The present day economic problems of the World are too baffling and their solution under the traditional economic systems-capitalism, socialism and mixed economics is proving too difficult, if not impossible. Thus the contemporary world is experiencing a number of grave economic ills, including abject poverty of a large proportion of mankind, social and economic injustices, gross inequalities in income and wealth, high rate of unemployment, economic instability, inflation and erosion of the value of money and monetary assets, increasing disparities in regional, national and international income levels, co-existence of widespread hunger and pockets of affluence, and inconsistency between technology and developmental needs, etc. Even the otherwise affluent Western industrialized countries are suffering from alternative bouts of prosperity and depression accompanied with soaring and sagging interest rates. The Present condition of the world economy is considered to be alarming and the future bleak and uncertain.

Under these circumstances and in the search for solution to the above problems, renewed interest has bean expressed in their Islamic way of solution based on the Holy Quran and Sunnah. This interest has not been confined to the Muslims but also percolated to the responsible non-Muslim quarters¹. No economic system can sustain its health and vigour or contribute positively to the achievement of socio-economic goals without the support of a sound end equitable money and banking system. It is believed to be possible to design such a beneficial money and banking framework in the light of Islamic teachings. A lot of studies have been made in this regard in recent years in different parts of the Muslim World.

It is no wonder that firm faith in God, service to man, co-operation with fellow beings and balanced behaviour in society are the cornerstones of the Islamic economic system for which the Quran and the traditions of the Prophet of Islam (P.H.) have laid the broad and fundamental principles. The Islamic banking and financial institutions would have to be an integral part of such a beneficial system- The doldrums occurring in the existing systems and the resultant sufferings caused to the greater mass of human beings in recent times point to the urgency of introducing and developing the Islamic system of economics (with ethics), banking and finance. Thus not only the forgetful Muslim but also the errant non-Muslims are lately showing interest in the emergence and nascent growth of such a system in different parts of the contemporary world. We would attempt a brief survey of the developments in this field in the following paragraphs.

Survey of Developments

In recent years steps have been taken towards the Islamization of the banking and financial system in a number of Muslim countries in the Middle East, Africa and Asia. These measures should be viewed as an integral part of the ultimate goal to move towards the Islamic ideal of a society based on the principle of social justice. As one important element of this policy, a number of Muslim countries have made efforts to abolish what the Quran condemns as Riba which is interpreted to mean both usury and interest and which is more precisely defined as the fixed charge for the use of money. The issue of abolishing Riba was seriously considered first in 1972 at the Islamic Conference of Foreign Ministers of Foreign Ministers of O. I. C. countries in Jeddah. This was followed by a second Islamic Conference in 1974 the deliberations of which, inter alia, led to the establishment of the Islamic Development bank (IDB) in Jeddah in 1975. Once established, IDB splendidly served as the model of a development bank operating on Islamic principles and modes, and demonstrating a viable alternative financial system to replace the conventional interest-based system. The determined studies made in some Muslim countries, the groundwork made for IDB and its successful operation have facilitated the multiplication of Islamic financial institutions in quick succession.

Measures to Islamise the financial   system   have been introduced in various Muslim countries (10), specially Bahrain, Egypt, Jordan, Kuwait, Malaysia, Sudan, Saudi Arabia, Turkey, The United Arab Emirates, and on a grand scale in Pakistan. In general, as the first step, Islamization has consisted largely in founding Islamic banks that operate strictly on Islamic principles and more specifically, without charging or paying interest on loans or deposits. Besides performing normal banking functions, Islamic banks have special features like Quard-l-Hassan (beneficent loan) and also Zakat for those who are not credit-worthy or economically viable in society.  Interestingly, some Islamic banking, holding and investment companies have also been established in non-Muslim countries (5) such as the Bahamas, Britain, Denmark, Luxembourg and Switzerland like oasis in   deserts. Here we may provide a list of Islamic banks and financial institutions so far set up in different countries of the world:

LIST OF ISLAMIC BANKS AND FINANCIAL INSTITUTIONS

We shall analyze the working of an Islamic banking system based on a Profit and Loss Sharing (PLS) principle, and discuss the possible impact of such a system on the mobilization of savings, on the allocation of scarce resources through banks, on investments and generation of real economic activity, and the effectiveness of monetary policy, before drawing some conclusions on the basis of experiences gained so far.

