development of islamic banking and financial system

8/8/2019 Development of Islamic Banking and Financial System

1/9

Present World Economic Setting

The present day economic problems of the World are too baffling and their solution under thetraditional economic systems-capitalism, socialism and mixed economics is proving too difficult,

if not impossible. Thus the contemporary world is experiencing a number of grave economic ills,including abject poverty of a large proportion of mankind, social and economic injustices, grossinequalities in income and wealth, high rate of unemployment, economic instability, inflation anderosion of the value of money and monetary assets, increasing disparities in regional, nationaland international income levels, co-existence of widespread hunger and pockets of affluence, andinconsistency between technology and developmental needs, etc. Even the otherwise affluent

Western industrialized countries are suffering from alternative bouts of prosperity and depressionaccompanied with soaring and sagging interest rates. The Present condition of the world economyis considered to be alarming and the future bleak and uncertain.

Under these circumstances and in the search for solution to the above problems, renewed interest

has bean expressed in their Islamic way of solution based on the Holy Quran and Sunnah. Thisinterest has not been confined to the Muslims but also percolated to the responsible non-Muslimquarters1. No economic system can sustain its health and vigour or contribute positively to theachievement of socio-economic goals without the support of a sound end equitable money and

banking system. It is believed to be possible to design such a beneficial money and bankingframework in the light of Islamic teachings. A lot of studies have been made in this regard inrecent years in different parts of the Muslim World.

It is no wonder that firm faith in God, service to man, co-operation with fellow beings andbalanced behaviour in society are the cornerstones of the Islamic economic system for which theQuran and the traditions of the Prophet of Islam (P.H.) have laid the broad and fundamental

principles. The Islamic banking and financial institutions would have to be an integral part ofsuch a beneficial system- The doldrums occurring in the existing systems and the resultantsufferings caused to the greater mass of human beings in recent times point to the urgency ofintroducing and developing the Islamic system of economics (with ethics), banking and finance.Thus not only the forgetful Muslim but also the errant non-Muslims are lately showing interest inthe emergence and nascent growth of such a system in different parts of the contemporary world.

We would attempt a brief survey of the developments in this field in the following paragraphs.

Survey of Developments

In recent years steps have been taken towards the Islamization of the banking and financialsystem in a number of Muslim countries in the Middle East, Africa and Asia. These measuresshould be viewed as an integral part of the ultimate goal to move towards the Islamic ideal of asociety based on the principle of social justice. As one important element of this policy, a numberof Muslim countries have made efforts to abolish what the Quran condemns as Riba which isinterpreted to mean both usury and interest and which is more precisely defined as the fixedcharge for the use of money. The issue of abolishing Riba was seriously considered first in 1972 atthe Islamic Conference of Foreign Ministers of Foreign Ministers of O. I. C. countries in Jeddah.


2/9

This was followed by a second Islamic Conference in 1974 the deliberations of which, inter alia,led to the establishment of the Islamic Development bank (IDB) in Jeddah in 1975. Onceestablished, IDB splendidly served as the model of a development bank operating on Islamicprinciples and modes, and demonstrating a viable alternative financial system to replace theconventional interest-based system. The determined studies made in some Muslim countries, thegroundwork made for IDB and its successful operation have facilitated the multiplication ofIslamic financial institutions in quick succession.

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

LIST OF ISLAMIC BANKS AND FINANCIAL INSTITUTIONS

Country Name Year established

BAHRAIN 1. Bahrain IslamicBank

1979

BAHAMAS 2. Dar Al-Maal Al-Islami(DMI)

1981

3. Islamic Investment CompanyLtd.

1979

EGYPT 4. Faisal Islamic Bank ofEgypt

1977

5. Nasser SocialBank

1972

6. International Islamic Bank ofInvestment & Development

1980

7. Bank MisrIslamic Branches 1980

IRAN 8. Sepah Islamic Bank of Iran 1979

JORDAN 9. Jordan Islamic Bank forFinance & Investment

1978

KUWAIT 10. Kuwait Finance House 1977

LUXEMBOURG 11. Islamic Banking SystemInternational Holding S. A.

