of the Shari’ah. This view, when applied to the economic aspect of life, implies economic well-being through satisfaction of all basic human needs removal of all sources of hardship and discomfort, and improvement in the quality of life. In fact, any struggle intended to fulfil basic human needs, to remove misery and to make life a blessing has been equated by Islam with an act of virtue. Thus full and efficient employment of human resources is an indispensable goal of the Islamic system, as it helps realize the objective of broad based economic well-being and also imparts to human beings the dignity demanded by their status as God's vicegerents. Full and efficient employment of material resources is also essential, because according to Islam all resources in the heavens and the earth are meant for human welfare and need to be exploited adequately, without excess or wastefulness, for the purpose for which they have been created.

While a high rate of economic growth should be the natural result of policies leading to full and efficient employment of human and material resources and broad based economic well-being, it is not of prime importance if it entails the production of inessential or morally undesirable goods and services, excessive and overly rapid use of God-given resources at the expense of future generations who are equal owners of these resources, and degeneration of the moral or physical environment. A high rate of growth is only essential to the extent to which it contributes to full employment and broad-based economic well-being but beyond this its importance would have to be carefully weighed against all its other implications.³

(ii) Socio-economic justice and equitable distribution of income and wealth: The goals of socio-economic justice and equitable distribution of income and wealth are an integral part of the moral philosophy of Islam and are based on its unflinching commitment to human brotherhood. The capitalist conversion to socio-economic justice and equitable distribution of income, on the contrary is based not on a spiritual commitment to human brotherhood but on expedience arising from group pressures. Accordingly, the system as a whole, particularly its money and banking arrangement, is not geared to these goals, and gaining disparities of income and wealth continue to be generated. Nevertheless, because of the influence of socialism and political pressures, some of these inequalities are being partly reduced by taxation and transfers. In contras, Islam tries to upshot the causes of gross inequalities at their source, also using Zakat taxation and transfers as additional measures to reduce inequalities even further to bring about a distribution of income which is in conformity with its concept of human brotherhood. Hence, it is essential that the money and banking system and monetary policy are so designed that they are finely interwoven into the fabric of Islamic values and contribute positively to the reduction of inequalities.

(iii) Stability in the value of money: Stability in the value of money should be an important goal in the Islamic frame of reference because of the unequivocal stress of Islam on honesty and fairness in all human dealings and the adverse effect that inflation tends to have on social justice and general welfare. Inflation implies that money is unable to serve as a just and honest unit of account. It makes money an inequitable standard of deferred payments and an untrustworthy store of value, and enables some people to be unfair to others, even if unknowingly, by stealthily eroding the purchasing power of monetary assets. It thus imposes a welfare cost on society by reducing the efficiency of the monetary system. It tends to pervert values, rewarding speculation (discouraged by Islam) at the expense of productive activity (idealized by Islam) and intensifying inequalities of income (condemned by Islam). Moreover, inflation conflicts with Riba-free economy, because it corrodes its raison detre of social justice. Although Islam urges justice to the borrower, it does not approve of injustice to the tender. Inflation undoubtedly does injustice to the Riba-free lender by eroding the real value of Qard Hasan.

It may be suggested that in the current world-wide inflationary climate the Islamic imperative of socio-economic justice could be satisfied by indexation, or monetary correction, of all incomes and monetary assets including Qard Hasan. Proper monetary correction would, however, require the indexation not of income or monetary assets but of purchasing power, which is determined by the Consumption and investment pattern of individuals. Socio-economic justice would hence require the indexation of income and monetary assets by the use not of one universal index but of several indices based on different expenditure patterns. In contrast with this, widespread index-linking of incomes and monetary assets, based on even one universal index has not been found to be feasible, because of the complexities involved and the high administrative costs of implementation. Hence indexation of only some incomes and monetary assets has been tried. The widest use of indexation has been in the field of wages, salaries and pensions. Indexation has also been tried for some financial assets (e.g., bank loans and deposits, and Government bonds), taxes, rents and mortgages.⁴

While indexation might help ameliorate partially the inequities arising from inflation, it is not a cure for inflation. It may, in fact, tend to accelerate inflation.⁵ It may well be self-defeating, unless inflation is on the decline and remedial monetary, fiscal and incomes policies are being adopted.⁶ It seems, therefore, that while indexation may be feasible to a limited scale and may be resorted to as a temporary, sedative for the pain of inflation the policy alternative, which would best conform to the norm of socio-economic justice emphasized by the Shari’ah, is price stability and not indexation.

