CHAPTER 1 PROBLEM & ITS BACKGROUND 1.

1 Introduction

In any economy banks play very important role. A bank is a reliable financial institution, which has core business of mobilizing the savings of people for investment purposes. It receives the money from one group and lends to other group of people. So bank performs the duty of financial intermediary.

Usually there are two types of banks, conventional banks and Islamic banks. In simple words Islamic banks operate in interest free system. Prohibition of interest is ordained in Islam in all forms and intent. This Prohibition is strict, absolute and unambiguous.

The Holy Qur'an in verse 278 of Surah Al-Baqarah states:

"O ye who believe! Fear Allah and give up what remains of your demand for riba, if ye are indeed believers."

Verse 2: 279 says:

"If you do it not, take notice of war from Allah and His Messenger. But if ye turn back, ye shall have your capital sums. Deal not unjustly and you shall not be dealt with unjustly."

It therefore, follows that interest is prohibited as it leads to injustices and Islam is against all forms of injustices and exploitations and pleads an economic system, which aims at securing extensive socio-economic justice. The Islamic law of prohibition of riba, which includes interest, was originally not based on economic theory but on Divine Authority which considers the charging of interest as an act of injustice (Dr. Siddiqui).

Islamic banks appeared on the world scene as active players two decades ago. But many of the principles on which Islamic banking is based have been commonly acceptable all over the world for centuries rather than decades, as it is evident that Islamic finance was practiced predominantly in the Muslim world throughout the middle Ages, promoting trade and business activities. In Spain and the Mediterranean and Baltic States, Islamic merchants became indispensable middlemen for trading activities. It is claimed that many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businesspersons. "Although the western media

frequently suggest that Islamic banking in its present form is a recent phenomenon, in fact, the basic practices and principles date back to the early part of the seventh century" (Islamic Finance: A Euro money Publication, 1997).

The main issue here is to know about the differences between operations of a 2

conventional bank and an Islamic bank by focusing on the principles and instruments of Islamic banking.

It is difficult to say with accuracy which was the first such company or bank that pioneered this concept of Islamic banking in practice. Some analysts and experts in the field are of the opinion that, Islamic banking and finance, in the modern context, first emerged in 1963, when Mit Ghamr Saving Bank began an experimental project offering interest free banking in Egypt. The project was a success and lead to the bank opening four new branches by 1967. In the same year, eight new banks mushroomed offering interest free banking. Due to the political climate prevailing in Egypt during that period, the success of these Islamic banks was seen as a threat, and they were forced to close down in 1971.

Some observers are of the opinion that the concept of an "Islamic bank" was born at the Islamic Summit of Lahore, Pakistan in 1974 which recommended the creation of an Islamic Development Bank. Since then Islamic banking and financial institutions have grown rapidly. A 1993 report from the International Association of Islamic Banks estimated the then industry to be valued at $80 billion. A more recent article appearing in the Wall Street Journal estimates the potential market for Islamic investments to be up to $150 billion.

Within a time span of a few decades, Islamic banking and financial institutions have been swift to establish themselves in all parts of the world in the form of Islamic 3

Commercial Banks, Investment and Holding Companies, Takaful (Insurance) Companies, and Development Banks. The over 150 such institutions that invest money according to Islamic economic principles, are poised to increase in number over the next few years. Several Muslim countries, Indonesia, Iran, Malaysia, Pakistan, Sudan and Turkey, in recent years have been taking systematic steps to establish an Islamic banking and financial sector. The speed with which Islamic banks have sprung up and the rate at which they have progressed make it worth while to study them systematically.

Malaysia in 1983 passed an Islamic Banking Act to facilitate the growth of indigenous Islamic banks and finance companies thus became the first Muslim economy to issue bonds on an Islamic basis. Since then, some 50-60 institutions have been established, and are now in the process of forming an Islamic inter-bank market (i.e. in which banks borrow or lend to each other). Within 10 years of introducing the Islamic Banking Act, the Malaysian government has taken further steps to popularize Islamic banking and finance, by allowing conventional banks to offer Shariah-compliant instruments. The most distinctive feature of Islamic banking in Malaysia is that it is being embraced by its Chinese and non-Muslim population who are opting to deposit their savings or borrow money on an Islamic basis.

The momentous decision of the Pakistani Supreme Court, in Ramadan 1420, to strike down all laws that condone interest and their orders to the Federal government to bring all existing financial organizations in line with Islamic principles is truly path-

breaking. The world is watching with bated breath to see how the whole economy faces this challenge (www.alrajhibank.com.sa/islamicebanks.htm).

These trends in Malaysia and elsewhere are having a profound effect on the banking and financial world as a whole. For example, America's Citibank was the first major conventional bank to establish an Islamic bank in Bahrain, with an operating capital of $20 million (The Economist, 1996). It may be a puny sum, but, it does suggest to some degree that conventional banks have begun to embrace Islamic banking on a moderate scale. Here again the point arises, that, there is some difference between the operations of two banking systems and also there is something which is attracting conventional banks towards Islamic banking system.

A significant proportion of the banking system has been Islamized in Pakistan. Recently the state bank of Pakistan has allowed commercial banks to set up Islamic banking subsidiaries or provide full Islamic banking facilities through dedicated branches (Dawn economic & business review, 2003).

Meezan Bank of Pakistan had conducted a research last year to ascertain, is Islamic banking really a need of the people? The main findings of the research were that there is a strong need for a riba-free banking system. People perceive a number of emotional benefits from a product that is based on the tenets of Islam. The objective is to alleviate the feeling of guilt by following the tenets of Islam. There is also a belief that Islamic banking will help fight the ills of the economy of the country. 5

A number of other Western financial institutions have followed suit by offering Islamic mutual funds and other investment products. For example, ANZ Grindlays is now offering financial products that meet Islamic criteria. Germany's fourth largest bank, Commerz bank, started offering Islamic mutual funds from December 1999. In February 1999, Dow Jones introduced the Dow Jones Islamic Market index (DJIM) of 600 companies worldwide that comply with the Shariah laws.

Many Western Academic Institutions are introducing Islamic Economy and Banking as Subjects, like Harvard University Center for Middle Eastern Studies (CMES), Durham University, UK, Dow Jones University.etc.

These indicators reflect the rising trend of Islamic banking and finance throughout the world. This encourages one to know in detail what Islamic banking is all about, what are its principles and how it is different from conventional banking system.

The Amana Fund, the LARIBA bank, in USA and the Halal investment company in London is another indicator of the growing salience of Islamic banking institutions not just in Muslim countries, but in the West as well. These efforts in different countries for Islamic banking present not only an excellent working examples for those who did not believe in the practicality of the interest free banking but also provide a spade work over which the infrastructure of interest free banking for a country could be built up.

1.2

Rationales for the Study

6

An Islamic bank is a financial institution which identifies itself with the spirit of Shariah, as laid down by the Holy Qur'an and Sunnah. Normally from Islamic banking it is meant the interest free banking system, while conventional banking is perceived as interest based banking system. To replace interest, the ideal mode of financing under the Islamic banking system is "Financing on Profit & Loss Sharing" (PLS) basis.

There could be no denying of the fact that under the interest-based system of banking or in a system not strictly based on the principles and spirit of Shariah, depositors as well as borrowers are exploited in one form or the other. (Dr. Siddiqui)

Interest is usually paid on borrowed money or in other words on debt. In last decades debt is considered as most effective resource of financing. It was contended that debt has a better control function because the threat of failure to make debt-service payments serves as a strong motivating force (Jensen, 1988).

On the other hand it is considered that, although an increasing level of debt helps the economy grow faster for a while, it foments endogenous instability and financial fragility.

Minsky (1982) has propounded and popularized the idea of endogenous instability and financial fragility. That is, initially when the debt equity ratio of a corporate is low, it really pays to finance expansion by borrowed funds. At this stage, expectations of both borrower and lender are usually satisfied, or existing debt is validated without any 7

problem, which provides the basis to go further deep in debt. As a result, demand for borrowed funds grows faster than the ability to pay, or in Minskian terminology, the economy moves from hedge to Ponzi finance. Also demand for further borrowing becomes inelastic because initially, due to the positive slope of term structure, borrowers themselves prefer to borrow on a short-term basis, but later they have to borrow to keep their existing debt rolling and to fulfill their other committed payments, which in turn, pushes the interest rate up. However, the problem starts when at some point along the line, the supply of credit lags behind the demand. This happens because on one hand lenders become pessimistic about future prospects of underlying projects or they no longer share euphoric expectations with borrowers or, on the other hand, the net worth of borrowers and the value of their collateral erode because of high interest rates. As a consequences, their relationship become strained, lenders may want to extend minimum credit or may even want to liquidate what they have already loaned, while debtors scramble for liquidity. Minsky calls this a financially fragile situation because borrowers become vulnerable to disruption of their economic activity.

A business cycle model of financial crises by Wolfson 1994a also emphasizes the non-contingent nature of a debt contract as a starting point for financial difficulties.