1978

PAKISTAN 12. Profit and Loss Sharing(PLS) Operation in all

1981


3/9

Nationalised Commercial Banks'Branches (7,000)

13. Pakistan House BuldingFinance Corporation, Islamizedto share income/rent

1980

14. Investment Corporation of

Pakistan, Islamized

1980

15. National Investment TrustIslamized

16. Pakistan Bankers' Equity

17. Islamic ModarabaCompanies

QATAR 18. Qatar Islamic Bank.

19. Islamic Exchange andInvestment Corporation

SAUDI ARABIA 20. Islamic Development Bank(IBD) [Members are 41 Muslimcountries].

1979

SUDAN 21. Faisal Islamic Bank ofSudan

1979

SWITZERLAND 22. Dar AI-Maal Al-Islami

1980

23. Islamic Investment CompanyLtd.

1979

UNITED ARAB EMIRATES 24. Dubai Islamic Bank 197525. Islamic Arab InsuranceCompany

1980

26. Islamic investment CompanyLtd.

1979

UNITED KINGDOM 27. Islamic FinaceHouse

1982

BANGLADESH 28. Islami Bank Bangladesh Ltd. 1983

ISLAMIC BANKS UNDER ESTABLISHMENT

DENMARK 29. Islamic Bank International of

Denmark

1982

MALAYSIA 30. Malaysian IslamicBank

1982

SAUDI ARABIA 31. Saudi Islamic Bank 1982

SWITZERLAND 32. European Islamic Bank 1982

TURKEY 33. Ankara & Istanbul IslamicBanks

1982


4/9

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

the basis of experiences gained so far.

Methods of Financial Intermediation

The most far-reaching experiments with the PLS system have been undertaken in Pakistan, wherethe abolition of Riba is an objective of the State's constitution. The aim is not only to phase outfixed interest payment but to replace interest with equity participation arrangements that willallow incentives for savings and efficient resource allocation to be retained consistent with Islamicprinciples. Since January, 1981, Interest-free counters have been established in all 7,000

branches of the five nationalized bank permitting depositors to choose between interest-bearingdeposits, and interest-free accounts in the first phase. By opting for the latter, depositors areentitled to share in the profits and losses of the investments financed by the bank. PLS Savings

Accounts are opened with multiples of Rs.100 while PLS Term/Investment Deposit Accounts canbe opened with multiple, of Rs.1,000. Profit uptoRs.15000 is exempted from income-Tax.Investment deposits in Islamic banks correspond to fixed deposit or "time deposit" accounts, inconventional banks and to savings accounts in Western banks. The funds raised in investmentaccount, are invested by banks on the basis of the PLS principle, sharing the amount of profitsresulting from their investors with depositors. The calculation of profits and losses and adividend/profit declaration can be under taken annually or every six months or even threemonths as in Egypt and Kuwait. In Pakistan, the PLS principle is applied to the fixed depositaccounts of banks that issue fixed deposit receipts, which are only accepted in amountsdenominated in multiples of one thousand rupees.

Current Account deposits in Islamic banks as in the other banks are held of transaction andcontingency motives, while the investment motive playing a strictly secondary role. Fundsmobilized in current accounts can legally be used only to meet short-term financial needs, such as

balancing the liquidity position of companies, and cannot be used for long-term finance.

Whereas in Western financial system companies raise funds mainly through the issuance ofequity shares, debentures, or by medium-term and long-term borrowing from banks at fixedinterest, the latter two possibilities are not in accord with Islamic principles. Consequently,

Islamic countries are taking various steps to change their existing financial systems and bringthem into conformity with Islamic tenets. For example the Government of Pakistan passed theModaraba law to basic financial transactions on the PLS principle and introduced ParticipationTerm Certificates (PTC) to replace interest bearing debentures. Banks and other financialinstitutions are asked to grant long-term loans on a PLS basis as another possibility of providinglong-term finance to industry and commerce. Short term working capital finance is also given onPLS principle on u selected basis.


