In moulding a traditional system of banking to bring it in alignment with standards set by Islam the following guiding principles need to be kept in view:

1. Riba (interest) must be eliminated as the basis of banking transactions.

2. Activities financed by banks must be 'HALAL' (Islamically permissible and socially desirable).

3. The choice of modes of financing should be based on their economic merit.

4. The objectives of the banking system should be related to the economic ideals of Islam.

To achieve a full-fledged Islamic Banking system none of the above four aspects can possibly be ignored. A choice can however be made either to tackle the four aspects all at once or in phases according to circumstances. The process of Islamisation of the banking system in Pakistan is still grappling with problems of the initial stage relating to elimination of Riba. The most essential part of the exercise, however, is to make sure that it keeps moving in the right direction.

Elimination of Riba (interest) from the banking and financial system demands a clear understanding of the basic economic concepts of Islam. Without this, it will not be possible to find acceptable Islamic solutions to contemporary problems of a complex economy. At the same time it is also essential to have a supportive framework of laws so as to keep the new system on right tracks.

Some of the laws dealing with banking and finance in Pakistan are over one hundred year old. For instance, the Negotiable Instruments Act dates back to the year 1881.   There are laws which regulate the conduct of affairs of banks as a separate legal entity. There are laws which authority to regulate the monetary and credit system of the country of which banks from an integral part. Laws pertaining to limited companies and partnership firms are also relevant to banks as they are part of banks’ clientele. So are some other laws which govern the contractual obligations of banks with their customers. Besides the above there are laws which provide for recovery procedures. These are important to banks as the health of the banking system depends on quick adjudication of disputes and prompt recovery in cases of customers’ defaults. The laws dealing with all matters concerning banks were enacted in a context which recognized ‘interest’ as the kingpin of the system. Elimination of interest has lot more technical ramifications than what  may meet the eyes on the surface. This article is a modest attempt to review the efforts so far made in restructuring of laws in Pakistan for eliminating Riba from the banking system.

Banking Defined

In 1962 a Banking Companies Ordinance was promulgated which sought to consolidate and amend the law the law relating to banking companies. The provisions of this ordinance were intended to the supplement and in addition to the Companies Act of 1913 and other laws except where it was expressly provided. According to Banking Companies 1962 ‘banking’ means the accepting for the purpose of lending or investment, of deposits of money from the public repayable on demand or otherwise and withdrawal by cheque, draft, order or otherwise. Deposits accepted by a company for financing of its own business of manufacturing or trading are therefore excluded from the definition of ‘banking’. Likewise, lending of money alone falls outside the scope of banking as defined. The accepting of deposits from the public repayable on demand or otherwise always implied that the repayment of the principal sum was guaranteed and payment of a fixed rate of interest was also guaranteed if it was agreed to between a bank and its depositors. In theory this meant that the system of banking in Pakistan prior to January 01, 1981 was based on the certainty of repayment of the principal sum and also return on it if it formed the basis of the contract.

New Dimensions

Introduction of interest-free banking in Pakistan as from January 01, 1981 needed suitable amendments in the existing banking laws. Consequently some amendments were made in the Banking Companies Ordinance 1962 which took effect from December 24, 1980. One of the amendments added a new section 26A which authorised the banks in Pakistan to accept deposits as under:

(a) On participation in profit and loss of the banking company

(b) Free of interest or return in any form

Since, the then existing system of interest-based deposits was not intended to be abolished overnight, section 26A also provided that banks could continue to accept deposits on the basis of interest until such time it is notified by the Federal Government that domestic operations of banks are to become interest-free. Section 26A also required that the banks accepting deposits on the basis of participation in profit and loss maintain separate accounts in respect of PLS deposits, investments made, cash and liquidity reserves maintained there against as well as all income and expenditure relating to these deposits. The amendment requires that the PLS deposits accepted by banks can only be invested in such transactions or business from which income does not accrue by way of interest. The amendment further provides that the depositors on the basis of participation of profit and loss of the banks are entitled to a share in the profits calculated according to general directions of State Bank of Pakistan issued from time to time in light of the needs of monetary stability. In case banks suffer a loss, the depositors are to bear the loss proportionately.

That the depositors are now to share in the profits or loss of their banks replaces a well established traditional system of banking which rests on the principle of certainty of capital and certainty of return on it. Equally unique is the other side of the new system which requires the banks to share their profits or loss with their depositors against their traditional role of being the residual claimant. The 'rigid financial intermediation' of interest-based system has been replaced by a system of 'participatory financial intermediation' in which there is participation for the common benefit. This change in the relationship of depositors and banks though seemingly innocuous carries seeds of basic structural changes in the financial and monetary order. A system in which depositors and banks agree to share in profits or loss of banks seems to possess sufficient intrinsic strength to withstand many a crises which some time load to bank failures in the traditional system of interest-based banking which prides itself on the certainty of depositors' capital and return on it only as long as the weather is fair.

