Introduction

1. Banking since its very inception has never remained static. Keeping the needs and aspiration of different people and times in view it has undergone a continuous change. Thus, a variety of banking models have been developed all over the world. However the most remarkable and revolutionary development in the field of banking has been the emergence of Islamic banks. By now about 15 Islamic banks have emerged and two countries are replacing their entire banking system by Islamic one. In Bangladesh, too Islamic banking is being started very shortly both in public and private sectors.

2. If a bank is defined as a dealer in credit, an Islamic bank can be defined as a dealer in equity. Of course, an Islamic bank deals, to a limited extent, in credit as well. But unlike a conventional bank, it neither pays nor receives interest in any form on any of its operations. To elaborate, Islamic banks generally receive funds from its clients on the basis of profit and loss sharing. The depositors are not promised or paid pre-determined fixed return (i.e. interest) but paid variable return i.e. profit/dividend: on the actual working result of the bank. The funds thus collected are deployed in the form of profit and loss sharing investments and interest-free loans. Projects having  high  social  priority but low private profitability and legitimate consumption needs are generally covered by interest-free credit. All other profitable concerns are generally financed under Profit-loss sharing arrangement. Islamic banks also maintain a Zakat Fund to provide financial assistance to eligible non-viable clients. Thus in planning the earnings li an Islamic bank is guided by the ability-to-pay consideration of the project or sector. Above all, an Islamic bank does not associate itself with any business not approved by Islamic shariah.

3. Islamic banking, as the name implies, got its initial inspiration from Islam and made its first appearence in Islamic countries. Later, it started receiving attention of the banking experts of the western world. Of late, one Islamic bank has been established in the Luxembourg and some more are being planned for London. Initially it was apprehended that Islamic banks might not get international correspondents. Contrary to this apprehension, quite a good number of interest-based banks have accepted correspondent relationship with Islamic banks on interest-free basis. Naturally, a question arises as to the basic reasons for this fast acceptanceof this institution. If we study the concepts and practices associated with Islamic banking and contrast them with those of conventional banking we shall find that Islamic banking can better serve the latest socio-economic goals which are professed by most of the developed and developing countries. In this short article we shall examine some of these superior features of Islamic banking.

Rural Sector

4. In any discussion on banking reform, the problems of rural credit occupies a predominant position. This is more so when we discuss the problems of the developing world. Let us briefly discuss the problem and see how Islamic banking is going to address it.

5. The interest-based conventional banks have remained traditionally urban oriented and have left an institutional vaccum in the rural areas. This vaccum has facilitated the money lenders to a great extent. The private money lenders operating in the informal sector charge exhorbitant interest, encourage default, manipulate accounts and find excuse to confiscate the securities. The money lenders are rich and through these exploitative means, i.e. high rate of interest and liquidation of the income-earning securities they are growing still richer and the poor borrower, still poorer. Of late, the conventional banks are required to move to the rural scene, but their way of financing and recovery forces the borrower to off load their crop immediately on harvesting. This reduces their money income and increases the fluctuation of crop prices to the disadvantage of the growers and borrowers.

6. How this issue is being handled by Islamic banking, one country which is having a total approach to the issue has introduced 3 mechanisms of Islamic banking i.e. Bai-mujjal, Bai-salam and interest-free loan. Through the process of Bai-Muajjal which means sale on deffered payment basis, agricultural inputs are being supplied to the farmers. This process combines credit and input supply and works as a safeguard against diversion of funds. Needless to mention, diversion of funds generally reduces the productivity of loans, causes eventual default and inflation. Thus this Islamic mechanic is a definite improvement over traditional loaning. Similarly, through the mechanics of Bai-salam, a bank makes advance purchase of future crop at a reasonable price. This mechanism solves the marketing problem of the client farmers and works as or safeguard against price fall during harvesting, period.

7. Simultaneusly it ensures recovery of bank's money advanced through bai-muajjal or interest-free loan. The marginal farmers who cannot be served through either bai-muajjal or bai-salam are being provided with interest-free loan. We are yet to see the result of these mechanics, but it is expected that these are likely to serve the varied credit needs of the rural mass, dislodge the money lenders stabilize prices improve production and ensure recycling of bank funds.

Institutional Sector

8. Under the conventional framework, the formal financial sector has got the following features:

i) There is no provision for consumption loan even for purposes which are necessary to maintain productive efficiency like food, schooling, health services, etc.

ii) The banks do not offer any financial assistance to non-viable clients.

iii) They offer productive loans to clients who can offer collateral securities.

