"Banking Without Interest" by Muhammad Siddiqi

Research Report on Islamic Banking – Part 2

by Mohamed Ariff, University of Malaya, taken from Asian-Pacific Economic Literature, Vol. 2, No. 2 (September 1988), pp. 46-62

Anatomy

As mentioned earlier, Islam does not deny that capital, as a factor of production, deserves to be rewarded. Islam allows the owners of capital a share in a surplus which is uncertain. To put it differently, investors in the Islamic order have no right to demand a fixed rate of return. No one is entitled to any addition to the principal sum if he does not share in the risks involved. The owner of capital (rabbul-mal) may ‘invest’ by allowing an entrepreneur with ideas and expertise to use the capital for productive purposes and he may share the profits, if any, with the entrepreneur- borrower (mudarib); losses, if any, however, will be borne wholly by the rabbul-mal. This mode of financing, termed mudaraba in the Islamic literature, was in practice even in the pre-Qur’anic days and, according to jurists, it was approved by the Prophet.

Another legitimate mode of financing recognized in Islam is one based on equity participation (musharaka) in which the partners use their capital jointly to generate a surplus. Profits or losses will be shared between the partners according to some agreed formula depending on the equity ratio.

Mudaraba and musharaka constitute, at least in principle if not in practice, the twin pillars of Islamic banking. The musharaka principle is invoked in the equity structure of Islamic banks and is similar to the modern concepts of partnership and joint stock ownership. In so far as the depositors are concerned, an Islamic bank acts as a mudarib which manages the funds of the depositors to generate profits subject to the rules of mudaraba as outlined above. The bank may in turn use the depositors’ funds on a mudaraba basis in addition to other lawful modes of financing. In other words, the bank operates a two-tier mudaraba system in which it acts both as the mudarib on the saving side of the equation and as the rabbul-mal on the investment portfolio side. The bank may also enter into musharaka contracts with the users of the funds, sharing profits and losses, as mentioned above. At the deposit end of the scale, Islamic banks normally operate three broad categories of account, mainly current, savings, and investment accounts. The current account, as in the case of conventional banks, gives no return to the depositors. It is essentially a safe-keeping (al-wadiah) arrangement between the depositors and the bank, which allows the depositors to withdraw their money at any time and permits the bank to use the depositors’ money. As in the case of conventional banks, cheque books are issued to the current account deposit holders and the Islamic banks provide the broad range of payment facilities – clearing mechanisms, bank drafts, bills of exchange, travellers cheques, etc. (but not yet, it seems, credit cards or bank cards). More often than not, no service charges are made by the banks in this regard.

The savings account is also operated on an al-wadiah basis, but the bank may at its absolute discretion pay the depositors a positive return periodically, depending on its own profitability. Such payment is considered lawful in Islam since it is not a condition for lending by the depositors to the bank, nor is it pre-determined. The savings account holders are issued with savings books and are allowed to withdraw their money as and when they please. The investment account is based on the mudaraba principle, and the deposits are term deposits which cannot be withdrawn before maturity. The profit- sharing ratio varies from bank to bank and from time to time depending on supply and demand conditions.4 In theory, the rate of return could be positive or negative, but in practice the returns have always been positive and quite comparable to rates conventional banks offer on their term deposits.5

At the investment portfolio end of the scale, Islamic banks employ a variety of instruments. The mudaraba and musharaka modes, referred to earlier, are supposedly the main conduits for the outflow of funds from the banks. In practice, however, Islamic banks have shown a strong preference for other modes which are less risky. The most commonly used mode of financing seems to be the ‘mark-up’ device which is termed murabaha. In a murabaha transaction, the bank finances the purchase of a good or asset by buying it on behalf of its client and adding a mark-up before re-selling it to the client on a ‘cost-plus’ basis. It may appear at first glance that the mark-up is just another term for interest as charged by conventional banks, interest thus being admitted through the back door. What makes the murabaha transaction Islamically legitimate is that the bank first acquires the asset and in the process it assumes certain risks between purchase and resale. The bank takes responsibility for the good before it is safely delivered to the client. The services rendered by the Islamic bank are therefore regarded as quite different from those of a conventional bank which simply lends money to the client to buy the good.

Islamic banks have also been resorting to purchase and resale of properties on a deferred payment basis, which is termed bai’ muajjal. It is considered lawful in fiqh (jurisprudence) to charge a higher price for a good if payments are to be made at a later date. According to fiqh, this does not amount to charging interest, since it is not a lending transaction but a trading one.

