What is the nature of Islamic banking and what is a possible alternative model on the basis of which it can be functionally organized? This is the question this article attempts to discuss. By suggesting a starting point and possible growth path, it is intended to provide a direction in which thinking and planning may take place and creative minds may actively contribute.  

Launched in Pakistan in 1981, the new system of Islamic banking has been kept optional for the depositors as well as for users of banks' funds, except for some specified transactions and for the financing of 'Commodity' and 'Trading' operations of the government and its wholly owned organisations. It is now being proposed to make Islamic banking the sole method of resource mobilisation and financing in Pakistan. The application of Islamic principles in banking on such a large scale has not been tried anywhere in the world. It, therefore, becomes essential that an adequate model and framework is properly developed. The model should incorporate all salient operational aspects of banking including new methods of management of liabilities, assets, profit-sharing and control by the Central bank. One view commonly prevalent is that through minor modifications in some of the laws and a re-arrangement of the bases of liabilities and assets, etc. a suitable framework can be obtained for launching a complete system of Islamic banking. It is the view of the author that this is not possible, and that in order to make it grow smoothly, a complete reformulation of the legal codes and operational techniques of banking is required. Similarly, radical modifications are needed in the organisational structure of banks to meet the demands and the challenges which the elimination of interests shall pose. In short, a totally new model of banking is required. This paper presents one such model that could possibly serve as a base for future sophistications. The paper is divided into three parts.  

Part - I discusses the role of financial intermediation in Islamic banking. It shows that the classical concept of financial intermediation has a limited application in the Islamic system and the financial instruments devised on this principle, even if these meet the minimum requirements of acceptability, shall be inadequate to fully convert the existing interest based system to the desired Islamic system. It also discusses the alternate approaches towards finding appropriate solutions and highlights the frontal clash between the existing banking laws and the injunctions of Sharia.

Part - II discusses possibilities of finding new outlets for utilisation of resources in accordance with principles of Sharia and presents a model of trade-based banking within the existing legal frame-work.

Part - III deals with operational problems of deposits management, division of profits between PLS depositors and the share-holders of banks, the maintenance of liquid Assets, and avenues of profitable short-term investment under Islamic banking.

PART- I

Financial Intermediation: It is in the nature of interest, and therefore, in the nature of interest-based banking, that banks could limit themselves to the role of classical financial intermediation. Over a period of centuries banks have developed a large number of interest-based instruments that facilitate financial intermediation between the depositors and the borrowers of funds. In the changeover this aspect of banking requires careful study. For Islamic banking an adequate answer to classical financial intermediation is a formidable challenge. 

Financial intermediation in Islamic Banking: In the last three years which was period of trial and testing for the utilization of interest-free deposits, the exercise in Islamic banking in Pakistan in our-view, has not moved on a path that could ultimately prove a highway for its long journey.

 Islamic investment is a field about which people had little idea practically. Naturally they experimented with such Islamic investment techniques which apparently corresponded with the prevalent instruments of the interest-based system and provided a semblance of financial intermediation. Consequently, the techniques of mark-up in price and hire-purchase, etc., were extensively utilised. Now that Pakistan is going for full scale Islamic banking, it is incorrect to assume that total conversion can take place on the basis of these techniques alone. Being second-rate techniques, these must be used sparingly in Islamic banking, and then only as a second line of operation. Moreover, where it is unavoidable to make use of such techniques, these must be applied and operated at least in a first-rate manner. This observation particularly applies to the operational aspects of mark-up in price which technique is not adequate to meet the full working capital requirements of a present day manufacturing industry besides being full of accounting difficulties.

These second-line techniques are primarily resorted to because the truly versatile and front-line Islamic alternative of shared-risk is considered difficult by banks as well as users of bank finance for their own reasons, while the government has taken no affirmative action to promote this arrangement. Now, if the system of profit and loss sharing has its difficulties, the second line techniques are also not free from problems. For example, in case a lessee or a hirer or a buyer under mark-up arrangements defaults the payment to a bank on the due date, he can not be charged any additional sum for the delayed payment, as was the case under the interest-based system. Only the government can decide to impose legal penalties or a fine, as a deterrent against willful defaults. The banks thus face a serious problem in investing their interest-free deposits, as classical financial intermediation is not possible while the second-line techniques are not expected to provide sufficient outlets for the available PLS funds.

 Islamic alternatives:

 There can be two approaches towards developing Islamic alternatives to financial intermediation.

