Islam aims at building a socio-economic order based on the Quranic injunction of "al-adl wal-ahsan" and considers economic activity as a means to an end and not an end itself. It enjoins on the Muslims to harness natural resources which are a trust from Allah for carrying out 'halal’ activities but abhors exploitation and man made inequalities of income and wealth. The prevailing banking and financial system strikes at the very root of this fundamental principle as it tends to promote concentration of wealth in a few hands and breeds inequalities. Interest which is the kingpin of modern banking and financial system serves as a powerful tool of exploitation of one segment of society by another. It has created "haves" and "have-nots", and acted as a barrier to the achievement of maximum welfare for the maximum number of people. It is in this context that Islam forbids interest and it is for the achievement of the egalitarian objective of Islam that the Muslim world is now embarked on the task of Islamising the financial system by unfettering it from the clutches of interest.  

The institution of interest is wholly repugnant to the teachings of Islam. Indeed, there is a consensus among Muslim scholars that "riba" is prohibited in all forms and manifestations. The injunctions of the Holy Quran in this regard are unambiguous and clear. The Quran says:

"Those who swallow 'riba' cannot rise up save as he ariseth whom the devil has prostrated by (his) touch. That is because they say: Trade is just like riba: whereas Allah permitteth trading and 'forbideth 'riba'. 

He unto whom an admonition from his Lord cometh, and (he) refraineth (in obedience thereto), he shall keep (the profits of) that which is past, and his affairs henceforth is with Allah. As for him who returneth (to 'riba') such are rightful owners of the Fire. They will abide therein. Allah has bligh-teth 'riba' and made 'sadaqat' fruitful. Allah loveth not the impious and guilty".

(2: 275-276)

Mr. DM.  Qureshi is the Managing Director, Bankers Equity Limited, Karachi.

"O ye who believe, observe your duty to Allah and give up what remaineth (due to you) from 'riba' if you are (in truth) believers. And if you do not, then be warned of war (against you) from Allah and His messenger. And if ye repent then ye have your principal. Wrong not, and ye shall not be wronged".

(2: 278-279)

DEFINITION AND INTERPRETATION OF 'RIBA'

 Various schools of thought interpret 'riba' in the present day world-differently. At one end of the scale are those who say that any return on financial transactions is in the nature of 'riba' and should be weeded out to eliminate 'riba' from the society. At the other end are those who say that simple interest does not fall in the category of 'riba'.

 It is only compound interest, or usury, which falls in the category of 'riba', and therefore, the elimination of 'riba' should' deal with the elimination of compound interest only. There are others who distinguish between interest on production loans and consumption loans and assert that 'riba' only pertains to interest on consumption loans. Still others assert that 'riba' pertains to interest charged between the physical persons and excludes interest entering into the transactions of legal persons such as banks, corporations and companies. Yet still others assert that since banking was unknown in the early period of Islam when 'riba' was banned, interest entering into the transactions of banks and financial institutions which were non-existent at that time does not fall in the category of 'riba'. The fallacy of distinction between interest and 'riba' in the various viewpoints outlined above stems, firstly, from fact that it seeks to find a meaning in terms of the socio-economic conditions prevalent in the early period of Islam and assumes that the application of the principle was restricted to certain form in that environment. Secondly, it -degrades. Quran-and Sunnah to be relevant to a certain given time and space and does-not accept its dynamic reality and validity in an inter-temporal and space dimension. A modern version of riba-free financial transactions can be evolved, firstly, by identifying the key elements of 'riba' and trading as enunciated in the Quran and Sunnah and interpreted from time to time by eminent jurists of different  schools of thought in Islam, and then test the existing system of interest in all its forms on that touchstone to arrive at a judgment on whether  or not,  and  to  what extent, the various forms of financial transactions in the present day  world fall in the category of ‘riba’. Broadly speaking the fundamental distinction between ‘riba ’and trading as enunciated in Islam appears to be based on one fundamental principle, that is, whether or not a certain relationship between individuals or between individuals and institutions or between institutions and institutions is based on risk-free or risk-sharing arrangement. Any increase over the original undiluted value of the asset — physical or financial — irrespective of the time differential will,  subject to adjustment, if any, for the actual carrying/handling cost of the asset, fall in the category  of 'riba' pure and simple. All risk-sharing relationships, provided they remain within the framework of 'halal’ activity and the return thereon is not unreasonably high and is not derived by hoarding, speculation,  mis-representation, monopoly and cornering, will fall in the category  of trading interpreted in  the widest sense of the term today, i.e. trade, industry, investment and services. Again, in the risk-sharing relationship, if the arrangement is between two partners of capital, each partner will have to share the risk of loss in exact proportion to his capital. However, the return between various partners can be mutually agreed in any proportion, leaving first a compensation for management to the active partner and .sharing the remaining portion of profit between the various partners in accordance with various degrees of exposure to risk.