Methods of Financial Intermediation

The most far-reaching experiments with the PLS system have been undertaken in Pakistan, where the abolition of Riba is an objective of the State's constitution. The aim is not only to phase out fixed interest payment but to replace interest with equity participation arrangements that will allow incentives for savings and efficient resource allocation to be retained consistent with Islamic principles. Since January, 1981, Interest-free counters have been established in all 7,000 branches of the five nationalized bank permitting depositors to choose between interest-bearing deposits, and interest-free accounts in the first phase. By opting for the latter, depositors are entitled to share in the profits and losses of the investments financed by the bank. PLS Savings Accounts are opened with multiples of Rs.100 while PLS Term/Investment Deposit Accounts can be opened with multiple, of Rs.1,000. Profit uptoRs.15000 is exempted from income-Tax.

Investment deposits in Islamic banks correspond to “fixed deposit” or "time deposit" accounts, in conventional banks and to “savings accounts” in Western banks. The funds raised in investment account, are invested by banks on the basis of the PLS principle, sharing the amount of profits resulting from their investors with depositors. The calculation of profits and losses and a dividend/profit declaration can be under taken annually or every six months or even three months as in Egypt and Kuwait. In Pakistan, the PLS principle is applied to the fixed deposit accounts of banks that issue fixed deposit receipts, which are only accepted in amounts denominated in multiples of one thousand rupees.

Current Account deposits in Islamic banks as in the other banks are held of transaction and contingency motives, while the investment motive playing a strictly secondary role. Funds mobilized in current accounts can legally be used only to meet short-term financial needs, such as balancing the liquidity position of companies, and cannot be used for long-term finance.

Whereas in Western financial system companies raise funds mainly through the issuance of equity shares, debentures, or by medium-term and long-term borrowing from banks at fixed interest, the latter two possibilities are not in accord with Islamic principles. Consequently, Islamic countries are taking various steps to change their existing financial systems and bring them into conformity with Islamic tenets. For example the Government of Pakistan passed the Modaraba law to basic financial transactions on   the    PLS principle and introduced Participation Term Certificates (PTC) to replace interest bearing debentures. Banks and other financial institutions are asked to grant long-term loans on a PLS basis as another possibility of providing long-term finance to industry and commerce. Short term working capital finance is also given on PLS principle on u selected basis.

Under the Modaraba law, management companies, banks, and financial institutions can register themselves as Modaraba companies. These can be of two types a multipurpose Modaraba with more than one specific objective and Modaraba having a specific purpose (e.g., for raising household finance). Modaraba companies may only engage in business that is permitted under the Islamic religious law, the Shariah. A Religious Board ensures that firm's activities are not contrary to the injunctions of Islam. Funds collected on a Modaraba basis can be used on PLS basis for most types of investment except, of course those are prohibited on religious grounds.

Under the Modaraba business, banks and other financial institutions are able to provide risk capital in the form of equity and loans with equity features. For the amount of capital provided, banks receive Modaraba Certificates, which are transferable certificates with a specific face value issued to the subscriber of the Modaraba. Before profits are distributed, the board of the Modaraba Company decides which part of them should be retained as reserves.

In addition to the Modaraba Certificates and   the PTCs mentioned above, another way to enable banks and   other   financial institutions to provide medium-term and long-term finance is the leasing system (Bai Muajjal). Banks acquire certain fixed assets such as transport vehicle, machinery and equipment, and lease them for a specific period to their customers for hire fee. Banks and their leasing subsidiaries are sharing in the profits and risks of the entrepreneurs' business as long as the rent for the leased assets is not fixed in advance, but related to financial success.

The provision of short-term loans by banks is an Integral part of modern business, but one that raises some problems for Islamic banks is a situation in which fixed interest charges are not permitted. The problems are not, however, insurmountable. A number of proposals have been advanced to remedy this difficulty, such as that the banks should provide short-term loans free of charge in deserving cases (Quard-i-Hasan) or that the profits of an enterprise could be computed for the period covered by the loan in a manner consistent with PLS principles.

Thus from July, 1982, Pakistani banks have also been allowed by the State Bank of Pakistan to provide selectively working capital finance to trade & Industry on PLS (Musharika)  basis. In the agricultural sector, which is the predominant sector in some developing countries like Bangladesh, the need for finance arises mainly from the seasonal   nature of agricultural activity. As a means of reducing the reluctance sometimes found in rural areas to use the services of banks, for strong feelings against interest, the introduction of a banking system that works on the principles endorsed by religious leaders could be helpful. Applying the PLS principle agricultural lending could be done by sharing-output, or net profits, at an agreed percentage between the bank and the farmer.

