The Islamic banking system is fundamentally different from the western banking system, which is secular and not guided by any religious authority. Islamic banking is based on Islamic teaching, in particular the unequivocal injunctions of the Holy Quran and Sunnah concerning the prohibition of interest. In recent years a number of Muslim experts in economics (see, for example, Siddique, (1980), finance, and banking have attempted to find ways of displacing interest through profit-sharing. The purpose of the paper is to evaluate Islamic banking in theory and practice in order to see its-viability and desirability in practice.

To get to the objective following are the most natural questions:

(a) If interest is strictly prohibited in Islam, how is that interest-based financial   institutions have been working quite successfully in Muslim countries?

(b) What factors   induced Muslims   to   restructure   their   financial sector according to the injunctions of Islam?

(c) If interest,   which lies at   the   heart   of modern   economy,   is abolished, how the economy could be run according to the teachings of Islam?

(d) How Islamic banking has fared in practice0

The paper has been divided into three sections. Section I will answer the first two questions. Section II deals with the Islamic banking has fared in practice?

SECTION I

Before the introduction of interest-based Western banks in the 19th century, there were no modern banks in the Muslim countries. However, these countries did have a financial system which was run by "moneychangers". Savers and traders did business efficiently without banks. Even today moneychangers play an important role in the Muslim financial system. The Egyptian Bank, established in 1856, was the first British-owned bank in a Muslim country.

There are three reasons why Western banks have succeeded in establishing themselves in the Muslim countries, even with the prohibition of interest. First, with the fall of Ottoman Empire and the rise of Western colonialism, Muslims lost their political and economic power. Most Muslim countries came under the direct or indirect control of a colonial power, either Britain or France. Western powers were able-to set up institutions, including banks, firmly and successfully. Second, the Western banking system was powerful, efficient, and innovative. Third, many highly educated and liberal Muslims as well as some religious schools considered Western banks desirable (Wilson, 1983).

Though interest-free financial houses were conceived as early as 1940, the movement gained momentum in the latter half of the 1970s when the first Islamic bank was established in Dubai in 1975. In the following years Islamic banks were founded in other Arab and non-Arab countries. Today there are more than one hundred Islamic banks and other financial institutions in Muslim countries (Khouri, 1987).

The development of Islamic banks has manifested itself in two forms. First, Islamic financial institutions have been established side by side with traditional banks. Islamic commercial banks were established in Muslim countries, but Islamic investment and holding companies started functioning predominantly in non-Muslim countries. The second form has led to transforming the whole financial system according to Islamic tenets (Khan and Mirakhor, 1989, p. 29).

The primary motivation for Islamic banking growth came from the oil boom of the early 1970s, which afforded tremendous economic power to the oil-rich Muslim countries. These countries were dissatisfied with the "rigid requirements" of Western banks which were primarily concerned with earning interest and paid no attention to socioeconomic development of Muslim society. The disgust with Western banks led Muslims to set up a financial system based on the Islamic principles of finance. "The growth of interest free financial structure reflected a desire to purify a system that was seen as essentially contrary to Islam"(Abbasi and Hollman, 1990. p. 37).

SECTION II

Islamic banking; is based on the abolition of interest which requires a complete restructuring and innovations in the financial sector. To replace interest-based modes of financing, Muslim experts in banking and finance have devised novel financial techniques. In Islamic banking deposits are treated as shares and depositors purchase equity position regardless of where the bank invests their capital. The financial techniques used by Islamic banks are mostly based on equity participation. These techniques, with the closely comparable Western techniques, are:

1. Mudarabah (Silent partnership)

2. Muqaradah (debt and equity financing)

3. Murabaha (mark -up)

4. Musharika (limited partnership)

5. Salam (forward purchase)

6. Muzara (share cropping)

These techniques arc considered Islamic because they do not carry interest or "a disguised form of interest". Furthermore, these techniques, because of close compatibility with their Western alternatives, do not pose logistic and administrative problems (Abbasi and Hollman. 1990, p.39)