Profit Sharing with Depositors

In exercise of powers vested in it under Banking Companies Ordinance 1962 State Bank of Pakistan directed banks and development financial institutions having PLS deposits to declare rates of profits on various categories of PLS deposits on half-yearly basis (i.e. June 30 and December 31) after obtaining clearance from them. For this purpose detailed guidance was provided by State Bank of Pakistan in their Banking Control Department Circular No. 34 of November 26, 1984 salient features of which are summarised below:

(a) Only non-interest income earned by banks is to be distributed to their PLS depositors as during the period of transition banks will also be receiving interest income on their existing loans. Banks in Pakistan were also directed not to sanction or renew any loans on the basis of interest after April 1,1985.

(b) If a' bank carries more PLS deposits than its non-interest investments some of its PLS deposits will remain un- utilised which will reduce its rates of profit.

(c) If a bank carries more non-interest investments than its PLS deposits, non-interest income proportionately to the extent of its PLS deposits only shall be distributable to its PLS depositors in accordance with the given formula.

(d) During the period of transition when banks are conducting interest-based and interest-free banking simultaneously, the establishment expenses incurred by banks on domestic operations are to be charged to the two systems in proportion of the amount of interest and non-interest income earned by a bank. For instance, if the total establishment expenses during a given period are Rs.10,000/- and for the same period the interest and non-interest income are Rs.12000/- and Rs.8000/- respectively,  expenses  of Rs.6000/- shall be charged to interest income and expenses of Rs.4000/- shall be charged to non-interest income.

(e) To non-interest income left after deduction of establishment expenses shall be debited the amount of provisions if any, for bad and doubtful debts. Another amount not exceeding ten percent of the remaining non-interest income can be debited by a bank by way of its 'management fee'.

(f) The remaining non-interest income is now distributable to the various categories 'of PLS deposits and to individual PLS depositors in each category on the basis of daily products with the following weightage:

1. Special Notice Deposits withdrawal at 7 to 29 day's notice to be allowed profit at 0.65 times of the rate to be allowed on PLS Savings deposits.

2. Special Notice Deposits withdrawal at 30 days notice or more to be allowed profit at 0.75 times of the rate to be allowed on PLS Savings Deposits.

3. PLS Savings Deposits. Rate of profit payable to be 1.00.

4. PLS Call Deposits from other banks to be allowed profit with a weightage as agreed between the banks concerned (Weightage to be related to rates on PLS Savings Deposits).

5. PLS Term Deposits of upto six months terms to be allowed profit with additional weightage of 0.05  for each month over and above the rate payable on PLS Savings deposits.

6. PLS  Term   Deposits  in  excess  of  six  months  to   be allowed  profit  at  1.30 times of rate on PLS Saving Deposits for the first six months plus 0.01 for each subsequent month subject to the maxim urn1 of 2.08 time.

7. PLS borrowings of various  maturities to  be allowed share in profits equal to PLS term deposits rates of corresponding maturities described above.

8. Equity-holders to be paid profit at a rate not exceeding five times the rate of profit to be allowed on PLS Savings deposits of the bank. The actual weightage is to he determined by the bank concerned subject to the above maximum. This means that a bank may reduce the rate of profit on its own equity so as to pay more to its PLS depositors. But a bank cannot pay to its equity-holders more than five times the rate of profit paid to its PLS Savings Depositors.

The above formula is based on the directives issued by State Bank of Pakistan. The quantum of weightages seems to be related to the comparative liquidity (and usability to the bank) of deposits of different maturities. The system of weightages became necessary as banks in Pakistan are not maintaining separate pools of deposits of different maturities with separate accounting for investments and income derived from it.

Partnership Act Amended

Accepting deposits from clients on the basis of sharing of profit and loss had another legal implication in the light of section 4 of the Partnership Act 1932 which defines "partnership" as the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. The new system of accepting deposits by banks on the basis of sharing of profit and loss within the meaning of section 4 of the Partnership Act 1932 could possibly be interpreted to the effect that depositors had become partners of the bank. Under the Act a partner's liability is unlimited and the liabilities of a partnership can be recovered from any one of the partners. In a situation like this the liability of a PLS depositor could even exceed the principal sum of his deposits though it is difficult to believe that a partnership can inadvertently come into existence between a bank and its depositors. Another limiting factor is that the Partnership Act 1932 restricts the number of partners in an ordinary partnership to twenty and it is hardly to be expected that the number of PLS depositors of a bank could be so scant. However, to remove this confusion an amendment has been made on December 31, 1984 by adding a new section 6A in the Partnership Act 1932 which reads as under:

"Act not to apply to certain relationship — Nothing contained in this Act shall apply to a relationship created by any agreement between a banking company and a person or group of persons providing for sharing of profits and losses arising from or relating to the provision by the banking company of finance to such person or group of persons, For the purpose of this section, "banking company" and "finance" shall have the same meaning as is in Banking Tribunals Ordinance 1984”.