5/9

Under the Modaraba law, management companies, banks, and financial institutions can registerthemselves as Modaraba companies. These can be of two types a multipurpose Modaraba withmore than one specific objective and Modaraba having a specific purpose (e.g., for raisinghousehold finance). Modaraba companies may only engage in business that is permitted underthe Islamic religious law, the Shariah. A Religious Board ensures that firm's activities are notcontrary to the injunctions of Islam. Funds collected on a Modaraba basis can be used on PLS

basis for most types of investment except, of course those are prohibited on religious grounds.Under the Modaraba business, banks and other financial institutions are able to provide riskcapital in the form of equity and loans with equity features. For the amount of capital provided,

banks receive Modaraba Certificates, which are transferable certificates with a specific face valueissued to the subscriber of the Modaraba. Before profits are distributed, the board of theModaraba Company decides which part of them should be retained as reserves.

In addition to the Modaraba Certificates and the PTCs mentioned above, another way to enable banks and other financial institutions to provide medium-term and long-term finance is theleasing system (Bai Muajjal). Banks acquire certain fixed assets such as transport vehicle,machinery and equipment, and lease them for a specific period to their customers for hire fee.Banks and their leasing subsidiaries are sharing in the profits and risks of the entrepreneurs'

business as long as the rent for the leased assets is not fixed in advance, but related to financialsuccess.

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

Thus from July, 1982, Pakistani banks have also been allowed by the State Bank of Pakistan toprovide selectively working capital finance to trade & Industry on PLS (Musharika) basis. In theagricultural sector, which is the predominant sector in some developing countries likeBangladesh, the need for finance arises mainly from the seasonal nature of agricultural activity.

As a means of reducing the reluctance sometimes found in rural areas to use the services of banks,for strong feelings against interest, the introduction of a banking system that works on theprinciples endorsed by religious leaders could be helpful. Applying the PLS principle agriculturallending could be done by sharing-output, or net profits, at an agreed percentage between the bankand the farmer.

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


6/9

An alternative way of providing consumers' credit is the hire purchase (Bai Salam) arrangement,under which the title of ownership gradually passes to the customers with the paying ofinstalments. In Pakistan, the House Building Finance Corporation (HBFC) advances loans forhousing on a hire-purchase basis. Under this arrangement, the purchaser pays instalments to the

HBFC until the entire principal is paid. The Corporation assesses both the total value of the houseand its rental value and is entitled to a share of the rent, from which it derives its profits. ThePakistani nationalised commercial banks also have been permitted to finance house-building onthe same basis from July, 1982.

Implementing the PLS System

Providing finance on PLS basis requires thorough vigilance by the banks over the utilization offunds and involves certain practical problems that may require banks to increase the size of their

staffs, at least, at the initial stage. But then the experience of the present interest-based banks isalso that the intensively supervised credit is always better utilized and better realised than theloans given on paper security only. Another proposal aimed at long-term financing is theInvestment Auctioning System under which financial Institutions would auction investmentauthorization to investors. Supply of and demand for investable funds determine the scarcityprice of available capital. Within the framework of such a system, entrepreneurs would remainsole, responsible for their investment decisions, whereas banks would only act as financialintermediaries. Scarce capital resources would flow into those investments that yielded thehighest expected rates of returns.

Despite of spectacular success of the large-scale experiment with PLS banking in Pakistan as

mentioned below, a note of caution would perhaps be in order. It has been suggested in somequarters that not all the 7,000 branch Managers of the nationalised commercial banks whichopened interest-free banking counters in the country in January, 1981 have been equallyenthusiastic or meticulous about implementing the new system in its letter and spirit as againsttheir known and beaten track. Thus is the process, at least, a few of them may have mixed upand/or taken up the experiment as just another official mandate. The same experience may beencountered elsewhere too. It is, therefore, of critical Importance to ensure efficiency and purityof the system for its success and growth.

Islamic Bank of Denmark2An Exception

Denmark has become the first Western country to grant a full banking license to an Islamic bank.The Islamic Bank International of Denmark (IBID-1982) has been given the go-ahead to open itsdoors in Copenhagen's Jernbanegade after long negotiations with the Danish Central Bank, theMinistry of Industry and the Banking Control Commission of Denmark. European Central Banksincluding the Bank of England have up to now been very reluctant to recognise Islamic banking

because the latter forbids the charging of interest. IBID is authorised to take deposits and issuecheque books like any ether high street bank. Whereas other Danish banks depend on interest for


7/9

their survival, the IBID shuns interest and shares the risk of investment with its depositors orborrowers on a Profit and Loss (PLS) basis.