In each theory, when a firm is over-indebted there appears a sort of conflict of interests between lenders and borrowers, that is, a point at which borrowers become desperate for further borrowing whereas lenders want or have liquidated their already

loaned funds, let alone countenance further lending (Uchitelle, 1994).

The literature on this topic, that interest based financing is the basic cause of business cycle and instability is increasing day by day. Even non-Muslims are looking for some way out of this cyclical nature of interest based system. Without mentioning their proposal a viable alternative could be financing on the basis of profit & loss sharing and that is Islamic banking system.

1.3

Problem Statement

From the rationale given in the previous section, it is now clear that attention must be given to the viability of Islamic banking as compared to conventional banking system while focusing on the problem statement:

Why some of conventional banks are moving towards Islamic banking system?

Focusing the problem this study will answer the following questions:

1. What is Islamic banking system with respect to its principles and instruments?

2. How Islamic banking system is different from conventional one?

3. What are the advantages of Islamic banking system, and what is its future?

4. Why Islamic banking is more viable than conventional banking system?

1.4

Objectives

This research report or thesis is the basic requirement of Bahria Institute of Management And Computer Sciences, Islamabad, for any student to obtain the degree. This is a way to help students enhance their knowledge by making them learn from the practical environment and also to apply the learned theoretical concepts in the practical field. Thus, the main objective of this research is to fulfill the partial requirement of the University for obtaining the degree.

An attempt is made in this research:

To highlight salient features of Islamic banking system.

To compare Islamic banking system with conventional banking system.

To investigate whether Islamic banking is at least as viable as conventional banking system on economic grounds.

To simulate future prospects of Islamic banking system, if people are

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made aware of the difference between Islamic banking system and conventional banking system.

To simulate future prospects of Islamic banking system, if people are made aware of the viability of Islamic banking system.

1.5

Significance of the Study

It is true that external financing is utmost important almost for every kind of business in an economy and banking industry is the main facilitator in this regard. Islamic banking system plays its role in the banking industry as its minor part. Even though its a minor part it cant be left behind because banks are the citadels of the economic growth. So, studying Islamic banking system in detail will not only benefit the researcher but also will be a source of effective information for many classes of bank customers. It will help better understanding Islamic banking system and its salient features.

Only a minority of Muslims strongly believe in efficacy of Islamic banking system, whereas a majority of Muslims and non-Muslims have doubts about its viability on economic grounds. They are not convinced to its practicality and viability. Description of Islamic banking in this study will clarify such doubts about the system and will speed up the process of Islamizing of banking industry. This study will be of great help for students of banking to understand deeply the Islamic banking and to differentiate it from

11

conventional banking system. It will be a contribution to the existing literature of administrative sciences and will serve as a base for further research. This project will also give the idea to reader which type of investment is forbidden in Islam and which type is good for Muslim investors. It will be helpful for bankers and investors too.

1.6

Limitations of the Study

The research is conducted within the following limitations:

To keep the study manageable research is conducted on limited grounds.

The study is conducted on small level and only the important aspects are considered.

There was a shortage of time thats why limited data is collected. Still the researcher has tried to collect sufficient data to make an effective analysis.

1.7

Definition and Meanings of Terms

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Al-wadiah means safe keeping.

Bai'muajjal means deferred-payment sale.

Bai'salam means pre-paid purchase.

Baitul mal means treasury.

Fiqh means jurisprudence.

Hadith means prophet's commentary on Qur'an.

Halal means lawful.

Haram means unlawful.

Ijara means leasing.

Iman means faith.

Mudaraba means profit-sharing.

Mudarib means entrepreneur-borrower.

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Murabaha means cost-plus or mark-up.

Musharaka means equity participation.

Qard hasan means benevolent loan (interest free).

Rabbul-mal means owner of capital.

Riba means interest.

Shariah means Islamic law.

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15

CHAPTER 2

LITERATURE REVIEW

This chapter deals with two parts, first part consists of basic explanation of Islamic banking system its principles and instruments and the second part is concerned with summary of previous researches being done on these respective research areas. It includes the general information about the banking sector and Islamic banks.

2.1

Banking and Financial System (Fredric Mishkin)

A healthy and vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities.

There are many different types of institutions: banks, insurance companies, and so on, all of which move funds from savers to investors.

The system based on these institutions is called the financial system. And this Financial System is complex in structure and function throughout the world.

Figure 2.1 indicates how the different countries financed their business activities using external funds, in the period of 1970-1985.

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SOURCES OF EXTERNAL FUNDS 80 60 40 20 1) 0 loans Bonds

Series1 Series2 Series3

Loans

Made up primarily of bank loans but also includes loans by other

Series5 Series6

Series4

non-bank institutions. Stock Other

2)

Stock

Consist of stock market-shares

3)

Bonds

Includes marketable debt securities.

4)

Others

Includes govt. loan and Foreign loan etc.

As seen in the picture the main source of fund has been loan and loans are made by mostly banks. So this institution will be discussed in detail.

Figure 2.1

2.2

What is Bank? (Fredric Mishkin)

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Bank is defined as an institution, which deals with money. The bank draws the surplus money from the people i.e. excess of income over consumption, which is a form of loan to the bank and in return pays interest on it for the loans of those who have saved or deposited their money. The bank then gives out loans to those who need it particularly for productive purposes, and charges interest on returning it.

In present days the banking system has been familiarized as an organized organization. This organization by giving greed of different benefits induces peoples to deposit their money in banks. Then the bank lends this money on huge interest to others. A portion of the interest money is awarded to the creditors of savings and the rest of money is spent by bank for its own expenditures.

2.3

What are Islamic Banks (RIIC by Prof. Khursheed)

Unlike their counterparts elsewhere, Islamic bankers do not expect to advance money and receive a predetermined sum on a fixed date in the future. Under the Shariah, the bedrock of the Islamic faith, they are instead responsible for ensuring that money is invested in viable projects, with reliable borrowers. If the project succeeds the banker shares in the profit. If it fails he suffers the losses.

The Shariah, which dictates the activities of the banks as well as forming the basis of the daily lives of all Muslims, requires that reward comes from risk sharing. Profit must be justified through the creation of value that the banker brings to complement the 18

value of the borrowers efforts and skill as mentioned in report on Islamic ideology council.

Against a background of rapid growth in Middle Eastern economies over the last 20 years and a desire to increasingly compete internationally, Islamic banks have begun to change and develop to provide a range of alternative financial products - still firmly based on Islamic principles.

Islamic financial techniques have been employed successfully in a growing number of major projects in the West. Al Rajhi Bank has completed deals for the financing of ships and aircraft (using the Ijara - lease financing technique), and many industrial projects including the building of power stations, a refinery and schools, and the expansion of an aluminium smelter in Bahrain (using the Istisna - deferred financing technique).

Given the huge potential for development in the Islamic world and the increasing amount of funds being invested according to the Shariah, it seems perfectly reasonable to suppose that the recent growth in Islamic banking will continue at an accelerated pace (Colin Willis).

2.4

Knowledge about Islamic Bank

A research on Bank Patronage Factors of Muslim and Non-Muslim Customers 19

conducted in Malaysia in 1994 shows that almost 100 per cent of the Muslim population was aware of the existence of the Islamic bank; the sources of knowledge are mainly newspapers and magazines, television and radio, and family members. Many of the Muslim respondents visit the banks branch and seek information about the bank services and operations on their own initiative. For non-Muslims, about 75 per cent of the respondents know of the existence of the Islamic bank from information derived mainly from newspapers and magazines. Other sources of information are not so effective for the non-Muslims.

Even though it has been nearly a decade since the Islamic bank was first established in the country, only about 63 per cent of the Muslims have understood either partly, or completely, the differences between the Islamic bank and conventional banks. Non-Muslims showed much less understanding. Only 12 per cent of the Muslims and 32 per cent of the non-Muslims believe that the Islamic bank is for Muslims customers only. In terms of why people patronized the Islamic bank, about 39 per cent of the Muslim respondents believe that religion is the only reason why people patronize the Islamic bank, and, surprisingly, the percentage is much lower for non-Muslims. More than half of both respondent groups have indicated the possibility of establishing a relationship with the Islamic bank if they have a complete understanding about the operations of an Islamic bank (International journal of bank marketing, 1994).

The changes in the banking system have created a new dimension in the banking

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industry within which the institutions in the banking system have to compete, not only with financial institutions outside the banking system, but also with themselves to remain in business. Indeed, the fiercer level of competition is not only faced by the banking industry in Pakistan, but also it is becoming the most influential factor in the structure and activities of the banking system around the globe.

In the UK, for example, increasing competition has pushed British banks into much greater customer-oriented and competitive behavior. In other countries, the industry has been transformed from its traditional staid image to that of a vibrant and dynamic environment (Turnbull and Gibbs, 1989).

2.5

History of Islamic Banking

Haqiqi & Pomeranz in their article Accounting Needs of Islamic Banking gave the history of Islamic banking. They explained that, In Muslim communities, limited banking activity, such as acceptance of deposits, goes back to the time when the Prophet Muhammad was still alive. At that time, people deposited money with the Prophet or with Abu Bakr Sedique, the First Khalif of Islam. The first modern Islamic bank, established in Egypt in 197, was called Nasser's Social Bank. Islamic accounting, an essential tool for the success of Islamic banks, is said to have been developed contemporaneously at the University of Cairo (Crane).