Indexation of Qard Hasan has so far been rejected by the Fuqaha because they generally consider it similar to Riba in its essence. Their opposition to indexation of Riba-free loans is also defensible on economic grounds because even though it is proposed with the innocent objective of doing justice to the Riba-free lender, it has the potential of initiating gross injustice to the borrower.⁷

While inflation is in conflict with Islamic values, prolonged recession and unemployment are also unacceptable because they bring misery to certain sectors of the population and act counter to the goal of broad-based economic well-being. A recession also tends to increase uncertainty and discourages investors from undertaking risks associated with projects that earn a return over many years. Hence in the interest of achieving the overall objectives of Islam, it should be considered obligatory for the Islamic State to eliminate or minimize economic fluctuations and to stabilize the value of money.

A generally accepted principle in capitalist economies is a trade-off between unemployment and inflation. In the context of Islamic values, such a trade-off is questionable, for Islam rejects both unemployment and inflation. Moreover, it is doubtful whether it is essential to have inflation to achieve full employment or to have unemployment to avoid inflation.⁸

In the Islamic system both unemployment and inflation are-undesirable, and both need to be eschewed even though this may require a fundamental change in economic relationships. If aggregate demand is to be contained or lowered to avoid inflation, then in the overall interest of social justice and broad-based economic welfare a value judgement needs to be made about which demand should be contained or reduced and how. In a value-oriented system it would be indefensible to allow demand to expand in inessential directions to attain a high rate of economic growth and, if this generates inflation, it would be equally indefensible to try to control it by reducing aggregate demand in a general across- the-board manner by creating human unemployment.

Similarly full employment must be ensured even if this demands a restructuring of production and designing of suitable technology. Hence it would be essential to regulate aggregate demand restructure production design a suitable technology and have an appropriate mix of monetary, fiscal and incomes policies in order to avoid both inflation and unemployment and to ensure broad-based economic well-being with a realistic rate of economic growth.

(iv) Mobilization of savings. The goal of mobilization of saving is essential because Islam categorically condemns boarding of savings and demands their productive use for the realization of the socio-economic goals of Islam. Nevertheless, it is not possible for every saver to employ his savings productively. It would therefore be in the nature of fulfilling Islamic teachings if efficiently-organized financial institutions mobilize idle savings and channel them efficiently into productive uses. Such institutions should be properly equipped to be generally able to meet the genuine, non-inflationary needs of both the public and the private sectors.

However, Riba or interest has been prohibited by Islam and neither the saver nor the user of savings is allowed to receive or pay Riba, defined by the Fuqaha as a predetermined positive rate of return on savings or loans. Profit, which may be positive or negative and which is not predetermined,⁹ is recognized by the Fuqaha Hence in the interest of implementing Islamic teachings it is necessary to organize a banking system which mobilizes savings and yet operates on the basis not of Riba as in the capitalist system, but by sharing the net outcome be it profit or loss.

Moreover, if the economy is unable to generate adequate demand that would ensure gainful employment of idle physical and human resources, then the system should be able to bring about a sufficient monetary expansion within a non-inflationary framework.

(v) Rendering other services: The system should not only be able to mobilize savings effectively and allocate them efficiently for their optimum productive use to meet the needs of a growing and healthy economy, but also be able to develop primary and secondary money markets, render all banking services to the public at least as efficiently as the existing banking institutions and fulfil the non-inflationary financial needs of the government.

The development of both primary and secondary markets is essential for efficient mobilization of financial resources. While the existence of primary markets is needed for providing financial resources to those who can employ them productively, the existence of secondary markets is essential to help savers and investors "liquefy" their investments whenever they feel the need to do so. The absence of a secondary market would compel savers to hold larger balances for precautionary motives thus increasing hoardings and reducing the rate of economic growth by preventing savings from performing their natural role.