The phrasing of the above amendment indicates that the law makers were overly concerned to exclude finances provided by banks to others on the basis of sharing profit & loss from the provisions of Partnership Act 1932. Obviously cases of finance provided by banks to others on the basis of sharing of profit & loss are very small in number while the number of domestic depositors sharing in the profit and loss of banks runs into millions. This demanded that the relationship of depositors with their banks should have been more explicitly excluded in the newly added section 6A. The intention of the law makers is however sufficiently evident that the profit-sharing relationship between banks and others is excluded from the purview of the general provisions of the Partnership Act 1932.

Banker & Customer Relationship

Now, if the relationship of PLS depositors with their banks and of banks with others using banks' finance on the basis of sharing of profit or loss is not to be treated as 'partnership' then what is the legal basis of this new relationship under interest-free banking in Islamic context. Under interest-based system it was a settled issue that the banker-customer relationship was that of debtor and creditor depending on the state of a customer's account. Whoever owed money to the other was a debtor and this position could change several times in the course of a day. Since Islam does not permit transactions on the basis of interest, the debtor-creditor relationship is relevant only in the context of Qard-e-Hasna i.e. interest-free loan. Where profit is desired to be carried by owners of funds several Islamic alternatives such as Modaraba, Musharika, Murabaha, Ijara etc. are available. According to Islamic law in each of these arrangements the relationship between the financier and the financed is different. To cope with this situation and to avoid dislocation definitions of 'Creditor' and 'Debtor' have been enlarged through an amendment on December 24, 1980 in Banking Companies Ordinance 1962. New clauses (dd) and (ee) have been added in section 5 of the Companies Ordinance 1962 text of which is reproduced below:

(dd) "Creditor" includes persons from whom deposits have been received on the basis of participation in profit and loss and a banking company or financial institution from which financial accommodation or facility has been received on the basis of participation in profit and loss, mark-up in price, hire-purchase, lease or otherwise.

(ee) "Debtor" includes a person to whom or a banking company or financial institution to which financial accommodation or facility has been provided on the basis of participation in profit and loss, mark-up in price, hire purchase lease or otherwise''

With above amendments the banker-customer relationship under the interest-free banking system in Pakistan continues to remain that of 'debtor' and 'creditor' as before. The most probable rationale of this is that even in a profit and loss sharing arrangement the principle sum subject to adjustments for profit or loss, as the case may be, is recoverable at the end of the contracted period.

Definition of Finance

Similarly definition of "loans, advances and credit" has also been enlarged by adding clause (gg) in section 5 to include finance provided on the basis of participation in profit and loss, mark-up in price, lease, hire-purchase or otherwise. This change in the definition of 'loans, advances and credit is relevant to many other laws such as State Bank of Pakistan Act 1956, Banks (Nationalisation) Act 1974, Banking Companies (Recovery of loans) Ordinance 1979. Further amendments in various laws have again been made on December 31, 1984 through a Banking and Financial Services (Amendment of Laws) Ordinance. The definition of 'Debtor' in section 5 of the Banking Companies Ordinance 1962 has been further changed. Anyone who is provided 'finance' is a 'Debtor'. Through another amendment 'loans, advances and credit' include 'finance' which has been exhaustively defined in the Banking Tribunals Ordinance 1984 as under:

"Finance includes an accommodation or facility under a system which is not based on interest but provided on the basis of participation in profit and loss, mark-up or mark-down in price, hire-purchase, lease, rent-sharing, licensing, charge or fee of any kind, purchase and sale of any property, including commodities, patents, designs, trade marks and copy rights, bill of exchange, promissory notes or other instruments with or without buy-back arrangements by a seller. Participation Term Certificate, Musharika Certificate, Modaraba Certificate, Term Finance Certificate or any other mode other than an accommodation or facility based on interest and also includes guarantees, indemnities and tiny other obligation, whether fund-based or non-fund based and any accommodation or facility the real beneficiary whereof is a person other than the person to whom or in whose name it was provided". The definition of 'finance' throws light on the nature of the new system of banking.

Another issue of importance pertains to 'interest'. Though the pivotal issue in the whole exercise is the elimination of interest (Riba), yet the definition of 'interest' has not been provided as has been done in the case of debtor, creditor, loan, advances, credit etc. A legal definition of interest is badly needed to avoid controversies. In the context of unclaimed deposits or articles of value after the word 'interest' the words 'or rank for a share of profit or loss' have been added in sub section (4) of section (31) of Banking Companies Ordinance 1962. In the third paragraph of section 5 of the Negotiable Instruments Act 1881 after the word 'interest', the words 'or return in any other form' have been added by a legal amendment. This amendment has been made in a reference to the definition of Bill of Exchange and also to a Promissory Note.