The desirability of abolishing fixed interest rates and the Islamization of financial 21

systems were discussed at the first meeting of the Islamic Organization Conference (IOC) in Jeddah in 1973. Subsequently, many Islamic banks were founded under the profit-andloss sharing system (PLS), which will be discussed below.

Modern Islamic banking has undergone three phases of development:

Emergence-1972 through 1975: This period was marked by a surge in oil revenues and great liquidity .Parallel events included a resurgence of fundamentalist Muslim movements, reemphasis on the Wahabi School of Brotherhood and Pan-Islamism, and establishment of IOC.

Expansion-1976 to the early 1980s: Islamic banking spread from the: Arabian Gulf eastward to Malaysia, and westward to England. More than Accounting Needs of Islamic Banking 155 20 Islamic banks were established, including international and intercontinental institutions.

Maturity--1983 to the present: The Arab world was confronted by economic setbacks, including slowdowns in oil revenues, the collapse of Ku- wait's Souk alManakh, the relative strength of the U.S. dollar, higher interest rates in the United States, and capital outflows from OPEC nations. At the same time, Arab banks opened branches in the United States and Islamic banking practices were implemented in both Pakistan and Iran.

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Islamic banking operations are not limited to Arab soil, or Islamic countries, but are spreading throughout the world. One reason is the "growing trend toward transcending national boundaries, and unifying Muslims into a political and economic entity that could have a significant impact on the pattern of world trade. ...Since Muslims are inclined to follow Islamic traditions, there is a tendency to establish an Islamic economic system in every Islamic nation, And to restore Shariah Law as the basic source for legislation" (Abdel-Magid).

Further expansion is planned for example; DMI has announced a five-year program to create a network of branches and subsidiaries in more than twenty countries (The Economist, 1982). An American businessman of Iraqi origin plans to establish a U.S. based financial institution to be administered in accordance with Islamic banking practice. When approved by U. S. authorities, the institution will serve several million American Muslims (Barron's 1985).

2.6

Islamic Banking System (Fredric Mishkin)

Islamic banking system deal with money and not deal in money

It is argued by Muslim scholars that whereas traditional banking is concerned with financial intermediation on the basis of lender-borrower relationship between depositors and banks, on one hand, and banks and the fund-seekers, on the other hand, Islamic banking is about addressing genuine concerns of the owners of funds and needs 23

of the resource-strapped through Shariah permitted forms of transactions.

The argument is built on the following premise.

What is permitted for an individual is also permissible for the banks (that are groups of individuals shareholders) unless there are reasons to conclude otherwise.

2.7

Instruments of Islamic Banking. (Fredric Mishkin)

The Islamic instruments which govern the operations of Islamic banks are also known as Shariah instruments. The applicable instruments are called Mudharabah, Musharakah, Murabahah, Al-Bai Bithaman Ajil, Al-Ijrah, Al-Takjiri, Qard Hasan, AlWakalah, Al-Kafalah and Wadiah.

Foundations for modern banking operation in Shuriah are defined in terms of trade, leasing and partnership based arrangements and collateral and guarantees. The following options are pro-posed to be initially made available for banking system.

Trade-related modes. Bai-muajjal (sale on deferred payment basis), Baisalam (sale with cash payment with future delivery)

Leasing modes... Ijarah (operating on lease)

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Partnership modes..Modarabahah & Mosharakah

Lending Qard (loan)

Collateral and Guarantees

Shariah requires that not only the ends be Shuriah compatible but that the means to achieve those ends be right as well. In the light of this principal the above modes can be adopted.

2.7.1

Trading-based arrangements

Baimuajjal is the Arabic acronym for sale on deferred payment becomes debt against the buyer payable in lump sum or in installments (as per agreement with the seller). In addition to the concurrence of the seller, conditions for a valid baimuajal are as follows:

1.

The price to be paid must be agreed and fixed at the time of the deal. It may include any amount of profit without qualms about riba.

2.

Complete/total possession of the thing in question must be given to the buyer, while the deferred price is to be treated as debt against him.

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Bai salam involves advance payment to a party for delivery of a thing in future a converse of baimuajjal. It applies to the case in which things come into the possession of the seller due to his being their producer or towards discharging his occupational functionsfor instance, a wholesaler acquiring goods from a manufacturer and supplying them to the retailers.

Baisalam is a valid transaction with the following three basic conditions:

1.

The nature, quality and quantity of the merchandise (to be delivered in future) must be clearly specified along with the delivery date.

2.

The price to be paid in advance should also be fixed.

3.

The transaction should be settled with the delivery of goods, not on the margin.

2.7.2

Leasing-based arrangements

Ijarah or leasing is a contract for the usufruct of an asset while its ownership still remains with the original owner, i.e., the lessor. In this case, the lessor leases his asset to another party, the lessee, against a predetermined rental for a prescribed period. Thus, besides the concurrence of the concerned parties, there are three fundamental conditions for a valid ijarah contract:

26

1.

The asset is the property of the lessor.

2.

The period of contract is specified.

3.

The rental and its payment schedule are precisely stated.

That the asset remains in working condition (during the period of lease is the lessors responsibility.

2.7.3

Partnership-based arrangements

Modarabah and musharakah are two partnership modes that allows two or more parties to share both the contributions to and the fruits of economic activity, albeit in varying degrees, trough mutually agreed arrangements. The bank can adopt both of these modes. It can act as mudarib as well as a partner.

Critical points and conditions about modarabah and musharakah from the Shariah perspective are as follows:

1.

All these arrangements represent a situation in which (a) ownership of capital is shared, albeit for the duration of the contract, (b) rewards are addressed through a share in the outcome of the activity, and (c) material losses are shared in proportion to ownership stakes of the various partners along with labour going

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totally unrewarded.

2.

The modarib should not lay any material claims against the joint venture except those necessary for discharging the required functions according to the letter of the contract.

3.

In the settlement of accounts, the first claim on revenues, over and above the operating costs, would be in lieu of the capital contributions. After this, the residual or operating profit can be distributed among all partners according to the prescribed profit-sharing ratios.

2.7.4

Collateral (Rehn) guarantees

Creditors may seek collateral to protect their interests. In this regard, the following principles need to be observed:

Collateral should not be of the same kin as the object of the loan/debt.

Creditors may not draw benefits from the object of collateral.

The collateral may be liquidated as per agreement. However, if the liquidation proceeds exceed the quantum of debt, the balance has to be paid to the debtor. Likewise, if the value of liquidated collateral falls below the amount of debt, the balance would

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stand as unpaid debt against the debtor.

2.8

Principle of Islamic Banking

For millions of Muslims, banks are institutions to be avoided. Islam is a religion which keeps Believers from the teller's window. Their Islamic beliefs prevent them from dealings that involve usury or interest (Riba) Yet Muslims need banking services as much as anyone and for many purposes: to finance new business ventures, to buy a house, to buy a car, to facilitate capital investment, to undertake trading activities, and to offer a safe place for savings. For Muslims are not averse to legitimate profit as Islam encourages people to use money in Islamically legitimate ventures, not just to keep their funds idle (Nida'ul Islam 1995).

However, in this fast moving world, more than 1400 years after the Prophet (s.a.w.), can Muslims find room for the principles of their religion? The answer comes with the fact that a global network of Islamic banks, investment houses and other financial institutions has started to take shape based on the principles of Islamic finance laid down in the Quran and the Prophet's traditions 14 centuries ago. Islamic banking, based on the Quranic prohibition of charging interest, has moved from a theoretical concept to embrace more than 100 banks operating in 40 countries with multi-billion dollar deposits world-wide. Islamic banking is widely regarded as the fastest growing sector in the Middle Eastern financial services market. Exploding onto the financial scene

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barely thirty years ago, an estimated $US 70 billion worth of funds are now managed according to Shari'ah. Deposit assets held by Islamic banks were approximately $US5 billion in 1985 but grew over $60 billion in 1994.

The best known feature of Islamic banking is the prohibition on interest. The Quran forbids the charging of Riba on money lent. It is important to understand certain principles of Islam that underpin Islamic finance. The Shari'ah consists of the Quranic commands as laid down in the Holy Quran and the words and deeds of the Prophet Muhammad (s.a.w.). The Shari'ah disallows Riba and there is now a general consensus among Muslim economists that Riba is not restricted to usury but encompasses interest as well. The Quran is clear about the prohibition of Riba, which is sometimes defined as excessive interest. "O you who believe! Fear Allah and give up that remains of your demand for usury, if you are indeed believers." Muslim scholars have accepted the word Riba to mean any fixed or guaranteed interest payment on cash advances or on deposits. Several Quranic passages expressly admonish the faithful to shun interest.

The rules regarding Islamic finance are quite simple and can be summed up as follows:

a)

Any predetermined payment over and above the actual amount of principal is prohibited.