Leasing or ijara is also frequently practised by Islamic banks. Under this mode, the banks would buy the equipment or machinery and lease it out to their clients who may opt to buy the items eventually, in which case the monthly payments will consist of two components, i.e., rental for the use of the equipment and instalment towards the purchase price.

Reference must also be made to pre-paid purchase of goods, which is termed bai’salam, as a means used by Islamic banks to finance production. Here the price is paid at the time of the contract but the delivery would take place at a future date. This mode enables an entrepreneur to sell his output to the bank at a price determined in advance. Islamic banks, in keeping with modern times, have extended this facility to manufactures as well.

It is clear from the above sketch that Islamic banking goes beyond the pure financing activities of conventional banks. Islamic banks engage in equity financing and trade financing. By its very nature, Islamic banking is a risky business compared with conventional banking, for risk-sharing forms the very basis of all Islamic financial transactions. To minimize risks, however, Islamic banks have taken pains to distribute the eggs over many baskets and have established reserve funds out of past profits which they can fall back on in the event of any major loss.

Literature: Theory

It is not possible to cover in this survey all the publications which have appeared on Islamic banking. There are numerous publications in Arabic and Urdu which have made significant contributions to the theoretical discussion. A brief description of these in English can be found in the Appendix to Siddiqi’s book on Banking without Interest (Siddiqi l983a). The early contributions on the subject of Islamic banking were somewhat casual in the sense that only passing references were made to it in the discussion of wider issues relating to the Islamic economic system as a whole. In other words, the early writers had been simply thinking aloud rather than presenting well-thought-out ideas. Thus, for example, the book by Qureshi on Islam and the Theory of Interest (Qureshi l946) looked upon banking as a social service that should be sponsored by the government like public health and education. Qureshi took this point of view since the bank could neither pay any interest to account holders nor charge any interest on loans advanced. Qureshi also spoke of partnerships between banks and businessmen as a possible alternative, sharing losses if any. No mention was made of profit-sharing.

Ahmad, in Chapter VII of his book Economics of Islam (Ahmad l952), envisaged the establishment of Islamic banks on the basis of a joint stock company with limited liability. In his scheme, in addition to current accounts, on which no dividend or interest should be paid, there was an account in which people could deposit their capital on the basis of partnership, with shareholders receiving higher dividends than the account holders from the profits made. Like Qureshi, above, Ahmad also spoke of possible partnership arrangements with the businessmen who seek capital from the banks. However, the partnership principle was left undefined, nor was it clear who would bear the loss if any. It was suggested that banks should cash bills of trade without charging interest, using the current account funds.

The principle of mudaraba based on Shariah was invoked systematically by Uzair (l955). His principal contribution lay in suggesting mudaraba as the main premise for ‘interestless banking’. However, his argument that the bank should not make any capital investment with its own deposits rendered his analysis somewhat impractical.

Al-Arabi (l966) envisaged a banking system with mudaraba as the main pivot. He was actually advancing the idea of a two-tier mudaraba which would enable the bank to mobilize savings on a mudaraba basis, allocating the funds so mobilized also on a mudaraba basis. In other words the bank would act as a mudarib in so far as the depositors were concerned, while the ‘borrowers’ would act as mudaribs in so far as the bank was concerned. In his scheme, the bank could advance not only the capital procured through deposits but also the capital of its own shareholders. It is also of interest to note that his position with regard to the distribution of profits and the responsibility for losses was strictly in accordance with the Shariah.6 Irshad (l964) also spoke of mudaraba as the basis of Islamic banking, but his concept of mudaraba was quite different from the traditional one in that he thought of capital and labour (including entrepreneurship) as having equal shares in output, thus sharing the losses and profits equally. This actually means that the owner of capital and the entrepreneur have a fifty-fifty share in the profit or loss as the case may be, which runs counter to the Shariah position. Irshad envisaged two kinds of deposit accounts. The first sounded like current deposits in the sense that it would be payable on demand, but the money kept in this deposit would be used for social welfare projects, as the depositors would get zero return. The second one amounted to term deposits which would entitle the depositors to a share in the profits at the end of the year proportionately to the size and duration of the deposits. He recommended the setting up of a Reserve Fund which would absorb all losses so that no depositor would have to bear any loss. According to Irshad, all losses would be either recovered from the Reserve Fund or borne by the shareholders of the bank.

