Description
Islamic banking document covers Interest-free banking, Interest-free banking, Current practices, Deposit accounts, Current accounts, Savings accounts, Investment account, Modes of financing and Investment financing.
ISLAMIC BANKING Introduction Modern banking system was introduced into the Muslim countries at a time when they were politically and economically at a low ebb, in the late 19th century. The banks were generally confined to the capital cities and the local population remained largely untouched by the banking system. With the passage of time, however, and other socio-economic forces demanding more involvement in national economic and financial activities, avoiding the interaction with the banks became impossible. As countries became independent the need to engage in banking activities became unavoidable and urgent. This state of affairs drew the attention and concern of Muslim intellectuals. Historical development It seems that the history of interest-free banking could be divided into two parts. First, when it still remained an idea; second, when it became a reality -- by private initiative in some countries and by law in others. Interest-free banking as an idea Interest-free banking seems to be of very recent origin. The earliest references to the reorganisation of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties. They have all recognised the need for commercial banks and the evil of interest in that enterprise, and have proposed a banking system based on the concept of Mudarabha profit and loss sharing. In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, First International Conference on Islamic Economics in Mecca in 1976, International Economic Conference in London in 1977 were the result of such involvement. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process. The coming into being of interest-free banks The first private interest-free bank, the Dubai Islamic Bank, was also set up in 1975 by a group of Muslim businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and the Sudan. In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 interest-free banks have come into being. Though nearly all of them are in Muslim countries, there are some in Western Europe as well: in Denmark, Luxembourg , Switzerland and the UK. In most countries the establishment of interest-free banking had been by private initiative and were confined to that bank In Pakistan, effective 1 January 1981 all domestic
commercial banks were permitted to accept deposits on the basis of profit-and-loss sharing (PLS). From 1 July 1985 no banks could accept any interest bearing deposits, and all existing deposits became subject to PLS rules. Yet some operations were still allowed to continue on the old basis. Interest on deposits was also converted into a ‘guaranteed minimum profit. Current practices Generally speaking, all interest-free banks agree on the basic principles. However, individual banks differ in their application. These differences are due to several reasons including the laws of the country, objectives of the different banks, individual bank’s circumstances and experiences, the need to interact with other interest-based banks, etc. In the following paragraphs, we will describe the salient features common to all banks. Deposit accounts All the Islamic banks have three kinds of deposit accounts: current, savings and investment. Current accounts Current or demand deposit accounts are virtually the same as in all conventional banks. Deposit is guaranteed. Savings accounts Savings deposit accounts operate in different ways. In some banks, the depositors allow the banks to use their money but they obtain a guarantee of getting the full amount back from the bank. Banks adopt several methods of inducing their clients to deposit with them, but no profit is promised. In others, savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals and minimum balance. Capital is not guaranteed but the banks take care to invest money from such accounts in relatively risk-free short-term projects. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands. Investment account Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit (or loss) in a given proportion with the bank. Capital is not guaranteed. Modes of financing Banks adopt several modes of acquiring assets or financing projects. But they can be broadly categorised into three areas: investment, trade and lending. Investment financing This is done in three main ways: a) Musharaka where a bank may join another entity to set up a joint venture, both parties participating in the various aspects of the project in varying degrees. Profit and loss are shared in a pre-arranged fashion. This is not very different from the joint venture concept. The venture is an independent legal entity and the bank may withdraw gradually after an initial period. b) Mudarabha where the bank contributes the