2B. Some Fundamental Reforms

The range of objectives mentioned above would call for a fundamental reform of the economic system in general and the money and banking framework in particular. While this reform would include the abolition of Riba as an indispensable element, it would also include the introduction of some essential changes in the economy and the banking system. Some of the essential reforms, without which it would be difficult to achieve the socio-economic objectives of Islam, are briefly indicated below.

(i) Avoidance of wasteful spending and conspicuous consumption: Moderation is the core of the Islamic message which emphatically discourages extravangance and conspicuous consumption. However, in keeping with its universal and rational approach to problems. Islam has enunciated qualitative and not quantitative restrictions on consumption. The expenditure should be befitting a Muslim who is morally conscious and humble at heart.

Since Islam wishes to foster social equality and brotherhood any behaviour pattern that destroys or weakens these values must be avoided. All expenditures undertaken with the intention of showing off or displaying pomp and grandeur and reflecting arrogance have the effect of widening, rather than narrowing the social gulf between the rich and the poor, and have been condemned by Islam. Said the Prophet (peace be upon him): "God does not look at those who wear clothes reflecting arrogance".¹⁰ "God has revealed unto me to teach you to be humble so that no one wrongs others or shows arrogance".¹¹

While wasteful spending has been discouraged hoarding of savings has also been unequivocally condemned by the Qur'an as well as by the Sunnah. God-given resources are meant to be used for one's own benefit (within limits prescribed by Islam) as well as for the benefit of others, thus fulfilling the very purpose of their creation. Leaving them idle without using them for rightful consumption or for fostering the common good through welfare contributions (e.g., Zakat, Sadaqat, etc.) or for productive investments has been condemned by Islam. "And there are those who bury gold and silver and spend it not in the way of God; announce to them a most grievous penalty- (the Qur'an, 9:34). The Prophet (peace be upon him) disapproved of leaving productive resources idle saying: "Let him who owns land cultivate it himself; if he does not cultivate it himself let him have his brother do so".¹² Khalifa Umar also used to exhort Muslims, saying:" Hewho has money let him invest it, and he who has land let him develop it"¹³

The money and banking system should be so organized and regulated that wasteful spending is not promoted and savings are mobilised and channelled into socially productive uses. Under no circumstances should it encourage or facilitate the production or consumption of goods and services that carry a lower priority in the Islamic value system. The deposits used by banks to advance loans belong to society and should be so allocated that they help finance the production and distribution of all essential needs of society before funds are made available for other purposes. The capitalist virtue of abstaining from making value judgements should have no place in the Islamic system. There is no escape from values which have been prescribed by the Qur'an and the Sunnah. Hence the capitalist criterion of equalizing the marginal rate of return on all investments to attain "efficiency", irrespective of the social priority of goods, tends to bring about a lower than "optimum" production of essentials, because scarce funds get diverted to the production of luxuries.¹⁴ "Efficiency" needs to be understood within the context of the overall ethos of the value system and not just of the variable of interest and profit.

The values of avoiding wasteful expenditure and using resources efficiently in accordance with Islamic values apply not only to individuals but also to the government and more so because governments use resources which are provided to -them by the people as a trust to be used for the welfare of the people in accordance with Islamic teachings. The criterion for undertaking any government expenditure should be that the total sacrifice made by society in providing the resources is at least offset by the positive contribution to general social welfare and the realization of the socio-economic goals of Islam.

(ii) Increased equity financing: The obligation to abolish interest would make it indispensable that there be primary reliance on 'equity capital and little dependence on borrowed money in an Islamic economy. The Islamic economy would thus have to be essentially equity-based, compared with capitalism which is predominantly loan-based and in which a vast superstructure of finance is usually raised on a small foundation of equity capital in the style of an inverted pyramid.¹⁵ Business in an Islamic economy would have to rely on equity for mustering additional financial resources. All financial needs of a permanent nature, whether for fixed or working capital would have to come out of equity and not from borrowings from banks; it is not of material significance whether this increase in equity is by way of joint-stock companies or partnerships. Resort to borrowing should be allowed only to the extent of bridge -financing and temporary shortages of funds resulting from seasonal peaks in business. Under normal circumstances, there would be no justification for medium or long-term borrowing in an Islamic economy. Dependence on borrowing implies that either the owner of the business is not willing to share the ownership and the fruits of his expanding business with others or that the lenders are not willing to share in the risks of business and wish to have a predetermined positive rate of return both of which constitute undesirable traits in a Muslim society.

