ABSTRACT  

Islamic banking, a financial innovation, has come to be seen as the most ‘visible’ aspect of Islamization. Notwithstanding its novelty, it has made considerable progress, measured by the rapidity with which it has been adopted in the Muslim (even non-Muslim) countries in a relatively short period of time. However, the progress made by Islamic banking is seen by some Muslim economists as more apparent than real because it is not being run exclusively (or even mostly) on the basis of the Shari^cah-favored profit and loss sharing (PLS) principle; rather, the fixed-rate type of financial instruments, which are seen as a ‘deviation’ from the Islamic ideal, have proliferated. It is argued in this paper that there is no warrant whatsoever for this misplaced ‘financial puritanism’, which has obfuscated the subject and its manifestations. The fact of the matter is that, deviation or not, the fixed-rate financial instruments, duly approved by the Shari^cah, form an integral part of Islamic banking; and that it would be counterproductive to limit the possibilities of this institution just to the PLS principle. Hence, respecting the preferences of the consumers, Islamic banks should aim to evolve a risk-minimizing ‘mixed’ investment portfolio, containing both the variable and fixed-rate of return types, without any ‘imperfection complex’. Even more important, rather than pursue an ambiguous financial ideal, which cannot be reached, the focus of the future reform. Should be to produce something strikingly original which can win the acknowledgement of the people. To this end. Islamic banking should be informed with an earnest knowledge of the ethical objectives of an Islamic economic system, the truth of which can be established only by the quality of social justice and the primacy it accords to the needs of the underclass in society. If Islamic banking is unmindful of its economic consequences and remains hooked on ‘procedural purity’, it will wither on the vine of public apathy, even its disapproval.

 Key words: Islamic banking, Islamic Economics, Profit and loss sharing.

* The author is formerly the Director, Pakistan Institute of Development Economics. He is indebted to the Editor of the IIUM Journal of Economics and Management and to two anonymous referees for making very useful suggestions on an earlier draft of this paper. He also gratefully acknowledges a stimulating exchange of views with the Chairman (Justice Khaliur Rahman Khan) and the members (Justice Munir A. Sheikh, Justice Wajihuddin Ahmad, Justice Mohammad Taqi Usmani, and Justice Mahmood Ahmad Ghazi) of the Shariat Appellate Bench of the Supreme Court of Pakistan, before whom he presented the basic thesis of the present paper on 18th and 19th May 1999. Thanks are due to Professor A. A. Hashmi for making very useful suggestions. Mr. Abdul Karim Rana gave invaluable help in the preparation of this paper. Only the author is responsible for the views expressed in this paper.

I. INTRODUCTION  

Islamic banking (read, interest-free banking) is now regarded as the defining characteristic of an Islamic economic system (Kuran, 1995a). Many Islamic banks have been operating throughout the world for the last several years with differing degrees of success. However, what constitutes success and what are its indicators from the Islamic point of view are questions about which opinions tend to differ. The most widely held view is that Islamic banks should de emphasize use of the fixed rate of return instruments, and that, reversing present trends, they should be run exclusively on the basis of the profit and loss sharing (PLS) principle to become truly Islamic. It is argued that any attempt to dilute the importance of the PLS principle in Islamic banking theory or practice by the use of even the Shari^cah-compatible fixed rate of return instruments will make Islamic banking less efficient and less equitable because this is the one principle most recommended by the Shari^cah (i.e., the Islamic Law) (e.g., Siddiqui, 1983a; Chapra, 1985; and Usmani, 1998). From this point of view, it does not matter if the PLS instruments have lost out in the process of ‘natural selection’, practically vanishing from the Islamic bank’s portfolios. The almost ‘universal’ recommendation still is that the PLS principle be observed faithfully, even exclusively, because it is hoped that — presumably by some variant of Say’s Law — an ample supply of such instruments will create their own demand. But this argument comes dangerously close to circular reasoning: it makes the desired efficiency and equity outcomes of Islamic banking contingent on the adoption of the PLS principle, which is prejudged as the only one which is Islamically just! The possibility that the PLS principle, if implemented universally and without any safeguards, may itself lead to inefficiency and inequity is totally alien to this antiseptically ‘consequence-insensitive’ procedural way of thinking.1   

While making an invaluable contribution to clarifying the ‘procedural’ aspects of Islamic banking, this approach has been parent to an unending but sterile theoretical debate. Furthermore, it has impeded the growth of Islamic banking as an effective instrument of Islamic reform by downplaying its ethical content2. The more promising line of thought is to analyze the basic premises of Islamic banking in a consequence-sensitive scenario — i.e., from the point of view of its potential to maximize social welfare.3 In this context, the multiplicity of Islamic financial instruments, including both the fixed and variable rate of return types, should be seen as an advantage (indeed, a Divine blessing!) which would permit Islamic banking to do financial engineering, develop new consumer-friendly products, eschew unnecessary risk exposure, and minimize the cost of project evaluation and monitoring. This approach is also consistent with the general Islamic philosophy: that primacy be accorded to the maqasid al-Shari^cah (i.e., the objectives of Islamic Law), which would then help to evaluate the relevance, even the validity, of Shariah-based legal and economic injunctions in specific contexts.4   

It is, therefore, argued in this paper that making Islamic banking a prisoner of the PLS-based, variable rate of return financial instruments, developed centuries ago in a totally different economic and social environment, will be totally counterproductive. Any set of unyielding anachronisms cannot be expected to usher in the new Islamic era, any more than hanging autumnal leaves back on top of the trees may create a new spring. In the present century, an all-enveloping revolution in the realm of ideas has come about, and in economics with a vengeance. To make it ‘forward-looking’, innovative initiatives will have to be taken to raise the structure of Islamic banking, brick by brick, on the solid foundations of modern knowledge, which needs to be seen as the common heritage of all humankind. Released from the narrow ‘procedural’ box, Islamic banking should focus increasingly on realizing the basic egalitarian objectives of an Islamic economy in the altogether new institutional contexts. 

2. ISLAMIC BANKING AND THE ISLAMIC ECONOMIC SYSTEM   

To put the analysis of Islamic banking in a systemic perspective, I assume throughout this paper that an Islamic economic system is needed in Muslim societies. I am opposed to the rejectionist’s view that it is a pointless exercise to opt for an ‘unknown’ Islamic economic system because there exist tried and known systems like Capitalism and Socialism. We need an Islamic economic system precisely because other systems have engendered a schizophrenic confusion between what Muslims believe in and what they practice; and because it will be easier and more efficient for Muslims to work with a system whose ethical foundation are ‘universally’ accepted by them without question. Also, it is possible to construct, on the logical plane, an Islamic economic system, complete with its own ethical values, policy objectives, and policy instruments, which alone can satisfactorily explain the economic and social behaviour of Muslims, and prescribe first-best policies when change becomes necessary to enhance the growth potential and the quality of social justice in Muslim societies. It can also be rigorously proved that an internally consistent Islamic system, duly informed by sound ethical values, can interact successfully with other present-day economic systems.5 

 However, a proof of the existence of an Islamic economic system does not necessarily imply that such a logical construct can be transformed into a reality in its entirety just by administrative flat; and that its success will be guaranteed because it is Divine, in sharp contrast to Capitalism and Socialism, which are man-made, secular and liable to ‘failure’. Instead, I assume that the Islamic economic system, including Islamic banking, is going to be as man! woman-made as any other system — in the sense that the task of translating the timeless, institution-free Divine ethical and economic principles into a workable economic system, at a specific time and within the matrix of specific institutions, will have to be accomplished by Muslim men or women. The end-product of these efforts will bear the mark of human imperfection for which they will be held accountable in this world and in the Hereafter. Indeed, it is precisely this ‘imperfection’ which makes the study of Islamic (or secular) economic, social, and legal systems interesting. A perfect system designed by Allah Himself would be ‘beyond justice’, as no issue of injustice can ever arise in it. A methodological implication of this inherent ‘imperfection’ is that the basic statements about an Islamic economic system — e.g., the PLS principle — are not absolute truths transcending the limitations of time and space; instead, they are a set of refutable hypotheses, whose truth and utility must be established, within the matrix of the state of economy and the nature of the society (Naqvi, 1994).