finance and the client provides the expertise, management and labour. Profits are shared by both the partners in a pre-arranged proportion, but when a loss occurs the total loss is borne by the bank. c) Financing on the basis of an estimated rate of return. Under this scheme, the bank estimates the expected rate of return on the specific project it is asked to finance and provides financing on the understanding that at least that rate is payable to the bank. If the project ends up in a profit more than the estimated rate the excess goes to the client. If the profit is less than the estimate the bank will accept the lower rate. In case a loss is suffered the bank will take a share in it. Trade financing This is also done in several ways. The main ones are: a) Mark-up where the bank buys an item for a client and the client agrees to repay the bank the price and an agreed profit later on. b) Leasing where the bank buys an item for a client and leases it to him for an agreed period and at the end of that period the lessee pays the balance on the price agreed at the beginning an becomes the owner of the item. c) Hire-purchase where the bank buys an item for the client and hires it to him for an agreed rent and period, and at the end of that period the client automatically becomes the owner of the item. d) Sell-and-buy-back where a client sells one of his properties to the bank for an agreed price payable now on condition that he will buy the property back after certain time for an agreed price. e) Letters of credit where the bank guarantees the import of an item using its own funds for a client, on the basis of sharing the profit from the sale of this item or on a mark-up basis. Lending Main forms of Lending are: a) Loans with a service charge where the bank lends money without interest but they cover their expenses by levying a service charge. This charge may be subject to a maximum set by the authorities. b) No-cost loans where each bank is expected to set aside a part of their funds to grant no-cost loans to needy persons such as small farmers, entrepreneurs, producers, etc. and to needy consumers. c) Overdrafts also are to be provided, subject to a certain maximum, free of charge. Services Other banking services such as money transfers, bill collections, trade in foreign currencies at spot rate etc. where the bank’s own money is not involved are provided on a commission or charges basis. Problems in implementing the PLS scheme Financing There are four main areas where the Islamic banks find it difficult to finance under the PLS scheme: a) participating in long-term low-yield projects, b) financing the small businessman, c) granting non-participating loans to running businesses, and d) financing government borrowing. Let us examine them in turn.
Long-term projects
Table 1 shows the term structure of investment by 20 Islamic Banks in 1988. It is clear that less than 10 percent of the total assets goes into medium- and long-term investment. Admittedly, the banks are unable or unwilling to participate in long-term projects. This is a very unsatisfactory situation. Table 1 Term Structure of Investment by 20 Islamic Banks, 1988 Type of Investment Short-term Social lending Real-estate investment Amount* % of Total 4,909.8 64.2 1,498.2 68.4 0.9 20.9
Medium- and long-term investment 707.7 9.8 Source: Aggregate balance sheets prepared by the International Association of Islamic Banks, Bahrain, 1988. Quoted in: Ausaf Ahmed (1994). * Unit of currency not given. The main reason of course is the need to participate in the enterprise on a PLS basis which involves time consuming complicated assessment procedures and negotiations, requiring expertise and experience. The banks do not seem to have developed the latter and they seem to be averse to the former. There are no commonly accepted criteria for project evaluation based on PLS partnerships. Each single case has to be treated separately with utmost care and each has to be assessed and negotiated on its own merits. Other obvious reasons are: a) such investments tie up capital for very long periods, unlike in conventional banking where the capital is recovered in regular instalments almost right from the beginning, and the uncertainty and risk are that much higher, b) the longer the maturity of the project the longer it takes to realise the returns and the banks therefore cannot pay a return to their depositors as quick as the conventional banks can. Thus it is no wonder that the banks are averse to such investments. Small businesses Small scale businesses form a major part of a country’s productive sector. Besides, they form a greater number of the bank’s clientele. Yet it seems difficult to provide them with the necessary financing under the PLS scheme, even though there is excess liquidity in the banks. Running businesses Running businesses frequently need short-term capital as well as working capital and ready cash for miscellaneous on-the-spot purchases and sundry expenses. This is the daily reality in the business world. Very little thought seems to have been given to this important aspect of the business world’s requirement. The PLS scheme is not geared to cater to this need. Even if there is complete trust and exchange of information between the bank and the business it is nearly impossible or prohibitively costly to estimate the contribution of such short-term financing on the return of a given business. Neither is the much used mark-up system suitable in this case. It looks unlikely to be able to arrive at general rules to cover all the different situations. The enormity of the damage or hindrance caused by the inability to provide financing to this sector will become clear if we realise that running businesses and enterprises are the mainstay of the country’s very economic survival.
