Islamic banking is based on the following two fundamental principles:

(1) It should help in achieving the socio-economic objectives of an Islamic society; and
(2) It should be conducted without transgressing any injunctions of the Shariah.

The Islamic banking movement, which embodies these principles, is comparatively of recent origin. It represents a radical departure from the banking practices developed in the West. The Western banking system has evolved on secular lines and is not conditioned in its operations by any religious commandments. Islamic banking, on the other hand, has to derive its inspiration from the religious edicts of Islam and has to mould its operations within the framework of the teachings of Islam.

The starting point of Islamic banking is its abstinence from interest. This abstinence is based on the clear injunctions in the Holy Quran and Sunnah with regard to the prohibition of interest. The Arabic word used is riba which encompasses interest in all types and forms, irrespective of whether it relates to loans for consumption purposes or for productive purposes and whether the rate of interest is low or high. Prohibition of interest is enjoined by the verses in the Holy Quran in strongest terms, and those who do not desist from this practice are warned of "war from Allah and His Messenger". A number of authentic sayings of the Holy Prophet (Peace be upon him) elaborate on the Quranic injunction prohibiting riba. These sayings also severely admonish those who dare to violate it as well as those who may be helpful in a riba transaction even as a scribe or witness. A lender is prohibited to accept from borrower any gift or even a small favour unless it was customary between the two of them to exchange gifts and other favours before the loan was granted.

In the early history of Islam, the injunction relating to prohibition of interest was strictly observed but with the decadence of moral values and later the spread of Western influence, financial practice based on interest began to permeate the Muslim societies as well. In tht period of colonial domination of Muslim countries by Western powers the interest system became solidly entrenched.

With the attainment of freedom from foreign yoke and resurgence of Islam, there is wide-spread yearning in Muslim countries to reorder their economic life in the light of injunctions of Islam. Elimination of interest, which is prohibited in Islam, is one of the big challenges facing the Muslim world in this context.

In recent years a good deal of attention has been paid by Muslim experts in economics, banking and finance to find ways and means of replacing interest. There is widespread agreement among Muslim scholars that keeping in view the teachings of Islam the ideal alternatives to interest in an Islamic economic system are profit/loss sharing and Qard-e-Hasanah. Interest is disallowed in Islam because it is a socially unjust practice. If interest is charged on loans taken for meeting the basic consumption requirements, it amounts to taking advantage of a man's inferior economic position and is, therefore, morally reprehensible and prohibited. Charging of interest on loans taken for productive purposes is also prohibited because it is not an equitable form of transaction. When money is invested in a productive undertaking the quantum of profits that may accrue is not known beforehand and there is also possibility of a loss. Charging of a fixed and pre-determmed rate of interest on loans for productive purposes cannot, therefore, be morally justified. Islam, however, does not prohibit return on capital if the provider of capital funds is prepared to share the risk of productive enterprise with the entrepreneur. It is for this reason that profit/loss sharing is considered the real alternative to interest in an Islamic economy.

The basis of cooperation between capital and enterprise in Islam is Mudarabah (or Qiradh). It denotes an agreement by virtue of which money is given for trading or investment purposes by one party to another on the principle of profit/loss sharing. When capital is provided entirely by one party and enterprise and/or labour entirely by another party, the profit earned can be divided between the parties in proportions agreed upon and stipulated in the agreement. However, in the event of a loss, the entire loss has to be borne by the provider of capital unless it is due to the negligence of the worker/entrepreneur. If there are more than one providers of capital, profit can be distributed among them in agreed proportion, while loss is to be shared by them strictly in proportion to their respective capital contributions. The same principles apply in the case of Sharakah, also permissible in Islam, in which all the partners contribute to the capital and all or some of them may participate in the work/management of the business.

BANKS IN ISLAMIC SYSTEM

The available literature on Islamic banking provides enough material to show how the principles of Mudarabah and Sharakah can be translated into institutionalised banking practices to suit the realities of the modern day economies. The main features of the working of Islamic banks may be enumerated as follows:

(a) The main function of commercial banks under the Islamic system would be to mobilise the savings of the community in the form of various types of deposits and investment accounts and to deploy these resources for financing various types of productive activity permitted in an Islamic society.

(b) Commercial banks would accept current deposits as well as open investment accounts. Current deposits would be payable on demand and no return would be payable on them. As for investment accounts, there would be no commitment on the part of the bank to pay a fixed return on them but holder of such accounts would share in the profits earned by the banks in  agreed proportion. In the event of loss, holders of investment accounts would share in the loss strictly in proportion to the share of such investment account in the total capital funds employed by the bank in the particular accounting period.

(c) Commercial banks would provide funds to business enterprises for short, medium and long tern, and would be entitled to receive a part of the profits earned by the enterprise in accordance with the agreed proportions. For the purpose of profit distribution, the respective capital contributions of various parties, utilised for varying periods, would be brought to a common denominator by multiplying the amounts with the number of days during which each particular item such as equity capital of the firm, its current cash surpluses, suppliers' credit as well as the finance provided by the bank were actually deployed in the business. In the event of loss, the amount of loss would be shared strictly in proportion to the capital of each of the parties.