 What it boils down to is to develop an equitable and scientific system of compensation or penalty for good or bad management, or service charge to the institutional intermediary and a system of profit-sharing that rewards or penalises the performer or the non-performer and compensates the non-participative partner for various degrees of risk exposure commensurate with the extent and nature of his capital participation. It should also protect the non-participative partner against incompetence, inefficiency or lack of business ethics on the part of operative partner. It should also apportion returns commensurate with the degree of risk-exposure of various types of partners in assets, providing smaller return to partners of redeemable capital and larger return to partners of non-redeemable capital. Between the providers of redeemable capital, the short-term provider should get a lower share compared to the medium and long-term provider. This will envisage the evolution of a system of weights for apportioning profits to various partners based on whether the capital is redeemable or non-redeemable and within redeemable capital, between capital which is redeemed in a short period and that which is redeemed in a long period.

 In short, the Islamic Society will have two types of savors of assets: the risk averters and the risk-takers, and a similar two types of users of assets, users who indemnify the saver from any loss of their assets and undertake to return the asset at stipulated intervals without any erosion in its original value, and users who enter in the risk-sharing arrangement of assets for various dimensions, non-redeemable and redeemable, and between redeemable assets, for assets of different maturities. It is only return on assets of risk-averters or the return on non-risk bearing assets by users of funds which falls within the category of 'riba' whether it is handled by individuals or by institutions. The essential condition of a riba-type of relationship is non-sharing of loss and the undiluted return of the original value of the asset without any addition in its original real value. At the same time, in order to ensure that 'riba' does not creep into risk-exposed assets by the back-door or indirectly, it will be necessary to maintain a constant vigil where risk exposed assets of risk-takers, which distinctly fall in the category of business and industry, do not introduce any element of return if the original value of capital is to be returned without any dilution and the asset is not exposed to any loss.

 THE BASIC PARAMETERS

 The classification of assets or activities between 'riba' and trading, where Allah denounces 'riba' and exhorts trading, envisages a highly' dynamic and entrepreneurial society in which the risk-averters can only preserve the value of their assets and the risk-takers are rewarded equitably for their enterprise and effort. Viewed in this perspective the Islamic system of finance and banking will have to be developed on the following parameters:  

a) whereas risk-averters will be protected against the erosion in the original value of their assets, they cannot receive any return, irrespective of time  differences,  over and above the original value of their assets as it will fall in the category of 'riba'. 

b) whereas the risk-takers will be rewarded for their risk, the exposure of assets to loss will have to be proportionate to their capital participation, no more and no less.  

c) in the matter of sharing of profits, we shall have to evolve a system of sharing which compensates the financial intermediary for the actual cost of the service and the operative partner by a management fee for the efficient running of business subject to the return being above a certain norm of efficiency.  

d) for the remainder, profits, after setting aside the fees as at (c)  above,  will have to be apportioned to various partners by assigning proper weights for different degrees of risk exposure, a larger share to the providers of non-redeemable capital and a smaller share to providers of redeemable capital, and within redeemable, capital, an ascending scale of returns for capital contracted for redemption in longer maturities.

Based on the above touchstones of Islamic finance, the present day interest whether paid or received by a legal person in the nature of State and its enterprises or institutions in the private sector or individuals in a Muslim  Society, cannot be  de-categorised from 'riba' by giving it the nomenclature of 'income' or 'return' or by renaming it as 'interest-free prize bonds' or by explaining it away as an implicit compensation for inflation or share in the profits of business and industry. Financial instrumentation will have to make it loud and clear, not merely in its letter or semantics, but also in its soul and spirit that the funds of risk-averters will be protected against the erosion of its original value   neither more nor less, and no return of whatever nature will be given   for it is 'riba' pure and simple. At the same time, financial instruments for channeling funds amongst the fraternity of savers and investors will have to embody the principle  of proportionate sharing of losses and spell out a rational scale of apportionment of profits related ' to various degrees of risk-exposure of assets.