IBID is a wholly owned subsidiary of the Islamic Banking System international Holding SA of

Luxembourg (IBS) whose shareholders include the Kuwait Finance House and the Ministry ofAwqaf religious endowments) of Abu Dhabi. The Chairman of IBS is the ex-Kuwaiti Minister ofFinance and Oil, Abdur Rahman A, the Vice-Chairman is the present Minister of Justice of theUnited Arab Emirates, Sheikh Mohammed Abdur Rahman al-Baqr, and the Managing Director isthe prominent Egyptian banker and legal expert, Doctor Gamal Attia. The capitalisation of IBID isat present 10 million Danish kroner and is expected to rise to well over 25 million Danish kroner

by April, 1983, the date of the official opening of the bank.IBID differs from other Islamic banks in the Middle East in that its main aim is "to promote the

business of Danish and other Scandinavian companies connected with the Islamic world, to serveother Islamic banks, accept deposits in various currencies and finance the activity of itssubsidiaries, including the Islamic Finance House in London's

Baker Street

". Already, many Western banks are said to have approached IBID for joint cooperation whilevarious Arab and Islamic groups within OAPEC3 have expressed an interest to work together withthe bank.

Effects of an Islamic Financial System

The introduction of financial intermediation based on the PLS principle has potentially beneficialimpacts on the behaviour of savers, banks, and investors. The PLS system turns savers intoentrepreneurs, at least to some extent, by encouraging them to participate directly in the financialsuccess of the investors' business, thereby also sharing the risk involved. In an Islamic banking

system inflation is not expected to be an evil hazard as at present while the yield on investmentdeposits would be naturally variable

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

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


8/9

CONCLUSION

The introduction of financial, intermediation based on the Islamic principles has not only beensuccessful but also proved to have beneficial impact on the behaviour of savers, banks and

investors. The evidence so far demonstrates that Islamic banks have operated quite successfully indifferent countries as can be seen from their operating results. In Pakistan, the nationalizedcommercial banks gathered Rs.6,489 million in PLS deposits through Islamic banking countersduring the first year, 1981 out of which term/Investment deposits were Rs.4,283 million. PLSdeposits reached the mark of Rs.10,000 million by June, 1982. The banks declared profits, for the

year, of 9 per cent on PLS savings accounts, and on PLS term deposits from 11.5 per cent (forperiods of less than one year) to 15.5 per cent (for periods of five years and above). As against this,savings bank deposits earn 7.5 per cent interest while term deposits for 5 years and over areallowed interest at the maximum rate of 12.75 per cent in Pakistan. The Jordan Islamic Bankregistered an overall profit of 8.2 per cent on investment accounts for 1980. Depositors withBahrain Islamic Bank received a profit of 9-9.5 per cant on term deposit accounts and 5.25 percent on savings accounts for 1980. The Kuwait Finance House declared profits of 6.75 per cant onsavings deposits and 9 10.12 per cent on term deposits ; the Faisal Islamic Bank of Egypt andthe FIB of Sudan paid profits of 12.03 per cent and 16 percent respectively for the year 1980. TheDubai Islamic Bank declared profit of 12 per cent on investment deposits for 1981.

The practical handling of all banking operations under Islamic financial system based on the PLSprinciple leaves yet some unresolved Issues. In particular, remunerating lenders for makingshort-term loans to industry and commerce and for providing consumers' credit remains difficultif the PLS system Is to be applied fully. In any case, in the poorer countries like Bangladesh orPakistan the Central Banks hardly allow any consumer credit to be given by the commercial

banks. Another area that has not been dealt with comprehensively is that of the foreign operationsof Islamic banks. However, the Islamic banks have already established excellent correspondentrelationships with reputable banks in many developed Western countries and are handling mostof the foreign trade and foreign operations on Islamic principles without difficulty. Recently,consideration has also been given to adapting transactions with non Islamic banks to the PLSsystem.

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

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


9/9

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

1. Of Islam and Financial Intermediation, IMF Staff Papers, March, 1982.2. Vide The GUARDIAN, London, 10 December, 1982,3. OAPEC = Organization of Arab Petroleum Exporting Countries.4. Roger Cooper, article on Islamic Banking published in EUROMONEY, December, 1982.

development of islamic banking and financial system

Documents