Negotiable Instruments Act Amended

A Bill of Exchange is defined as an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay on demand or at a fixed or determinable future time a certain sum of money only to or to the order of a certain person or to the bearer of the instrument. The requisites of a valid Bill of Exchange are that:

i) it must be in writing and signed by the maker

ii) it must contain an order to pay on demand or at a deter minable future time.

iii) Order contained in the bill must be unconditional

iv) the person directed to pay must be certain

v) the sum payable must be CERTAIN

As regards to the additional amount of interest at a given rate in a bill of exchange or promissory note, the sum payable with interest was considered 'CERTAIN' within the meaning section 5 and 4 of the Negotiable Instruments Act 1881. Now with the abolition of 'interest' and its replacement with the words 'or return in any other form' which may comprise of a share in profit or loss (an unknown sum), mark-up in price in a deferred-payment sale and rental in lease or hire-purchase. This additional 'return' may not be capable of being described with the same certainty, as was 'interest' at a given rate per annum.

Whether a bill of exchange or a promissory note could remain a valid financial instrument within the meaning of the Negotiable Instruments Act 1881 if it was payable with 'return' the amount or rate of which could not be specified in the manner of rate of interest per annum. To overcome this problem a new paragraph has been added after the third paragraph in section 5 of the Negotiable Instruments Act 1881 which reads as under:

"A promise or order to pay is not conditional nor is the sum payable 'uncertain' within the meaning of this section or section 4 by reason of the sum payable being subject to adjustment for profit or loss, as the case may be of the business of the maker."

This new paragraph refers to section 4 which pertains promissory note while the section 5 pertains to the definition of a bill of exchange. For the general readers it may be mentioned that a bank draft is a bill of exchange drawn by a branch of a bank on its own branches, or on a branch of another bank. Similarly a 'cheque' is also defined as a bill of exchange drawn on a specified banker and not expressed to be payable otherwise than on demand. Addition of the above paragraph pertaining to the certainty of the sum payable takes care of the commonly used forms of Negotiable Instruments within the country. Changes in modes of financial transactions in future will have to be taken care of when these become incumbent with the introduction of 'electronic banking' when conditions that a Bill of Exchange must be in writing and signed by the maker will become difficult to comply.

Relief of Debtors

Section 79 and 80 of the Negotiable Instruments Act 1881 dealt with the relief of debtors in the context of payment of interest expressly made payable at a specified rate without mentioning dates or when the promissory note or bill of exchange were silent as regards to interest or its rate. With the introduction of interest free banking addition has been made through a legal amendment in section 79 and 80 of the Act, The new provisions added lay down the following rule for payment of return.

(i) In the case of return on the basis of mark-up in price, lease, hire-purchase or service charges, at the contracted rate of mark-up, rental, hire or service charges as the case may be and

(ii) In the case of return on the basis of participation in profit, and loss at such rate as the Court may consider just and reasonable in the circumstances of the case, keeping in view the profit-sharing agreement entered into between the banking company and the judgement debtor when the loan was contracted. And the return on an amount due on an instrument shall be allowed from the date it becomes due till the date it is actually paid.

An amendment in code of Civil Procedure 1908 has also been made which provides that in a decree for payment of money due to a banking company in repayment of a loan advanced by it, the court shall in the decree provide for return on the judgement debt from the date of decree till payment in the case of finance provided on the basis of  mark-up in price, lease, hire-purchase or service charges for the contracted rate or at the latest rate of the banking company whichever is higher but in case of finance provided on the basis of participation of profit and loss, for return at such rate, not being less than the annual rate of profit for the preceding six months paid by the banking company on term deposits of six months accepted by it on the basis of participation in profit and loss, as the court may consider just and reasonable in the circumstances of the case keeping in view the profit sharing agreement entered into between the banking company and the judgement debtor when the finance was contracted.

Forms of Banking Business

Section 7 of the Banking Companies Ordinance 1962 provides for forms of business in which banking companies may engage. The list is long and exhaustive and is similar to business conducted by banks in a well-regulated system. In addition to the list of existing forms of business banks have now been allowed through an amendment and addition of sub section (bb) to act as a Modaraba Company' under the provisions of the Modaraba Companies and Modaraba (Floatation and Control) Ordinance 1980. Restrictions on banks against forming subsidiary companies except for specified restricted purposes have been relaxed and banks can now form subsidiary companies for carrying on the business of Modaraba. Salient features of Modaraba Ordinance have been discussed elsewhere in this paper.

In 1980 through another amendment and addition of sub-section (ee) in Section 7, banks were allowed the purchase of properties, moveable or immovable, exclusively for being leased out or for being sold on hire-purchase basis or on deferred payment basis with mark-up. Banks were also allowed to underwrite the issue of Modaraba Certificates and Participation Term Certificates. Forms of business in which banking companies may engage has been further amended on December 31, 1984 and clause (ee) in section 7 of Banking Companies Ordinance has been substituted. The revised clause reads as under:

"Purchase or acquisition in the normal course of its banking business of and property, including commodities, patents, designs, trade-marks and copy rights, with or without buy-back arrangements by the seller, or for sale in the form of hire-purchase or on deferred payment basis with mark-up or for leasing or licensing or for rent-sharing or for any other mode of financing." A new clause (aa) section 7 authorises the banks to provide 'finance' as defined in the Banking Tribunals Ordinance 1984.