 (a) Simplistic View: We may assume that banks will continue financial intermediation, but in a modified and ‘Islamised’ manner. With this in view we may attempt to devise Islamic equivalents for each and every financial instrument and technique offered by interest-based banking. This could be an acceptable approach if it were practicable and adequate. Why the simplistic view is inadequate? The liability side of a bank's balance sheet, i.e. deposits, can be easily converted from the basis of interest to the basis of participation in profit and loss. In fact, the process of change is continuing smoothly and the PLS deposits as a whole are showing a steady growth.

However, to convert the entire assets of banks on the bases of the techniques, currently in use, i.e. participation in profit and loss, equity financing, mark-up in price, leasing, and hire-purchase in a formidable proposition. Will these financial instruments and techniques alone be adequate to facilitate, in the foreseeable future, an investment of Rs.115,000 million (Rupees eleven thousand five hundred crores), which is the present approximate size of domestic deposits in Pakistan ? In our view the answer is in the negative. The conversion of deposits without a commensurate shift of interest-based advances into the orbit of Islamic banking operations is leading the banks into a 'scissors crisis'. That is, in the interest-free sphere the banks are facing the problem of uninvested excess funds, while in the interest-based system they face stringent liquidity problems due to excess loans and advances. In the absence of adequate avenues for investment this will continue to remain a critical issue. This situation underlines the need for finding new avenues of interest-free investment at an accelerated pace. But the new avenues must have enough elasticity for the growing amount of PLS deposits to be fruitfully utilised. The Islamic instruments and techniques currently available seem to lack this elasticity.

 (b) The Comprehensive View: We may determine the basic needs of an Islamic economy and then develop practicable and effective methods of mobilisation of resources and their productive utilisation strictly on Islamic principles while keeping the banks viable in all respects. We must concentrate on substance and objectives of the system even if it requires radical changes in the traditional form and functions of banks.

 Main Hurdle:

 "Allah permits trading and forbids Riba", enjoins the Holy Quran (II:275), In Pakistan, the Banking Companies Ordinance, 1962, permits interest and prohibits trading, and a similar situation prevails in almost all Muslim countries. This confrontation persists despite the fact that the constitution of Pakistan clearly specified that no laws shall be framed which was repugnant to the Holy Quran and the Sunnah. Such conflicts in the situation, and many more, have to be faced and resolved if we have the determination to achieve our objective of eliminating interest from our economy. Now assume that the Banking Companies Ordinance is amended and the banks are forbidden to deal in interest. It will then amount to saying that Banking Companies Ordinance 'forbids interest and prohibits trading'. In a hypothetical legal situation like this, what outlet will remain available to banks to profitably employ the deposits mobilised by them?

 PART- II

 The Solution: Trade based banking: While disallowing interest Allah provided the alternative as well. We have been told that "Allah permits trading" before being told that Allah "forbids interest". At another place, the Holy Quran enjoins "O you who believe! devour not each others wealth among yourselves through evil/undesirable means except it be a trade by mutual consent" (IV:29). Obviously the most favoured Islamic alternative to interest-based transactions is the concept of sale/trade with all its varied applications. Trade-based banking is, therefore, the only logical Islamic alternative to interest based financial intermediation.

 The First Step: Change in Banking Laws: This calls for a fundamental change in the approach. To really help Islamic banking take roots, grow and flourish in a natural way, the basic governing laws first need to be recast in such a manner that a natural path for trade-based Islamic banking is clearly demarcated. Piece-meal legislations may prove incompatible with its innate long-term path of growth. Only a synchronized and integrated legal framework can provide a sustaining environment for the development of a full fledged Islamic banking system. And this is possible only if its future pattern is considered in a long-term perspective. Some amendments were made in Pakistan's banking laws in December, 1980 which allowed the banks to undertake specific financing operations of a trading nature on a restricted scale on the basis of profit and loss sharing, mark up, leasing and hire-purchase. While allowing that it was stated that the relevant clause pertaining to ‘prohibition of trading’ did not apply to the said techniques. This indicates a patchwork approach. Unless a grand strategy is devised with full recognition of the long term future needs of the Islamic banking system, and until a supportive legal framework is developed, we will find ourselves bogged down with the inertial and gravitational pull of the vast size of the existing interest-based system.

 The New Strategy: Trade-based Islamic banking can be conducted in two different manners: through indirect trading, and direct trading. In indirect trading as well as in direct trading operations, banks shall be performing the role and functions of a ‘Modareb’. This will be totally in accordance with Sharia. However, currently, banking laws while allowing indirect trading, do not permit direct trading. Investments can be made through indirect trading operations such as participation in profited loss mark-up, leasing and hire-purchase which techniques are considered free from interest and present a semblance of financial intermediation. This is being done at present with the help of a patched up law.