Consumer Credit has become a very important business activity for commercial banks in developed countries, and Islam does not absolutely forbid lending for consumption purpose, in a number of countries, special consumption loans—the Quard-l-hasan-existed, which were granted in hardship cases by neighbours or friends without any financial consideration. However; the application of the partnership principle to consumption loans does not seem an acceptable solution, since these generally do not yield profits that could be shared by lender and borrower. It has been proposed that such loans be grantee through a government agency or through co-operative societies, but this does not solve the problem of remuneration altogether.

An alternative way of providing consumers' credit is the hire purchase (Bai Salam) arrangement, under which the title of ownership gradually passes to the customers with the paying of instalments. In Pakistan, the House Building Finance Corporation (HBFC) advances loans for housing on a hire-purchase basis. Under this arrangement, the purchaser pays instalments to the HBFC until the entire principal is paid. The Corporation assesses both the total value of the house and its rental value and is entitled   to a share of the rent, from which it derives its profits. The Pakistani nationalised commercial banks also  have been permitted to finance house-building on the same basis from July, 1982.

Implementing the PLS System

Providing finance on PLS basis requires thorough vigilance by the banks over the utilization of funds and involves certain practical problems that may require banks to increase the size of their staffs, at least, at the initial stage. But then the experience of the present interest-based banks is also that the intensively supervised credit is always   better   utilized and better realised than the loans given on paper security only. Another proposal aimed at long-term financing is the Investment Auctioning System under which    financial Institutions would auction investment authorization to investors. Supply of and demand for investable funds determine the scarcity price of available capital. Within the   framework of such a system, entrepreneurs would remain sole, responsible for their investment decisions, whereas banks would only act as financial intermediaries. Scarce capital resources would flow into those investments that yielded the highest expected rates of returns.

Despite of spectacular success of the large-scale experiment with PLS banking in   Pakistan as mentioned below, a note of caution would perhaps be in order. It has been suggested in some quarters that not all the 7,000 branch Managers of the nationalised   commercial    banks   which   opened    interest-free banking counters in the country in January, 1981 have been equally enthusiastic or meticulous about implementing the new system in its letter and spirit as against their known and beaten track. Thus is the process, at least, a few of them may have mixed up and/or taken up the experiment as just another official mandate. The same experience may be encountered elsewhere too. It is, therefore, of critical Importance to ensure efficiency and purity of the system for its success and growth.

Islamic Bank of Denmark² An Exception

Denmark has become the first Western country to grant a full banking license to an Islamic bank. The Islamic Bank International of Denmark (IBID-1982) has been given the go-ahead to open its doors in Copenhagen's Jernbanegade after long negotiations with the Danish Central Bank, the Ministry of Industry and the Banking Control Commission of Denmark. European Central Banks including the Bank of England have up to now been very reluctant to recognise Islamic banking because the latter forbids the charging of interest. IBID is authorised to take deposits and issue cheque books like any ether high street bank. Whereas other Danish banks depend on interest for their survival, the IBID shuns interest and shares the risk of investment with its depositors or borrowers on a Profit and Loss (PLS) basis.

IBID is a wholly owned subsidiary of the Islamic Banking System international Holding SA of Luxembourg (IBS) whose shareholders include the Kuwait Finance House and the Ministry of Awqaf religious endowments) of Abu Dhabi. The Chairman of IBS is the ex-Kuwaiti Minister of Finance and Oil, Abdur Rahman A, the Vice-Chairman is the present Minister of Justice of the United Arab Emirates, Sheikh Mohammed Abdur Rahman al-Baqr, and the Managing Director is the prominent Egyptian banker and legal expert, Doctor Gamal Attia. The capitalisation of IBID is at present 10 million Danish kroner and is expected to rise to well over 25 million Danish kroner by April, 1983, the date of the official opening of the bank.