Government borrowing In all countries the Government accounts for a major component of the demand for credit -both short-term and long-term. Unlike business loans these borrowings are not always for investment purposes, nor for investment in productive enterprises. Even when invested in productive enterprises they are generally of a longer-term type and of low yield. This latter only multiplies the difficulties in estimating a rate of return on these loans if they are granted under the PLS scheme. Legislation Existing banking laws do not permit banks to engage directly in business enterprises using depositors’ funds. But this is the basic asset acquiring method of Islamic banks. Therefore new legislation and/or government authorisation are necessary to establish such banks. In Iran a comprehensive legislation was passed to establish Islamic banks. In Pakistan the Central Bank was authorised to take the necessary steps. In other countries either the banks found ways of using existing regulations or were given special accommodation. In all cases government intervention or active support was necessary to establish Islamic banks working under the PLS scheme. Iran and Pakistan are countries committed to ridding their economies of riba and have made immense strides in towards achieving it. Yet there are many legal difficulties still to be solved as we have seen above. In other Muslim countries the authorities actively or passively participate in the establishment of Islamic banks on account of their religious persuasion. Such is not the case in non-Muslim countries. Here establishing Islamic banks involves conformation to the existing laws of the concerned country which generally are not conducive to PLS type of financing in the banking sector. We will see some of these problems below in section 4.4. Involvement in specialised non-bank activities Traditional banks do perform a certain amount of project evaluation when granting large medium- and long-term loans. But doing such detailed evaluation as would be required to embark on a PLS scheme, such as determining the rates of return and their time schedule, is beyond the scope of conventional banks. So is the detailed accounting and monitoring necessary to determine the actual performance. Under Islamic banking these exercises are not limited to relatively few large loans but need to be carried out on nearly all the advances made by the bank. Yet, widely acceptable and reliable techniques are yet to be devised. This is confounded by the fact that no consensus has yet been reached on the principles. Both the unprecedented nature of the task as well as the huge amount of work that need be done and the trained and experienced personnel needed to carry them out seems a daunting prospect. Re-training of staff As was seen in the previous section, the bank staff will have to acquire many new skills and learn new procedures to operate the Islamic banking system. This is a time consuming process which is aggravated by two other factors. One, the sheer number of persons that need to be re-trained and, two, the additional staff that need to be recruited and trained to carry out the increased work. Principles are still to be laid down and techniques and procedures evolved to carry them out. It is only after the satisfactory achievement of these that proper training can begin. This
delay and the resulting confusion appears to be among the main reasons for the banks to stick to modes of financing that are close to the familiar interest-based modes. Other disincentives Among the other disincentives from the borrower’s point of view are the need to disclose his accounts to the bank if he were to borrow on the PLS basis, and the fear that eventually the tax authorities will become wise to the extent of his business and the profits. Several writers have lashed out at the lack of business ethics among the business community, but that is a fact of life at least for the foreseeable future. There is a paucity of survey or case studies of clients to see their reaction to current modes of financing. As such we are not aware of further disincentives that might be there. Accounts When a business is financed under the PLS scheme it is necessary that the actual profit/loss made using that money be calculated. Though no satisfactory methods have yet been devised, the first requirement for any such activity is to have the necessary accounts. On the borrowers’ side there are two difficulties: one, many small-time businessmen do not keep any accounts, leave alone proper accounts. The time and money costs will cut into his profits. Larger businesses do not like to disclose their real accounts to anybody. On the banks’ side the effort and expense involved in checking the accounts of many small accounts is prohibitive and will again cut into their own share of the profits. Thus both sides would prefer to avoid having to calculate the actually realised profit/loss. Tax The bank is a big business and it has to declare its profit and loss and is legally required to present an audited account of its operations. Once the bank’s accounts are known it doesn’t take much for the tax collectors to figure out the share of the businesses financed by the bank under the PLS scheme. Thus it’s no surprise that businesses are not too very happy about the situation. The fact that suggestions have been made to use the banks to collect taxes due has not helped the matter either. Excess liquidity Presence of excess liquidity is reported in nearly all Islamic banks. This is not due to reduced demand for credit but the due to the inability of the banks to find clients willing to be funded under the new modes of financing. Islamic banking in non-Muslim countries The modern commercial banking system in nearly all countries of the world is mainly evolved from and modelled on the practices in Europe, especially that in the United Kingdom. The philosophical roots of this system revolves around the basic principles of capital certainty for depositors and certainty as to the rate of return on deposits. In order to enforce these principles for the sake of the depositors and to ensure the smooth functioning of the banking system Central Banks have been vested with powers of supervision and control. All banks have to submit to the Central Bank rules. Islamic banks which wish to operate in non-Muslim countries have some difficulties in complying with these rules. We will examine below the salient features.32 Certainty of capital and return