Except as authorised under amended section 7 of Banking Companies Ordinance banking companies are not authorised to deal directly or indirectly in the buying or selling or bartering of goods or engaging in any trade or buying selling or bartering goods for others, otherwise than in connection with bills of exchange received for collection or negotiation. For the purpose of section 9 of the Banking Companies Ordinance pertaining to prohibition of trading 'goods' means every kind of moveable property other than actionable claims stocks, shares, money, bullion and specie and all financial instruments in which banks are allowed to deal. Prohibition of trading by banking companies therefore does not apply to finances provided by banks on the basis of participation in profit and loss, mark-up, lease, hire-purchase or otherwise as explained in the preceding paragraphs.

Credit Control and Secondary Reserves

Win a view to empowering State Bank of Pakistan to discharge its functions as a Central Bank, legal amendments have been made in State Bank of Pakistan Act 1956. State Bank has been authorised to purchase, sale and rediscount the Participation Term Certificates, a new instrument based on profit and loss sharing which has been introduced in place of interest-based debentures. State Bank has also been authorised to provide finance to scheduled banks and financial institutions on bases other than interest. Promissory notes of scheduled banks supported by Modaraba certificates or Participation Term Certificates are now eligible for grant of financial accommodation by State Bank of Pakistan which has also been authorised to determine from time to time, the terms and conditions either generally or specifically for providing finances on bases other than interest. In terms of section 36 (1) all scheduled banks are required to maintain with State Bank a cash reserve of five per cent of their total demand and time liabilities in Pakistan. Under the interest based system penal interest was recovered by State Bank on the amount of shortfall in the cash reserves of the scheduled bank. With the introduction of interest-free system, recovery of penal interest has been replaced by a system of penalties and fines.

Through an amendment in section 25 of Banking Companies Ordinance 1962 State Bank has been allowed the discretion to give directions to banking companies in respect of credit ceilings to be maintained, credit targets to be achieved for different purposes, sectors and regions, margins to be maintained and the rates of mark-up, profit-sharing ratios and other charges to be applied on finances provided by them. If any default is made by a banking in complying with the directions given, every officer who is knowingly a party to such defaults is liable to financial penalties. In some cases of non-compliance by a banking company, State Bank has powers to direct the bank concerned to make a special deposit with it. Demanding a special deposit without any return on it from a banking company is one way to replace the technique of penal interest. Extensive use of this technique can be made by a Central bank in an interest-free banking system. 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 of not less than thirty five per cent of the total of its demand and time liabilities in Pakistan. Since banks are required to maintain 'cash reserves' equal to five per cent of total of their demand and time liabilities in Pakistan in terms of section 36 (1) of SBP Act 1956, the question arises as to in which liquid assets banks shall maintain the remaining liquidity requirements of thirty per cent. This problem was temporarily solved by amending and enlarging the definition of "approved securities' given in section 5 of Banking Companies Ordinance 1962 which now include such Pakistani Rupee obligations of the Federal or Provincial Government or of a Corporation wholly owned or controlled directly or indirectly by the Federal or a Provincial Government and guaranteed by the Federal Government as the Federal Government may, by notification in the official Gazette, declare to the extent determined from time to time, to be approved securities for the purpose of that section.

A notification issued has declared the following financial obligations as an 'approved security' to the extent of thirty per cent of a bank's PLS liabilities.

(a) Funds provided by a bank out of its own resources for financing the 'commodity operations' of the Federal and Provincial governments on the basis of mark-up in price.

(b) Funds provided by a bank out of its own resources to the following corporations for   financing their 'commodity operations' on the basis of mark-up in price and guaranteed by the Federal Government:

1. Rice Export Corporation of Pakistan

2. Trading Corporation of Pakistan

3. Pakistan Agricultural Storage & Services Corporation

4. Sind Agricultural Supplies Corporation

5. Punjab Seeds Corporation

6. Punjab Agricultural Development & Supplies Corporation

7. Federal Directorate of Fertilizer Imports

(c) Funds provided by a bank out of its own resources to Trading Corporation of Pakistan, Rice Export Corporation of Pakistan and Cotton Export Corporation for their 'trading operations' on the basis of mark-up in price and guaranteed by the Federal government.

(d) Funds placed by a bank in a separate account with State Bank of Pakistan on profit & loss sharing basis for a term of one year.