Muslim scholars have proposed a number of models of Islamic banking (Uzair 1982, Siddique 1982, Mohsin 1982, Chapra 1982, Ariff 1982, Khan and Mirakhor 1989). They have attempted, on one hand to justify interest-free banking. On the other hand, they have provided solution under interest-free banking. Uzair (1980) has discussed at length the theoretical and practical aspects of interest-free banking. His analysis is based on the crucial assumption that capital as a "separate factor of production does not exist but is a part of another factor of production, namely enterprise". He rationalizes the assumption by contending that, with the passage of time: and technological changes, the definition of other factors of production has also changed. For example, land now stands for natural resources. He argues that present day interest on capital cannot be rationalized. He is of the view that the basis of banking also has to be revised after merging capital as a part of enterprise and establishing profit as the only form of reward for this joint factor of production. To further justify his assumption he argues that interest comprises two parts, namely "return on capital" and "risk premium". This implies that interest and profit have some similarity because interest embraces reward for risk whereas profit is the reward for uncertainty (Uzair. 1980, pp. 38-39).

Uzair proposes interest-free banking on a profit-sharing basis between the suppliers and users of capital. Profit will be shared between the entrepreneur and bank and the bank and the depositor. The depositor will get one-third of the share received by the bank and the entrepreneur will get two-thirds of the profit (Uzair, 1980, p. 47). Short-term loans of less than one year maturity can be advanced either on the basis of actual profits of the firm or at an average annual rate of profitability for the borrowing firm. For loans less than one month maturity the bank will recover a service charge only. These loans can be provided out of the idle funds available in current accounts while consumer credit needs can likewise be met out of savings or current accounts. The banks could provide these loans on a service charges basis or through specialized institutions sponsored by the government (Uzair, 1980, pp. 50-54).

Uzair made his assumption -- capital and enterprise are a single factor -- in order to rationalize interest-free banking. Since capital and enterprise are one factor, capital cannot claim a separate, fixed, and predetermined return, i.e. an interest rate. Uzair's assumption is not valid and tenable, even from an Islamic point of view. In mudarabah, loss is borne by the provider of capital whereas profit is shared in an agreed ratio between the enterprise and the supplier of capital. If capital and enterprise are a single factor, then both should share the profit and loss. Similarly, the provision of consumer credit on service charges only cannot be justified on economic grounds because consumer credit has an opportunity cost. This will encourage a parasitic life style in Islamic economies. Will Islam countenance a parasitic life style which aims at establishing a socioeconomic order based on justice and fair play?

Since interest is the kingpin of the modern economy, many Western economists are skeptical about the viability and efficiency of the interest-free banking. Pryor (1985, p. 209), for example, says "elimination of a nominal; interest rate would lead to a reduction of savings in an Islamic economic system".

Haque and Mirakhor (1987A) have examined this assertion and have developed a model which deals with variation in returns and uncertainty in a traditional; framework. Their model derived a condition that must be met so that: saying declines when riskiness increases. According to this condition the "rate of return when risk is present' should not exceed "the rate of return when risk is absent". If the rate of return also increases as risk increases, then saving may in fact rise. They argue that in the traditional system rate of return to investment is higher than the rate of interest on borrowed funds. Since in an Islamic system the saver shares the profit, the rate of return on financial assets may be higher, they conclude that on a priori grounds the said belief cannot be accepted.