While the conventional banks guarantee the capital and rate of return, the Islamic banking system, working on the principle of profit and loss sharing, cannot, by definition, guarantee any fixed rate of return on deposits. Many Islamic banks do not guarantee the capital either, because if there is a loss it has to be deducted from the capital. Thus the basic difference lies in the very roots of the two systems. Consequently countries working under conventional laws are unable to grant permission to institutions which wish to operate under the PLS scheme to functions as commercial banks. Two official comments, one from the UK an the other from the USA suffice to illustrate this. Sir Leigh Pemberton, the Governor of the Bank of England, told the Arab Bankers’ Association in London that:33
o o
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It is important not to risk misleading and confusing the general public by allowing two essentially different banking systems to operate in parallel; A central feature of the banking system of the United Kingdom as enshrined in the legal framework is capital certainty for depositors. It is the most important feature which distinguished the banking sector from the other segments of the financial system; Islamic banking is a perfectly acceptable mode of financing but it does not fall within the definition of what constitutes banking in the UK; The Bank of England is not legally able to authorise under the Banking Act, an institution which does not take deposits as defined under that Act; The Islamic facilities might be provided within other areas of the financial system without using a banking name.
In the United States, Mr Charles Schotte, the US Treasury Department specialist in regulatory issues has remarked:34 There has never been an application for an Islamic establishment to set up either as a bank or as anything else. So there is no precedent to guide us. Any institution that wishes to use the word ‘bank’ in its title has to guarantee at least a zero rate of interest -- and even that might contravene Islamic laws. Supervision and control Besides these, there are other concerns as well. One is the Central Bank supervision and control. This mainly relates to liquidity requirements and adequacy of capital. These in turn depend on an assessment of the value of assets of the Islamic banks. It is evident then that even if there is a desire to accommodate the Islamic system, the new procedures that need be developed and the modifications that need be made to existing procedures are so large that the chances of such accommodation in a cautious sector such as banking is very remote indeed. Any relaxation of strict supervision is precluded because should an Islamic bank fail it would undermine the confidence in the whole financial system, with which it is inevitably identified. The question has engaged the attention of Central Banks in Muslim countries as well. But reliable satisfactory methods are still to developed. Tax regulations Another important consideration is the tax procedures in non-Muslim countries. While interest is a ‘passive’ income, profit is an earned income which is treated differently. In
addition, in trade financing there are title transfers twice -- once from seller to bank and then from bank to buyer -- and therefore twice taxed on this account decreasing the profitability of the venture Conclusions Islamic banking is a very young concept. Yet it has already been implemented as the only system in two Muslim countries; there are Islamic banks in many Muslim countries, and a few in non-Muslim countries as well. Despite the successful acceptance there are problems. These problems are mainly in the area of financing. With only minor changes in their practices, Islamic banks can get rid of all their cumbersome, burdensome and sometimes doubtful forms of financing and offer a clean and efficient interest-free banking. All the necessary ingredients are already there. The modified system will make use of only two forms of financing -- loans with a service charge and Mudaraba participatory financing -- both of which are fully accepted by all Muslim writers on the subject. Such a system will offer an effective banking system where Islamic banking is obligatory and a powerful alternative to conventional banking where both co-exist. Additionally, such a system will have no problem in obtaining authorisation to operate in non-Muslim countries. Participatory financing is a unique feature of Islamic banking, and can offer responsible financing to socially and economically relevant development projects. This is an additional service Islamic banks offer over and above the traditional services provided by conventional commercial banks.
doc_352695239.doc
Islamic banking document covers Interest-free banking, Interest-free banking, Current practices, Deposit accounts, Current accounts, Savings accounts, Investment account, Modes of financing and Investment financing.