Retrograde Step

The notification SRO. 1285(I)/80 dated December 24, 1980 issued by the Finance Division of Government of Pakistan in exercise of powers conferred under section 5 of Banking Companies Ordinance 1962, while declaring certain Rupee obligations to be "approved securities’ for the purpose of section 29(1) of the Banking Companies Ordinance 1962 clearly laid down that any obligation where interest is payable by the obligor shall not constitute approved security. Also, State Bank of Pakistan in their BCD Circular No. 27 of December 24, 1980 pertaining to the requirements of maintaining 'liquid Assets' in respect of PLS time and demand liabilities of banking companies clarified that "as required under sub-section (4) of the new section 26A of the (Banking Companies) Ordinance, investments even for purposes of liquidity shall be made only in interest-free avenues." After waiting for about five years, State Bank of Pakistan through their BCD Circular letter No. 13/600-26-85 dated August 24, 1985 authorised the banks to invest their PLS deposits in Government securities, including Treasury Bills. The implication of this authorisation is that the 'Treasury Bills' have been approved by State Bank of Pakistan as an interest-free avenue of investment and the return obtained from investment in Treasury Bills can be distributed to PLS depositors treating it as non-interest income. Declaring certain 'Rupee obligations' to be 'approved securities' for the maintenance of liquid assets by banks in respect of their PLS deposits was to create avenues of interest-free investment by banks for the purpose of secondary reserves for liquidity. It was a tacit admission on the part of the Government and State Bank of Pakistan that the Treasury Bills were then considered as an interest-based investment which position was also in line with the recommendations of the Council of Islamic Ideology. Instead of finding an acceptable solution for eliminating Riba from the savings scheme of the Government or creating a new interest-free financial instrument to be used by banks for maintaining their Secondary Reserves in liquid assets, after waiting for five precious years, a retrograde step was taken which allowed the banks to invest their PLS deposits in government Treasury Bills.

Indexed Deposits For Secondary Reserves

As far as 'liquid assets' are concerned these can be maintained entirely in cash which will be free from interest. This will provide liquidity, but without any income. The problem can be solved by creating a new interest-free financial instrument to be declared a 'approved security' for the purpose of section 29 (1) of Banking Companies Ordinance. This can be an 'Interest-Free Indexed Deposit Certificate' which should not earn any return but its nominal value should be eligible for 'indexation' so that the holder is compensated for the loss of purchasing power due to price inflation. Interest-Free Indexed Deposit Certificates to be used by banks as a liquid asset meet all the requirements of a good security for the purpose of banks' secondary reserves.

Turkey Sets Example

For the investment by general public the government should introduce interest-free 'Revenue — Sharing Bonds' on the pattern adopted by the Government of Turkey. According to a paper presented by Mr. Turgut Ozal, Prime Minister of Turkey at UNESCO, Paris, the revenue-sharing bonds' scheme has been a great success in generating funds for development through an interest-free instrument. In Turkey, a 'Public Participation Fund' has been established under a new law called 'Encouragement of Savings & Acceleration of Public Investment'. The fund is used for developing infra-structure facilities such as bridges, dams, power-plants highways, telecommunications, railways, ports and airports. The other advantage of the scheme mentioned by Mr. Turgut Ozal is that being outside the public budget, the fund is less open to bureaucratic red-tape. The income earned from the above mentioned infra-structure facilities is distributed to the holders of revenue-sharing bonds.

Financing for meeting the temporary liquidity difficulties including TT discounting facilities which were allowed by State Bank of Pakistan to other banks and development financial institutions on the basis of interest were discontinued on December 31, 1984. As from January 1, 1985 State Bank started allowing these facilities on the basis of profit & loss sharing. The rate of profit on such facilities was to be equal to the rate of profit declared by the receiving bank on its PLS Savings deposits for the relevant half-year. If a bank or financial institution did not have any PLS deposits in Savings accounts the rate of profit was to be equal to PLS deposits for a term of six months. Provisional share in profit can be paid to State Bank of Pakistan on the basis of last declared rates of profit subject to adjustments when rates of profit for the concerned period are declared. If the receiving bank suffers a loss, the loss is to be shared proportionately by all providers of finance to the concerned bank.

Criminal & Civil Liability of Banks

In view of the nature of interest-free banking adopted in Pakistan, banking companies and their officers and employees have been excepted from criminal or civil liability of every description provided for in any law in respect of any property movable or immovable, owned by a banking company, exclusively or jointly with another person so long as the property remains in the custody, power and control of such person under an arrangement of providing finance as defined. Banking Companies have also been exempted from the requirement of a license or permit to import or export any commodity or article or its purchase or sale if undertaken in the normal course of its banking business under an agreement of providing the finance. Banking companies have also been authorised to exchange information on confidential basis about their clients. Legal protection has been provided to banking companies in respect of continuance of charge and priority. Where a charge on a property was created in favour of a banking company to secure any interest-based facility and if such facility is at any time converted into or substituted by any facility not based on interest, such charge shall continue to remain valid and shall maintain its priority against all charges created in favour of any other person subsequent to the original date of registration of such charge. These changes have been introduced by addition of new sections 93A, 93B, 93C and 93D in the Banking Companies Ordinance 1962.

