Present World Economic Setting

The present day economic problems of the World are too baffling and their solution under the
traditional 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, gross
inequalities in income and wealth, high rate of unemployment, economic instability, inflation and
erosion of the value of money and monetary assets, increasing disparities in regional, national
and international income levels, co-existence of widespread hunger and pockets of affluence, and
inconsistency between technology and developmental needs, etc. Even the otherwise affluent
Western industrialized countries are suffering from alternative bouts of prosperity and depression
accompanied with soaring and sagging interest rates. The Present condition of the world economy
is 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. This
interest has not been confined to the Muslims but also percolated to the responsible non-Muslim
quarters1. No economic system can sustain its health and vigour or contribute positively to the
achievement 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 banking
framework in the light of Islamic teachings. A lot of studies have been made in this regard in
recent 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 and
balanced behaviour in society are the cornerstones of the Islamic economic system for which the
Quran 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 of
such a beneficial system- The doldrums occurring in the existing systems and the resultant
sufferings caused to the greater mass of human beings in recent times point to the urgency of
introducing 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 in
the 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 financial
system in a number of Muslim countries in the Middle East, Africa and Asia. These measures
should be viewed as an integral part of the ultimate goal to move towards the Islamic ideal of a
society based on the principle of social justice. As one important element of this policy, a number
of Muslim countries have made efforts to abolish what the Quran condemns as Riba which is
interpreted to mean both usury and interest and which is more precisely defined as the fixed
charge for the use of money. The issue of abolishing Riba was seriously considered first in 1972 at
the Islamic Conference of Foreign Ministers of Foreign Ministers of O. I. C. countries in Jeddah.
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. Once
established, IDB splendidly served as the model of a development bank operating on Islamic
principles and modes, and demonstrating a viable alternative financial system to replace the
conventional interest-based system. The determined studies made in some Muslim countries, the
groundwork made for IDB and its successful operation have facilitated the multiplication of
Islamic 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, The
United Arab Emirates, and on a grand scale in Pakistan. In general, as the first step, Islamization
has consisted largely in founding Islamic banks that operate strictly on Islamic principles and
more specifically, without charging or paying interest on loans or deposits. Besides performing
normal banking functions, Islamic banks have special features like Quard-l-Hassan (beneficent
loan) 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 been
established in non-Muslim countries (5) such as the Bahamas, Britain, Denmark, Luxembourg
and Switzerland like oasis in deserts. Here we may provide a list of Islamic banks and financial
institutions so far set up in different countries of the world:

LIST OF ISLAMIC BANKS AND FINANCIAL INSTITUTIONS

Country Name Year established

BAHRAIN 1. Bahrain Islamic 1979

Bank
BAHAMAS 2. Dar Al-Maal Al-Islami 1981
(DMI)

3. Islamic Investment Company 1979

Ltd.

EGYPT 4. Faisal Islamic Bank of 1977

Egypt
5. Nasser Social 1972
Bank
6. International Islamic Bank of 1980
Investment & Development
7. Bank Misr—Islamic Branches 1980
IRAN 8. Sepah Islamic Bank of 1979
Iran
JORDAN 9. Jordan Islamic Bank for 1978
Finance & Investment
KUWAIT 10. Kuwait Finance House 1977
LUXEMBOURG 11. Islamic Banking System 1978
International Holding S. A.
PAKISTAN 12. Profit and Loss Sharing 1981
(PLS) Operation in all
 Nationalised Commercial Banks'
Branches (7,000)
13. Pakistan House Bulding 1980
Finance Corporation, Islamized
to share income/rent
14. Investment Corporation of 1980
Pakistan, Islamized
15. National Investment Trust—
Islamized
16. Pakistan Bankers' Equity
17. Islamic Modaraba
Companies
QATAR 18. Qatar Islamic Bank.

19. Islamic Exchange and

Investment Corporation

SAUDI ARABIA 20. Islamic Development Bank 1979

(IBD) [Members are 41 Muslim
countries].