Islam allows only one kind of loan and that is qard-el-hassan (literally good loan) 30

whereby the lender does not charge any interest or additional amount over the money lent. Traditional Muslim jurists have construed this principle so strictly that, according to one commentator "this prohibition applies to any advantage or benefits that the lender might secure out of the qard (loan) such as riding the borrower's mule, eating at his table, or even taking advantage of the shade of his wall." The principle derived from the quotation emphasizes that associated or indirect benefits are prohibited.

b)

The lender must share in the profits or losses arising out of the enterprise for which the money was lent.

Islam encourages Muslims to invest their money and to become partners in order to share profits and risks in the business instead of becoming creditors. As defined in the Shari'ah, or Islamic law, Islamic finance is based on the belief that the provider of capital and the user of capital should equally share the risk of business ventures, whether those are industries, farms, service companies or simple trade deals. Translated into banking terms, the depositor, the bank and the borrower should all share the risks and the rewards of financing business ventures. This is unlike the interest-based commercial banking system, where all the pressure is on 31

the borrower: he must pay back his loan, with the agreed interest, regardless of the success or failure of his venture.

The principle which thereby emerges is that Islam encourages investments in order that the community may benefit. However, it is not willing to allow a loophole to exist for those who do not wish to invest and take risks but rather content with hoarding money or depositing money in a bank in return for receiving an increase on these funds for no risk (other than the bank becoming insolvent). Accordingly, under Islam, either people invest with risk or suffer loss through devaluation by inflation by keeping their money idle. Islam encourages the notion of higher risks and higher returns and promotes it by leaving no other avenue available to investors. The objective is that high risk investments provide a stimulus to the economy and encourage entrepreneurs to maximize their efforts.

c)

Making money from money is not islamically acceptable.

Money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it. Muslim jurists consider money as potential capital rather than capital, meaning that money becomes capital only when it is invested in business. Accordingly, money 32

advanced to a business as a loan is regarded as a debt of the business and not capital and, as such, it is not entitled to any return (i.e. interest). Muslims are encouraged to purchase and are discouraged from keeping money idle so that, for instance, hoarding money is regarded as being unacceptable. In Islam, money represents purchasing power which is considered to be the only proper use of money. This purchasing power (money) cannot be used to make more purchasing power (money) without undergoing the intermediate step of it being used for the purchase of goods and services.

d)

Gharar (Uncertainty, Risk or Speculation) is also prohibited.

Under this prohibition any transaction entered into should be free from uncertainty, risk and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. Also, parties cannot predetermine a guaranteed profit. This is based on the principle of 'uncertain gains' which, on a strict interpretation, does not even allow an undertaking from the customer to repay the borrowed principal plus an amount to take into account inflation. The rationale behind the prohibition is the wish to protect the weak from exploitation. Therefore, options and futures are 33

considered as un-Islamic and so are forward foreign exchange transactions because rates are determined by interest differentials.

A number of Islamic scholars disapprove the indexation of indebtedness to inflation and explain this prohibition within the framework of qard-el-hassan. According to those scholars, the creditor advances the loan to win the blessings of Allah and expects to obtain the reward from Allah alone. A number of transactions are treated as exceptions to the principle of gharar: sales with advanced payment (bai' bithaman ajil); contract to manufacture (Istisna); and hire contract (Ijara). However, there are legal requirements for the conclusion of these contracts to be organized in a way which minimizes risk.

e)

Investments should only support practices or products that are not forbidden in Islam.

Trade in alcohol, for example would not be financed by an Islamic bank; a realestate loan could not be made for the construction of a casino; and the bank could not lend money to other banks at interest.

2.9

Prohibition of Interest (Dr. Mazhir Iqbal)

34

Basically Riba is prohibited in Christianity and Judaism also, but over time followers of these religions have changed their teachings.

According to Muslim law Riba is

An excess according to legal standard of measurement or weight, in one or two homogeneous articles opposed to each other in a contract of exchange and in which such excess is stipulated as an obligatory condition on one of the parties without any return.

Encyclopedia Americana-International Edition (1970) says:

Interest is a charge for the use of money. Interest has not always been considered a legitimate or even moral payment. Until the end of middle ages, any charge for a loan was generally considered to be usury. The teachings of Christians, Judaic and Islamic religion, all condemned in varying degrees, the taking of interest. In more recent times, however, usury has come to be regarded as only the charging of illegal rates of interest. In more recent times, however, usury has come to be regarded as only the charging of illegal rates of interest.

Though there is currently consensus among Muslim economists that riba (the word used in Quran for usury and interest) is prohibited, yet there is difference of opinion what riba exactly means. Different views on prohibition of interest can be classified

35

roughly under three headings: modernists, mainstream, and pro-socialists.

a)

Modernists

Modernists like Jafri (1988), Pal (1994), Rahman (1963), Shah (1959), and Ulgener (1967) equate riba with usury, exorbitant and compounded rate of fixed return that is charged mainly on consumption loans. These writers, with different reasoning, believe that the bank interest, which is quite reasonable, determined by market forces and is mainly charged on productive loans, does not come under the Quranic prohibition of riba. Consequently they do not feel any real need to introduce mudharaba as the basis of banking business and corporate financing.

b)

Mainstream Economists

Mainstream economists like Ahmad (1978), Chapra (1984), Khan and Mirakhor (1987), the Report of the Council of Islamic Ideology (1983), Siddiqui (1993), and Uzair (1980) equate riba with usury as well as with all kinds of interest known in the literature, whether charged on productive loans or on consumption ones. Thus, all of them feel the need to change from current interest based banking system towards an interest free one and they nearly unanimously propose mudharaba as the main tool for this switch over. However, among themselves they differ on particular forms of interest free banking: whether it be a 100 percent reserve system where all power to create inside money is vested to a 36

central bank, or fractional reserve banking or nationalized banking, or a centralized banking in which the central bank of a country owns equity of member banks, but not the other way around.

The argument of the first group is that under a fractional reserve system, banks amass a lot of financial power which they use for their own profit maximization and not purely for the needs of the economy. Under this system, banks find many loopholes to get around regulatory measures taken by monetary authorities. Thus they propose that all power to create money, whether outside or inside, should be vested to a central bank or monetary authorities.

Supporters of fractional reserve system, who are the dominant group within this perspective, hold that the mechanism of fractional reserve banking originated from the habit of people of not withdrawing all their deposited money at a time rather than from any coercion by financial capitalists. Therefore, they argue that 100 percent reserve banking would involve unnecessary rigidities.

Furthermore, they argue that after the switch over from debt to mudharaba based banking, banks advances to their corporate clients would not exceed cautious limits even under euphoric expectations, as they would have to bear normal business losses, in addition to extreme losses of bankruptcies, if their expectations went wrong.

37

The argument of third group is more or less same as of the first group. However, this group proposes complete nationalization of financial sector.

c)

Pro-Socialists

Pro-socialists like Abu-Sulayman (1968), Ali (1946, his commentary on the verse 2:275 on p. 111), Haque (1985, 1989, 1993), and Naqvi (1982), equate riba with usury and all other kinds of exploitation, like profiteering, monopoly profits, speculation, or a return without any counter value. These economists believe that the main motive behind prohibition of interest is to establish social justice and an equitable distribution of income. Mere replacement of riba with profit in the prevailing exploitative system may not be a sufficient measure to achieve the objective of social justice. They claim that the bank interest rate is not so exploitative as are profiteering, appropriation of profits by capitalists in absentia, share cropping, and speculation. Therefore, on their priority list, curbing of these exploitative forms comes before the abolition of bank interest rate. Haque even doubts the legality and validity of mudharaba.

To sum up, pro-socialist and mainstream Muslim economists believe that the word riba is an antonym to sharing or charity, and to trade, respectively. Accordingly, the former group extends the meaning of this technical term, riba, to a much wider concept of social justice and thus gives priority to achievement of this objective over a technical definition of riba. They propose a more active role 38

for the state in private economic activity to bring about social justice, without caring much about prohibition or allowance of bank interest rate. On the other hand, mainstream economists believe that any increase, whether small or large, on loaned capital is riba, and thus call both usury and bank interest rate riba. According to this group, the alternative to interest based lending is to trade with non-fixation of return for money capital. Therefore, they propose to replace only a pre-fixed rate of return with an uncertain one for money capital, while maintaining the same or even higher level of liquidity for financial assets as is currently observed in the developed world. They do not differentiate between speculation and enterprise, as Keynes does. In their view, speculation is undesirably only when it is destabilizing, and that happens mainly because of trading large quantities of interest bearing bonds on secondary capital markets. So, according to their logic, when there are not many interest bearing securities, trading of interest free financial assets will not generate any negative effects: either the destabilizing speculation will cease to exist or it will be easily controllable by appropriate regulatory measures.

39

2.9.1 Economic reasons for prohibition of riba

Though there is little confusion about prohibition of riba, there is much difference among Muslim jurists and economists about defining and determining the underlying reasons for its prohibition. As discussed above, mainstream economists concentrate on defining riba without really caring about its economic consequences, whereas prosocialists and skeptics of the actual working of many interest free financial intermediaries neglect the definition part and show more concern how to achieve the objective, social justice, for which riba was prohibited. Here, a middle way is adopted, that is, an attempt is made to determine pure economic reasons for prohibition of interest, which if accepted, would mean that these conditions are necessary to achieve the ultimate objective of Islamic economics, social justice.