 Thus viewed, except for the common-stocks in the western money and capital markets, every other instrument of finance, be it current account deposits, savings bank deposits or term deposits of the banks, loans advances and overdrafts, bills, acceptances, bonds and debentures or preferred stocks, is riddled with the spectre of 'riba' in one form or the other No amount of semantics or subterfuges by changing their name in Arabic, or other languages, will robe them with riba less raiments.

 ADVERSE EFFECTS OF 'RIBA'

 Looked at from another point of view also, the prevailing financial system based on the fixity of return on capital has failed to solve the socio-economic problems of mankind. The institution of interest runs counter to the vision of a just economic and social order envisaged by Islam. As stated by the Council of Islamic Ideology of Pakistan, the main rationale for prohibition of interest stems from the concept of justice between man and man which is the cornerstone of the Islamic philosophy of social life. Uncertainty is inherent in a business enterprise irrespective of time and space dimensions. The results of an enterprise cannot be foreseen. The basis of financial and business relationship in Islam   is, therefore, equitable sharing of risks and gains. This is from the following verse of the Holy Quran:

 "O ye who believe! devour not your substance among yourselves unlawfully, but let it be a trading among you by mutual agreement". (4:29)

The fixity of return on capital, irrespective of the operating reserve of the business, is unfair both to the user and the provider of funds. The borrower is required to pay interest irrespective of whether earns profits or suffers losses. Non-payment of interest can have serious repercussions and may even lead to liquidation of the enterprise which is neither in the interest of the entrepreneur nor in the interest of the economy as a whole. Similarly, a fixed return to the supplier of funds is unfair insofar as it deprives him of his share in the improved profits ability to which his funds must surely have contributed.

Under the prevailing banks practice, the focus of attention is creditworthiness of the borrower and the collateral which he can offer rather than the end-use of the funds. Consequently, credit operations of the banking sector in the capitalistic system reinforce the tendency of wealth to accumulate in a few hands, leading to gross inequalities of income, which is bound to culminate in social strife. The prevailing interest-based financial system hampers capital formation and optimum allocation of scarce resources in the economy. Islam, on the other hand encourages productive activity and does not allow gain from financial activity without participation in profit and loss.

 KEY ELEMENTS OF'RIBA-FREE BANKING

 The task before the Islamic banks in the Muslim countries, therefore, is to eliminate the element of interest from financial transactions. Putting it more succinctly, it boils down   to reshaping or devising an institutional framework and designing and restructuring a variety of financial instruments which conform to the teachings of Islam and also aim at the optimum channelisation of savings for meeting the requirements of investment financing in an Islamic economy. Thus the reorganisation of the economic system on Islamic lines will have to reconcile, on the one hand, the freedom of the individual for the optimum use of total resources in the society, and, save it, on the other hand, from running into conflict with the Islamic tenets of equity and fairness.

 This is a herculian task and it is essential that every move in this direction is preceded by careful forethought. Needless to say, the approach will have to be both pragmatic and innovative. The elements of the new system should not only stand the test of scientific analysis but will also have to be in strict conformity with the injunctions of Quran and Sunnah.

 It is a historical fact that as economic life of a society becomes more complicated, savings and investment tend to divide into separate functions, giving rise to an entire complex of financial instruments and financial institutions. The basic reason for financial assets in an economy is that the savings of various economic units during a given period differ from their investment in real assets. Moreover, modern means of production inevitably involve huge outlays of capital which is lumpy and is characterised by long periods of gestation. Hence, financial assets will be as much needed in a riba-free society as in any other society and the Islamic banks will be expected to play an effective role as financial intermediaries and respond to the changing conditions in the financial markets, for it is generally observed that investors have varying time dimensions and are by and large, risk-averse. The Islamic banks will, therefore, have to devise an institutional framework which engenders confidence in the savers and compensates them adequately and tailors the type and denomination of the financial assets to suit the means, preferences and habits of the investing public.