SUDAN 21. Faisal Islamic Bank of 1979

Sudan
SWITZERLAND 22. Dar AI-Maal Al- 1980
Islami
23. Islamic Investment Company 1979
Ltd.
UNITED ARAB EMIRATES 24. Dubai Islamic Bank 1975
25. Islamic Arab Insurance 1980
Company
26. Islamic investment Company 1979
Ltd.
UNITED KINGDOM 27. Islamic Finace 1982
House
BANGLADESH 28. Islami Bank Bangladesh Ltd. 1983
ISLAMIC BANKS UNDER ESTABLISHMENT

DENMARK 29. Islamic Bank International of 1982

Denmark
MALAYSIA 30. Malaysian Islamic 1982
Bank
SAUDI ARABIA 31. Saudi Islamic Bank 1982
SWITZERLAND 32. European Islamic Bank 1982
TURKEY 33. Ankara & Istanbul Islamic 1982
Banks
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 real
economic 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, where
the abolition of Riba is an objective of the State's constitution. The aim is not only to phase out
fixed interest payment but to replace interest with equity participation arrangements that will
allow incentives for savings and efficient resource allocation to be retained consistent with Islamic
principles. 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-bearing
deposits, and interest-free accounts in the first phase. By opting for the latter, depositors are
entitled 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 can
be 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, in
conventional banks and to “savings accounts” in Western banks. The funds raised in investment
account, are invested by banks on the basis of the PLS principle, sharing the amount of profits
resulting from their investors with depositors. The calculation of profits and losses and a
dividend/profit declaration can be under taken annually or every six months or even three
months as in Egypt and Kuwait. In Pakistan, the PLS principle is applied to the fixed deposit
accounts of banks that issue fixed deposit receipts, which are only accepted in amounts
denominated in multiples of one thousand rupees.

Current Account deposits in Islamic banks as in the other banks are held of transaction and
contingency motives, while the investment motive playing a strictly secondary role. Funds
mobilized 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 of
equity shares, debentures, or by medium-term and long-term borrowing from banks at fixed
interest, 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 bring
them into conformity with Islamic tenets. For example the Government of Pakistan passed the
Modaraba law to basic financial transactions on the PLS principle and introduced Participation
Term Certificates (PTC) to replace interest bearing debentures. Banks and other financial
institutions are asked to grant long-term loans on a PLS basis as another possibility of providing
long-term finance to industry and commerce. Short term working capital finance is also given on
PLS principle on u selected basis.
Under the Modaraba law, management companies, banks, and financial institutions can register
themselves as Modaraba companies. These can be of two types a multipurpose Modaraba with
more than one specific objective and Modaraba having a specific purpose (e.g., for raising
household finance). Modaraba companies may only engage in business that is permitted under
the Islamic religious law, the Shariah. A Religious Board ensures that firm's activities are not
contrary 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 risk
capital 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 value
issued to the subscriber of the Modaraba. Before profits are distributed, the board of the
Modaraba 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 the
leasing 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 financial
success.

The provision of short-term loans by banks is an Integral part of modern business, but one that
raises some problems for Islamic banks is a situation in which fixed interest charges are not
permitted. The problems are not, however, insurmountable. A number of proposals have been
advanced to remedy this difficulty, such as that the banks should provide short-term loans free of
charge in deserving cases (Quard-i-Hasan) or that the profits of an enterprise could be computed
for 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 to
provide selectively working capital finance to trade & Industry on PLS (Musharika) basis. In the
agricultural sector, which is the predominant sector in some developing countries like
Bangladesh, 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 the
principles endorsed by religious leaders could be helpful. Applying the PLS principle agricultural
lending could be done by sharing-output, or net profits, at an agreed percentage between the bank
and the farmer.

Consumer Credit has become a very important business activity for commercial banks in
developed countries, and Islam does not absolutely forbid lending for consumption purpose, in a
number of countries, special consumption loans—the Quard-l-hasan-existed, which were granted
in hardship cases by neighbours or friends without any financial consideration. However; the
application of the partnership principle to consumption loans does not seem an acceptable
solution, since these generally do not yield profits that could be shared by lender and borrower. It
has 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.
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 of
instalments. In Pakistan, the House Building Finance Corporation (HBFC) advances loans for
housing 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 house
and its rental value and is entitled to a share of the rent, from which it derives its profits. The
Pakistani nationalised commercial banks also have been permitted to finance house-building on
the same basis from July, 1982.