Redeemable Capital

In the Companies Ordinance 1984 which replaced the Companies Act 1913 a new concept of ‘redeemable capital' has been introduced which includes outside capital not based on interest and raised for business other than the permanent part of equity of a company. 'Redeemable Capital' includes finance obtained through Participation Term Certificate (PTC), Musharika Certificate, Term Finance Certificate (TFC) or any other instrument not based on interest other than an ordinary share of a company, representing an instrument or certificate of specified denomination, called the face value or nominal value, evidencing investment of the holder in the capital of the company on terms and conditions of the agreement for the issue of such instrument or certificate. Of the said 'redeemable capital' such part or instrument which is entitled to participate in the profit or loss of a company is known as 'participatory redeemable capital'. The instruments and certificates described, under 'redeemable capital' take the place of debentures and bonds of the interest-based system and have been devised to facilitate the system of interest-free banking. Other changes which were necessary to back-up the functioning of 'redeemable capital' have also been made in the Companies Ordinance 1984.

Besides the above amendments in the laws, two self-contained pieces of legislation have been enacted in Pakistan. These are:

(1) Modaraba Companies and Modaraba (floatation & Control) Ordinance 1980

(2) Banking Tribunals Ordinance 1984

Modaraba Ordinance 1980:  It is the first attempt in modern times to codify into a law the conditions governing the conduct of Modaraba contract which is a historical form of financing on the basis of profit sharing (loss is borne only by the providers of capital). Muslims in other parts of the world may have their own views on some provisions of the Modaraba law adopted in Pakistan. The law provides that 'Modarabas' can be floated by such joint stock companies which register themselves a 'Modaraba Company' with the Registrar of Modaraba Companies. The parent Modaraba Company is required to contribute at-least ten percent of the capital in each 'Modaraba' floated by it. (Modaraba is like a close-end Mutual fund managed by the parent Modaraba Company). Banks are authorised to finance the 'Modarabas' by taking up the Modaraba Certificates floated by another company and are also authorised to buy Modaraba Certificates on the stock exchange just like other ordinary shares. Banks are permitted to register themselves as a ‘Modaraba Company' for floatation and management of their own Modarabas.

The parent Modaraba Company is entitled under the law to a remuneration of a fixed percentage not exceeding ten percent of the net annual profit of a Modaraba. This remuneration is for managing the ‘Modaraba' and is in addition to the share in profit (dividend) on the capital invested in Modaraba Certificates. If ninety percent income of a ‘Modaraba' is distributed to the certificate holders, the entire income of the Modaraba is exempt from income tax. Banking Companies ordinance 1962 has been amended to allow banks to act as Modaraba Company. Restrictions on banks against forming of subsidiary companies has been removed for .the purpose of carrying on the business of a Modaraba. Since Modaraba Ordinance provides that the business of a parent Modaraba Company must not be in competition with the ‘Modaraba' floated by it, it means that a 'Modaraba' floated by a bank (after registering itself as a Modaraba Company) has to be for a non-banking business. This allows an opportunity to banks to diversify into any other business which is not opposed to the injunctions of Islam. Modarabas floated can be either for a specific purpose or for multipurpose. Modaraba can be floated for a limited period or for perpetuity. Modaraba is a legal person capable of suing and being sued in its own name through the parent Modaraba Company.

Financial Impact of Riba-Free Banking: Under interest-based banking even if the borrowers delayed the repayment of loans the banks did not lose their interest income. On the other hand interest debited periodically to borrowers' accounts also became part of the principal amount of loan for the purpose of future calculation of interest. This technique is known as compounding of interest while simple-interest is charged only once at the time of adjustment. Islam categorically forbids dealings on the basis of interest whether it is simple or compound. Compounding of interest was prohibited by the Holy Quran as a first step in the third or fourth year after the Holy Prophet's (PBUH) migration to Madina (Al-i-Imran-130) and the total prohibition of interest was revealed during the last days of the Holy Prophet (PBUH). The real importance of the prohibition of compounding of interest as an initial step shall be evident from the following example:

(a) 100 Units of Money at simple interest of 10% per annum in 100 years become 1100/-

(b) 100 Units of Money at compound interest of 10% per annum in 100 years become 1,378,061 /-

This example should help in putting into proper perspective the debt burden of the long-term external loans contracted by the poor and developing countries of the world.

Under interest-free methods of financing adopted in Pakistan, the most common mode of financing is the sale of goods on the basis of deferred payment with mark-up in price. For example goods purchased by a bank for Rs.100/- are sold to a client for Rs.115/- on deferred payment of price after one year. The mark-up in price in this transaction is 15%. The rate of return to the bank is simple 15% per annum without compounding. Under this system of financing if the purchaser (client) defaults in payment of price to the bank on due date, the contracted price of Rs.115/- remains unchanged. Any increase in the contracted price (i.e. Rs.115/-) is considered Riba (interest) as the unpaid price is also a kind of a loan. Therefore, in financing on the basis of mark-up in price (Murabaha), banks are more vulnerable than in a system of banking which may be based on simple interest. In the interest-free system of banking, users of banks' funds have a upper hand. It is this financial vulnerability of banks which made it essential that the government adopted special measures to augment and streamline the legal procedures of recovery available to banks. For this purpose a Bunking Tribunal Ordinance was promulgated on December 31. 1984.