There is no doubt that the jurists have recognized Mudarabah.¹⁶ However, a deeper analysis of the concept of Mudarabah reveals that it is essentially an investment-management agreement. The Sahib al-Mal (capital contributor or investor) is basically not the lender but the owner of the business to the extent of his share in the total financing of the business. The Mudarib (manager or entrepreneur) manages the investment funds placed at his disposal by the Sahib al-Mil in accordance with the Mudarabah agreement, Mudarabah is a form of equity which is temporary in nature and is liquidated as soon as the objectives are realized. The liability of the Sahib al-Mal is limited to the extent of his capital and no more.¹⁷ In accordance with the rationale behind the prohibition of Riba, the manager of Mudarabah funds is not entitled to a fixed return for his management services irrespective of what happens to the business. If there is a profit, he shares the profit in an agreed proportion as a reward for his managerial and entrepreneurial services. If there is a loss, he gets no reward, and his loss amounts to the opportunity cost of his services. However, he shares the loss if he has a share in the equity of the business, but only to the extent of his share because losses according to the Fuqaha constitute erosion of equity. This fits perfectly into the rationale of the Islamic model of Riba free economy and implies that the spirit of business relationship preferred by the Shari'ah is "investment-management" and not "borrowing- lending", taking into account the modern connotation of these terms.

Equity-financing in place of loan-financing will help eliminate the possibility of a large superstructure of finance being raised on a narrow equity base. It would help bring about a wide dispersal of ownership of business and contribute substantially to the realization of the goal of equitable distribution of income and wealth. It may, however, be remarked that even when ownership is widely dispersed, the large number of small shareholders may have neither the ability nor the inclination to participate in the decision-making process. This tends to lead to the concentration of power in the hands of a few persons in large enterprises. Since competition tends to be inadequate, particularly when the enterprises are very large, and regulations can be circumvented, the general tenor of business in an Islamic economy should preferably be small and medium-scale. "Big" business should be allowed only when necessary in the larger interest of society. In such cases, the state should intervene more effectively, to safeguard public interest and to ensure that vested interests do not exploit the "bigness" for their private benefit.

(iii) Reducing the power of banks: In the capitalist framework, society’s resources mobilized by banks are utilized by them for enriching a few families. One of the primary reasons why banks tend to become the centers of control under capitalism is that capitalists who operate through a bank -obtain access to other people's "capital".¹⁸"TheRockefellers and Mellons can thus control corporate empires of far greater worth than their own personal fortunes" and, "it is not surprising that the wealthiest and most powerful capitalists operate through banks".¹⁹

The inverted pyramid of power in the banking system arises from the low equity base, on top of which rest "primary" deposits that support a substantially large volume of "derivative" deposits. The equity of banks in the capitalist banking system is usually very small. Shareholders of all U.S. commercial banks holding equity worth $73.1 billion (stocks worth $16.4 billion plus surplus. undivided profits. and reserves against contingencies worth $56.7 billion) in 1976 had control of total assets worth over $1,040 billion or fourteen times as much.²⁰ People who had real control over these assets owned a substantially smaller proportion of the total stock of 16.4 billion:

The net income of banks from their operations may tend to be no more than "normal-for the ordinary stockholder but the "privileged" few who control bank operations derive considerable personal benefits through various clandestine methods which are difficult to check and control. Through their immense economic power they are also able to exercise political and social influence which makes them among the most powerful members of their society.