It follows from the preceding observations that we cannot just race to the Islamic El-Dorado, tooting horns and waving flags, and hope only for the best. Instead, an Islamic economic system, with Islamic banking as its integral element, will emerge gradually out of a creative and forward-looking symbiosis of the Islamic ideal and the reality in the Muslim countries. Not only that, the Islamic economic system will be failure-prone, like any other real-world system. Its superior merit will be judged not by its supposed Divine origin, but by its success in achieving the Divine purpose: solving the timeless, fundamental, and universal problems of human existence, so that freedom is not allowed to degenerate into unlimited licence for the exercise of individual greed, nor is social responsibility seen as synonymous with human bondage. There is also the additional criterion of Islamic success. The Islamic system should reinvigorate the withered lives of the least-privileged in the society to fulfil Allah’s Will: “And we have desired to show favor unto those who were oppressed in the Earth; And to make them examples and make them the inheritors, and to establish them on earth ...“ (Qur’an, 28:5 – 6).6 

3. FUNDAMENTAL CONSIDERATIONS  

The theory of Islamic banking is wedged in between two connected logical statements: (i) that riba is equivalent to all interest-based financial transactions, including bank interest, in modern times; and (ii) that profit-based banking—to be more accurate, a banking system raised on the principle of universal PLS and unsupported by any guarantee about the return on bank deposits or bank advances — is superior to the capitalistic interest-based banking. Both these assertions, although (incorrectly) regarded by most Muslim thinkers as absolute truths unconstrained by space and time, do raise difficult theoretical and empirical questions and there are no easy answers to them. As for the first assertion — that bank interest is riba, and is, therefore, prohibited, while profit is allowed — the source of the difficulty is that interest and profit are not separable in a capitalistic system; indeed, the two are as interlinked as Siamese twins. The dominant view among ‘secular’ economists is that the average rate of interest is determined, independently of the monetary variables, by the same set of forces which determine the rate of profit on the capital invested in production (Panica, 1991); and that changes in the profit rates have been caused by changes in the interest rates, speculative trading, and productivity (Pindyck, 1988). Thus, separating the twins would require nothing less than a complicated surgical operation on the economic structure. Also, the possibility of a zero interest rate in a world not saturated by a surfeit of capital is flatly denied,7 because it is hard to visualize a situation in which people will have saved enough to bring the net productivity of capital down to zero. This, however, does not mean that we should not do away with bank interest, if it is recognized as riba, but we should be clear in our minds that once interest rate is permanently abolished as a source of income in a capitalist economy, we simply do not know what the outcome of such a step would be. 

The second assertion, that Islamic banking be based exclusively on PLS, is no less tricky.8 True, it has been asserted that Islamic banking, based only on the variable rate of return PLS principle, is viable (Siddiqui, 1983b; and Khan and Mirakhor, 1987). Yet, it is difficult to understand even the necessity of making statements whose theological basis is fragile if not plain wrong, because a large number of fixed rate of return instruments — e.g., bay^c mu ‘ajjal, salam, ijarah, istisna’, etc — have also been allowed by the Shari^cah Therefore, there is no warrant whatsoever to confine islamic banking to a narrower set of investment of options based only on the PLS — even if, as has been claimed, this “crucial insight” has led Muslim economists to link Islamic banking to the modern theory of finance (Mirakor, 1997). More important is the question of whether the PLS-only option would better meet the maqasid al-S hari^cah — i.e., whether an only-profits-based system will take us nearer to, or farther from, the Islamic ega1itarian ideal As I argue below, the odds are against a favorable outcome because specific Islamic economic policies, like Islamic banking, can bear fruit only within the matrix of an Islamic economic system when it is fully established; but they are likely to run into irreconcilable contradictions in a capitalistic economic set-up.9 Thus, for instance, it can be shown easily that a universal ‘unprotected’ PLS system — which, in practice, means having to work only with variable-return type of financial instruments — will generate adverse distributive (and efficiency) consequences, as a rule, when implanted in a capitalistic economic system (Naqvi and Qadir, 1986). It follows that when bank interest is abolished, the challenge for Islamic Banks is to look for all types of Shari^cah-compatible fixed and variable financial instruments, whose number and scope will have to be greatly enlarged by financial engineering. The aim should be to work the Islamic financial mechanism efficiently and equitably into the extant economic systems — and, eventually, into a fully fledged Islamic economic system. 

4. THE ABOLITION OF BANK INTEREST  

The logical first step in our enquiry would naturally be to look at the equivalence of riba with interest (especially, bank interest), on which the entire structure of Islamic banking rests; but I do not wish to question the existing near-universal consensus on this matter (e.g., Mawdudi, 1967; Sadr, 1982b; Taleghani, 1982; Siddiqui, 1983b; and Chapra, 1996). I also do not take issue with the position that once it is granted that bank interest is riba, then the distinction between interest on production and consumption. Loans cannot be drawn too sharply wherever the money market is competitive; and also because production is financed by investment, which is simply postponed consumption. Also, in a formalist, consequence-insensitive perspective, the difference between the simple and the compound rates of interest is a matter of degree, not one of kind. However, the whole issue assumes an altogether different character if it is accepted that riba is not just interest, much less only bank interest; and that it has been likened to waging a war against Allah and his Prophet (Qur ‘an, 2: 278- 281) because it denotes, in a deeper sense, all those states of the economy which perpetuate and promote gross imbalances in the distribution of income and wealth;  that is, zulm (social disequilibrium) is a negation of al-^c adl wa al ihsan (Naqvi et al., 1980, 1987).10 It stands to reason because the injunction against riba could not have been a matter merely of arithematic. This being the case, the point of policy emphasis should be to abolish all those forms of transactions, including interest, which are blatantly exploitative. An obvious example is the practice in rural areas, where the private money-lenders, acting as monopolists in the money market, get away with the highly unethical practice of lending small sums of money to the poor farmers at exorbitant rates of interest, which at some places in southern Punjab and Sindh in Pakistan are as high as 120 percent! Ironically, in these cases, the large monitoring cost and the non-availability of micro credit are the main problems, which can be solved only financial resources become available at normal rates of interest changed by the banks (Irfan et al., 1999; and Aleem, 1990). But the usual argument is to emphasize only the ‘formal’, procedural aspects of the problem, according to which bank interest is unacceptable because it shares the following characteristics of riba, as identified by the fuqaha ‘ (jurists). These are: (i) the amount to be repaid in excess of the principal amount at the end of the contract period is fixed in advance, in relation to time, by the lender as an essential condition of the loan (Rahman, 1992; esp. paragraph 78); 11 and (ii) the amount so stipulated is risk-free and involves no uncertainty (Shafi, 1979). To a much lesser extent, indeed only tangentially, it has also been argued that bank interest is riba because it causes a perverse transfer of resources from the poor to the rich (Rahman, 1992; Mawdudi, 1967; and Sadr, 1982b).  