ISLAMIC BANKING Introduction Modern banking system was introduced into the Muslim countries at a time when they were politically and economically at a low ebb, in the late 19th century. The banks were generally confined to the capital cities and the local population remained largely untouched by the banking system. With the passage of time, however, and other socio-economic forces demanding more involvement in national economic and financial activities, avoiding the interaction with the banks became impossible. As countries became independent the need to engage in banking activities became unavoidable and urgent. This state of affairs drew the attention and concern of Muslim intellectuals. Historical development It seems that the history of interest-free banking could be divided into two parts. First, when it still remained an idea; second, when it became a reality -- by private initiative in some countries and by law in others. Interest-free banking as an idea Interest-free banking seems to be of very recent origin. The earliest references to the reorganisation of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties. They have all recognised the need for commercial banks and the evil of interest in that enterprise, and have proposed a banking system based on the concept of Mudarabha profit and loss sharing. In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. Early seventies saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, First International Conference on Islamic Economics in Mecca in 1976, International Economic Conference in London in 1977 were the result of such involvement. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process. The coming into being of interest-free banks The first private interest-free bank, the Dubai Islamic Bank, was also set up in 1975 by a group of Muslim businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and the Sudan. In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 interest-free banks have come into being. Though nearly all of them are in Muslim countries, there are some in Western Europe as well: in Denmark, Luxembourg , Switzerland and the UK. In most countries the establishment of interest-free banking had been by private initiative and were confined to that bank In Pakistan, effective 1 January 1981 all domestic
commercial banks were permitted to accept deposits on the basis of profit-and-loss sharing (PLS). From 1 July 1985 no banks could accept any interest bearing deposits, and all existing deposits became subject to PLS rules. Yet some operations were still allowed to continue on the old basis. Interest on deposits was also converted into a ‘guaranteed minimum profit. Current practices Generally speaking, all interest-free banks agree on the basic principles. However, individual banks differ in their application. These differences are due to several reasons including the laws of the country, objectives of the different banks, individual bank’s circumstances and experiences, the need to interact with other interest-based banks, etc. In the following paragraphs, we will describe the salient features common to all banks. Deposit accounts All the Islamic banks have three kinds of deposit accounts: current, savings and investment. Current accounts Current or demand deposit accounts are virtually the same as in all conventional banks. Deposit is guaranteed. Savings accounts Savings deposit accounts operate in different ways. In some banks, the depositors allow the banks to use their money but they obtain a guarantee of getting the full amount back from the bank. Banks adopt several methods of inducing their clients to deposit with them, but no profit is promised. In others, savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals and minimum balance. Capital is not guaranteed but the banks take care to invest money from such accounts in relatively risk-free short-term projects. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands. Investment account Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit (or loss) in a given proportion with the bank. Capital is not guaranteed. Modes of financing Banks adopt several modes of acquiring assets or financing projects. But they can be broadly categorised into three areas: investment, trade and lending. Investment financing This is done in three main ways: a) Musharaka where a bank may join another entity to set up a joint venture, both parties participating in the various aspects of the project in varying degrees. Profit and loss are shared in a pre-arranged fashion. This is not very different from the joint venture concept. The venture is an independent legal entity and the bank may withdraw gradually after an initial period. b) Mudarabha where the bank contributes the