Its objective is to ensure prompt recovery of banks' finances lest some clients should be tempted to default for the reason already explained.

Banking Tribunals Ordinance 1984

The procedure for recovery provided for in the Banking Tribunals Ordinance 1984 is as under:

1. Where a customer defaults in fulfilling any of his obligations to a bank, the branch manager files a plaint on oath with a Banking Tribunal.

2. The Tribunal issues notice to the defendant to show cause within ten days as to why the decree as prayed be not passed against him.

3. Upon the defendant failing to file a reply or upon rejection of his plea, the Tribunal passes the decree as prayed.

4. Where the decree is passed by the Tribunal for want of a reply to the notice, the Tribunal is competent to set aside the same if the defendant files his reply within thirty days of the passing of the decree provided that the Tribunal is satisfied that there was sufficient cause for the defendant for not filing his reply within the specified time.

5. All suits filed in the Banking Tribunal are to be disposed of within ninety days of the filing of the plaint by the bank. If proceedings continue beyond ninety days the defendant is asked to deposit cash equal to the claim. On failure of the defendant to deposit the cash, the Tribunal passes decree in favour of the bank. If the delay in completing the proceedings in the opinion of the Tribunal is not attributable to the conduct of the defendants, the requirement of deposit of cash   may be dispensed with by the Tribunal.

6. Any amount deposited by the defendant with the Tribunal may be withdrawn by the bank upon an undertaking to refund the same if so ordered.

7. If the claim filed before the Tribunal is for the enforcement of a mortgage of immovable property, 'decree' means final decree for fore-closure, sale or redemption as the case may be.

8. Banking Tribunal imposing any fine may direct that whole or part of it be applied towards payment of cost of proceedings or for payment to the bank as compensation for the loss caused by the offence including the loss of income.

9. Any aggrieved person can prefer an appeal in a High Court within thirty days of the decree or order or sentence passed provided that no appeal filed by the defendant is entertained unless the defendant deposits with the Banking Tribunal the amount claimed in the suit.

10. Subject to the provision of appeal no court or other authority is permitted to call in question the legality or propriety of any proceedings, order, judgement or decree of a Banking Tribunal.

11. The Banking Tribunal on the written application of a decree holder forthwith orders execution of the decree by way -of arrears of land revenue. On the application of a decree-holder for execution of the decree by arrest and detention of the judgement debtor in prison, the Tribunal after giving the judgement debtor an opportunity of being heard, orders for his detention in civil prison and causes him to be arrested if he is not already under arrest.

12. If a decree remains unsatisfied beyond a period of thirty days, the Tribunal on application of the decree-holder may impose a penalty on the judgement debtor and the fine recovered may be given to the bank as liquidated damages. Penalty imposed once is not a bar to the imposition of further penalty by the Tribunal at a later date where the failure to pay the decretal amount continues.

The Banking Tribunal Ordinance 1984 also provides that anyone who intentionally destroys or removes or reduces (without the prior approval of the bank) the value of property on the security of which finance was provided or transfers such property or any part of it, is punishable with imprisonment extending upto five years in addition to a fine. The tribunal may further order the refund of the value of the property destroyed, removed, reduced or transferred. If the person guilty of above offences is a company then the same punishments can be awarded to its chief executive, executive directors, managers, secretary or any other officer unless they prove their innocence in the commission of the offence. All offences under the Banking Tribunals Ordinance 1984 are bailable, non-cognizable and compoundable. A Banking Tribunal is to consist of two members and a chairman who has been or qualifies for appointment as a Judge of High Court or a District Judge. In civil jurisdiction the tribunal carries the powers vested in a civil court under the Code of Civil Procedure 1908 while in criminal jurisdiction it carries the powers vested in a Court of Sessions under Code of Criminal Procedure 1898. 

What Is Being Eliminated

As time passes and experience is gained, the techniques of Riba-free banking are destined to be improved, refined and innovated. So shall be the legal framework needed to back-up the emerging system. This paper reviewing the modest efforts made for eliminating Riba (interest) from the banking system in Pakistan, may serve as a piece of information to be shared by all those who would like to see the germination of a new economic order through application of the benevolent doctrines of Islam of which freedom from Riba is one of the essential conditions. Yet this author could not find a legal definition of 'Riba' in any of the laws amended or promulgated for its elimination. The question then is, what is it that is being eliminated?

May God show us the straight path which earns His favour.

(Courtesy: Journal of Institute of Bankers in Pakistan)

The author is Executive Vice President, Islamic Banking Division, United Bank Ltd., Karachi. Thin paper in based on the personal views of the author.