Each of these considerations merits careful scrutiny.

 i. Contrary to the above-stated assertion, interest rate may not always be fixed in advance. Also, only the ‘pure’ average interest rate is risk-free; but around this risk-free rate “there is a whole spread of interest rates for ventures of different riskiness” (Samuelson, 1976, 602). Furthermore, even the risk-free rate exists only so long as the investor makes decisions under conditions of perfect certainty, which is seldom the case. However, if uncertainty prevails, which is almost always the case, then the average interest rate will be primarily determined by the information structure of the investor; and it will consist of a risk-free rate plus a variable risk premium, whose size will depend on the degree of uncertainty at a given time and on the changes in it over a period of time (Ingersoll, 1991). Thus, the Euro-dollar syndicated borrowing, which includes a risk premium over the London Inter-Bank Offer Rate (LIBOR), is both variable and risky and not necessarily related to the rate of return on specific projects; which, incidentally, makes it worse than the borrowing done at a fixed rate, because, unlike the latter, there is also an uncertainty about both the nominal and real interest obligations (Wilson, 1998). Whence follows that the fixity of the bank rate by itself does not make it riba because the variable alternatives are even more exploitative

ii. To assert, as many Muslim economists do, that time does not add anything of value to the principal amount, and that it should not, therefore, be really rewarded, amounts to saying that time is a free good. Were this the case, then either all present consumption would be turned into investment, or all investment converted into present consumption. Needless to point out, both these statements are economically nonsensical. A positive (private) time preference — i.e., for individuals (though not for the society) to systematically prefer present consumption over future consumption — is human nature; and it is as much a property of an Islamic system as of any other economic system. The Islamic alternative to interest, therefore, will have to devise equally efficient ways to more than offset private time preference in order to generate positive savings and investment (Naqvi, 1981b; and Naqvi and Qadir, 1986). 12 

iii. As opposed to the popular conception, risk and uncertainty do not necessarily constitute Islamically legitimate characteristics of interest in the meaning of riba. If this were so, then their values would have to be maximized. But this is not the case, because Islam has prohibited gambling, betting, and speculation. (Just think of Monaco and Las Vegas as shining examples of an Islamic economy!) (Naqvi, 1981b). 

iv. It has been widely noted by Muslim economists that the rationale (^cillat al-hukm) of the prohibition of riba is not just the mathematical formula per se used to compute it; it is rather the alleged adverse consequences of it on the distribution of income and wealth This is a correct position to take because, contrary to the Nozickian non-consequentialism (Nozick, 1974), Islam evaluates the correctness (or their opposite) of specific policies in terms of the acceptability of their consequences from the moral, economic,  and social points of view .13 However, such an assertion is essentially a refutable hypothesis, which needs to be examined from the theoretical and empirical points of view.   

Here I examine this argument, using Pakistani data, as given in Table 1. The situation in other Muslim countries can be examined likewise. It should be clear that the information given in the table does not unambiguously verify the hypotheses noted above. Instead, it shows that both the profit and interest incomes — as well as all other types of incomes identified in table — accrue more to the rich than to the middle-income and lower- middle-income groups; while the lowest of the low-income group gets nothing of interest and next-to- nothing of profits. The reason is that the initial distribution of income is highly unequal (see columns 1 and 2 of Table 1). Thus those who have more already shall be given even more! The table even makes clear that, relatively speaking, interest income is more important than profit income for the low-income and lower-middle-income groups (in the Rs 1001 to Rs 4000 range) and the reverse is the case for the high-income group (in the Rs 4000 and above range).

The next important question is: Would abolishing interest income make a significant difference to the relative income capabilities of different households so that the low-income and lower-middle-income groups will be better off and the high-income groups worse off as a result of the proposed Islamic financial ‘reform’? the figures given in parentheses in Table 1 suggest a negative answer

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TABLE 1

 

Distribution of Various Types of Incomes among Households and

 

Their Relative Shares in Total Household Income (1996-97)

 

         % of Total @                                                              Types of incomes (In percentages)

 

Income                Number of          Household       Interest  Profits  Wages and          others   Total income    

 

                 Households       Income in Rs                                     Salaries                                                       (%)

 

1.63             9.46                 Up to 1000                   0.00           1.02             1.14                    3.29          (100)             

 

                                                                                          (0.0)       (22.89)      (26.40)                               (50.71)

 

12.14          45.19                               1001 – 2500     7.53     5.89            16.59                               14.58           (100)

 

                                                                                       (0.06)     (17.88)       (51.79)               (30.27)

 

22.21        24.26                                2501 – 4000                 18.55        16.85          28.44                                20.71         (100)

 

                                                                                     (0.08)      (27.94)        (48.49)               (23.49)

 

64.02        21.09        4001 & Above          73.92    76.24       53.83                 61.42            (100)

 

                                                                                        (0.11)    (43.86)          (31.85)                     (24.18)          

 

100.00                    100.00                                          100.00   100.00                   100.00                             100.00                               

 

 

Source: Computed from Federal Bureau of Statistics (1996-97) Income and Household Survey (unpublished); and Rizwana Siddiqui and Zafar Iqbal (1999).

 Notes ^@ Columns 1 and 2 are taken from 1989/90 in Rizwana Siddiqul and Zafar Iqbal (1999) because the social accounting matrix for 1996/97 is not yet available; but it is reasonable to assume that these variables have not changed much in the short time-span of five years.

 1.Figures in parentheses show the relative share of each income type in total household income (read horizontally); whereas the figures without parentheses denote the distribution of each income type in different households (read vertically). 

 2. Income from profits in the low-income groups is derived from crop farming, livestock, and self-employment; while that from “others” comes from commercial and industrial activities, including rent from buildings, etc.  to this question as well: the weight (in percentages) of interest income in the total incomes of different household groups ranges from 0.00 percent (lowest- income group) to 0.11 percent (for the highest-income group). By contrast, income from profits dominates interest income in all income groups and lies between 22.89 percent (for the lowest-income group) and 43.86 percent (for the highest-income group). Thus, even if interest income is altogether abolished, the relative (monetary) entitlement patterns (and their expenditure patterns) will not change significantly for any of the income groups identified in the table. 

 But the point is that Islamic financial reform does not aim at abolishing interest income altogether. It rather seeks to convert it into profit income; which reform, if implemented, would at best leave the distribution of income between income classes unchanged. To eliminate zulm, the optimal remedy is to reverse the perverse flow of income by redistributing assets (e.g., by implementing land reforms, levying death duties, etc.) and by instituting an effective tax-cum-subsidy scheme in which the interest and profit incomes are appropriately taxed, and the tax proceeds used to compensate the losers in the marketplace. And, wherever it can be established that the institution of interest is ‘immiserising’ (as it is in the rural informal markets) for the poor and the indigent, the real remedy is to remit interest altogether, and/or to provide micro credit as interest-free loans (qara-al-hasan) or at low rates of interest; it is not to replace it by a profit-sharing system. 