finance and the client provides the expertise, management and labour. Profits are shared by both the partners in a pre-arranged proportion, but when a loss occurs the total loss is borne by the bank. c) Financing on the basis of an estimated rate of return. Under this scheme, the bank estimates the expected rate of return on the specific project it is asked to finance and provides financing on the understanding that at least that rate is payable to the bank. If the project ends up in a profit more than the estimated rate the excess goes to the client. If the profit is less than the estimate the bank will accept the lower rate. In case a loss is suffered the bank will take a share in it. Trade financing This is also done in several ways. The main ones are: a) Mark-up where the bank buys an item for a client and the client agrees to repay the bank the price and an agreed profit later on. b) Leasing where the bank buys an item for a client and leases it to him for an agreed period and at the end of that period the lessee pays the balance on the price agreed at the beginning an becomes the owner of the item. c) Hire-purchase where the bank buys an item for the client and hires it to him for an agreed rent and period, and at the end of that period the client automatically becomes the owner of the item. d) Sell-and-buy-back where a client sells one of his properties to the bank for an agreed price payable now on condition that he will buy the property back after certain time for an agreed price. e) Letters of credit where the bank guarantees the import of an item using its own funds for a client, on the basis of sharing the profit from the sale of this item or on a mark-up basis. Lending Main forms of Lending are: a) Loans with a service charge where the bank lends money without interest but they cover their expenses by levying a service charge. This charge may be subject to a maximum set by the authorities. b) No-cost loans where each bank is expected to set aside a part of their funds to grant no-cost loans to needy persons such as small farmers, entrepreneurs, producers, etc. and to needy consumers. c) Overdrafts also are to be provided, subject to a certain maximum, free of charge. Services Other banking services such as money transfers, bill collections, trade in foreign currencies at spot rate etc. where the bank’s own money is not involved are provided on a commission or charges basis. Problems in implementing the PLS scheme Financing There are four main areas where the Islamic banks find it difficult to finance under the PLS scheme: a) participating in long-term low-yield projects, b) financing the small businessman, c) granting non-participating loans to running businesses, and d) financing government borrowing. Let us examine them in turn.
Long-term projects
Table 1 shows the term structure of investment by 20 Islamic Banks in 1988. It is clear that less than 10 percent of the total assets goes into medium- and long-term investment. Admittedly, the banks are unable or unwilling to participate in long-term projects. This is a very unsatisfactory situation. Table 1 Term Structure of Investment by 20 Islamic Banks, 1988 Type of Investment Short-term Social lending Real-estate investment Amount* % of Total 4,909.8 64.2 1,498.2 68.4 0.9 20.9
Medium- and long-term investment 707.7 9.8 Source: Aggregate balance sheets prepared by the International Association of Islamic Banks, Bahrain, 1988. Quoted in: Ausaf Ahmed (1994). * Unit of currency not given. The main reason of course is the need to participate in the enterprise on a PLS basis which involves time consuming complicated assessment procedures and negotiations, requiring expertise and experience. The banks do not seem to have developed the latter and they seem to be averse to the former. There are no commonly accepted criteria for project evaluation based on PLS partnerships. Each single case has to be treated separately with utmost care and each has to be assessed and negotiated on its own merits. Other obvious reasons are: a) such investments tie up capital for very long periods, unlike in conventional banking where the capital is recovered in regular instalments almost right from the beginning, and the uncertainty and risk are that much higher, b) the longer the maturity of the project the longer it takes to realise the returns and the banks therefore cannot pay a return to their depositors as quick as the conventional banks can. Thus it is no wonder that the banks are averse to such investments. Small businesses Small scale businesses form a major part of a country’s productive sector. Besides, they form a greater number of the bank’s clientele. Yet it seems difficult to provide them with the necessary financing under the PLS scheme, even though there is excess liquidity in the banks. Running businesses Running businesses frequently need short-term capital as well as working capital and ready cash for miscellaneous on-the-spot purchases and sundry expenses. This is the daily reality in the business world. Very little thought seems to have been given to this important aspect of the business world’s requirement. The PLS scheme is not geared to cater to this need. Even if there is complete trust and exchange of information between the bank and the business it is nearly impossible or prohibitively costly to estimate the contribution of such short-term financing on the return of a given business. Neither is the much used mark-up system suitable in this case. It looks unlikely to be able to arrive at general rules to cover all the different situations. The enormity of the damage or hindrance caused by the inability to provide financing to this sector will become clear if we realise that running businesses and enterprises are the mainstay of the country’s very economic survival.