The equity capital of banks in the capitalist system tends to provide generally less than even the infrastructure needs of commercial banks except where an equity/deposits ratio is legally prescribed. In contrast to this, banks in an Islamic economy. If they are to remain in the private sector, should operate on a substantially larger and more widely-owned equity base with a view to dispersing the controlling power of total bank assets over a larger and more broad-based sector of society. No single family or group should be allowed to hold more than a certain maximum proportion of total shares and no holding companies should be allowed in the banking business. Moreover, members of the board of directors or management of banks should not be allowed to become directors or managers of other businesses to avoid concentration of power in society. This will help disseminate the power wielded by the banks reducing concentration of wealthy the hands of a few families.

In the existing system, the power to issue currency is exercised by the central bank, while the power to "create" deposits is enjoyed by the totality of commercial banks with some indirect controls exercised by the central bank. Hence total deposits consist of "primary" deposits which provide the banking system’s reserves held in the form of cash or deposits with the central bank, and "derivative" deposits arising from the process of commercial bank credit extension. In the US, "primary" deposits amounted to 129.3 billion in 1976, and constituted only about one-sixth of total deposits. This implies that "derivative" deposits constituted five-sixths of total deposits.

Derivative deposits thus constitute a major part of total money supply (currency plus deposits) in the capitalist system. The creation of these deposits gives rise to a subsidy or "seigniorage" (the difference between the return on, or purchasing power of created money and the costs incurred in its creation) from society to the commercial banks.²¹ The question is: who should benefit from this subsidy? In the existing system, the subsidy goes directly or indirectly to three groups: (a) the banking public through the provision of a number of banking services free of charge: (b)"privileged-borrowers from banks through the lower rate of interest the loss to society being the difference between the opportunity cost of created money to society and the "prime" rate of interest; and (c) the bank stockholders through increased profits.²² The poor and the needy people of society and the non-banking public get no direct benefit from deposit creation.

It can he argued that in the social welfare-oriented value system of Islam, the power to create money should be considered a social prerogative and. Therefore, the net income from money creation should be used for general welfare and particularly, for improving the tot of the poor people.²³ There are two ways in which this may be arranged.

Firstly, bank credit should be used for broad-based economic welfare by being directed to an optimum number of borrowers for the production of goods and services required for satisfying the needs of the mass of society. The criteria for its allocation, as of other God-given resources, should first be the realization of the goals of Islamic society and then the maximization of direct nominal profit. This would, of course necessitate value oriented planning in accordance with values and goals of Islam and dovetailing the commercial banking system into the plan for its efficient implementation.

Secondly, the total of derivative deposits rather than just central bank credit to commercial banks should be considered as Mudarabah advances to commercial banks. If commercial banks are nationalized, the total net income will go to the public exchequer automatically. If the commercial banks continue to remain in the private sector, the net income arising from "derivative" deposits should be passed on to the state after allowing for the Mudarabah share of commercial banks, determined in accordance with an agreed formula. This entire income should be used by the state for social welfare projects, particularly those benefiting "the orphans and the needy" so that in the words of the Qur’an. "Wealth does not circulate among your rich- (59:7).

The objection could be raised that the proposed scheme could have the effect of making banking unprofitable and hence unattractive. This objection is not valid. Of the three beneficiaries from credit creation, the one to be affected most will be the privileged "prime" borrowers who will have to pay a higher rate of return in the form of profit to the banks because their productivity is "claimed" to be higher. Hence the net residual rate of return of such "privileged" borrowers will be smaller by the difference between the rate of Mudarabah profit they will pay to the banks in the Islamic system and the "prime" rate of interest they pay to the banks in the capitalist system. Of the other two beneficiaries from credit creation, the users of bank services may continue to benefit to the extent to which the benefit derived by them is accompanied by a high rate of social return. For example, checks may continue to be cashed freely if this benefits society generally through the spread of the banking habit and the mobilization of savings. However, to the extent to which the benefit from bank services is confined to individuals or firms and is not widespread, the users should be made to pay the cost of these services. The normal stockholders of banks should be able to get a reasonably attractive rate of return and the Mudarabah ratio of profit sharing on derived deposits can be adjusted to ensure this. The only sufferers from the proposed scheme will be (a) the "privileged" borrowers and users of those bank services which yield private benefit but have a low, or no, social return and (b) bank stockholders to the extent to which they earn a higher than "normal" rate of return on their equity. The general public would benefit through a more goal-oriented allocation of credit as well as through the Mudarabah profit diverted to the state.

