Interest-Free Banking
Each of the three constitutions of Pakistan (1956, 1962, 1973), adopted so far, contains a clause making the elimi nation of riba (interest) an objective of the state. However, the first serious initiative in this direction was taken when the late General Ziaul Haq assumed power in 1977 and the Council of Islamic Ideology, on his directive, constituted a panel of economists and bankers to suggest ways and means for eliminating riba from country’s economy. In the light of the recommendations of the panel, as approved by the council, the State Bank prescribed 12 different non-interest-based modes of financing which the banks could use for extending finances with effect from April 1, 1985. Similarly, on the liabilities side, all bank deposits, with the exception of foreign currency deposits, were to be on the basis of participation in profit and loss of the banks effective from July 1, 1985.
Two of the modes of financing prescribed by the State Bank, namely financing through the purchase of client’s property with a buy-back agreement and sale of goods to clients on a mark-up, involved the least risk and were closest to the old interest-based operations. Hence, the banks confined their operations mostly to these modes, particularly the former, after changing the simple buy-back agreement (prescribed by the State Bank) to buy-baek agreement with a mark-up, as otherwise there was no incentive for them to extend any finances. The banks also reduced their mark-up- based financing, whether through the purchase of client’s property or through the sale of goods to clients, to mere paper work, instead of actual buying of goods (property), taking their possession and then selling (back) to the client. As a result, there was no difference between the mark-up as practiced by banks and the conventional interest rate, and hence, it was judged as repugnant to Islam in the recent decision of the Federal Shari‘ah Court.
Fixation with Certain Modes of Financing
Besides, problems inherent in the menu of financial assets allowed to banks in 1985, there has been one fundamental problem with our approach to the Islamisation of the financial sector in the past. We seem to have a fixation with certain types of musharakah and mudarba and do not seem to be willing to go beyond these modes of financing. The fact is that these modes of financing were in vogue in Hijaz even before the advent of Islam and the Prophet (pbuh) approved them. In the present era, if Muslim experts in finance devise some other modes of financing based on profit-and-loss sharing and religious scholars judge them as not repugnant to Islam, these should be as Islamic as various forms of musharakah and mudarba in vogue at the lime of the Prophet (pbuh). The same creativity of the Muslim mind, which invented calligraphy as an alternative expression in the field of creative arts because of the prohibition of painting of human figure, should be at work in this area. We should come up with a wide menu of financial instruments suiting the preferences of different groups of savers and investors with regard to the mix of risk and return.
In the following paragraphs, an attempt has been made to briefly describe the existing relationship between depositors, banks and borrowers and then propose alternative framework in which the nature of the relationship will be quite different from the present one. Some measures should also be suggested for ensuring the disclosure of actual profits and losses of the units being financed by the bank.
A commercial bank in the present age serves as a financial intermediary between those economic units who have more funds than they want to use, i.e. surplus units and those units who have plans to spend more than what their own financial resources would allow, i.e. deficit units. Surplus units deposit their surplus funds with banks which, in turn, lend these funds to deficit units for meeting their working capital requirements, for financing their investment expenditure and even for consumption expenditure. Some economic units also keep their transaction balances with banks in the form of current deposits and draw upon them as and when the need for spending them arises.
In addition to deposits, which are the main source of financing bank operations, equity of shareholders also contributes to the total pool of funds available to banks for their operations. The two items, deposits and equity, appear as liabilities in the balance-sheet of the bank. On the assets side, the major item is the loans made by the bank besides the physical assets like buildings, furniture and office equipment. Both lending and deposit-taking by banks is done on the basis of fixed interest rate. The banks charge a fixed rate of interest on the funds lent by them irrespective of the actual magnitude of profit earned or loss incurred by the borrowing entity, except in the case of the bankruptcy of the borrower when the bank may lose even a part of the principal amount. Similarly, depositors receive a fixed rate of interest on their deposits which is known at the time of making the deposit.
In a financial market, where the forces of demand for and supply of loanable funds are allowed to operate freely, there could be a link between what the users of funds (borrowers) earn and what the providers of funds (depositors) receive. Increase in the earnings of borrowers will lead to an increased demand for funds, rise in the rate of interest paid by them to banks, which will eventually be passed on to depositors. But even in the most free enterprise economies, interest rates are manipulated or at least influenced by the central bank through its open market operations and discount rate policy, even when it is targeting monetary aggregates rather than the rate of interest as such. The interest rate is as much a reflection of the state of the economy in terms of the profitability of business as it is a policy instrument for influencing the level of economic activity and for the allocation of funds. Even McKinnon and Shaw, the two leading advocates for freeing of interest rates in formal credit markets from government control in developing countries, advocate an increase in interest rates for improving the allocation of resources and for channelising more funds through financial intermediaries.
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