 Direct trading operation can be undertaken by banks on their own account like any other joint stock company. For this, amendments in laws will be needed as already discussed. The accounting for the two types of trading operations will have to be kept segregated. In order to keep adequate control on the direct trading operations, these shall also be regulated and supervised by the central bank. The Central Bank shall ensure that banks do not utilize their entire PLS deposits in their direct trading operations to the exclusion of other users of bank finance by specifying any of the following conditions:

It can be laid down by the central bank that:

 (a) no more than a certain percentage of banks' total PLS deposits shall be invested in direct trading operations, or

(b) PLS deposits held with banks for more than a certain term (for example PLS deposits kept for 5 years) can be invested in direct trading operations, or

 (c) banks can conduct direct trading operations through funds mobilised on the basis of Modaraba. A proper frame-work can be developed to regulate the direct trading operations and also to provide the necessary safe-guards.

 Based on the concept of Modaraba it is possible to devise a workable model of trade-based Islamic banking which can be molded even under the existing laws. The steps involved are as under:

1. The banks shall get themselves registered as a 'Modaraba Company' under Ordinance No.XXXI of 1980 known as Modaraba Companies and Modaraba (Floatation & Control) Ordinance. The banks can thereafter float Modarabas.

 2. Of the four different kinds of modarabas, the 'Multipurpose Perpetual Modaraba' shall be appropriate for conducting the direct trading operations as an additional outlet for investments under Islamic banking. The three other kinds of Modaraba are (1) multi-purpose fixed period, (2) specific-purpose perpetual, and (3) specific-purpose fixed period.

 3. The business of this Modaraba should neither be in competition with the parent Modaraba Company (i.e. the banks) nor be opposed to injunctions of Islam which has to be certified as such by a 'Religious Board'.

 4. The banks as Modaraba Companies shall be required to subscribe a minimum of ten percent of the paid-up capital of the proposed Modaraba. The banks can subscribe this amount out of their PLS deposits and the Modaraba certificates held by them shall be treated as an approved PLS Investment as permitted by State Bank of Pakistan vide BCD Circular No.37 dated November 2, 1982. The banks can subscribe a higher percentage of the paid-up capital of the proposed Modaraba as ten percent is the minimum legal requirement.

 5. Banks are permitted to act as a Modaraba Company in terms of the 1980 amendment and addition of clause (bb) under section 7 of Banking Companies Ordinance 1962.

 6. In case of need, banks shall be eligible to obtain finances from the State Bank of Pakistan against the security of Modaraba certificates held by them. This is permissible as a result of the 1980 amendment in section 17(4)(d) of State Bank of Pakistan Act of 1956.

 Guaranteed Liquidity: The Modaraba can be offered to the public in the form of a unit-trust or a mutual fund. These, in turn, can either be close-ended or open-ended. Close-ended modaraba certificates can be traded only on the stock exchange. Open-ended Modaraba certificates, handled on the pattern of a unit-trust can be more convenient and popular with the investing public due to their easy encashment by the Modaraba Company (i.e. banks) on the basis of prevalent unit cost on the pattern of NIT (Unit) trust in Pakistan.

 Modarabad Business: The banks shall utilize the funds raised through floatation of modarabas for investing in their direct trading operations in accordance with Modaraba objectives listed in the prospectus filed with the Registrar of Modarabas. The entire income of the modaraba has been exempted from income-tax provided that ninety percent of the income is distributed to modaraba certificate holders. The banks shall also be entitled to a 'management fee' of upto ten percent of the net annual profit of Modaraba in addition to profit on banks' investment in modarabad certificates. The parent Modaraba Company i.e., the bank, shall manage the affairs of the Modaraba through a separate team of professional managers who will be solely entrusted with the management of modaraba business. Modaraba being a separate legal person shall have totally separate liabilities and assets independent of the bank.

 The Modaraba business (or the direct trading operations out of banks PLS deposits, as stated earlier) shall comprise of several distinct operational divisions with separate accounting for their profit & loss. To being with it may have the following:

(A) Trading Division

(B) Leasing Division

(C) Industries Division

Later on the areas of operation can be expanded by diversifying into other business activity such as construction, mining, transport, agriculture, cattle/dairy farming, computer services, consultancy etc. etc.

(A) Trading Division shall consist of Import and Export wings.  