As mentioned earlier there are two kinds of riba in Islamic law, riba in Quran riba in lending and borrowing (riba al-nasia) or explicit riba, and riba in Hadith riba in exchange (riba al-fadl) or implicit riba. Both are explained in turn.

2.9.2 Riba in Quran

In this study, the definition of interest adopted by mainstream economists is accepted, but neither of the proposed alternatives to interest, sharing and trade, is accepted. On the contrary, it is argued that interest in Quran is prohibited for the following two reasons. 40

2.9.3 Non continuing economic relation

As mentioned above, charity and trade are presented as alternatives to lending on interest by pro-socialist and mainstream economists, respectively. Here it is contended that both these alternatives are spot concepts that do not require any time horizon for their maturity, and thus do not warrant any economic relationship between the contracting parties. In Islamic law, this is illegitimate and that is why riba is prohibited.

It is therefore contended that economic alternatives to debt financing are different kinds of partnerships, like mudharaba, because these contracts involve a specific time horizon. However, unlike debt financing, a legal relation involving agency (wakala) or surety (kafala), or both, is developed between contracting parties. So there are two things which distinguish debt financing from Islamic alternatives. One is that the return for money capital is fixed and positive in the former while it is non-fixed and could be even negative in the latter. The other is that in the former lender and borrower have no legal relationship while in the latter they do. What this relation exactly means is explained below.

In Islamic law, there are two main kinds of partnership, universal (mufawadha) and limited (inan); the former entails both surety and agency relations between contracting partners, whereas the latter entails only agency relation. Mudharaba, like 41

limited partnership, entails only agency relation but the nature of agency relation is a little different in both cases.

Both Surety (kafala) and Agency (wakala) Relations Together: In a surety relation, an insurer stands liable personally as well as economically for all consequences of all specified and relevant actions of the insured. On the other hand, in an agency relation, the principal is responsible only economically, not personally, for the economic dealings of the agent, provided the agent does not transgress his agreed upon or customarily well understood rights. In a universal partnership (mufawadha), either party is responsible for the other. That is, each party is equally responsible for an economic deal contracted with a third party, whether by either of them separately or by both of them together. In other words, a liability of universal partnership (mufawadha) towards a third party can be claimed by the third party from either of them even if the liability was incurred by one of them separately. Similarly, a claim of universal partnership due to a third party can be claimed by either of them from the third party even if the claim was contracted by one of them separately. In this partnership, both parties are required to have equal investment and to exercise equal managing rights. Each party has the right to monitor the other on managerial and financial accounts. This is so because if a partner, taking a stand on a new issue not mentioned in the original contract, does not listen to the other partners the other partners may take a counter action in the same capacity as did the first one. Furthermore if mutual trust is damaged for any reason, each party has the right to leave the partnership by allowing appropriate time to the others so that none of them

42

suffers any losses because of hasty liquidation of the underlying business. Before termination of their business relation, each partners has to show complete accounts to the others, which can be interpreted as each partner having the right to monitor accounts of the partnership. This kind of partnership is used mostly among family members.

Agency Relation (wakala) in a Limited Partnership (inan): In a limited partnership, each partner has managing rights proportional to his investment in the partnership but he can transfer some of his rights to another partner at the time of contract. A third party that has some liabilities due to a limited partnership can claim those liabilities only from the partner who contracted with the third party, though the partner himself has recourse to the other partners. Similarly, any claims of partnership due to a third party can be claimed only by that partner who contracted the deal with the third party. In case of disagreement on a new issue, a dissenting partner can offset partially or fully the action of others. However, as per agency relation and by giving notice to leave the partnership, either one has the right to see complete accounts of the partnership. Thus it can be generalized that a partner may have limited rights to monitor another partner in managerial assignments but has full rights to monitor financial accounts maintained by the other.

2.9.4 Riba in Hadith

This riba has never been very clear to Muslims. The Prophet Muhammad prohibited exchange of six things: gold, silver, wheat, barley, dates, and salt-unless it is a 43

spot exchange and in the case of different varieties of any one of these commodities, the quantity or measure of exchanged varieties is also equal. However, in the case of different commodities, say gold with silver, exchange of unequal quantities is allowed but the restriction of exchange at hand remains. It is not permitted to exchange equal or unequal quantities of the same variety, or different varieties of the same commodity, or different commodities when the delivery of one quantity comes a significant time after the delivery of the other. In simple words, the Prophet Muhammad prohibited two things: (a) the barter exchange of unequal quantities of different varieties of the same commodity on spot, and (b) the barter exchange of any two commodities with deferment.

Some early jurists confine this prohibition only to those six commodities which were mentioned by the Prophet Muhammad, but a majority of them extends this prohibition to all commodities which have similar characteristics; that is, they are measurable or they are essential foodstuffs like wheat, barley, dates, and salt, or they are a common store of value, like gold and silver at that time. However, such generalization contradicts another saying of the Prophet Muhammad, in which he himself directed an exchange of one camel of one kind with two camels of another kind, with deferment. Without being able to give any rationale for this tradition of the Prophet, it is treated by majority of jurists as a special case. Furthermore, a companion of the Prophet, Muawia, once exchanged a vessel of gold with gold coins, probably different in weight, on the spot. Some other companions of the Prophet objected to this deal, but Muawia did not revoke it, commenting that it did not contradict the famous saying mentioned above.

44

If, instead of measurability of a commodity or its being an essential foodstuff or an essential way to store value, as proposed by early jurists, the underlying reason (illa) for prohibiting exchange of six commodities with deferment is considered to be the obscurity of the object of a time related deal, as happens in mudharaba and partnership too, apparent contradictions between this Hadith and the other Hadith of the Prophet Muhammad can be removed. Furthermore, considering both sayings of the Prophet Muhammad and the exchange deal of Muawia at the same time, the following standard rules can be derived for universal application.

2.10 The Basic Points of Difference between Money and Commodity

(a)

Money has no intrinsic utility. It cannot be utilized in direct fulfillment of human needs. It can only be used for acquiring some goods or services. A commodity, on the other hand, has intrinsic utility and can be utilized directly without exchanging it for some other thing.

(b)

Commodities can be of different qualities while money has no quality except that it is a measure of value or a medium of exchange. Therefore, all the units of money of the same denomination, are hundred per cent equal to each other. An old and dirty note of SR.100 has the same value as a brand new note of SR.100.

(c)

In commodities, the transactions of sale and purchase are effected on an identified particular commodity. If A has purchased a particular car by pin-pointing it, and 45

seller has agreed, he deserves to receive the same car. The seller cannot compel him to take the delivery of another car, though of the same type or quality.

Money, on the contrary, cannot be pin-pointed in a transaction of exchange. If A has purchased a commodity from B by showing him a particular note of SR.100 he can still pay him another note of the same denomination.

Based on these basic differences, Islamic Shar'iah has treated money differently from commodities, especially on two scores:

Firstly, money (of the same denomination) is not held to be the subject-matter of trade, like other commodities. Its use has been restricted to its basic purpose i.e. to act as a medium of exchange and a measure of value.

Secondly, if for exceptional reasons, money has to be exchanged for money or it is borrowed, the payment on both sides must be equal, so that it is not used for the purpose it is not meant for i.e. trade in money itself.

In short, money is treated as "potential" capital. It becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes the time value of money, but only when it acts as capital, not when it is "potential" capital.

46

It is pertinent to quote herein the following, which vindicate the Islamic viewpoint concerning the nature of money:

During the horrible depression of 1930s, an "Economic Crisis Committee" was formed by Southampton Chamber of Commerce in January 1933. The Committee consisted of ten members headed by Mr. E. Dennis Mundy. In its report the committee had discussed the root causes of the calamitous depression in national and international trade and had suggested different measures to overcome the problem. After discussing the pitfalls of the existing financial system, one of the committee's recommendations was that: "In order to ensure that money performs its true function of operating as a means of exchange and distribution, it is desirable that it should cease to be traded as a commodity."

James Robertson observes in his latest work, Transforming Economic Life in the following words:

"Today's money and finance system is unfair, ecologically destructive and economically inefficient. The money-must-grow imperative drives production (and thus consumption) to higher than necessary levels. It skews economic effort towards money out of money, and against providing real services and goods (It also results in a massive world-wide diversion of effort away from providing useful goods and services, into making money out of money. At least 95% of the billions of dollars transferred daily 47

around the world are for purely financial transactions, unlinked to transactions in the real economy" (The following text has been excerpted from the historic Judgment passed by the Supreme Court of Pakistan in Ramadhan 1420 H., upholding the Prohibition of Interest. The full judgment of the court ran into 1100 pages. The part from which the excerpts have been taken was written by Justice Mohammed Taqi Usmani).