In an other study, Haque and Mirakhor (1987B) analyzed the effects of an interest-free economic system on investment. The adoption of the Islamic system of finance will lead to risk sharing between the saver and borrower which in turn will affect the investment environment. They analyzed the issue in terms of "certainty" and uncertainty" with complete as well; as with incomplete information. They showed that under perfect certainty and complete information, investment decisions will not be different in the two systems. However, under uncertainty, they assert, there will be favorable effects on investment due to absence of a "fixed cost" of borrowed capital. They conclude that there will be no market failure and both lender and investor can do their business quite smoothly. Second, "individual-firm-specific" or "project-specific" contracts can be made to avoid the moral hazard which arises when the lender and the investor have diverse information on the profit from investment, their most important conclusion is that under an Islamic financial system, investment will not decline. To prevent adverse effects on investments they strongly recommend the reduction of the monitoring, enforcement, and contract-design costs. To achieve this they emphasize the implementation of a legal and institutional infrastructure to facilitate and safeguard the Contracts.

Theoretically, Haque and Mirakhor's analysis and conclusions are sound and plausible, but, from a practical point of view, there are many problems and difficulties. Unless those problems are resolved, an Islamic financial system does not have bright prospects of success. They have pointed out (1987B, p. 159) that in both Iran and Pakistan investment of bank assets has concentrated in trade related modes of finance which carry fixed returns. This implies that banks are not willing to share in loss. They also point out that in countries which have adopted an Islamic banking system, legal and institutional safeguards have not been developed. This implies that the Islamic banking system is adversely affecting the saving and investment environment and the skepticism of Western economists is not unfounded.

M.S. Khan (1986) has provided a theoretical description: of Islamic banking and formulated a simpler theoretical model that explicitly incorporates the constraints imposed by religion.

Khan's model has many similarities with standard models used to analyze the behavior of banks at an aggregate level. According to Khan, skepticism about the viability of an Islamic economic system stems from the confusion between the terms "rate of interest" and "rate of return" Islam forbids the former and allows trade and therefore profit. But profit is not an Islamic concept, it originated with 16th century industrial capitalism. Today the concept of profit is radically different from the medieval concept "when the entrepreneurial, managerial, and financial aspects combined in one person" (Naqvi, 1982, p. 92).

M.S. Khan (1986, p, 19) states,

the principal difference stems from the fact that an Islamic system treats deposits as shares and accordingly does not guarantee their nominal value. In the traditional banking system such deposits are guaranteed either by the banks or by the government. This distinction has apparently not been generally appreciated in literature.

He also points that an interest-free banking system is not alien to Western economists. For example, prominent economists, like Henry Simon (1948) and Charles Kindleberger (1985) have proposed certain banking reforms, which, if implemented, will lead to a system closer to an Islamic banking system, particularly on the deposit side. Besides Weitzman ( 1984) has strongly supported the principle of profit sharing as the remedy for stagflation. But these suggestions might be relevant to resolving the U.S. banking crisis which, because of its peculiar structure, suffers from frequent bank failures, but not for the European, Japanese, and other interest-based systems which don't face the same problems as U.S. banks.

Khan contends that the tradition of paying depositors a fixed and predetermined  interest rate,  regardless of whether or not the bank  is making a profit; prevents banks from instantaneously adjusting to potential asset shocks. He concludes that this rigidity can lead to possible financial instability. Against this, Khan shows that an interest-free Islamic banking .system can provide immunity against bank failures and financial instability, a similar conclusion has also been made by Habibi (1987) on the basis of a Keynesian-type macroeconomic model.

An Islamic banking system is not a foolproof system. If the borrower suffers a loss, the loss will be communicated back to the bank and depositors and, consequently, banks may face "potential shocks".

Chishti (1985) has examined two hypotheses. First, a fixed fluctuating short-term interest rate is responsible for the cyclical behavior of investment and, therefore, for the instability of an interest-based economy. Second, an Islamic financial system based on fluctuating profit-loss sharing provides built-in stabilizers to the investment process. He uses a qualitative model of two differential equations to express financing conditions and investment behavior. He demonstrates that the amplitude of all phases of the business cycle will be smaller in an Islamic economy compared to advanced capitalist economies where the fixity of the fluctuating short term interest rates accounts for the unstable and cyclical behavior of investment. The author has not substantiated his assertion from empirical evidence. His conclusions are hard to accept.