Implementing the PLS System

Providing finance on PLS basis requires thorough vigilance by the banks over the utilization of
funds 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 is
also that the intensively supervised credit is always better utilized and better realised than the
loans given on paper security only. Another proposal aimed at long-term financing is the
Investment Auctioning System under which financial Institutions would auction investment
authorization to investors. Supply of and demand for investable funds determine the scarcity
price of available capital. Within the framework of such a system, entrepreneurs would remain
sole, responsible for their investment decisions, whereas banks would only act as financial
intermediaries. Scarce capital resources would flow into those investments that yielded the
highest 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 some
quarters that not all the 7,000 branch Managers of the nationalised commercial banks which
opened interest-free banking counters in the country in January, 1981 have been equally
enthusiastic or meticulous about implementing the new system in its letter and spirit as against
their known and beaten track. Thus is the process, at least, a few of them may have mixed up
and/or taken up the experiment as just another official mandate. The same experience may be
encountered elsewhere too. It is, therefore, of critical Importance to ensure efficiency and purity
of the system for its success and growth.

Islamic Bank of Denmark2 An 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 its
doors in Copenhagen's Jernbanegade after long negotiations with the Danish Central Bank, the
Ministry of Industry and the Banking Control Commission of Denmark. European Central Banks
including 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 issue
cheque books like any ether high street bank. Whereas other Danish banks depend on interest for
their survival, the IBID shuns interest and shares the risk of investment with its depositors or
borrowers 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 of
Awqaf religious endowments) of Abu Dhabi. The Chairman of IBS is the ex-Kuwaiti Minister of
Finance and Oil, Abdur Rahman A, the Vice-Chairman is the present Minister of Justice of the
United Arab Emirates, Sheikh Mohammed Abdur Rahman al-Baqr, and the Managing Director is
the prominent Egyptian banker and legal expert, Doctor Gamal Attia. The capitalisation of IBID is
at 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 serve
other Islamic banks, accept deposits in various currencies and finance the activity of its
subsidiaries, including the Islamic Finance House in London's
Baker Street
". Already, many Western banks are said to have approached IBID for joint cooperation while
various Arab and Islamic groups within OAPEC3 have expressed an interest to work together with
the bank.

Effects of an Islamic Financial System

The introduction of financial intermediation based on the PLS principle has potentially beneficial
impacts on the behaviour of savers, banks, and investors. The PLS system turns savers into
entrepreneurs, at least to some extent, by encouraging them to participate directly in the financial
success 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 investment
deposits would be naturally variable

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

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

The introduction of financial, intermediation based on the Islamic principles has not only been
successful 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 in
different countries as can be seen from their operating results. In Pakistan, the nationalized
commercial banks gathered Rs.6,489 million in PLS deposits through Islamic banking counters
during the first year, 1981 out of which term/Investment deposits were Rs.4,283 million. PLS
deposits 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 (for
periods 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 are
allowed interest at the maximum rate of 12.75 per cent in Pakistan. The Jordan Islamic Bank
registered an overall profit of 8.2 per cent on investment accounts for 1980. Depositors with
Bahrain Islamic Bank received a profit of 9-9.5 per cant on term deposit accounts and 5.25 per
cent on savings accounts for 1980. The Kuwait Finance House declared profits of 6.75 per cant on
savings deposits and 9 – 10.12 per cent on term deposits ; the Faisal Islamic Bank of Egypt and
the FIB of Sudan paid profits of 12.03 per cent and 16 percent respectively for the year 1980. The
Dubai 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 PLS
principle leaves yet some unresolved Issues. In particular, remunerating lenders for making
short-term loans to industry and commerce and for providing consumers' credit remains difficult
if the PLS system Is to be applied fully. In any case, in the poorer countries like Bangladesh or
Pakistan 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 operations
of Islamic banks. However, the Islamic banks have already established excellent correspondent
relationships with reputable banks in many developed Western countries and are handling most
of 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 PLS
system.

Even if the PLS system is introduced on an optional basis side by side with the present banks, or
as a transition to a complete switch over to Islamic banking,' it is most likely that the enlargement
of choice would have generally beneficial consequences, particularly for savings. A complete
transformation to a PLS system, however, would require satisfactory handling of issues that still
have to be resolved, particularly those concerning the allocation and remuneration of short-term
financing. But even in serious Western economists' assessment an alternative banking and
financial system with superior concept and ideals has already been born and taken root, and the
same 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 the
system on Islamic principles and ideals, as briefly mentioned above. But, unless determined and
sustained efforts are also made by the public authorities of the Islamic countries, despite great
public enthusiasm and support and promise of the new system for social benefit, progress
towards Islamization of the banking and financial system in the Muslim world is bound to be a
slow and time consuming process.
• The author is the Director of Research, Bangladesh Bank. However, the article is contributed
strictly 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.