 5. THE ‘SORROWS’ OF PLS 

 I now take up the second question: Does the PLS-only (or PLS-mostly) system offer a ready-made workable Islamic alternative to the modern-day banking interest? In particular, can it be predicted with a reasonable degree of confidence that such a system will tend to enhance the Islamic banks’ profitability and make them more depositor-friendly as compared with the interest-based banks? Even more important, can such a system definitively contribute to achieving the basic egalitarian objective of an Islamic economy? My answer to these fundamental questions is that, contrary to the almost universally-held opinion among Muslim economists and jurists, the PLS alternative does not guarantee an Islamically acceptable outcome in terms of the efficiency and equity objectives. In this context, it does not matter that only this principle meets all the legal and procedural requirements of the Shari^cah.  What matters is that the PLS principle, if applied ‘universally’, is likely to do more harm than good to the economy.

I shall first briefly recount the main theoretical reasons why a negative outcome is more likely when profits are substituted for interest in the banking  operations. Next, I shall present some empirical evidence on the working of Islamic banks in the last 15 years or so, which also tends to confirm some of these theoretical statements. 

 a. Equity 

 Is an unprotected (i.e., that without any guarantee about the nominal or real rate of return on deposits) and ‘universal’ (i.e., if only) PLS system likely to make the present financial system more equitable? It can be shown that a positive answer to this question is not possible on a priori grounds.

 i. I have shown elsewhere that, in sharp contrast to the usual assertions (Siddiqui, 1 983a; Rahman, 1992; Ahmad, 1994; and Chapra, 1996), a shift from the present interest-and-profit financial system to an all-profit financial system will not, in general, lead to a better equity outcome; instead, it is more likely to increase, rather than decrease, the size of the perverse flow from the poor to the rich. The reason is that in the new system the risk-averse savers/investors will be crowded out of the market, letting the risk-taking capitalists gain the most from a profit-sharing system; unless, of course, the former can anticipate with complete confidence that they will always get a higher reward in such a system; which is a contradiction (Naqvi and Qadir, 1986, 43-4)14 In other words, credible guarantees about a better rate of return on private savings must be provided to ensure that a PLS system will be preferred by the savers/investors.15

 ii. If the ‘power equation’ between the borrower and the lender is unequal, as it is between the banks and the depositors, then a profit-sharing system will most likely be inequitable (Kuran, 1995). 16Hence, to redress such imbalances, the PLS ratios will need to be determined exogenously by the government in such a manner that the inequality of the power relationship is offset by such an action.

 b. Efficiency

  Is a financial system based on profits alone (read, only variable rate of return) necessarily more efficient than the one based on interest-cum-profits? 17 Once again, my answer is that there is no positive answer as a general rule. Consider the following real-world situations, where the profit-based banking will be inferior to the traditional banking.

 i. In typical monopolistic or oligopolistic market structures, which also characterize the Muslim economies, excess profit, if any, made by Islamic banks is not necessarily a sign of (Pareto) efficiency, nor does it indicate a potentially equitable outcome; instead, as a rule, it signifies an ‘excess burden’ on the society in the form of a lower level of output and higher product prices.

 ii. Islamic banks, guided only by considerations of private profitability, will tend to under-invest in public-good type projects whose social profitability is typically higher than private profitability (e.g., public infrastructure, education, public health, etc.) because investment in them does not, as a rule, yield immediate (and large) profits. In sharp contrast, more investment will be made in high profit-yielding projects whose social profitability is very low, even negative (e.g., investment in wasteful luxuries). Also, such wasteful, though high-profit, investment may not be considered Islamic because it belongs in the category of tabdhir (squandering).

 iii. The moral hazard problem — when, due to information asymmetry, the mudarib (the agent) cheats the rabb al-mal (the principal) -  will be much larger than it is in the present system if Islamic banking is run on the PLS-only principle; and it will be more intractable because of the much higher cost of obtaining relevant information. Without a successful resolution of this problem, the PLS-based system will neither be efficient nor equitable.18 Indeed, it has been shown that a PLS-based system will not be preferred by the public unless perfect honesty prevails (Khan, W., 1985 and 1987), a condition unlikely to be satisfied in the real world because honesty is not a free good; it is rather a scarce resource which tends to constrain activities in which its input is large. It is well-known that investors almost never share true information about their profits with banks (and depositors). To enforce universal, unprotected PLS banking in such an atmosphere would entail unacceptable risk exposure and/ or heavy monitoring costs.

 6. THE EMPIRICAL EVIDENCE ON ISLAMIC BANKS

 Some information is now available to evaluate the main theoretical propositions of Islamic banking. As of the 1997 count, there are 177 Islamic banks in the world, of which 51 are in South Asia, 36 in Africa, 31 in South East Asia, 37 in the Middle East, and 12 in Europe, Central Asia, Australia and USA. The growth of these Islamic banks has been rather rapid. Thus, during the 1985—1995 period, such banks and financial institutions have increased 6.5 times; their total capita! is US$73 billion, total assets are US$147 billion, total deposits are US$112 billion, and net profits are a little over US$1 billion. However, the rapid growth of Islamic banks does not unambiguously bespeak their financial health: it has been estimated that 80 percent of the Islamic financial institutions are below the optimal size of US$500 million (Kahf, 1999). Many empirical studies have been done on the working of these Islamic banks, including those located in Pakistan, Iran, and Sudan. Also, a recent survey of expert opinion has been conducted by the Islamic Research and Training Institute of the Islamic Development Bank (IRTI, 1998) on 30 major, and some relatively minor, problems being faced by Islamic banks — both where they coexist with the traditional interest-based banks and where the former have completely replaced the latter (in Pakistan, Iran, and Sudan). 19

The essence of these findings is as follows.20

  Contrary to the theoretical expectations, the rate of return offered by Islamic banks has been generally lower than that of the interest-based banks in cases where they both coexist, as well as in Pakistan, Iran, and Sudan, where they have completely replaced the latter type. This unfavorable outcome may partly be attributed to excessive borrowing in Muslim countries to finance large fiscal deficits instead of controlling public expenditure and financing it with efficient and just taxes. However, the villain of the piece in reducing the rate of return is the large cost of monitoring the profits earned by the bank- financed projects, and of evaluating the feasibility of such projects in the first place.21 iii.    The incidence of the moral-hazard problem, which mainly explains points (i) and (ii), is pervasive; indeed, it threatens the very fabric of Islamic banking (IRTI, 1998) It has sharply reduced the capacity of Islamic banks to utilize their funds, and this has led to excess liquidity, which has lowered their profitability. In Iran, banks have not been able to invest more than 38 percent of their total assets after the introduction of Islamic banking — though, to some extent, this state of affairs is also due to the restrictions placed by the government on the type of investments where bank involvement is allowed (Iqbal and Mirakhor, 1987).ii.    A related development is that the cases of loan default have risen dramatically since the introduction of Islamic banks, which appear less able to deal with such cases effectively than the interest-based banks. It may sound odd but the fact is that Islamic banking has made it relatively easier for rich borrowers to indulge in dishonest behaviour at the expense of the not-rich depositors, who outnumber the rich depositors by a large margin. Thus, the size of the (involuntary) resource transfer from the poor to the rich has tended to be much bigger in Islamic banking

 Islamic banks have generally favored (near) fixed rate of return financial instruments like murabahah and leasing because of the severity of the moral- hazard phenomenon. Mark-up and instalment systems — and, to some extent, salam-type instruments — generally dominate (Haron, 1998; Wilson, 1998; Anwar, 1992; Khan and Mirakhor, 1990; and Iqbal and Mirakhor, 1987). The fixed return, i.e., the sale-and lease-based financing, accounts for more than 75 percent of total financing of Islamic banks, and the PLS-type financing only less than 14 percent. The experience of the Islamic Development Bank is no different in this respect: during the last 21 years of its operations, profit-sharing and equity- financing claimed no more than 7.7 percent of its total approved financing, while the rest was given as loan (35 percent), leasing (27.4 percent), and sale (22.2 percent) (1DB, 1998). Thus, notwithstanding its ‘optimality ‘from the Shari^cah. Point of view, the PLS financing has had few takers.