Waqar Masood Khan (1989), using the "theory of contracts" and "economics of information", examined the implications of the abolition of interest in an economy. He has used rigorous mathematical techniques to compare an Islamic financial system based on a variable return scheme (VRS) with a traditional system based on a fixed return scheme (FRS). His major conclusion is that an Islamic financial system is superior to a non-Islamic system because it spreads the risk of an enterprise, if both lender and borrower have the same information. He demonstrates that if the assumption of systematic information is relaxed, a fixed return contract becomes more desirable because it minimizes monitoring costs. He, however, shows that costs will not be substantial in an Islamic financial system if both the lender and borrower exercise honesty. He concedes that the condition of honesty is highly prohibitive for the success of the success of the new system.

The most crucial question of Khan's research is "whether the efforts of Islamization". especially transforming the traditional economic system according to Islamic principles, "would be successful or not". He concludes that the answer in the very short-run is not positive. Monitoring costs will be high under an Islamic financial system, honesty is a stringent condition, prospects of success in the short-run are bleak, and society must pay a high price for the Islamization process. In return society will get "the preservation of spiritual values". This is not a bad deal. This implies that the major objective of the Islamization process is the preservation of spiritual values, not the amelioration of the vast majority steeped in abject poverty, hunger and disease.

SECTION III

Darrai (1988) has provided empirical evidence on the relative efficiency and stability of Islamic banking in Tunisia vis-a-vis interest-based banking. He points out that reliable cross-section, as well as time series, data were not available for several Muslim countries, but because of the similarity of economic conditions between Tunisia and other Muslim countries, especially African Muslim countries, he argues that the results of his study are relevant for other Muslim countries as well. He used time series data covering two and a half decades to test his hypothesis. He used historical examination, regression analysis, and formal stability techniques for empirical examination.

He concludes that Islamic banking is superior to interest-based banking in terms of efficiency and stability for three reasons. First, an Islamic monetary system has a well-behaved and smooth velocity of money. Second, an Islamic; financial system has "stable public demand" for financial assets. Third, interest-free monetary assets can be used as an appropriate intermediate policy target because policy makers have effective control over these assets.

Since the 1970s the problem of inflation has assumed distressing proportions. It is quite natural that people may question the viability of interest-free banking in the face of inflation. Two important questions are what is the likelihood of inflation being faced by an Islamic economy and if inflation occurs what are the ways and means to control it in an Islamic economy?

Akram Khan (1982) asserts that, in normal circumstances, an Islamic economy will not have a high rate of inflation due to built-in stabilizers, which include interest-free banking, a speculation-free stock exchange, just wages, and the absence of market rigidities. For controlling inflation he proposes monetary, fiscal, and income policies. He, however, points out that inflation is most likely to occur for reason outside the control of the built-in stabilizers (i.e., earthquake, war, famine etc.). He indicates that the introduction of an Islamic economic system will give rise to many problems in practice. (What is the need then for an Islamic system?). Me concedes that his analysis of inflation in an Islamic economy may not prove valid in practice, but suggests that society should "give a trial" to the Islamic economic system (IES) and find solutions to the problems which arise due to Islamization.

Hasan (Ariff. 1982, p. 161) points out that Khan's model theoretical and has relevance for a closed economy. Under an open economy his model will need complete revision and, without empirical evidence, no valid analysis could be made. Khusro (Ariff, 1982, pp. 267-268) disagrees that interest-free banking will reduce the risk of inflation. He concedes that Islamic banking (IB) possesses some desirable features but it does not offer solutions for all problems. He argues that the demand for higher wages will not disappear in an Islamic economy and the monopoly and oligopoly may exist despite Islamization.