Government borrowing In all countries the Government accounts for a major component of the demand for credit -both short-term and long-term. Unlike business loans these borrowings are not always for investment purposes, nor for investment in productive enterprises. Even when invested in productive enterprises they are generally of a longer-term type and of low yield. This latter only multiplies the difficulties in estimating a rate of return on these loans if they are granted under the PLS scheme. Legislation Existing banking laws do not permit banks to engage directly in business enterprises using depositors’ funds. But this is the basic asset acquiring method of Islamic banks. Therefore new legislation and/or government authorisation are necessary to establish such banks. In Iran a comprehensive legislation was passed to establish Islamic banks. In Pakistan the Central Bank was authorised to take the necessary steps. In other countries either the banks found ways of using existing regulations or were given special accommodation. In all cases government intervention or active support was necessary to establish Islamic banks working under the PLS scheme. Iran and Pakistan are countries committed to ridding their economies of riba and have made immense strides in towards achieving it. Yet there are many legal difficulties still to be solved as we have seen above. In other Muslim countries the authorities actively or passively participate in the establishment of Islamic banks on account of their religious persuasion. Such is not the case in non-Muslim countries. Here establishing Islamic banks involves conformation to the existing laws of the concerned country which generally are not conducive to PLS type of financing in the banking sector. We will see some of these problems below in section 4.4. Involvement in specialised non-bank activities Traditional banks do perform a certain amount of project evaluation when granting large medium- and long-term loans. But doing such detailed evaluation as would be required to embark on a PLS scheme, such as determining the rates of return and their time schedule, is beyond the scope of conventional banks. So is the detailed accounting and monitoring necessary to determine the actual performance. Under Islamic banking these exercises are not limited to relatively few large loans but need to be carried out on nearly all the advances made by the bank. Yet, widely acceptable and reliable techniques are yet to be devised. This is confounded by the fact that no consensus has yet been reached on the principles. Both the unprecedented nature of the task as well as the huge amount of work that need be done and the trained and experienced personnel needed to carry them out seems a daunting prospect. Re-training of staff As was seen in the previous section, the bank staff will have to acquire many new skills and learn new procedures to operate the Islamic banking system. This is a time consuming process which is aggravated by two other factors. One, the sheer number of persons that need to be re-trained and, two, the additional staff that need to be recruited and trained to carry out the increased work. Principles are still to be laid down and techniques and procedures evolved to carry them out. It is only after the satisfactory achievement of these that proper training can begin. This
delay and the resulting confusion appears to be among the main reasons for the banks to stick to modes of financing that are close to the familiar interest-based modes. Other disincentives Among the other disincentives from the borrower’s point of view are the need to disclose his accounts to the bank if he were to borrow on the PLS basis, and the fear that eventually the tax authorities will become wise to the extent of his business and the profits. Several writers have lashed out at the lack of business ethics among the business community, but that is a fact of life at least for the foreseeable future. There is a paucity of survey or case studies of clients to see their reaction to current modes of financing. As such we are not aware of further disincentives that might be there. Accounts When a business is financed under the PLS scheme it is necessary that the actual profit/loss made using that money be calculated. Though no satisfactory methods have yet been devised, the first requirement for any such activity is to have the necessary accounts. On the borrowers’ side there are two difficulties: one, many small-time businessmen do not keep any accounts, leave alone proper accounts. The time and money costs will cut into his profits. Larger businesses do not like to disclose their real accounts to anybody. On the banks’ side the effort and expense involved in checking the accounts of many small accounts is prohibitive and will again cut into their own share of the profits. Thus both sides would prefer to avoid having to calculate the actually realised profit/loss. Tax The bank is a big business and it has to declare its profit and loss and is legally required to present an audited account of its operations. Once the bank’s accounts are known it doesn’t take much for the tax collectors to figure out the share of the businesses financed by the bank under the PLS scheme. Thus it’s no surprise that businesses are not too very happy about the situation. The fact that suggestions have been made to use the banks to collect taxes due has not helped the matter either. Excess liquidity Presence of excess liquidity is reported in nearly all Islamic banks. This is not due to reduced demand for credit but the due to the inability of the banks to find clients willing to be