   7. THE  ROAD AHEAD  What inference do we draw from the above-mentioned theoretical arguments and empirical evidence about the working of Islamic banks? Let me make it clear that the above arguments do not necessarily imply that Islamic banking should be scuttled, if only because the empirical evidence presented so far is not enough to reject its basic hypotheses. However, this evidence also does not verify them, so that Islamic banking can neither be judged as an unqualified success nor declared a total failure. Thus, while we should do everything feasible to improve the efficiency and equity of Islamic banking, it is important that undue haste is avoided in making it ‘perfectly’ acceptable from an Islamic point of view. For what else is Islamically so perfect in Muslim societies? Rather than aim for an ambiguous ideal, we had better be content with doing something safer under the present circumstances. The following points are relevant to reorientate Islamic banking in a more realistic direction. iii. It should be accepted, and the sooner the better, that the PLS-based financial instruments in their classical form, like mudarabah and musharakah, are totally inadequate to meet all (or most of) the financial needs of a modem society, even though they have a definite place in the Islamic bank’s tool-box. To make progress, the relevant information about their failure so far to create a strong demand for the PLS products must be carefully analyzed. By the same token, the present mark-up and other sales-related instruments should be treated as essential aspects of Islamic banks because there is a demand for them; and also because these have been explicitly approved by the SharFah. Far from being considered as efforts to “sabotage” the Islamic banking system from within,23  these presumably second-best options seem to offer the only realistic way for Islamic banks to safeguard the depositor’s money in view of the widespread moral-hazard problem, and to meet the borrower’s preferences.ii. It is generally not true that the more risky, the more variable, and the less protected the PLS instrument is, the better it will be from the Islamic point of view. Such a belief, that an Islamically-legitimate financial instrument must involve risk and uncertainty, is based on a mis-specification of the attributes of an Islamic financial instrument. Indeed, if not properly qualified, such a statement is false. This is because, as I have argued in the third section of this paper, risk and uncertainty impose a social cost on the economy which needs to be minimized, not maximized. The fact is that a minimum element of ‘fixity’ with respect to their rate of return is essential for modern financial institutions, including the Islamic ones, in order to keep a balance between risk-control and risk-taking.22i. The question of finding an optimal policy equivalent of bank interest (assuming that it has been correctly identified as riba) should not be taken as settled- certainly not because of its alleged Divine nature. Islamic banking will be judged as superior to interest-based banking only if it leads to better efficiency and equity outcomes. Such issues merit a rational response, not vapid moralizing, from Muslim scholars in the light of the feedback from the real world in order to make this important and original financial experiment a success — especially now that the news is not good for the Islamically-favored investment banking, from which even the top three specialist investment banks in the world (e.g., Merrill Lynch, Goldman Sachs, Morgan Stanley Dean Witter) are pulling away because of the difficulty of managing information risk (Cookson, 1999).viii.  The problems of Islamic banks in a ‘mixed’ set-up — i.e., where they coexist with interest-based banks — are no different from what they are facing by going it alone. Thus, in Malaysia, the rate of return offered by BIMB (Bank Islam Malaysia Berhad) has been generally lower than that offered by the traditional banks (Ariff, 1989); people generally do not understand, even after ten years of its operations, what it stands for, and that only the Malays bank with it because they are Muslims (Haron, Ahmed and Shanmugam, 1993); and that the sources of funds of BIMB have generally declined over the years (Haron and Ahmed, 1993). Islamic banks in other countries, where a similar ‘mixed’ system prevails, have not done any better. In addition to the difficulties noted in (i) to (vii), such banks are also likely to face the problem of adverse selection — i.e., that only investors with inferior projects (in terms of their profitability) tend to go to Islamic banks, while those having financially sound projects may like to do business with the interest-based banks (IRTI, 1998).vii. In Sudan, according to some recent studies, the financial development and the degree of intermediation of the banking system have sharply deteriorated since 1990, when Islamic banking was introduced. It slowed down economic growth, leading to macroeconomic instability (Elhiraika, 1998), and contributed to a greater volatility of asset returns (Bashir, 1999). Now, it will be unfair to blame Sudan’s economic woes entirely on Islamic banking; and things may start improving as the Islamic banks learn to manage risk by devising financially viable asset portfolios and as the state of the economy improves generally; but the point is that to make Islamic banking a success a lot of ingenuity and hard work will be required.vi.    The heavy concentration of the Islamic banks’ portfolios has made their asset structure highly unstable, as they cannot minimize their risks (IRTI, 1998).  Their incapacity in this respect is likely to be much greater than that of the interest-based banks, which too are finding it difficult to deal with the extreme financial volatility in the post-’97 world.

 Above all, Islamic banking should not be seen as an implementer of a strictly non-consequentialist type of financial ‘reform’, which insists only on the fulfilment of some formalistic, procedural aspects of the Shari^cah. True, doing this is also important, if only to differentiate Islamic banking from interest- based banking, and the work of the pioneers (Sadr, 1 982b; Siddiqui, 1 983b; and Chapra, 1985) in this respect must be duly acknowledged, but it will be counterproductive if we stop at that and do not devise ways and means of linking up these procedural aspects with the egalitarian objectives — i.e., maqasid al-shari^cah — of an Islamic polity; which are, among others, to prevent concentration of income and wealth and to accord priority to the needs of the underclass — say, by extending micro credit to the rural poor who at present must borrow from the informal market at exorbitant interest rates (see Section 4).24