(i) Import Wing will handle all imports on its own account. Machine equipment will be needed by the leasing division. In addition, it may import spare parts, components and raw materials in bulk for sale to industrial units under an order of supply so that the goods imported shall be almost presold with minimum risk of loss. The advantage to industrial units in buying the imported items from the Modaraba Company will be that their cash resources shall not be blocked for long periods. This shall be an additional technique in financing the working capital needs of the industry on an interest-free basis and this will be the purest form of the technique of mark-up-in-price. The imported goods shall be stored in the godowns of the Modaraba Company and delivery to industrial units shall be made strictly on cash basis on the agreed date,

(ii) Export Wing will handle the exports on its own account. It can play a major role in the promotion of Pakistani exports. The export wing of the Modaraba Company can establish display centres for Pakistani products in important centres of the world, provide ware-housing facilities for Pakistanis goods in other countries, and engage itself in effective marketing of our products. Modaraba Company's foreign centres can import Pakistani goods on their own account and thus introduce the innovative technique of pulling the exports, as against the existing efforts which are directed towards pushing of exports. The Modaraba Company can also enter into joint ventures with foreign importers of Pakistani goods thus providing further pull to Pakistani exports.

B. Leasing Division shall handle the leasing operations of machinery and equipment which is now being encouraged as an alternative for supply of fixed capital needs of industry on an interest-free basis. We may improve upon the concept of leasing of machinery and equipment and consider to lease out not only the machinery and equipment but also the factory premises to the interested parties. This will provide encouragement for the setting up of new industries in the country. Under a proper contract of leasing, the Modaraba Company may offer to construct factory premises according to agreed design and lease it out along with the required machinery thus leasing out complete units to the interested parties. The terms and conditions of such leasing business will have to be developed and a facility of this nature shall provide a great stimulus for setting up of new industries particularly in less developed areas of the country.

 C. Industries Division shall consist of industrial units run by Modaraba Company. It may acquire some on-going industries which are short of cash to cut short the gestation period which is inevitable in establishing new industries. New industrial units can be set up in due course in specially selected areas of the country.

 The prime reason for recommending direct trading are that, firstly, it is in conformity with Sharia, and, secondly it provides an elastic, profitable and productive outlet for bank deposits. However, there are numerous other benefits that will accrue to the society by an increase in the economic activity.

 PART- III

 Deposits Management: Changes are also needed in the methods of managing the liability side (deposits side) of banks’ balance sheets. For instance, at present, the entire deposits of a nationalised bank held in PLS savings accounts and PLS term deposits' of different maturities form one common pool of investible funds. The total income earned by the bank from investments of its entire PLS deposits (PLS savings deposits as well as PLS term deposits) is lumped together and then distributed among all the PLS depositors with a weightage in favour of depositors for longer duration. This might have been an easy way out for an interim period, but now this needs restructuring as a part of proper Islamic banking system.

 It is more appropriate to maintain separate pools for PLS deposits held in PLS saving accounts and in PLS term deposits of various maturities. With this change it will be possible for banks to invest PLS term deposits of longer duration in long term investments thus making it possible to earn and distribute better rate of profit on long term PLS deposits. This will also facilitate matching of banks' investments portfolio with their deposit-mix which is considered a good banking practice all over the world. Separate pools of funds may preferably be maintained for PLS term deposits for each maturity. It may even be advisable to reduce the number of maturities presently available under the PLS Term Deposits schemes.

 Share-holders' Profit: In the interest-based system the share-holders of a bank are the sole beneficiary of the residual profits of the bank. They also suffer in case the bank incurs a loss. This means that all income earned whether by employment of funds or sale of services belongs to the share-holders. Similarly, all expenses whether by way of payment of interest on deposits or expenses on establishment are incurred on account of the share-holders.

 With change-over to Islamic banking distinction will have to be made between the profits belonging to share-holders of the bank and the profits accruing to depositors of the bank. Income earned from investment of funds other than PLS deposits shall belong to the share-holders. These funds will include current deposits and margin held against letters of credit or letters of guarantee. Commission earned on various services rendered by the bank shall also belong to the shareholders. Total establishment expenses of the bank shall be met out of share-holders' income. The share out of depositors' profit paid to the bank for managing the investment of PLS, deposits shall be included in the share-holders' profit which shall also compensate the bank for the administrative cost incurred on managing the PLS investments. Similarly management fee received by the bank for managing the modaraba business shall be included in the share-holders' profit.

 Depositors' Profit: Depositors' profit shall comprise only of income generated through investment of their PLS deposits including PLS investment in modaraba certificates. A predetermined part of this profit expressed by way of percentage shall be paid to the bank as remuneration for managing the PLS investments and to cover their out-of-pocket expenses. The remaining profit shall be distributed among the PLS depositors. The present practices of charging administrative cost in addition to a .management fee by the bank is neither the best arrangement nor can it be favoured on principles of Sharia. Neither it, provides any incentive to bank management to cut down their administrative expenditure.