 In the absence of a blueprint of a riba-free system, it appears that a financial system based on the principle of profit and loss sharing would meet the requirement of Islamic injunctions. Unlike interest, the return by way of profit is not pre-determined and fixed but is uncertain and variable. Profit is the residual that rewards the entrepreneurs for undertaking the risk in investments. The sharing of profit between the providers and users of funds, would be on a mutually agreed basis arrived through a bargaining process. Such a system will meet the Islamic principle of 'shirakat' and 'modarbat' insofar as the gross or net return on capital does not represent merely a share in profits, but also represents a share in risk in proportion to their share in the enterprise.

 Unlike the neo-classical theory in which the rate of interest performs the function of balancing the desired savings and planned investment, the individual saving function in an Islamic economy depends on the size of "halal" activity and the allocation of income between consumption wants,  the inducements for spending for the sake of Allah and the savings motive. As for the decision to "invest, it will depend on the expected return on investments or the ratio of return sought by the saver, after making allowance for differences in risks and management.

ISSUES OF BUSINESS FINANCE IN ISLAM

The Islamic financial system governing the relationship between the providers and users of capital is based on certain fundamental principles. Firstly, a predetermined and fixed amount of reward over and above the amount of principal is forbidden for use of capital. Secondly, the funds can be invested in productive channels through intermediaries in the form of risk-free loanable capital or participative capital. The loanable capital enjoys immunity from erosion resulting from inflation and is free from all types of business risks. It is in the nature of 'amanat' which must be returned to the provider without any erosion in its original value. Participative capital, on the other hand, shares in the risks and rewards of business. The degree of risk assumed by providers of capital varies from one situation to another. The business losses are shared by the participative or risk capital on a proportionate basis regardless of the consideration of the size of exposure or terms of participation in profit of the individual investors. The terms of participation in the profit of a transaction of business venture can vary depending on the nature of business, need for funds by the business enterprise and the case with which participative capital can be raised from the market. There is no bar or restriction on the allocation of profits between providers of participative capital so long as it is backed by understanding and consensus amongst the parties concerned and is properly documented through a legally enforceable contract. As a matter of principle, however, the level of participation in profits will have a positive correlation with the exposure as measured by quantum as well as the duration of investment. As a logical corollary, of the principle of proportionate sharing of losses amongst the providers of participative capital, the larger the share and the period of a particular type of participative capital in overall financing, the higher should be the level of participation in profits of that particular type of capital.

Within the matrix of the Islamic theory of capital, the users need funds for meeting their needs in distress such as draught, hunger and some natural or man made calamity or they are needed by the business, the government, and the financial institutions for meeting their productive and non-productive needs. The requirements of funds by the needy may be met through the institution of Zakat and the grant of Qarz-e-Hasna. In business, funds may be needed either by way of loan capital, or on the basis of participation in the operating results of enterprise. According to the Islamic principles of finance, the like should be returned for the like and any excess over the loan amount would be defined as 'riba' which is strictly forbidden. In case of physical capital or metal or commodity, such as gold, the repayment of loan would strictly retain the original form, shape and substance of the borrowed capital. Thus, if an ounce of gold is borrowed, then exactly an ounce of gold, and nothing more nor less, will have to be returned at the time of repayment of the loan. Translated in terms of paper currency and modern financial transactions, the condition of retaining the form, substance and shape may be satisfied by repaying the loan in terms of undiluted purchasing power of the original amount of loan.

Any financial relationship, other than the loans, discussed above will be on the basis of 'modaraba', where one party contributes funds and the other contributes his skills, or 'musharika', where both parties contribute funds. The profit-sharing under both 'modaraba' and 'musharika, will be on a mutually agreed ratio. In case of loss, the supplier of modaraba funds will have to bear the entire loss, while in case of 'musharika' both the suppliers and the users of funds will be required to bear losses in proportion to the capital contributed by them.

The Islamic banks would similarly make funds available to the investors either by way of loans, or in the form of 'modaraba' or 'musharika'. In a paper money economy, which is charactarised by fluctuation in the value of money, some form of indexation will have to be evolved so as to ensure un-eroded return of the original loan amount. It is a well known fact that inflation affects different sectors of the economy differently. Therefore, a deflator based on a general price index may not be the appropriate measure to offset changes in the value of money. Similarly, in the case of agriculture, prices are generally controlled by the government. Moreover, the agricultural prices are influenced by conditions of international supply and demand.