2.11 Commercial Banks or Conventional Banks (Fredric Mishkin)

Despite the classical origin, banking in its modern form and structure started in British when many of the Lombardy merchants came to England and settled here. They were so resourceful that even the kings had to depend on them for loans despite the fact that the church was firmly against usury. They dealt with not only keeping the money safe but also changing money for travelers etc.

Consequently this business was taken over by the goldsmiths, who up to that time, were dealing only in gold & silver.

Over a period of time, these goldsmiths discovered that large sums of money were left in their custody for long periods therefore, they started the use of this cash to advance loans to others persons for a fixed period of time & at high rate of interest. Thus began

48

the issue and deposit banking of modern times up to non, this institution, bank became the need of the time and it provides so many functions for the economic activities of any country.

2.11.1 Objectives of commercial banking

Main objectives of commercial banks are as follows; earning profit, that is the main purpose of banks. For this purpose the bank charges very high rate of interest in it businesses.

With this main objective, the bank has to full fill some other commitments also e.g.

Issuing new currency

Providing loans to businesses

Operate for the stability of economy

Benefited their major clients who pay more interest.

And providing a set of services like check clearing, record keeping, credit analysis and soon.

49

2.11.2 Function of commercial banking

As we already know that how banks performs their I) primary and ii) secondary functions. Hove the most important point is to make clear how these banks operates. To understand how a bank operates, first we need to examine its Balance Sheet a list of the banks assets and liabilities, i.e.

Total assets

total liabilities + capital this sheet lists sources of bank

funds (liabilities) and uses to which they are put (assets).

a) Liabilities

A bank acquires funds by issuing (selling) liabilities. These funds are used to purchase income earning assets.

b) Bank Capital

It is a banks net worth, which equals the difference between total assets and liabilities it is a cushion against a drop in the value of its assets, falls below its liabilities, meaning that the bank is bankrupt.

c) Assets

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Accepting Deposits

Bank assets are referred to as else of funds and the interest payments earned on them are what enable, banks to make profit.

In general terms the basic operation of a bank is that it makes profits by selling liabilities with one set of characteristics (a particular combination of liquidity, risk and return) and using the proceeds to buy assets with a different set of characteristic this process is often referred to as asset transformation.

A COMMERCIAL BANK GENERALLY PERFORMS THESE FUNCTIONS

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Saving Accounts Current Account Fixed Advancing of Loans exchange Purchasing bonds and securities Discounting bill of opening a loan accountover drafting By Deposit

Transference of money

Creation of safest medium of exchange

Agency services

52

General utility services

Financing of foreign trade

These functions are briefly discussed as under:

1.

Accepting deposits

Main function of commercial banks is to receive surplus balances of the individuals, public institutions and households there are three types of accounts in which it receives deposits i.e. current account consist of those deposits that can be drawn at any time. Bank do not pay interest money can be drawn with out notice.

Fixed deposits are repayable after the contracted period. High rate of interest is allowed at there deposits.

In saving account, it is the responsibility of the bank to repay deposit on demand up to a certain limit. Further withdrawal needs permission from bank.

2.

Advancing of loans

Bank advances loans against securities at certain fixed rate of interest. It takes none interest from people on loans and gives low to depositors. And the difference

53

between these two is the profit of the bank.

Bank gives loans by opening new account it do not gives money in cash form same time for reliable customers, bank with draw money by over drafting their accounts i.e. withdraw money none than amount saved in the account.

Bank may also give out loans against bills of exchange presented before it upon which these bills are discounted at their market work.

Same times it purchases bonds and securities in the stock market. For record of transaction the bank then requires who sold shares to open account in the bank.

3.

Transference of money

The bank also transfers the money internally and externally for different purposes.

4.

Creation of safest medium of exchange

It creates safe medium of exchange by means of cheque, because it represents very high value with one not etc.

5.

Agency services to customers

54

It may act as an agent by collecting and paying money on cheques for its customers.

6.

Utility services

It also provides services like locker services foreign exchange business etc.

7.

Financing of foreign trade

It provides incentives to be involved in the export business by lowering interest rate on loan for this business.

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Now some theories and researchers work is reviewed which shows that interest is the basic cause of business cycles which further help in proving that interest based banking is more cyclical in nature or in other words that Islamic banking is less cyclical in nature.

Extractions of articles from different scholars and researchers work:

2.12 Concerns with Financial Stability (Abbas Mirakhor & Mohsin Khan, 1986)

For a number of reasons Islamic finance has become relevant for the stability of

56

the global financial system. Financial stability is an important prerequisite for sustained economic growth and social development. Experiences of past financial crises show that economic progress achieved over several years can be significantly reversed during a very short period of time. The international financial system has been experiencing recurring crises over the last two decades. As a result, there have been large losses in gross domestic product of the countries concerned with a serious adverse implication for the stability and growth of the world economy.

In response to these crises, the international financial community has reiterated the need to strengthen financial institutions by appropriate measures including effective regulation and supervision, better corporate governance, risk management and enhanced disclosures and transparency so that the crises can be prevented from occurring and they can be managed efficiently if they happen.

The implication of Islamic finance for stability of Islamic financial markets has some special considerations. First, investment deposits of Islamic banks are based on risk sharing and the financing extended by the Islamic financial institutions is asset-based. For this reason, Islamic finance has inherent positive implications for financial stability. Second, the practices of the Islamic principles of finance have taken a number of forms. Some Muslim countries have made an endeavor to implement the Islamic principles economy-wide. A number of countries have allowed establishment of Islamic financial institutions side by side with conventional institutions. Some other countries have

57

allowed their traditional financial institutions to write Islamic banking contracts as well. As a result, Islamic banking and finance has become important for the stability of financial systems in several countries.

Finally, the infrastructure of the Islamic financial system is in the evolutionary process. Hence despite the fact that the industry is fully regulated and supervised, there could be unwarranted misconceptions in some circles due to the lack of familiarity with the industry. Due to the requirements for financial transactions to comply with the Shari'ah, some risks of the Islamic financial contracts are unique. The Islamic financial industry can be strengthened by suitably adapting the international standards to its unique risk characteristics. In its part, the inherent features of the Islamic financial industry can contribute to strengthening the global financial architecture provided the basic supportive infrastructure is established.

2.13 Causes of Financial Instability (Abbas Mirakhor & Mohsin Khan, 1986)

Various causes of financial crises can be identified depending on the specific situations and circumstances in which the crises might have occurred. Some common causes of financial crises are:

(a)

Lack of proper regulation and supervision

58

Due to lack of proper regulation and supervision, in several developing countries financial institutions are not properly capitalized, loan loss provisions are not prudentially maintained, there are large amounts of imprudent connected lending, transparency and disclosure standards are low, risk management and internal control systems are weak, and the public sector's influence is large. As a result, financial institutions at times are not able to absorb even small shocks from internal or external sources.

(b)

Non-compliance with standards

For a sound financial system, compliance with the international standards on the part of governments as well as public and private sector institutions is extremely important. Noncompliance by public and private sector institutions with the best practice standards in financial reporting, accounting, auditing, transparency and disclosures make financial systems vulnerable to instabilities.

(c)

Currency crises

As a result of an unrealistic exchange rate regime or excessive speculation, the exchange rate of a currency may depreciate below normal levels. Consequently, the value of financial assets/liabilities held in foreign currency will appreciate and the value of those held in local currency will depreciate. Since in the developing countries there is always a scarcity of foreign exchange, a currency mismatch 59

leads to banking and payments crises and creates contagion effects.

(d)

Maturity mismatch

Maturity mismatch between short-term liabilities and short-term assets of the public and private sectors is also known to be an important cause of financial crises. If short-term foreign exchange liabilities are high as compared to the availability of liquid foreign exchange assets, foreign contractual obligations cannot be met in time, causing a larger financial crisis.

(e)

Moral hazard

Considerable part of financial instability is attributed to deposit insurance schemes and to not allowing inefficient financial institutions to fail. As a result of such policies, some financial institutions are motivated to practice imprudent policies, which weaken the overall state of the financial system. Several other causes of financial crises can be cited depending on the circumstances of their occurrences. It can be seen that the interest- mechanism is central to most of these causes. As mentioned above the fast movement of short-term interest-based funds is an important cause of financial instability. Furthermore, high leverage and expansion of credit without any linkage to the real sector of the economy also contributes to instability. Interest based credit finances undesirable speculative activities in stock, commodity and foreign exchange markets. Interest-based funds 60

also dilute the capital of banks and weaken their potential to overcome the crisis when it arises. Hence if the interest mechanism is avoided, the major cause of financial crises may be contained.