(iv) A sane stock market: A greater resort to equity financing in the Islamic economy will necessitate a more efficient organization of both primary and secondary capital markets to enable businesses to raise funds without difficulty and to provide liquidity to investors who cannot or do not wish to, hold the equity they have acquired. Development of an extended primary market will be difficult if a secondary market is not developed simultaneously. One of the first essentials for this purpose would be to bring about rational behaviour in stock prices with reasonable rates of dividend to inspire investors’ confidence in stocks and shares. Stock markets as they exist in the capitalist world, with erratic movements in stock values and low rates of dividend, do not offer an attractive let out for investors. They tend to make interest-bearing bonds with no risk of capital loss increasingly more popular.

A number of factors generate erratic and unhealthy movements in stock prices. One of these is destabilizing speculation. What specific remedial measures need to be taken to eliminate unhealthy speculation? This is a separate subject beyond the scope of this paper. However, the abolition of Riba will help eliminate speculation based on funds borrowed from banks for speculative purposes. In addition, it would be necessary to regulate all dealings in the stock markets in the light of Islamic teachings to eliminate all those unhealthy practices which create destabilising conditions or hurt the public interest.

Even though the proper organization of stock markets for increased equity financing of businesses is a key element in the proper organization of an economy along Islamic lines, this subject has unfortunately received scant attention from Muslim scholars and increased research needs to be encouraged.

It seems that only through an introduction of these fundamental changes could the banking system be made to serve the socio-economic goals of Islam. A mere replacement of Riba by profit-sharing will not serve the purpose although it could itself be welcome as it would help provide the necessary experience in Riba-free banking and could also set the way for bringing about the other major reforms later. Nevertheless, it must be borne in mind that such institutions, operating on a small scale in a hostile interest-based capitalist environment with lack of conviction on the part of the ruling 'elite' in the workability of the Islamic system, may find it difficult to survive. The failure of such institutions, if it happens, should not be construed as failure of the system because such institutions operating in an un-Islamic environment do not represent the system but only the struggle of an embryo to survive in hostile surroundings without support systems.

Such a system of banking poses a number of problems and difficulties, some of which may at first sight appear to be insurmountable. It may be useful to indicate some of the major problems that Islamic banking is likely to face to evaluate the nature and significance of these problems, and to discuss the possible ways of solving them.

(i) Losses incurred on deposits:

With respect to demand deposits, which would give no return, the problem could be solved by a system of deposit insurance which guarantees the safety of demand deposits from any loss that the bank may suffer. Some elements of such a system of deposit insurance are discussed later. With respect to time and savings deposits, the problem would still remain because of losses suffered by businesses financed by banks on the Mudarabah basis.

It is sometimes argued that banks may not have the relevant data and the technical know-how to evaluate the profitability of thousands of businesses they could be financing. This is not a valid objection because even in the capitalist system banks have to evaluate the soundness of businesses to which they are lending, because if borrowers suffer losses the banks may lose the interest as well as the principal. To determine the soundness of the borrower, the capitalist bank has to take into account not only the character and integrity of the borrower, his business acumen, experience and capital resources but also the purpose of the advance, the nature and prospects of the business, and the source of repayment.²⁴ This is because a sound bank loan should be collectible from the anticipated income or profit of the borrower rather than from the liquidation of any collateral that may be pledged. The proper function of collateral is to minimize the risk of loss to the bank in the event of the borrower failing to realize, for reasons which neither the bank nor the borrower can foresee, sufficient resources to repay the loan with interest.²⁵ Hence even in the capitalist banking system there is no escape from estimating the expected income which determines the "self-amortizing" nature of the loan.²⁶ However, in the capitalist banking system the bank need not have an interest in the income of the borrower beyond that necessary for the self-amortization of the loan But in the Islamic system the determination of the exact amount of profit earned by the Mudarib would be necessary to calculate the 'bank's "share". The Islamic bank would therefore face a dual risk: (a) the "moral" risk which arises from the Mudarib declaring a loss, or a profit lower than the actual, because of lack of honesty and integrity., and (b) the "business" risk which arises from the behaviour of market forces being different from that expected.