In the case of business and industrial ventures, a specific deflator may have to be developed for indexation of the price of products of each industry/sector for which the loan is used. In the case of government, however, the funds raised through loans may constitute a pool which may be used for a specific purpose or for the development of infrastructure, or for general purposes. Where the funds are required by the government for a public sector enterprise, the funds may be obtained on a 'musharika' or a 'modaraba' basis. However, in the case of funds raised by the government for general purposes or for the development of infrastructure, a general deflator based on the Gross National Product may provide the nearest substitute of a sensitive measure for indexing loans raised by the government.

ISLAMIC INSTRUMENTS OF FINANCE

The task of finding Islamic substitutes for the western instruments of finance is highly complex and difficult. The difficulty arises mainly from the fact that bulk of the population engaged in business and industry in the Muslim world is not given to the maintenance of proper books of accounts. Even among the few who maintain certain books of account the level of accounting morality for a variety of reasons leaves much to be desired. Similarly, not much reliance can be placed on the fraternity of public accountants who have a long way to go in establishing traditions of sound auditing. Until such time, therefore, accounting practices are not followed on a widespread scale and the quality of auditing by public accountants does not attain high standards, a major reliance will have to be placed on instruments which are not vulnerable to these factors. A few of such instruments found in vogue are 'bai muajjal' or mark-up, 'bai salam' or mark-down, leasing and hire purchase. The mark-up or mark-down have been the subject of acute criticism, firstly, because it is tending to encompass the bulk of financial transactions and, secondly , a resort has to be made to mark-up on mark-up for dealing with delinquent users of funds. Similarly, leasing is criticised because that component of lease rental which represents a share in income is kept constant irrespective of fluctuations in the earnings of the user of leased assets. By the same token, modaraba as an instrument of Islamic finance is taking time to pick up. A word about each instrument will perhaps be in order.

PLS Accounts: The nationalised commercial bank: have opened interest-free counters for attracting deposits from savers on a profit and loss sharing basis. Funds under this arrangement are received both for savings bank accounts and fixed deposit accounts. Given the profits on the use of these funds in Participation Term Certificates, musharikas, investment in shares and stocks, loan on mark-up for commodity operations, the returns are distributed on a daily product basis on funds of different maturities. The PLS counters have gained popularity in Pakistan and as much as one-fifth of the deposits of the banking system are kept under this counter. The return to the deposits have maintained a level higher than the return obtained on interest-ridden deposits.

Leasing: It is relatively a new method of long term financing under which the lessor retains the ownership of the asset and the lessee has possession and use of assets on payment of specified rentals over a specified period. The use of leasing enables the banks and other financial institutions to provide medium and long-term finance either directly or through their leasing subsidiaries without having to look into the accounts of the firm concerned.

Hire Purchase: Under this system, banks and other financial institutions provide finance for the purchase of various fixed assets under a joint ownership arrangement. In addition to repayment of the principal, the banks also receive a share in the nature of net rental out of the profits earned on the assets.

Mark-up: It is a sale in which the margin of profit or mark-up to the seller is mutually agreed upon between the buyer and the seller in advance. The payment of sale price may be either in lump sum or in installments. The technique of mark-up has found general application in financing input requirements of industry and agriculture as well as in the financing of domestic and import trade.

Modaraba: This means a business in which a subscriber participates with his money and the manager, a 'modarib', participates with his efforts and skill, and profits on investment made out of the modaraba funds are distributed among the subscribers. Modarabas are of two types:

a) Multipurpose modaraba,  that is to say, a modaraba having more than one specific purpose or objective. A company, for instance, may float a multi-purpose modaraba for funding a transport service, operating an automobile workshop and providing services as packers.

b) Specific purpose modaraba, that is to say, a modaraba for a specific purpose such as setting up a cement plant, or building and selling houses, or commercial buildings, or industrial structures, etc.