 It follows that the banking system will be seriously destabilized if even the Shari^cah -compatible fixed rate of return instruments are abolished forthwith as an act of financial cleansing and replaced by the presumably first-best PLS principle, as strongly recommended by many Muslim economists and jurists (e.g., Rahman, 1992). Doing this will also go against the latest thinking on Islamic banking, which explicitly recognizes that Islam’s is not a pure profit- sharing economy and that optimal financing arrangement will involve both debt and equity (Naqvi, 1994; and al-Jarhi, 1999). The point is that all sales contracts (e.g., istisna, ijarah, bay^c mu ‘ajjal, and bay^c al-salam), where either the actual payment of price or the delivery of goods or both the price and goods are deferred and which need to be financed, are allowed by the Shari^cah because the financial transactions in all these cases are related to the corresponding ‘real’ transactions (e.g., Elghari, 1999; Iqbal, Ahmed and Khan, 1998; Wilson, 1998; and Zarqa, 1997).25 The general belief that because all or some of these debt instruments look like riba, their use must be restricted is totally unwarranted, even from the Shari^cah point of view (Khan, F., 1994). These instruments have been adopted by the Islamic Development Bank as the basic set of Islamic modes to finance infrastructure investment, to promote trade in capital goods, and to meet the liquidity needs of corporations. What may attract the Shari^cah’s sanction are those financial transactions - e.g., the so-called ‘derivatives’ — which appear to belong in the realm of gambling. However, appearances may be deceptive because financial derivatives — the use of which has risen 12-fold since 1990— are relatively efficient methods to transfer investment risk from those who do not want to take it to those who do.26 The challenge facing the Muslim economists (and ^Culama) is to do financial engineering in the context of the fully monetized modern economies in which, unlike the medieval barter economies, the relationships between the nominal and real transactions are not always unambiguous and direct. The aim should be to make available the maximum number of financial instruments with a view to satisfying consumer demand, minimizing risk exposure, and limiting the incidence of moral hazard.

7.1 THE INDEXATION OF PUBLIC BORROWING

The most difficult problem, which has not been resolved satisfactorily anywhere in the Muslim world, is that of public borrowing from the bank and non-bank sources. The PLS principle is hopelessly out of place here. One option is to declare such borrowing at fixed rate as not interest, as has been done in Iran (Iqbal and Mirakhor, 1987). The other is a variant of the indexation scheme, which, in my view, is perhaps an ideal replacement for interest, especially in the case of government-borrowing from the banking system and the public.27

 My scheme is that the rate of indexation should be equal to the current (or expected) rate of inflation plus an amount equal to the increase in the Gross Domestic Product, due to the contribution of capital (K).28 The results of the calculation on the basis of this formula are given in Table 2.

 TABLE 2

 

Calculation of Rate of Indexation (Return) *

 

Year                      Inflation Rate                    GDP Growth                       K-share in           Rate of

 

      (%)                                   Rate (%)                               GDP** (%)           Indexation(%)

 

1990-91                      12.66                                             5.50                                      70.69                   16.50

 

1991-92                     10.58                                              7.71                                      0.69                      15.90

 

1992-93                   9.83                                   2.27                                      0.69                      11.40

 

1993-94                  11.27                                 4.54                                       0.69                      14.40

 

1994-95                  13.02                                 5.24                                       0.69                      16.63

 

1995-96                 10.79                                  5.19                                       0.69                      14.37

 

1996-97                 11.80                                 1.30                                       0.69                      12.70

 

1997-98                     7.8                                  5.44                                       0.69                      11.57

 

Averages                  10.97                                               4.66                                       0.69                      14.18

Notes:   * Estimated by the World Bank.

** Rate of Indexation Inflation Rate + (GDP x K-share in GDP), where K is

    capital.

The following points about this table are noteworthy:

i The rate of indexation does not necessarily increase with time alone. In other words, it is not true that the longer the period, the higher the rate of indexation. Thus, as Column 5 of Table 2 shows, the rate of indexation would have been 16.50 percent in 1990/91 when the GDP and the inflation rate were higher, but only 11.57 percent in 1997/98, when both were lower. Also, the average rate of indexation has fallen over time to 14.18 percent during the 1990- 98 period, as compared to 16.5 percent during 1990/9 1; but it could also have risen if the inflation rate and/or the GDP had increased.

ii. The rate of return due to indexation is not pre-determined in any way, nor can it be predicted with complete certainty.

 iii. The rate of indexation is related to the increase in the flow of goods and services in the economy.

 It should, therefore, be obvious that the proposed indexation formula satisfies even the strictest requirements of Islamic legitimacy, as noted in Section 4 earlier. It can also be applied with minor modifications to ensure a reasonable real rate of return on bank deposits.

8. EPILOGUE 

 The preceding arguments warn against faithfully translating the ideal of a universal, unprotected PLS principle into reality (and are there any ideals ever fully translated into reality?). I have argued above that what may be the first- best options from the Shari^cah point of view (i.e., mudarabah and musharakah) have not, in practice, turned out to be the first-best from the economic point of view. Here is yet another illustration of the ubiquity of the constrained optimization phenomenon in economics. In other words, the second-best policy options have to be accepted as a kind of ‘sub-reality’ when the first-best ‘real thing’ is excluded by institutional and informational constraints. Let the best not be the enemy of the good! By the same token, it would be counter productive to do away with mark-up, instalment sales, salam, istisna’, etc., just because they create debt-like liabilities. The fact is that these are Islamically legitimate policy instruments. A lot of confusion can be avoided at both the theoretical and practical levels if these instruments are accepted as integral parts of Islamic banking, without any sense of imperfection or sin.

Islamization must be seen as a process during which several ‘concessions’ to reality will have to be made, even if that means treading the thin line between Islamically-legitimate and illegitimate policy instruments. As long as a fully fledged Islamic economic system does not become operational, we will have to make do with Islamic policy instruments that are compatible with a capitalist economic system. This has already occurred in Pakistan and Iran — to minimize unnecessary risk and to save the depositors’ money against fraud by the borrowers. For example, in Iran, the return on deposits and the profit-sharing ratios are determined by Bank Milli (the central bank), not necessarily related to the growth of the GDP; and the nominal value of deposits is guaranteed. Even more important, as noted above, public borrowing from and within the nationalized banks is done on a fixed rate of return basis, which has been decreed as not interest. In Pakistan, the profit-sharing ratios are fixed by the State Bank according to their maturity structure, which makes it time-related. We now need to go a step further and devise Islamically-legitimate guarantees about the real rate of return on deposit.29

The financial system, with its never-ending search fur new ways to remain profitable, has always been a delicately balanced affair, but it will become the more so as globalization gathers momentum and as information risks get transmitted at a very rapid speed around the globe. It also implies that the Islamic financial system cannot be very different from the world financial system to be able to interact with the latter, as long as we do not find efficient and equitable financial instruments, and that is no going to be very easy. So, until such time, we must not rock the financial boat by raising the risk exposure of Islamic banks for the sake of an illusory financial ‘purity’. Harkening back to the beginning of time to fetch readymade answers to the difficult problems of the modem era is a futile venture. We should, instead, plant the roots of Islamic banking in the reality of today. To this end, we need to focus attention on building fences around this important institution by punishing dishonesty, by making loan default a social crime, by making it mandatory to honor voluntarily agreed contracts, and by promoting respect for private property rights where their exercise does not conflict with similar rights of others. It is only when these Islamic values have effectively been internalized that Islamic banking can win the support of the depositors, who should not be taken for a ride by the banks and the investors in the name of Islam.