 Reserves Requirement: In the context of Islamic banking the following pressing issues need examination for finding a solution:

 Maintenance of Liquid Assets: Under section 29(1) of Banking Companies Ordinance 1962 every banking company is required to maintain in Pakistan in cash, gold or unencumbered approved securities- at market price an amount of not less than thirty five percent of the total of its demand and time liabilities in Pakistan. Since banks are present^ required to maintain a cash reserve of five percent of their total of demand and time liabilities in Pakistan, in terms of section 36(1) of State Bank of Pakistan Act 1956, the problem arises as to in what shape they will maintain their liquidity of thirty, percent until an interest-free alternative to government treasury bills is found.

 Interim solution: The problem of maintenance of liquid assets was temporarily solved by revising the definition of approved securities in the Amended Clause (a) of Section 5 of Banking Companies Ordinance 1962, and by treating as approved security all funds provided out of banks' resources for financing of commodity operations of federal and provincial governments on the basis of mark-up in price, or funds provided to certain corporations on the guarantee of Federal Government, or funds provided for financing of trading operations of Trading Corporation of Pakistan, Rice Export Corporation of Pakistan and Cotton Export Corporation, or funds placed with State Bank of Pakistan on Profit and Loss Sharing basis in a separate account for investment by State Bank of Pakistan in interest free avenues in its sole discretions. This is not a proper solution, particularly when commodity financing is not generally handled by foreign banks operating in Pakistan. The foreign banks will, therefore, meet their liquidity requirements by deposit of the required amount with State Bank of Pakistan on Profit and Loss Sharing basis. The interest free avenues where State Bank of Pakistan shall invest the funds deposited by other banks on PLS basis can obviously have only a limited scope.

 Until a suitable alternative to government treasury bills is devised, one interim solution in connection with the maintenance of liquid assets pertaining to PLS deposits is to exempt these deposits from the operation of section 29(1) of Banking Companies Ordinance 1962, and, at the same time, enhance the cash reserve requirement from the present five percent minimum to a suitable higher percentage of the total demand and time PLS deposits of the banks. This also has the potential of being used as one of the device for regulating credit under Islamic banking system as well as a source of interest free funds to the government.

 Short-Term investment: The problem of finding avenues for short-term and profitable investment of PLS funds though closely linked with the issue of maintenance of liquid assets by banks under an interest-free system, has much wider dimensions. As already suggested the problem of statutory requirement for maintenance of liquid assets can be solved, by substituting it with enhanced cash reserve requirement, but the need for finding profitable avenues for short term investments on interest-free basis is essential for maintaining the profit wise competitive edge of Islamic banking. The problem is acute for the present and demands an early solution. In the long run, when the new system grows and its areas of operation expand nationally and internationally, a financial market shall, InshaAllah, develop. Then banks and other financial institutions operating on Islamic principles shall be able to deal among themselves in inter-bank call money on the basis of shared-risk in a national or even an international financial market comprising of Islamised institutions.

 In order to truly Islamise banking all aspects of this sector need to be redesigned, restructured and reorganised in the light of the long term needs of an Islamic society. The financial instruments currently being used in Islamic banking are not considered adequate to absorb the entire domestic deposits being mobilised. Direct trading by banks is the only alternative available which is elastic enough to provide a solution and is also in accordance with Sharia. Patched-up laws and facile techniques will not measure upto the challenge.

 The views expressed in this article are, however, his personal.  The author is grateful to Mr. Jalees Ahmed Faruqui for his observations on the earlier draft.

NOTE

We have used the term 'classical' financial intermediation to denote this function by banks and non-bank financial institutions which accept deposits on the basis of a certain interest or fixed return and lend the funds mobilised to ultimate users on the basis of a higher interest or fixed return. The difference earned by the intermediaries is retained by them. This covers their expenses and the remaining net figure, which is either positive (income), or negative (loss), is absorbed by the intermediaries themselves. Under Islamic banking, the banks shall mobilise deposits from the savers and provide finances to the ultimate users on a participatory basis. They shall pass on the profit or the loss to the depositors. The banks shall get a share in case of a profit, but in case of loss they will not get any reward for their efforts, and the entire loss shall be passed on to the depositors. This is a different kind of financial intermediation, and to distinguish it from interest-based financial intermediation we may call it 'Islamic' or 'Participatory' Financial Intermediation.

The author is a Senior Vice-president and Head of Islamic Banking Division, United Bank Ltd. Head Office, Karachi.