The "moral" risk may tend to be high in the beginning when the system is newly established. However, when the users of bank funds realize that their ability to secure funds from banks depends on the profit that their business generates there should be a substantial decline in the tendency to cheat banks. Hence market forces would have the effect of' almost eliminating such a risk. Moreover, a system of random audit of users of bank funds (discussed later) could be introduced to serve as a deterrent to entrepreneurs who contemplate cheating the banks.

The business risk is also a problem for the portfolio manager of the capitalist bank because he too, has to be constantly aware of the quality of his entire portfolio and to guard against loss through market failure. Such a risk could be minimized by the Islamic bank as is done by the capitalist bank, through proper "scenario planning"²⁷ and diversification of its Mudarabah portfolio by maturities as well as by sectors of business. If the bank diversifies its portfolio properly there is little likelihood of a 'net' loss except in rare circumstances. To meet such a contingency, the Islamic bank could be required to build a "loss-offsetting" reserve from its annual profits.

(ii) Short-term loans: A second problem of the Islamic banking system could be that all financing may not be amenable to profit-sharing: for example, call loans, overnight loans, day loans, and loans of very short maturity. In such cases, it is not possible to have any profit-sharing arrangement because of the difficulty of determining profit for such short periods. In this connection there will be conflict of interest between the borrower who would be happy to borrow an interest-free amount with a small service charge, and the lender, particularly the institutional lender, who would be reluctant to lend money, though for very short periods of maturity, to a borrower who he knows will profit from this loan even though it is difficult to determine the extent of the profit. Since the risk of non-payment is associated even with such loans, it is probable that such short-term loans may not be forthcoming in an Islamic system. Most financing of a very short-term nature would hence have to be made a part of the overall Mudarabah agreement. For the balance of the very short-term financing needs, a built-in arrangement, as discussed later, would have to be made in the Islamic system to the mutual satisfaction of both the borrower and the lender.

(iii) Instalment credit: A third problem is that of consumer credit and loans for such projects as house building and cottage industries. With respect to consumer credit, it may be pointed out that Islam does not encourage (as discussed earlier) a high consumption economy like that of capitalism. Resorting to unnecessary purchases for demonstration purposes to keep up with the Joneses, is not a value of the Islamic system. Therefore, some of the instalment credit may not be necessary. The rest, which is considered necessary for realizing Islamic objectives, could be arranged b% the dealers on a Mudarabah basis from financial institutions with whom the dealers share a part of the increased profit which results from the increased sales generated by the instalment plan. Instalment purchases of socially necessary goods, like taxis, sewing machines, and cottage industry equipment, which are in keeping with Islamic values and goals, could be arranged through financing from specialized credit institutions established by the Government or altruistic organizations (discussed later).

House-building finance need also not create a problem because the lending institution could share in the rent determined on the basis of the rent on similar property. For example if a loan of SR 200,000 is extended to a home-builder for a house costing, say, SR 300,000, the lending institution would get two-thirds of the imputed rent on such housing. The rent will be paid on the unpaid portion of the loan which will keep on declining as the loan is gradually amortized. Also associated with lone-term house-building finance is the question of the financier's share in the appreciation or depreciation of the property value. This question has received little attention in the literature and needs full discussion in the light of the Shari’ah.

(iv) Government borrowing needs: A fourth problem of the Islamic banking system would be the satisfaction of a part of government financial needs by borrowing from the private sector. This could be necessary not only for financing projects which are amenable to profit-sharing but also for projects which are not so amenable. A number of public works projects have a high rate of social return, but-it is not possible to determine the economic return because it may not be feasible or desirable to price the service rendered by such projects. Most public works projects and all defence projects are not amenable to pricing, and though some projects (like educational and health projects) could be priced to recover the total cost, it may not be considered desirable to do so, because of the Islamic emphasis on social welfare and equitable distribution of income and wealth.