 The time has come to go beyond mere rhetoric and sterile formalisms.30 There is a consensus among Muslim economists that Islamic banking is not just interest-free banking; it certainly does not mean that capital will become a free good once interest is abolished (Ahmed, 1976; Sadr, 1982a; Khan and Mirakhor, 1987; and Naqvi, 1981b). It is also agreed that Islamic banking, however defined, is only one of the policy instruments for the realization of the Islamic goal of an exploitation-free society (Naqvi, 1981a). An Islamic economic system will not emerge only if bank interest is abolished and Islamic banking instituted; rather, it will come when zulm is vanquished in all its manifestations, including interest. A comprehensive agenda for Islamic reform should include decisive steps to universal education, access to health facilities, reduction of the widening gap between  the rich and the poor, and stemming the rising tide of  poverty which darkens the face of the Muslim societies around the world. Then, there is the much publicized corruption to deal with; and, of course, ostentatious expenditure by the rich fosters social discontent, even when the basic needs of the poorest are relatively adequately met (as is the case of the oil-producing Arab countries). It also directly conflicts with Allah’s commandment: “Squander not your wealth among yourselves in vanity...” (Qur ‘an, 4:29). Ignoring such clear-cut instructions is also waging war against Allah, and those who do so are called the “Brothers of Devil” (Qur ‘an, 17:27).

• Islamic-reform, including Islamic banking, will evoke voluntary popular support only if it touches the people’s hearts and has the grasp of substantive social and economic issues which blight men’s/women’s daily lives in many societies. However, if we remain entangled in procedural issues and legalistic hair-splitting about unattainable financial ideals, then such efforts will be met only by an apathetic response from an enraged people. To rekindle the hope for a peaceful social change in Muslim societies, where social injustice abounds, there must be decisive action to end the treason against humanity by restoring to the poor their “due share” in the wealth of the rich as the Holy Qur ‘an ordains (Qur ‘an, 70: 24-25). Thus, initiating and completing the gigantic task of Islamic reform is both an opportunity and a challenge; an opportunity because modern societies have traded moral excellence for material prosperity, which too is a monopoly of a few; and a challenge because Islam has shown the way by emphasizing that we become more prosperous and gain spiritually by giving to those who do not have: “How will you comprehend what the steep ascent is? To free a neck (from the burden of debt or slavery), or to feed in times of famine. The orphan near in relationship, or the poor in distress. . .” (Qur ‘an, 90: 12-16). Until such challenge is accepted as a positive opportunity by Muslim societies, Islamic economic reform, much less Islamic banking, will continue to elude its advocates in any substantive sense.

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ENDNOTES

  

ENDNOTES

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Shariat Court

Judgement on Interest (Riba). Lahore: PLD Publications, 1992

 

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1 The problem noted in the text is a historical one. Rahman, F. (1980, 239) noted that “Islamic ethics proper, systematically based upon a genuine understanding of the purposes of the Qur’an, did not develop until later in Muslim history. The leaders of the Shari^cah made particularly no distinction between ethics and law..” (emphasis added). This point is elaborated in detail in Naqvi, (1981a and 1994).

2 Such a ‘procedural’ view has also been taken in the celebrated judgement of the

 Federal Shariat Court of Pakistan, written by (Rtd) Chief Justice Tanzilur Rahman.

3 A kind of consequence-sensitive approach is implied in F. Rahman (1964), Mawdudi (1967), Sadr(1982b), Jauhri (1986), Taleghani (l987),Ahmed (1976), Khan, F. (1994), and Chapra (1996). However, in each case, the ‘procedural’, legalistic point of view dominates.

4  See Kamali (1999, 206) for the importance of Maqasid al-Shari^cah to integrate “versatility and comprehension in the reading of Shari^cah.”

 5 1 have argued that all the basic Islamic economic statements can be deduced from an irreducible set of four Islamic ethical axioms—namely, Unity (Tawhid), Equilibrium (al-^c adl-wa-al-ihsan), Free Will (Ikhtiyar), and Responsibility (Fard). The corresponding policy objectives are individual freedom, distributive justice, universal education, economic growth, and maximum income generation. Prominent among the policy instruments are the restructuring of the private property rights, especially in the rural areas, to minimize the role of the rentier class; the adoption of growth-promoting policies which lead to a distributionally just growth path; the institution of a comprehensive social security system; a rationalisation of public ownership; and, of course, the abolition of interest from financial transactions (Naqvi (1978; 1981a and 1994). Together, the ethical axioms, policy objectives, and policy instruments define an optimum regime, which, as I noted in the text, is distinguished by its overarching quality of social justice and the primacy it accords to the needs of the underclass in society (Naqvi, 1997). See also Nazeer (1981), Anwar (1987), Haneef(1995), and Hasan (1998) for the outlines of an Islamic economic system. Jomo (1993) gives a good collection of various (even conflicting) points of view on Islamic economic system; and Sirageldin (1995) offers a useful review of the problems that Muslim societies are likely to face in implementing Islamic ethical axioms.

 7 . “A zero rate of interest is a little like an absolute zero temperature in Physics. We can imagine getting closer and closer to it, but we can hardly imagine actually reaching the limiting state of zero equilibrium rate of interest. Thus, interest is a basic phenomenon unlikely to disappear even in the most ideal economic world (Samuelson, 1976, 606, emphasis added). It follows that the possibility of reducing interest rates to a very low level (as is the case now in most OECD countries) must not be confused with a situation envisaged in Islamic economy, where it becomes zero and stays there for ever irrespective of the state of the economy.

 10 Haque (1985), pointed out that riba and bay^c essentially stand for two antithetical systems: while the former signifies all exploitative relationships, the latter indicates fair exchange. See also Naqvi et al. (1980 and 1987) for a full statement of a systemic approach to Islamic reform. Whence follows that a mere substitution of the PLS-only based system for the present financial system will not necessarily usher in an Islamic system, if the basic structure of private property, ownership and production relationships are also not suitably changed to conform to the Islamic ideals of al-^c adl wa al- ihsan..

12 Contrary to the opinion held by some Muslim economists (which has also been reflected in Rahman, 1992), savings are positively related to changes in the real interest rates (see Williamson and Mahar, 1998, 48).

 13 See Naqvi (1993) for details of the consequentialist and non-consequentialist philosophies, esp. chap. 5.

 15 Such guarantees can take the form of a commitment that the commercial banks will at least provide to the depositors a zero real rate of return (i.e., adjusted for the inflation rate) plus a reasonable amount depending on the growth rate of the GDP and /or on the profits made on their investment. (See the section on Indexation of Public Borrowing in this paper.) The institution of a ‘hedge fund’ (like the Long-term Capital Management in the US) and/or a stabilization fund can help, to some extent, to assure the depositors about the expected return on private bank deposits.

 

 17 . The argument in the text does not deny that equity financing is in some respects superior to debt financing. For instance, Klein (1991) argues that developing countries will be better off if private capital inflows took the form mostly of equity financing rather than of debt financing. However, this argument cannot be used to support the Islamic case for abolishing debt financing altogether.

 18 The moral hazard phenomenon, noted in the text, is by no means specific to Islamic banking; it exists in all situations, quite common in a capitalist system, where de centralized decision-making is the rule, and where there are incentives for economic agents (the agency), whose activities cannot be perfectly monitored because of high information cost by the provider of capital (the principal) (Akerlof, 1970). But the point is that such information costs will become too high in a profit-only system to insure against risk (as the premium will be too high). Ways and means must, therefore, be found to minimize such costs.

 19 The findings of IRTI’s survey have since been reported in Iqbal, Ahmed and Khan (1998 ).

 20 . For a relatively more favorable, though still critical, reading of the state of Islamic banking, seeAhmad (1994), Homoud (1994), and Mirakhor (1997).