9. The combined result of these three principles is exploitation of the vast majority of people by a few rich only. Let us examine how. In an interest based framework banks collect the deposits of the entire society at a very low rate of interest. These depositors are mostly from low and middle income groups. The funds thus collected by the bank are lent out to a few entrepreneurs at a rate of interest which, though a bit higher than deposit rate, is too low compared to the profit earned by these borrower entrepreneurs, who are generally from the high income group. This low-cost financing by the bank enables the few rich entrepreneurs to concentrate the ownership of the means of production in their hands. Since the banks offer loan against collateral securities, naturally loan follow the capacity to offer securities and the richer a party is the higher is his capacity to offer securities. Thus, in the conventional framework, there is a tendency towards concentration of bank loan and economic power in the hand of the rich. Moreover the capacity to offer securities does not remain static. Every production loan helps a borrower to increase his wealth and capacity to offer securities and to get still higher loan ceiling. Looking to the depositor's side, these vast number of people are satisfied with the moderate rate of interest, hands over the money to banks and lull into inaction whereas they are to buy the goods produced with the assistance of their resources at a fairly high rate. These depositor consumer group continue to grow poorer and poorer. Thus in the institutional sector only a few rich people get richer through the mechanism of low interest, security requirement and high profit. The ownership-base of the economy is gradually narrowed down and only few big enterprises develop which employ a large number of employees and produce a few products only. The large number of Salaried employees working through trade unions come in clash with the employers which result in bad industrial  relations and low productivity. Since the entrepreneurs and firms are few, the product also remains limited in number. This product limitation works as a constraint to further economic development.

10. The ultimate objective of Islamic banking is to convert all interest-based production loans to investments under profit and Loss-Sharing and consumption loans to Qard-Al-Hasan i.e., interest-free loans. As stated earlier, all priority sector loans having low private profitability are also to be brought under interest-free loaning scheme. that result of the above arrangement will be as follows:

To collect necessary funds the entrepreneurs will be required to equity-part with to get funds. The shares may be sold to the bank or to the ultimate owners of savings either directly or through the banks. Thus the debtor-creditor relationship between the entrepreneurs, the bank and the depositors will be restructured on the basis of ownership of economic activities. Along with the ownership, risk also will be spread over the whole society. The owners of savings who were hitherto indifferent to economic activities will be activised. The profit which was hitherto enjoyed by a few will be shared by the whole society. Aggressive trade unions will be replaced by constructive work groups. Improved industrial relations will automatically improve productivity. Society will be more integrated.

11. Under Profit-loss-sharing securities do not have any fixed charge. As such the importance of securities in investment activities will diminish and the special advantage of the rich in getting bank finance will automatically vanish. The rich and the poor will be placed on equal footing for getting bank assistance. Productivity consideration will reign supreme. Increased earning received from the profit-loss sharing advances will enable the banks to provide interest-free loans, Zakat to the deserving cases.

12. All these will result in more equitable distribution of economic opportunities and benefits, higher production, stable growth and social development.

Effect of Islamic Banking on inflation

13. Islamic banking by abolishing interest creates an anti-inflationary effect in the economy. To understand how this takes effect, let us analyse the contribution of interest to inflation.

14. In an interest-based framework, the depositors receive interest as to their money income despite their inaction. On the other hand, the interest paid by the borrowers' entrepreneur is added to the cost of production. The later rate (lending rate) is always 5 to 6% higher than the former (deposit rate). Thus, increased money income and inflated cost of production both caused by interest are two built-in causes of inflation in an interest-based economy. Moreover they do not remain static. The deposit rate, which is always lower than the lending rate and inflation to the extent of cost of intermediation, has a tendency to catch up with the inflation rate which pushes the cost further up. Moreover, the higher the rate of interest, the higher will be the opportunity cost of capital and expectation about the future remaining the same the lower will be the incentive for real investment. The lower real investment will result in lower production and lower supply of goods and services. This will add to the inflationary pressure further. Thus in our interest based economy there is a secular rise of prices. Abolition of interest removes these three basic built in causes of inflation. On the other hand PLS by its baneful effect on production and distribution eases the situation further. If the economy is sufficiently diversified which is also facilitated by Islamic bank and its dependence on foreign trade is reduced the imported causes of inflation are also checked.

15. Conclusion

Finally an Islamic bank is a commercial-cum-development-cum-welfare organisation based on Islamic values of life. It is a critical institution to materilise the economic objectives of Islam. It should however, be noted that it is not the whole of the Islamic framework. Compared to the conventional banks it is very much viable by itself, but if we want to have full impact we should supplement its effort by introducing corresponding reform in other walks of life in general and monetary and fiscal field in particular.

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BIBLIOGRAPHY

1. E.A. Bawany Revolutionary Strategy for National Development. 1970.

2. Dr. Muhammad Maslehuddin: Banking and Islamic Law, 1974.

3. Dr. Monzer Kahf: The Islamic Economy. 1978.

4. Dr. Ziauddin Ahmad: Inaugural Address at the IBP Seminar, 1980.

5. Dr. M. Umar Chapra. Money and Banking in an Islamic Framework. 1980.

6. Report of the Panel of Economists and Bankers on the Elimination of Interest from the Economy of Pakistan, June, 1980.

7. Abdullah Yusuf Ali: English Translation of the Holy Qur'an.

8. Sayed Abul Ala Maudoodi: Tafheemul Qur'an.

9. A.S.M. Fakhrul Ahsan: On the Nature and Significance of Banking without Interest, 1978.

10. Abdul jabbar Khan: A Proposal on Islamic Commercial Banking. 1980.

11. M. Azizul Huq: Welfare Banking, 1979.

12. Islamic Banks: Annual Reports.