2.14 Overall Effects of Interest

(Text from Historic judgment on interest given by supreme court of Pakistan)

Section Written by Justice Muhammad Taqi Usmani

Interest-based loans have a persistent tendency in favor of the rich and against the interests of the common people. It carries adverse effects on production and allocation of resources as well as on distribution of wealth. Some of these effects are the following:

(a)

Evil effects on allocation of resources

Loans in the present banking system are advanced mainly to those who, on the strength of their wealth, can offer satisfactory collateral. Dr. M, Umar Chapra (Senior Economic Advisor to Saudi Arabian Monetary Agency) who appeared in this case as a juris-consult has summarized the effects of this practice in the following words:

Credit, therefore, tends to go to those who, according to Lester Thurow, are

61

lucky rather than smart or meritocratic. The banking system thus tends to reinforce the unequal distribution of capital. Even Morgen Guarantee Trust Company, sixth largest bank in the U.S. has admitted that the banking system has failed to finance either maturing smaller companies or venture capitalist and though awash with funds, is not encouraged to deliver competitively priced funding to any but the largest, most cash-rich companies. Hence, while deposits come from a broader cross-section of the population, their benefit goes mainly to the rich (Dr. Chapras written statement under the caption Why has Islam prohibited Interest?).

The veracity of this statement can be confirmed by the fact that according to the statistics issued by the State Bank of Pakistan in September 1999, 9269 account holders out of 2,184,417 (only 0.4243% of total account holders) have utilized Rs.438.67 billion which is 64.5% of total advances as of end December 1998.

(b)

Evil effects on production

Since in an interest-based system funds are provided on the basis of strong collateral and the end-use of the funds does not constitute the main criterion for financing, it encourages people to live beyond their means. The rich people do not borrow for productive projects only, but also for conspicuous consumption. Similarly, governments borrow money not only for genuine development programs, but also for their lavish expenditure and for projects motivated by their 62

political ambitions rather than being based on sound economic assessment. Nonproject-related borrowings, which were possible only in an interest-based system have thus helped in nothing but increasing the size of our debts to a horrible extent. According to the budget of 1998/99 in our country 46 percent of the total government spending is devoted to debt-servicing, while only 18% is allocated for development which includes education, health and infrastructure.

(c)

Evil effects on distribution

When business is financed on the basis of interest, it may bring injustice either to the borrower if he suffers a loss, or to the financier if the debtor earns huge profits. Although both situations are equally possible in an interest-based system, and there are many examples where the payment of interest has brought total ruin to the small traders, yet in our present banking system, the injustice brought to the financier is more pronounced and much more disturbing to the equitable distribution of wealth.

In the context of modern capitalist system, it is the banks which advance depositors money to the industrialists and traders. Almost all the giant business ventures are mostly financed by the banks and financial institutions. In numerous cases the funds deployed by the big entrepreneurs from their own pocket are much less than the funds borrowed by them from the common people through banks and financial institutions. If the entrepreneurs having only ten million of 63

their own acquire 90 million from the banks and embark on a huge profitable enterprise, it means that 90% of the projects is created by the money of the depositors while only 10% was generated by their own capital. If these huge projects bring enormous profits, only a small proportion (of interest which normally ranges between 2% to 10% in different countries) will go to the depositors whose input in the projects was 90% while all the rest will be secured by the big entrepreneurs whose real contribution to the projects was not more than 10%. Even this small proportion given to the depositors is taken back by these big entrepreneurs, because all the interest paid by them is included in the cost of their production and comes back to them through the increased prices. The net result in this case is that all the profits of the big enterprises is earned by the persons whose own financial input does not exceed 10% of the total investment, while the people whose financial contribution was as high as 90% get nothing in real terms, because the amount of interest given to them is often repaid by them through the increased prices of the products, and therefore, in a number of cases the return received by them becomes negative in real terms.

While this phenomenon is coupled with the fact, already mentioned, that 64.5% of total advances went only to 0.4243% of total account holders, it means that the profits generated mostly by the money of millions of people went almost exclusively to 9,269 borrowers. One can imagine how far the interest-based borrowings have contributed to the horrible inequalities found in our system of

64

distribution, and how great is the injustice brought by the modern commercial interest to the whole society as compared to the interest charged on the old consumption loans that affected only some individuals.

(d)

Expansion of artificial money and inflation

Since interest-bearing loans have no specific relation with actual production, and the financier, after securing a strong collateral, normally has no concern how the funds are used by the borrower, the money supply effected through banks and financial institutions has no nexus with the goods and services actually produced on the ground. It creates a serious mismatch between the supply of money and the production of goods and services. This is obviously one of the basic factors that create or fuel inflation.

2.15 The Viability of Islamic Finance (Nejatullah Siddiqi)

It has been demonstrated that all market activities can be financed by using the various Islamic modes, such as musharaka, mudaraba, murabaha, Salam, istisnac, and ijara. No stratagems are needed. The author has argued that interest-free Islamic modes of finance can replace the conventional interest based finance with certain added advantages. By synchronizing entrepreneurial payment obligations and accrual of revenues, sharing-based modes of finance remove a major source of instability from freely functioning markets. Also by linking financial intermediaries' returns to the actual 65

revenue of the fund users, allocation of funds to invest is redirected to projects expected to produce more value than their alternatives.

Even though the predominance of non-sharing modes of finance in the current practice of Islamic banking dilutes these advantages, the Islamic system would score far better than any system that permits exchange of more money for less money. Part of the reason is the vast opportunities of exchange that this permission opens bypassing the real economy which is focused on exchange of goods and services with one another, money serving as a means of such exchange. Exchange of money for money degenerates into a game of chance in which people indulge to try their luck, little benefit flowing to the production of goods and services which exchange is supposed to promote. Prohibition of interest is directed at restoring money to its essential functions, which certainly do not include a means for gambling.

2.16 Hopes for the Future of Islamic Finance (Dr. Abbas Mirakhor)

By 1983-84, when Iran, Pakistan. and Sudan declared that they would adopt a system-wide Islamic banking and finance, the challenge was to show that such a system was first theoretically and analytically a viable financial system; second, it had to be shown that such a system was empirically workable as a whole and financially viable for each of its parts, meaning Islamic banks and financial institutions.

By 1988, this challenge was met when research, using modern analytic financial 66

and economic theory, showed that:

A modern financial system can be designed without the need for an ex ante determined positive nominal fixed interest rate. [In fact, it had been shown by western researchers that there was no satisfactory theory that could explain the existence of a positive nominal ex ante interest rate].

Moreover, it was shown that not assuming a nominal fixed ex ante positive interest rate, i.e, no debt contract, did not necessarily mean that there would have to be zero return to capital.

The basic proposition of Islamic finance was that the return to capital would be determined ex post, and that the magnitude of return to capital was determined on the basis of the return to the economic activity in which the funds were employed.

It was that expected return which determined investment.

It was also the expected rate of return, and income, which determined savings. Therefore, there is no justification for assuming that in such a system there would be no savings and investment.

It was shown that in such a system there would be positive growth.

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That monetary policy in such a system would function as in the conventional system, its efficiency depending on the availability of instruments which could be designed to manage liquidity.

Finally, it was shown that, in an open-economy macroeconomic model without an ex ante fixed interest, but with returns to investment determined ex post, there was no justification to assume that there would be a one-way capital flight.

Therefore, the system which prohibited a fixed ex ante interest rate and allowed the rate of return to capital to be determined ex post, based on the returns to the economic activity in which the funds were employed, was theoretically viable.

In the process of demonstrating the analytic viability of such a system, research also clearly differentiated it from the conventional system. In the conventional system, based on debt contracts, risks and rewards were shared asymmetrically with the debtor carrying the greatest part of the risk, and with governments enforcing the contract. Such a system had a built-in incentive structure that promoted moral hazard and asymmetric information requiring close monitoring whose costs could be managed if monitoring could be delegated to an institution which could act on behalf of the collectivity of depositor/investor: hence the reason for existence of banking institutions.

In the late 1970s - early 1980s, it was shown, mostly by Minsky, that such a 68

system was inherently prone to instability because there would always be maturity mismatch between liabilities (short-term deposits) and assets (investment-long-term). Because the nominal values of liabilities were guaranteed, but not the nominal value of assets, when the maturity mismatch became a problem, the banks would go into a liability management mode by offering higher interest rates to attract more deposits. There was always the possibility that this process could not be sustained resulting in erosion in confidence and bank runs. Such a system, therefore, needed a lender of last resort and bankruptcy procedures, restructuring processes, and debt workout procedures to mitigate contagion.

During 1950s - 60s. Lloyd Metzler of the University of Chicago had proposed an alternative system in which contracts were based on equity rather than debt, and in which there was no guarantee of nominal values of liability since these were tied to the nominal values of assets. Metzler showed that such a system did not have the instability characteristics of the conventional banking system. In 1985, in his now classic article in the IMF staff papers, Mohsin Khan, showed the affinity of Metzlers model to Islamic finance. Using Metzler's basic model, Mohsin Khan demonstrated that this system produces a saddle point and is, therefore, more stable than the conventional system.

By early 1990s, it was clear that an Islamic financial system was not only theoretically viable, but had desirable characteristics that rendered it superior to a debtbased conventional system. The phenomenon growth of Islamic finance during the

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decade of 1990s, demonstrated the empirical and practical viability of the system.

2.17 Debt-Deflation Theory

Fisher (1933) propounded a very concise and mechanical sequence of events that take place quite systematically over every business cycle. Each business cycle starts with over indebtedness that happens to occur mainly because of the common psychology of the business community that there exist new opportunities to invest at a big prospective profit together with the capability of financial community to provide easy money.