 21 The expectations for a higher rate of return are generally based on an accounting truism: “when the interest rates are replaced by profit-sharing, the constant per unit cost to the firm of borrowed capital is removed,” (Ul-Haque and Mirakhor, 1987). But this is an over- simplification of a rather complex situation, because Islamic banks have to incur large fixed unit cost on account of the comprehensive retraining of staff to enable them to evaluate and appraise investment projects, and for reform of the auditing arid monitoring system (Iqbal, Ahmad and Khan, 1998). In practice, such costs have tended to be at least as large as the interest cost; indeed, it appears that the former have been higher than the latter, which factor, among others, seems to account for a decline in the rate of return on deposits offered by Islamic Banks.

 22 Compare the statement in the text with that by lqbal, Ahmed and Khan (1998, 68), “under present circumstances the use of tools like murabahah by Islamic banks is indispensable. Until proper institutional set-up is built and needed products, including those for managing risk, are developed, it may not be advisable to drastically increase the use of risky modes.”

 23 See Nejatullah Siddiqui’s quote in paragraph 261 in Rahman (1992).

 24 The Islamic Development Bank is doing a commendable job in this respect: in the last 21 years of its operations, one –fifth of its total financing has gone to the Least Developed Member Countries (LDMCs) (IDB, 1997).

 25 It may be noted that the Appellate Bench of the Supreme Court of Pakistan, which announced its Judgement on riba on 23^rd December 1999, has rejected the earlier judgement of the Federal Shariat Court noted in the text. It has held that “murabahah mode of finance or the “mark-up” system with the conditions attached thereto is a permissible mode of Islamic finance and this mode cannot, therefore, be held repugnant to the injunction of Islam if the conditions prescribed are not being practised by some of the parties. . .” (Appellate Bench, 1999).

 26 Financial derivatives essentially comprise forward contracts and ‘options’. In the former case, the party to an exchange agrees to buy something at an agreed date in the future for an agreed price; while in the latter case a purchaser is enabled to buy or sell an asset on a given date but is allowed not to do either if he so decides. The proposition that an increasing use of financial derivatives has added to the volatility of the world financial system (the 1987 stock market crash has been blamed on it) because it encourages excessive risk taking is not generally true. The severe incidence of financial distress (including cases of financial bankruptcy) is due rather to specific unwise practices of certain firms and companies — e.g., an option seller hedging himself by buying and selling another option, or a company buying assets and using it as a collateral for a loan. See The Economist (1999), for an interesting discussion on financial derivatives.

 27 The arguments against the indexation principle occupy 34 pages of Rahman (1992, paragraphs 101 to 135). I am afraid that most of these arguments and assertions are either wrong or irrelevant to the problem in hand. Thus, for instance, no one has ever said that indexation “controls inflation” (paragraph 158), or that it is a “cure for inflation” (paragraph 161), or that indexation “drives out equity capital” (paragraph 162). Similarly, the opinions of the fuqaha’ (jurists) given at length regarding the consequences of demonetisation (paragraphs 213-218), of counterfeit coins (paragraph 219), of adopting the bimetallic standard (paragraph 221), etc., are totally irrelevant to the problem in hand. What is worse, Rahman (1992) even closes the door on ijtihad regarding this issue on the ground that no nas (directive) exists about such a problem (paragraph 174). However, his argument is unsatisfactory because nas (directive) cannot exist about a non-existent phenomenon! The fact is that modern inflation did not exist anywhere in the essentially non-monetised economies of the Middle Ages. The earth-shaking finding cited in Rahman (1992, paragraph 42) to prove that inflation did exist in the early Islamic period — that prices rose by 15 percent during the period of Khulafa ‘al-Rashidin and Imam Yüsuf— is really laughable. This is because a 15 percent increase in the price level over a period of more than 100 years comes to less than 0.145 percent per annum, which is really a zero inflation rate.

 28 . For details of the scheme given in the text, see Naqvi (1994, 132-5).

 29 I have shown that “banks and financial institutions will have to devise portfolios containing alternative investment possibilities, which are related to basic real profit rate, which is zero... All other profit rates on investments carrying varying degrees of risk will change as the basic rate changes.” (Naqvi, 1994, 131-2).

 30 The Holy Qur’an warns against socially insensitive religiosity: “Hast though observed him who belieth religion? That is he who repelleth the orphan, and urgeth not the feeding of the needy...!” (Qur’an, 107:1-3).

 This is referred to hereinafter as Rahman (1992). This judgement has been reviewed by

the Shariat Appellate Bench of the Supreme Court of Pakistan. See footnote 23.

 

 6 The translations of the Quran cited throughout this paper are by Yusuf Ali (1938), Pickthall (1979), and Ali (1984). 

8 The strong sentiment for PLS (mudarabah) -based financial system and against the one based on interest derives from the Qur’anic Verse: “Allah has allowed bay^c (sales) and has forbidden riba (interest)” (Qur’an, 2: 275); and it also draws support from the practice (Sunnah) of the Holy Prophet who, along with his wife Khadijah, took active part in trading. However, Haque (1985) argued against a simplistic equation of bay^c with PLS (and equity capital) on the ground that there may be an element of riba in PLS transactions as well! Incidentally, many trading practices, some of them similar to, though not identical with, mudarabah were also prevalent in the Jahiliyyah (pre -Islamic) period. On this, see Razavi (2000). In modem times, the sentiment for PLS can (mistakenly) be strengthened by the Asian crisis where debt capital (equated to riba), as opposed to equity capital (equated to bay^c), is alleged to have played havoc with these economies. This view is mistaken because the financial crisis in East Asia has been mainly due to an excessive reliance on short-term foreign capital to finance long- gestation period projects.

 9 Compare Sadr in Jomo (1991, 35-6): “. . . we should not study the Islamic  prohibition of usury or tolerance for private ownership separately from the general plan Of the Islamic economy.”

 11 However, it should be noted that any excess amount paid by the borrower voluntarily (by the borrower) at the end of the contract is not riba; indeed, the Prophet encouraged such a practice by his own example. See Rahman (1992), paragraph 88.

 14 The theoretical demonstration that the rate of return in an unprotected PLS will normally be higher than in the interest- and profit-based system (e.g., Ul-Haque and Mirakhor, 1987) is based on somewhat restrictive assumptions. See footnote 18.

 16 Russell (1938, 9) shows that the power equation plays a central role in social, political, and economic affairs: “Power is to social dynamics what energy is to Physics.”

 

 

 

 

 

 

 

 

 

 

 

 

v.   The investment portfolios held by Islamic banks are typically ‘loaded’ by trade-related activities. During 1994-96, only 13.4 percent of their lending went to agriculture and manufacturing, while the rest was taken up by trading (42.4 percent), real estate (12.9 percent), services (11.2 percent), and others (19 percent) (Iqbal, Ahmed and Khan, 1998; and Anwar, 1992). Also, the investments made by Islamic banks are of even shorter duration than is the case with the interest- based banks. The longer-term investments have generally suffered. In this respect, the Islamic Development Bank’s financing activities present a better picture: in the last 21 years of its operation, public utilities have accounted for 23.4 percent of its project financing and technical assistance activities, followed by industry and mining (20.4 percent), agriculture and agro-industry (18.7 percent), transport and communications (17.9 percent), social services (17.5 percent), and others (2.0 percent) (IDB, 1998).