(d) The financing arrangements under Mudarabah and Sharakah may provide for a certain amount of monitoring by the banks of the actual performance of the concern financed by them. For this purpose they may be entitled to inspect the projects and to call for any information and books of accounts of the concern. The financing arrangements may also stipulate conditions in regard to incurring of additional liabilities by the concern.

e) Commercial banks and other financial institutions may provide finances to new business concerns by subscribing to a part of the share capital of such concerns. They may also underwrite the share issue of a concern provided it does not involve charging of a fixed rate of interest. For example, they can take up a part of the equity at the very inception of a project at a negotiated price which can be below the face value of the shares. This can be a substitute for "bridge financing" arrangements under the interest based system.

(f) The system of bill discounting would have to be replaced by an alternative system compatible with Shariah. The drawer may enter into two separate agreements with the bank, one pertaining to the appointment of the bank as his agent for the collection of the amount from the drawee on the due date and the other for provision of finance in an amount equal to the value of the bill. The bank may charge a commission for the service rendered for collection of the proceeds of the bill. The commission may vary according to the amount of the bill, but not according to the period of payment. Finance equal to the value of the bill may either be provided by way of an interest-free loan or under profit/loss sharing arrangement.

SOME OTHER TECHNIQUES

It is recognised that while profit/loss sharing is the real alternative to interest in an Islamic economy, resort can be taken to other techniques, which are not prohibited in Islam, if the application of the system of profit/loss sharing in certain situations gives rise to special difficulties. Some of these techniques are:

(a)  Bai Muajjal/Murabaha (cost-plus trade financing) The financier arranges for the purchase of goods needed by the client and sells them to him on the basis of cost-plus agreed profit margin (mark-up) which can be paid in instalments over a specifed time period.

(b) Ijara (Lease or hire) The financier acquires equipment or building and rents them to the user against a fixed charge.

(c) Ijara wa iqtina (Hire-purchase) The bank may finance the purchase of equipment and let it be used by the client on the basis of a contractual agreement under which the former receives, in addition to payment of the cost of the equipment, a share in the net rental value of the item in proportion to their outstanding shares in the total investment.

(d) Bai-Salam: The financier enters into an agreement with the farmer for advance purchase of agricultural produce and makes the payment of the agreed amount at the time of entering into the apeement.

Islamic banks operating in different countries are using a combination of the different financing techniques permissible in Shariah. However, some of them lean heavily on Bai Muajjal/Murabaha in their operations. This is for two main reasons. Their orientation mainly is towards short term financing of trade transactions for which Bai Muajjal/ Murabaha appear to be more convenient devices compared to the system of profit/loss sharing. Secondly, they are in competition with interest based banks and are, therefore, anxious to earn at least as much on their investments as will enable them to give a return roughly comparable to prevailing interest, rates to their investment account holders. This is easier to achieve by engaging in Bai Muajjal/Murabaha transactions as the "mark up" car. be fixed in a manner which more or less assures the required return. On the other hand, considerable uncertainty attaches to earnings under a system of profit/loss sharing as the outcome depends on the operating results of various business units which are subject to the usual business hazards.

Though use of Bai Muajjal/Murabaha is not prohibited in Islam, its widespread adoption as the Islamic substitute for interest cannot be commended. Many writers have pointed out that though technically permissible in Shariah, the mark-up system does not differ in essence from the interest system. The resemblance becomes even more prominent if in the event of non-payment of the amount due on a specified date a "mark-up" is added over "mark-up". It has also been pointed out that Bai Muajjal/Murabaha are trade-specific practices rather than financing techniques. Their use occasionally by traders may, therefore, be alright but it is stretching the permission in Shariah too far to use them as general financing devices. There is genuine concern among Islamic scholars that if interest is largely substituted by "mark-up", it would represent a change just in name rather than in substance.

The fact that replacement of interest by "mark-up" does not represent any substantive change becomes apparent if one ponders over the philosophy behind the prohibition of interest. As mentioned earlier, the interest system is disallowed by Islam because intrinsically it is a highly inequitable system. The feature that makes the interest system inequitable is that the provider of capital funds is assured a fixed return while all the risk is bone by the user of these capital funds. Justice, which is the hallmark of the Islamic system, demands that provider of capital funds should share the risk with the entrepreneur if he wishes to earn profit. It is easy to see, therefore, that the mark-up system, and for that matter all other devices which involve a fixed pre-determined return on capital, are no real substitutes for interest.

Apart from equity considerations, the prohibition of interest in Islam is meant to stimulate overall productive activity, generate maximum employment and sncourage innovation which is the mainspring of growth. These blessings can only be reaped if the interest system is completely uprooted in the real sense of the term and replaced by a fundamentally different system like profit/loss sharing.

Before concluding this paper, it is important to stress that Islamic banking is much more than just abstinence from interest. To deserve the name, Islamic banking has to make a vital contribution to the achievement of the socio-economic objectives of an Islamic society. These objectives briefly are eradication of mass poverty, equitable distribution of wealth and sufficient opportunities for gainful employment. Many Muslim scholars have pointed out that the working of the banks in many capitalist countries has served to increase rather than decrease inequalities of income and wealth. Islamic banks are expected to deploy the resources mobilised by them in such a manner that the egalitarian objectives of an Islamic society are achieved with greater ease. One has to recognise, however, that Islamic banks cannot make their full contribution in this direction so long as they remain exposed to severe competition from interest based banks. The full blessings of the Islamic system of finance will accrue only when banking practices based on interest are completely given up and replaced by Islamic financing techniques.

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*Dr. Ziauddin Ahmed is the Director General, International Institute of Islamic Economics, Islamabad.