funded under the new modes of financing. Islamic banking in non-Muslim countries The modern commercial banking system in nearly all countries of the world is mainly evolved from and modelled on the practices in Europe, especially that in the United Kingdom. The philosophical roots of this system revolves around the basic principles of capital certainty for depositors and certainty as to the rate of return on deposits. In order to enforce these principles for the sake of the depositors and to ensure the smooth functioning of the banking system Central Banks have been vested with powers of supervision and control. All banks have to submit to the Central Bank rules. Islamic banks which wish to operate in non-Muslim countries have some difficulties in complying with these rules. We will examine below the salient features.32 Certainty of capital and return
While the conventional banks guarantee the capital and rate of return, the Islamic banking system, working on the principle of profit and loss sharing, cannot, by definition, guarantee any fixed rate of return on deposits. Many Islamic banks do not guarantee the capital either, because if there is a loss it has to be deducted from the capital. Thus the basic difference lies in the very roots of the two systems. Consequently countries working under conventional laws are unable to grant permission to institutions which wish to operate under the PLS scheme to functions as commercial banks. Two official comments, one from the UK an the other from the USA suffice to illustrate this. Sir Leigh Pemberton, the Governor of the Bank of England, told the Arab Bankers’ Association in London that:33
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It is important not to risk misleading and confusing the general public by allowing two essentially different banking systems to operate in parallel; A central feature of the banking system of the United Kingdom as enshrined in the legal framework is capital certainty for depositors. It is the most important feature which distinguished the banking sector from the other segments of the financial system; Islamic banking is a perfectly acceptable mode of financing but it does not fall within the definition of what constitutes banking in the UK; The Bank of England is not legally able to authorise under the Banking Act, an institution which does not take deposits as defined under that Act; The Islamic facilities might be provided within other areas of the financial system without using a banking name.
In the United States, Mr Charles Schotte, the US Treasury Department specialist in regulatory issues has remarked:34 There has never been an application for an Islamic establishment to set up either as a bank or as anything else. So there is no precedent to guide us. Any institution that wishes to use the word ‘bank’ in its title has to guarantee at least a zero rate of interest -- and even that might contravene Islamic laws. Supervision and control Besides these, there are other concerns as well. One is the Central Bank supervision and control. This mainly relates to liquidity requirements and adequacy of capital. These in turn depend on an assessment of the value of assets of the Islamic banks. It is evident then that even if there is a desire to accommodate the Islamic system, the new procedures that need be developed and the modifications that need be made to existing procedures are so large that the chances of such accommodation in a cautious sector such as banking is very remote indeed. Any relaxation of strict supervision is precluded because should an Islamic bank fail it would undermine the confidence in the whole financial system, with which it is inevitably identified. The question has engaged the attention of Central Banks in Muslim countries as well. But reliable satisfactory methods are still to developed. Tax regulations Another important consideration is the tax procedures in non-Muslim countries. While interest is a ‘passive’ income, profit is an earned income which is treated differently. In
addition, in trade financing there are title transfers twice -- once from seller to bank and then from bank to buyer -- and therefore twice taxed on this account decreasing the profitability of the venture Conclusions Islamic banking is a very young concept. Yet it has already been implemented as the only system in two Muslim countries; there are Islamic banks in many Muslim countries, and a few in non-Muslim countries as well. Despite the successful acceptance there are problems. These problems are mainly in the area of financing. With only minor changes in their practices, Islamic banks can get rid of all their cumbersome, burdensome and sometimes doubtful forms of financing and offer a clean and efficient interest-free banking. All the necessary ingredients are already there. The modified system will make use of only two forms of financing -- loans with a service charge and Mudaraba participatory financing -- both of which are fully accepted by all Muslim writers on the subject. Such a system will offer an effective banking system where Islamic banking is obligatory and a powerful alternative to conventional banking where both co-exist. Additionally, such a system will have no problem in obtaining authorisation to operate in non-Muslim countries. Participatory financing is a unique feature of Islamic banking, and can offer responsible financing to socially and economically relevant development projects. This is an additional service Islamic banks offer over and above the traditional services provided by conventional commercial banks.
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