The importance attached earlier to price stability will also prevent the state from resorting to inflationary financing. Even if the government eliminates, or substantially reduces, wasteful and unproductive spending, there may still be a need for government borrowing to finance some of its social welfare projects which have received considerable emphasis in Islam but for which sufficient resources may not always be available through taxation. How will this be arranged in the absence of interest (which is prohibited), profit-sharing (which may not always be feasible and inflationary financing (which is not desirable)? This question will be considered later.

(v) Allocation of resources: An objection often raised is that the Islamic banking system may not be able to bring about an optimum allocation of resources. The reason for this is that interest is a price and like all prices it performs the function of allocating "scarce" loanable funds among the -infinite- users of such funds in an objective manner on the basis of ability to pay the price. If the demand for, or supply of, loanable funds changes, a new equilibrium is reached at a different rate of interest.

This objection assumes that in the absence of interest, loanable funds will be available "free" to borrowers, the demand will thus be infinitely large and there will be no mechanism for equating demand with supply and also that, in the absence of an objective criterion for allocation of resources scarce financial resources will be used inefficiently to the detriment of society. This objection carries no weight, because the fundamental assumption is baseless. Funds will not be available "free" in the Islamic system. They will be available at a cost and the cost will be the "share" in profit. The rate of profit will hence become a criterion for allocation of resources as well as the mechanism for equating demand with supply. The greater the ex-ante rate of profit in any business, the greater the supply of funds to that business. If the e.v post profit for certain businesses is consistently lower than the ex-ante profit, such businesses may face difficulty in raising funds in the future. Therefore, while e.c-ante profit will be important immediately, the ex-post performance will be crucial for the future success of the business in raising funds. This is not the same as interest. The interest-oriented lender does not share the risk of the business financed. He is assured of a predetermined rate of interest irrespective of the net outcome of the borrower's business. The Sahib al-Mal in the Islamic system shares the risk of business and is not assured of a pre-determined return.

The rate of profit will tend to be a more efficient mechanism for allocation of resources than interest. The "equilibrium" rate of interest is only a text-book phenomenon. In reality such a "market clearing" rate does not exist and instead there are a host of rates and the function of allocating resources optimally is not performed efficiently. The rate of interest tends to be a---perverted-price and reflects price discrimination in favour of the rich-the more "credit-worthy" the borrower, the lower the rate of interest and vice versa. The result is that "big" business is able to get more funds at a lower price because of its "higher" credit rating. Thus those who are most able to bear the burden, because of their bigness or claimed productivity, bear the least burden.

In contrast, medium and small businesses, which may sometimes be more productive in terms of contribution to the national product per unit of financing used and at least equally "credit-worthy" In terms of honesty and integrity may be able to secure relatively much smaller amounts at substantially higher rates of interest. Therefore, the rate of interest reflects not the "objective" criterion of productivity of the business but the "biased" criterion of "credit rating". This is one reason why in the capitalist system, big business has grown bigger beyond the point dictated by economies of scale and medium and small businesses have been throttled by being deprived of credit. Does this indicate an optimum allocation of resources or an efficient banking system?²⁸

Instead, if credit is made available on the basis of profitability as a criterion, then small, medium and big business would stand on an equal footing. The higher the rate of profit the greater will be the ability to secure funds. Big business, if it is really more profitable, should pay a higher and not smaller rate of return to the lending institutions, thus benefiting the small depositors, who in the capitalist system are the worst sufferers because they receive an extremely low rate of return on their deposits. In sharp contrast with this, the business having a "higher" credit rating because of its claimed greater productivity and profitability is able to get funds at a relatively cheaper rate compared with the profits that big businesses make from the use of these funds - thus contributing to monopoly power, inequalities of income, and concentration of wealth.

It is not possible to rectify such inequalities adequately through the tax system without coming to grips with the basic causes of inequalities. The Islamic system, through the elimination of interest, introduction of profit-sharing and a broad-based use of bank resources, should be able to redistribute profits from big business to depositors and small enterprises. thus removing one of the major causes of inequalities.

Hence the charge that an interest-free economy would be unable to allocate resources optimally is baseless. In fact the Islamic system of profit-sharing should be able not only to bring about greater efficiency in the allocation of resources but also to reduce the concentration of wealth and power.