A pioneering attempt at providing a fairly detailed outline of Islamic banking was made in Urdu by Siddiqi in l968. (The English version was not published until l983.) His Islamic banking model was based on mudaraba and shirka (partnership or musharaka as it is now usually called). His model was essentially one based on a two-tier mudaraba financier-entrepreneur relationship, but he took pains to describe the mechanics of such transactions in considerable detail with numerous hypothetical and arithmetic examples. He classified the operations of an Islamic bank into three categories: services based on fees, commissions or other fixed charges; financing on the basis of mudaraba and partnership; and services provided free of charge. His thesis was that such interest-free banks could be a viable alternative to interest-based conventional banks.

The issue of loans for consumption clearly presents a problem, as there is no profit to be shared. Siddiqi addressed this problem, but he managed only to scratch the surface. While recognizing the need for such interest-free loans (qard hasan), especially for meeting basic needs, he seemed to think it was the duty of the community and the State (through its baitul mal or treasury) to cater to those needs; the Islamic bank’s primary objective, like that of any other business unit, is to earn profit. He therefore tended to downplay the role of Islamic banks in providing consumption loans, but he suggested limited overdraft facilities without interest. He even considered a portion of the fund being set aside for consumption loans, repayment being guaranteed by the State. He also suggested that consumers buying durables on credit would issue ‘certificates of sale’ which could be encashed by the seller at the bank for a fee. It was then the seller not the buyer who would be liable as far as the bank was concerned. However, the principles of murabaha and bai’ muajjal were not invoked.

Strangely, Siddiqi favoured keeping the number of shareholders to the minimum, without advancing any strong reasons. This is contrary to the general consensus which now seems to have emerged with reference to Islamic banks operating on a joint stock company basis, a consensus which incidentally is also in line with the Islamic value attached to a broad equity base as against heavy concentration of equity and wealth. Ironically, Siddiqi thought that interest-free banking could operate successfully ‘only in a country where interest is legally prohibited and any transaction based upon interest is declared a punishable offense’ (l983b:l3). He also thought it important to have Islamic laws enforced before interest-free banking could operate well. This view has not gained acceptance, as demonstrated by the many Islamic banks which operate profitably in ‘hostile’ environments, as noted earlier.

Chapra’s model of Islamic banking (Chapra l982), like Siddiqi’s, was based on the mudaraba principle. His main concern, however, centered on the role of artificial purchasing power through credit creation. He even suggested that ’seigniorage’ resulting from it should be transferred to the public exchequer, for the sake of equity and justice. Al-Jarhi (l983) went so far as to favor the imposition of a l00 per cent reserve requirement on commercial banks. Chapra was also much concerned about the concentration of economic power private banks might enjoy in a system based on equity financing. He therefore preferred medium-sized banks which are neither so large as to wield excessive power nor so small as to be uneconomical. Chapra’s scheme also contained proposals for loss-compensating reserves and loss-absorbing insurance facilities. He also spoke of non-bank financial institutions, which specialize in bringing financiers and entrepreneurs together and act as investment trusts.

Mohsin (l982) has presented a detailed and elaborate framework of Islamic banking in a modern setting. His model incorporates the characteristics of commercial, merchant, and development banks, blending them in novel fashion. It adds various non-banking services such as trust business, factoring, real estate, and consultancy, as though interest-free banks could not survive by banking business alone. Many of the activities listed certainly go beyond the realm of commercial banking and are of so sophisticated and specialized a nature that they may be thought irrelevant to most Muslim countries at their present stage of development. Mohsin’s model clearly was designed to fit into a capitalist environment; indeed he explicitly stated that riba-free banks could coexist with interest-based banks. The point that there is more to Islamic banking than mere abolition of interest was driven home strongly by Chapra (l985). He envisaged Islamic banks whose nature, outlook and operations could be distinctly different from those of conventional banks. Besides the outlawing of riba, he considered it essential that Islamic banks should, since they handle public funds, serve the public interest rather than individual or group interests. In other words, they should play a social-welfare-oriented rather than a profit-maximizing role. He conceived of Islamic banks as a cross-breed of commercial and merchant banks, investment trusts and investment-management institutions that would offer a wide spectrum of services to their customers. Unlike conventional banks which depend heavily on the ‘crutches of collateral and of non-participation in risk’ (p. l55), Islamic banks would have to rely heavily on project evaluation, especially for equity-oriented financing. Thanks to the profit-and-loss sharing nature of the operations, bank-customer relations would be much closer and more cordial than is possible under conventional banking. Finally, the problems of liquidity shortage or surplus would have to be handled differently in Islamic banking, since the ban on interest rules out resort to the money market and the central bank. Chapra suggested alternatives such as reciprocal accommodation among banks without interest payments and creation of a common fund at the central bank into which surpluses would flow and from which shortages could be met without any interest charges.