In Pakistan, the floatation and operations of modarabas is governed by a special law called the Modarabas Law. Under this law, management companies, banks and financial institutions can register themselves as modaraba companies and float a modaraba for a specific or general purposes. The objects of modaraba are restricted to only such business as are permitted under the Islamic Shariah. In order to ensure that modarabas do not engage in an activity that is repugnant to the tenets of Islam, the prospectus of each modaraba requires prior clearance from a Religious Board. Furthermore, after the modaraba goes into operation additional responsibility is also imposed on the auditors to certify that all business conducted, investments made and expenditure incurred by the modaraba are in accordance with the objects, terms and conditions of the modaraba. To safeguard the interest of the modaraba certificate — holders, statutes are provided in the law including quicker and simpler adjudication of disputed matters by a tribunal. In order to promote the growth of modarabas while keeping in view the larger interests of the modaraba certificate-holders, the entire income of the modaraba funds has been exempted from income tax provided 90 per cent of the income is distributed to the modaraba certificate-holders. As an instrument of finance, modaraba helps in raising risk capital on the basis of profit and loss sharing in the form of equity and loans with equity features for setting up ‘halal’ business. The banks and financial institutions can also use modaraba for channeling their funds into profit-sharing ventures.

Participation Term Certificates (PTCs): Participation Term Certificates are transferable corporate instruments evolved in Pakistan and are based on the principle of profit and loss sharing and aim at replacing debentures for providing medium and long-term loans for industrial and other financing. Instead of receiving interest, as in .the case of debentures, the holders of PTC shares in the profit or loss of companies raising finance through this device. The PTCs have the following features:

a) The certificates are issued for a specified period not exceeding ten years excluding the grace period.

b) The broad principles governing the legal aspects of Participation Term Certificates are prescribed by the governments by making suitable amendments in the statutes governing the operations of corporate entities.

c) As PTC finance is provided for a specific period, it is secured by a legal mortgage on the fixed assets of the company. It also enjoys a floating charge on the current assets.

d) For the purpose of allocation of profit to PTC holders, the investment rank pari passu with equity and share in profit on a basis to be determined by mutual agreement.

e) Profits for the purpose of determining return to the PTC holders axe taken to be pre-tax profit before appropriations.

f) Profits payable to PTC is treated as deductible expense for income tax purpose.

g) The share of PTC holders in the profit is deducted prior to the claim of shareholders in the profits of the company in any given year.

h) In case of loss, the first recourse is made to the free reserves including the credit balance in the profit and loss accounts of the issuer and the balance of the loss is shared between the PTC holders and other providers of funds in proportion to their funds.

i) The proceeds of PTCs are used exclusively for the project or the business concerned. The sponsors are required to give an undertaking to conduct the business with diligence and efficiency in accordance with sound engineering, financial and business practices and such other terms as may be agreed between the parties.

j) In order to provide protection to the purchasers of PTCs, a trustee is appointed who is responsible, among other things, for the appraisal of the business or the project. The trustee has the right to call for any information from the company, visit premises where the business or the plant and machinery of companies are located and have access to their records.

k) An option is also given to the PTC holders to convert a certain portion of outstanding Participation Term Certificates into ordinary shares.

l) A right option is also given to the existing ordinary stock-'holders to subscribe to the fresh issues of PTC.

Musharika: It has all the features of PTC except that, unlike PTC, the musharika contract is bilateral between the financial institution and the user of funds. Moreover, unlike PTCs, the musharika contract is not evidenced by a negotiable instrument and cannot be traded like any other financial asset on the capital market.

CONCLUSION

Although efforts are being made in a number of Muslim countries for the Islamisation of the financial system, the process of Islamisation is depressingly slow and fragmented. Moreover, the application of Islamic financial principles is restricted to trading activity. With the exception of Pakistan, institutions and individual businessmen in the Muslim countries have hardly ventured to introduce the Islamic concept of financing in the field of industrial financing. This is attributable mainly to the slow pace of institutional efforts for disseminating knowledge on profit and loss sharing schemes and imparting necessary training to the professional in the field of Islamic banking. Moreover, a lot of ground will have to be covered for altering the existing standards of corporate accounting and auditing to bring them in line with the ethical principles of business enshrined in Quran and Sunnah.

NOTE: The views expressed in the paper are the personal views of the author and do not necessarily represent the official views of the institution to which he belongs.