Laliwala (1982) has empirically analyzed the problem of inflation in ten Muslim countries. He concludes that budget deficits is non-oil exporting countries and rigid exchange rates in oil-exporting countries are responsible for inflation. Like Akram Khan, he asserts that in a true Islamic economy prolonged inflation is "neither possible nor desirable" (Laliwala. 1982, p 283). His own results are contrary to his assertion.  The  Review Committee (Ariff,   1982,  p.  285) of Laliwala's paper observed "the overall tenor of the arguments in the paper is more emotional and less scholarly than it ought to be".

Uzair (1980. p. 57) contends that profit-sharing compensates the depositors compared to the meager return in the existing banking system based on fixed and predetermined  interest.   He points out that in the present day inflation, commercial banks are making undue inflationary profits at the expense of depositors. Businessmen also gain because of higher prices for their products. In an interest-free economy, he asserts, the depositors, banks, and clients each get their due share.

Abbasi and Hollman (1990, p. 39) are of the opinion that Islamic banks are doing quite well and have proven that Islamic principles of finance can be applied quite successfully. Syedian (1989) argues that by combining religion, money, and politics, their operations have become controversial. Moreover, Islamic financial instruments are responsible for slowing channeling of funds for investments. At the same time, he contends Western banks will lose if Islamic banks flourish.

Pakistan has pioneered in the introduction of Islamic banking. Interest-free banking was introduced in phases. The process culminated in five years. On January 1, 1981, profit and loss sharing (PLS) counters were opened in all branches of the commercial banks. There was a tremendous growth in PLS deposits from 1981 to 1985 as a percentage of both total deposits and return bearing deposits. "By March  1985, they were about 36% of total return-bearing deposits. PLS accounts provided higher profits to the depositors than the interest-bearing deposits with same maturities" (Pakistan Economic Survey 1984-85, p. 6). This implies that depositors had an economic incentive to deposit in the PLS accounts.

The investment of PLS deposits shows that commercial banks invested more than 86% PLS deposits in trade related modes because they carry a fixed and predetermined return thereby ensuring no loss to the banks (PES 1984-85. p. 12). Ahmed (1985. pp. 3-17) has discussed at length the concerns of the general public and business community about the credibility of Islamic banking in Pakistan. He has conceded the strength of their arguments. Nawaz Khan (1988) has made an objective evaluation of Pakistan's Islamization of Banking. His major point is that government adopted an unrealistic definition of riba. Moreover, he maintains that government was not sincere in the introduction of true Islamic banking system. Even the government sector itself criticized the Islamization of banking in Pakistan (Pakistan Economic Survey 1984-85 pp. 1-13).

CONCLUSION

The revival of Islamic values during the 1970s has led to the creation of financial institutions with the aim of translating Islamic ideal into practical business solutions. Muslim economists have demonstrate that an Islamic banking system is superior to an interest-based banking system because the Islamic system is not based on exploitation and has the capability to adjust to shocks which  lead  to banking crises.   The Islamic banking experiment is of comparatively recent origin and thus is difficult to judge its viability and credibility conclusively. Evidence of its performance is scanty and mixed. Islamic banking, however, has great potential for growth because of a fundamentalist wave which is invading most of the Muslim countries of the world. However, due to grown interdependence in the international economy, the novel and significant development especially in the financial sector taking place in the Muslim world cannot and should not be treated as trivial. Most of the studies on Islamic banking and finance are theoretical. Substantial factual research is needed to adapt the edicts, Islam concerning economic behavior to the needs of modern economy.

NOTES

1. For detail see (Abbasi and Hollman 1990, Habib 1989, Qureshi I985A & I985B. Pakistan Economic Survey 1984-85).

2. The United States has a dual banking system in which state and federal banks operate side by side. There are 15,000 commercial banks, more than any other country in the world. Since 1985, bank failures have averaged over 100 per year (200 banks failed in 1987, the largest number of failures since the Great Depression). State-branching regulations and the McFadden Act of 1927 are the "strongest anticompetitive forces in the commercial banking industry"

(Mishkin, 1989, pp. 186-195).

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*Assistant Professor,  Department of Economics, Gomal University, Dera Ismail Khan