The literature also discusses the question of central banking in an Islamic framework. The general opinion seems to be that the basic functions of a modern central bank are relevant also for an Islamic monetary system, although the mechanisms may have to be different. Thus, for example, the bank rate instrument cannot be used as it entails interest. Uzair (l982) has suggested adjustments in profit-sharing ratios as a substitute for bank rate manipulations by the central bank. Thus, credit can be tightened by reducing the share accruing to the businessmen and eased by increasing it. Siddiqi (l982) has suggested that variations in the so-called ‘refinance ratio’ (which refers to the central bank refinancing of a part of the interest-free loans provided by the commercial banks) would influence the quantum of short-term credit extended. Siddiqi has also proposed a prescribed ‘lending ratio’ (i.e., the proportion of demand deposits that commercial banks are obliged to lend out as interest-free loans) that can be adjusted by the central bank according to changing circumstances. In this context, reference may also be made to a proposal by Uzair (l982) that the central bank should acquire an equity stake in commercial banking by holding, say, 25 per cent of the capital stock of the commercial banks. The rationale behind this proposal was that it would give the central bank access to a permanent source of income so that it could effectively act as lender of last resort. The discussion of central banking in an Islamic context is somewhat scanty, presumably because Islamic central banking is viewed as too far-fetched an idea, except in Iran and Pakistan.

It emerges from all this that Islamic banking has three distinguishing features: (a) it is interest-free, (b) it is multi-purpose and not purely commercial, and (c) it is strongly equity-oriented. The literature contains hardly any serious criticism of the interest-free character of the operation, since this is taken for granted, although concerns have been expressed about the lack of adequate interest-free instruments. There is a near-consensus that Islamic banks can function well without interest. A recent International Monetary Fund study by Iqbal and Mirakhor (l987) has found Islamic banking to be a viable proposition that can result in efficient resource allocation. The study suggests that banks in an Islamic system face fewer solvency and liquidity risks than their conventional counterparts. The multi-purpose and extra-commercial nature of the Islamic banking operation does not seem to pose intractable problems. The abolition of interest makes it imperative for Islamic banks to look for other instruments, which renders operations outside the periphery of commercial banking unavoidable. Such operations may yield economies of scope. But it is undeniable that the multipurpose character of Islamic banking poses serious practical problems, especially in relation to the skills needed to handle such diverse and complex transactions (Iqbal and Mirakhor l987).

The stress on equity-oriented transactions in Islamic banking, especially the mudaraba mode, has been criticized. It has been argued that the replacement of pre-determined interest by uncertain profits is not enough to render a transaction Islamic, since profit can be just as exploitative as interest is, if it is ‘excessive’ (Naqvi l98l). Naqvi has also pointed out that there is nothing sacrosanct about the institution of mudaraba in Islam. Naqvi maintains that mudaraba is not based on the Qur’an or the Hadith but was a custom of the pre-Islamic Arabs. Historically, mudaraba, he contends, enabled the aged, women, and children with capital to engage in trade through merchants for a share in the profit, all losses being borne by the owners of capital, and therefore it cannot claim any sanctity. The fact remains that the Prophet raised no objection to mudaraba, so that it was at least not considered un-Islamic.

The distribution of profit in mudaraba transactions presents practical difficulties, especially where there are multiple providers of capital, but these difficulties are not regarded as insurmountable. The Report of Pakistan’s Council of Islamic Ideology (CII l983) has suggested that the respective capital contributions of parties can be converted to a common denominator by multiplying the amounts provided with the number of days during which each component, such as the firm’s own equity capital, its current cash surplus and suppliers’ credit was actually deployed in the business, i.e., on a daily product basis. As for deposits, profits (net of administrative expenses, taxes, and appropriation for reserves) would be divided between the shareholders of the bank and the holders of deposits, again on a daily product basis.