IBID differs from other Islamic banks in the Middle East in that its main aim is "to promote the business of Danish and other Scandinavian companies connected with the Islamic world, to serve other Islamic banks, accept deposits in various currencies and finance the activity of its subsidiaries, including the Islamic Finance House in London's

Effects of an Islamic Financial System

The introduction of financial intermediation based on the PLS principle has potentially beneficial impacts on the behaviour of savers, banks, and investors. The PLS system turns savers into entrepreneurs, at least to some extent, by encouraging them to participate directly in the financial success of the investors' business, thereby also sharing the risk involved. In an Islamic banking system inflation is not expected to be an evil hazard as at present while the yield on investment deposits would be naturally variable

An argument based on religious ground is that an Islamic banking system could attract resources from devout savers, who are not willing to accept fixed interest payments on their deposits under the traditional banking system in fact this is the experience of many Muslim countries, including Bangladesh and Malaysia. If the PLS system were to be introduced as a complement to the traditional banking system, overall savings within the financial system may, therefore, increase even in the transitional phase.

Where an Islamic banking system works side by side with traditionally operating banks, the effects on savings are unambiguously positive, since the variety of savings instruments is expanded and no existing savings outlet is eliminated. It could also be argued that yields to depositors could be higher under the PLS system and offers a better chance for compensating depositors for an unexpected acceleration in the rate of inflation, as it happened in Pakistan.

CONCLUSION

The introduction of financial, intermediation based on the Islamic principles has not only been successful but also proved to have beneficial impact on the behaviour of savers, banks and investors. The evidence so far demonstrates that Islamic banks have operated quite successfully in different countries as can be seen from their operating results. In Pakistan, the nationalized commercial banks gathered Rs.6,489 million in PLS deposits through Islamic banking counters during the first year, 1981 out of which term/Investment deposits were Rs.4,283 million. PLS deposits reached the mark of Rs.10,000 million by June, 1982. The banks declared profits, for the year, of 9 per cent on PLS savings accounts, and on PLS term deposits from 11.5 per cent (for periods of less than one year) to 15.5 per cent (for periods of five years and above). As against this, savings bank deposits earn 7.5 per cent interest while term deposits for 5 years and over are allowed interest at the maximum rate of 12.75 per cent in Pakistan. The Jordan Islamic Bank registered an overall profit of 8.2 per cent on investment accounts for 1980. Depositors with Bahrain Islamic Bank received a profit of 9-9.5 per cant on term deposit accounts and 5.25 per cent on savings accounts for 1980. The Kuwait Finance House declared profits of 6.75 per cant on savings deposits and 9 – 10.12 per cent on term deposits ; the Faisal Islamic Bank of Egypt and the FIB of Sudan paid profits of 12.03 per cent and 16 percent respectively for the year 1980. The Dubai Islamic Bank declared profit of 12 per cent on investment deposits for 1981.

The practical handling of all banking operations under Islamic financial system based on the PLS principle leaves yet some unresolved Issues. In particular, remunerating lenders for making short-term loans to industry and commerce and for providing consumers' credit remains difficult if the PLS system Is to be applied fully. In any case, in the poorer countries like Bangladesh or Pakistan the Central Banks hardly allow any consumer credit to be given by the commercial banks. Another area that has not been dealt with comprehensively is that of the foreign operations of Islamic banks. However, the Islamic banks have already established excellent correspondent relationships with reputable banks in many developed Western countries and are handling most of the foreign trade and foreign operations on Islamic principles without difficulty. Recently, consideration has also been given to adapting transactions with non Islamic banks to the PLS system.

Even if the PLS system is introduced on an optional basis side by side with the present banks, or as a transition to a complete switch over to Islamic banking,' it is most likely that the enlargement of choice would have generally beneficial consequences, particularly for savings. A complete transformation to a PLS system, however, would require satisfactory handling of issues that still have to be resolved, particularly those concerning the allocation and remuneration of short-term financing. But even in serious Western economists' assessment an alternative banking and financial system with superior concept and ideals has already been born and taken root, and the same is regarded as a new force to be reckoned in the world of finance.

Admittedly, there are some problems yet to be tackled in the way of a rapid transformation of the system on Islamic principles and ideals, as briefly mentioned above. But, unless determined and sustained efforts are also made by the public authorities of the Islamic countries, despite great public enthusiasm and support and promise of the new system for social benefit, progress towards Islamization of the banking and financial system in the Muslim world is bound to be a slow and time consuming process.

• The author is the Director of Research, Bangladesh Bank. However, the article is contributed strictly in the personal capacity of tha writer.

1. Of Islam and Financial Intermediation, IMF Staff Papers, March, 1982.

2. Vide The GUARDIAN, London, 10 December, 1982,

3. OAPEC = Organization of Arab Petroleum Exporting Countries.

4. Roger Cooper, article on Islamic Banking published in EUROMONEY, December, 1982.