Under this state of over indebtedness, at some point in time, a mild gloom or a little shock to confidence might trigger liquidation of outstanding debt, which means the start of a vicious chain of events: distress selling, contraction of deposit currency, a fall in the level of prices, a still greater fall in the net worth of business, precipitating bankruptcies, a fall in profits, a reduction in output, in trade, and in employment of labor, pessimism and loss of confidence, hoarding and slowing down still more the velocity of circulation, and finally an increase in the real but a decrease in the nominal rates of interest.

Even though Fisher mentioned that expectations of big profits and availability of easy money to borrowers are equally responsible for over indebtedness, his interpretation of the exchange equation, and the following quotes from the same article, force us to conclude that he blamed a tight monetary policy more than a decrease in profits for the 70

onset and continuation of business contractions.

In the great booms and depressions, each of the above named factors has played a subordinate role as compared with two dominant factors, namely over indebtedness to start with and deflation following soon after. (Italics in original)

General over production, as popularly imagines, has never, so far as I can discover, been a chief cause of great disequilibrium. The reason, or a reason, for the common notion of over production is mistaking too little money for too much goods.

All the fluctuations listed in the above chain of events except debt and real interest on debt come about through a fall of prices. (Italics in original)

If the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflecting the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then 71

maintaining that level unchanged, And In order to have avoided depressions, the gold standards would have had to be abandoned or modified (by devaluation).

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2.18 Financial Instability Hypothesis

The financial instability hypothesis is an interpretation of the substance of Keyness General Theory because its interpretation holds that in The General Theory Keynes set out the foundations of an investment theory of business cycles and a financial theory of investment for capitalist economies. This hypothesis explains that the behavior of our economy depends upon the pace of investment because investment determines both aggregate demand and the viability of debt structures. Minsky further explains that the pace of current investment depends upon the subjective nature of expectations about future course of investment, as well as the subjective determination by bankers and their business clients of the appropriate liability structure for the financing of positions in different types of capital assets. Why do lending and borrowing tend toward over indebtedness? Minsky answers that as the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. As a result, the acceptable amount of debt to use in financing various types of activity and positions increases. Therefore, a financial system evolves from being robust to being fragile prone to crisis over a period in which economy does well. Thus, the assertion of this hypothesis is that the financial structure is a cause of both the adaptability and the instability of capitalism.

Though Minsky (1994) criticizes Fisher fro failing to explain how over

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indebtedness develops and claims that the financial instability hypothesis is a theory of the impact of debt on system behavior and also incorporates the manner in which debt is validated, he does not give any explicit reasons why debt is preferred, at all, over equity. However, diving into the vast body of literature produced by Minsky on the same subject, one can find four main reasons which justify more debt than equity.

1.

Robust financial structures with which an economy emerges from a recession that follows a financial crisis induce more debt than equity. This argument seems to be the same what Bernanke and Campbell (1988) call a risk-sharing argument to favor more debt at initial stages of an expansion path or what Dymsky and Pollin (1992) call the fallacy of composition.

2.

Financial intermediaries that have more expertise regarding project appraisal than individuals that have large pools of deposits from individual households, and that also have enough seigniorage power of creating inside money are legally bound to lend rather than to buy stocks. This institutional reality gears the system towards debt financing. Furthermore, a staggering number of government securities, and the existence of deeper and more resilient capital markets for these securities than for any other financial instrument, provide an open opportunity to even a novice investor to get involved in debt financing. The current rate of interest on government securities stands as the reference point for minimum acceptable rate of return on any stock. If emitters of a

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given stock cannot promise or fail to provide at least this riskless rate, investors would simply pull out their funds from the given stock and buy government securities. Perhaps for these reasons Minsky, following the lead of Keynes, assumes all economic units to be money in and money out units. It means that even individual investors who are traditionally net lenders to other sectors of an economy are assumed to be borrowing from banks in order to buy common stock.

3.

Every investment project that has a long gestation period warrants debt financing. The reason is that common investors who can earn positive returns from alternative investment opportunities would not be willing to buy stock at the start up time of a project when no dividends are expected. At least, they can earn a riskless rate of return on Treasuries over the gestation period and then can exchange them for the stock of the very project if it really promises higher return.

4.

Government insurance provided directly to depositors and financial institutions and the system of interventions and regulations that are designed to keep the economy operating within reasonable bounds induce more risk taking and thus debt financing than otherwise. Dymski and Pollin name this phenomenon an asymmetric reward structure; that is, the benefits of debt are personalized but its costs are socialized.

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Without making a formal set of assumptions, Minsky starts with a common setting.

Planning an investment project involves two sets of interlocking decisions. One set deals with revenues expected from using the capital assets in production and the cost of the investment. The second set deals with financing the capital a decision to acquire capital assets is, basically, a decision to put out liabilities.

Regarding the first element in the first set of decisions, Minsky adopts a heroic assumption from Kalecki that the structure of aggregate demand (particularly investment demand) determines profits [not the other way round] and thus rules out any direct role for expected profits to play in the determination of current investment. Next the cost of financing the production of investment is a cost that enters the supply price of output just like the costs of labor and purchased inputs. The fact that a firm has to borrow to pay wages and to buy other inputs before the underlying investment generates any revenues, makes short term interest rates to be the most important component of the cost of capital.

Regarding the first element in the second set of decisions, a decision to acquire a capital asset, it depends upon three things, the market or demand price of an equivalent existing asset, lenders and borrowers risk, and the supply price or replacement cost of the asset. The first and last elements are objectively measurable and set the range for the middle one, the effective demand price for the asset that is a purely subjective concept. Both borrowers and lenders want protection, and the demand of protection by borrowers 76

lowers the demand price for capital assets and by lenders raises the supply price of investment output. Successful operation of similar existing projects and the economy at large over an extended period, possession of liquid assets like Treasuries that are not directly used in the production process, and proliferation of refinancing possibilities (or depth and resilience of secondary capital markets) reduce borrowers risk, whereas fewer defaults on similar existing projects in the past, lower probability of any further regulatory restrictions, higher probability of lender of last resort action, more possibilities of innovating new financial instruments and coining new techniques of liability management by lending institutions, and, most importantly, positive growth expectations of lenders about the borrowing corporation, all reduce lenders risk.

The last decision concerns how a desired level of investment is to be financed. There are three types of financing of positions in assets that can be identified in the financial structure of our economy: hedge, speculative, and Ponzi finance. Hedge financing units expect the cash flow from operating capital assets to be more than sufficient to meet contractual payment commitments now and in the future. Speculative financing units expect the cash flows to be sufficient to pay interest but insufficient to pay any part of principal in some, typically near term, periods. Usually speculative finance involves the short financing of long positions. Consequently, a speculative unit has to roll over its debt periodically for its survival. Ponzi financing units are similar to speculative financing units except that their expected cash receipts are insufficient even to pay interest, let alone payments principal. A Ponzi unit has to roll over its existing debt

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and has to borrow further to capitalize its interest payments. Its total debt goes on increasing.

The choice among these three financing structures depends upon the memories of a previous financial crisis and upon the working of the economy in the recent past. As long as reverses of previous financial catastrophe remain fresh, both lenders and borrowers stick to hedge financing. But when the economy does better for a while, financial innovations take place that generate demand in excess of that allowed for by the existing tranquil state. Furthermore, when hedge financing is the dominant posture the interest rate structure offers inducements to increase indebtedness and increase the proportion of short term financing that require the rolling over of outstanding debts. In other words, speculative and Ponzi financing become a way of life and two margins of safety, liquid assets in portfolios and the excess of the PV of the expected quasi-rents from the project over the full cost of its completion, decrease. As a result, the demand for borrowing becomes inelastic that pushes up interest rates and pulls down ratings of highly indebted firms. This does not happen accidentally or due to any colorful personalities. Financial innovations are the key factor in capitalist development that reflects the profit maximization attitude of financial institutions rather then mere channelization of savings from depositors to corporations.

The last stage of the FIH is that after rise in interest rates because of inelastic demand for borrowing, and downgrading of highly indebted corporations because of the

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erosion of their margins of safety, the revaluation of risks by rational lenders demands imposition of constraints on further lending and, in extreme cases, even on rolling over of existing debt. This works like a self fulfilling prophecy, in that the cost of borrowing further increases and thus aggravates the already gloomy prospects for highly indebted corporations.

However, Minsky is quite clear that if there is regulatory backing, direct or indirect, to defaulting institutions, or there exist deep secondary capital markets where currently weak financial instruments can be exchanged with strong ones without much capital loss, then an ensuing financial panic and economic recession can be postponed for the time being even though it may cause more fragility in the future.

To conclude, the most critical element in both sets of decisions is the determination of an effective demand price of investment goods that incorporates borrowers as well as lenders risk. Out of these two risks, lenders risk plays the dominant role because for a project on the table, businessmen [borrowers] interpret the numbers and the expectations as enthusiasts, bankers as skeptics.

The beauty of Minskys argument is that without assuming information asymmetry (as do Bernanke and Gertler 1989 and 1990, and Gertler 1988), policy pitfalls (as do monetarists and mainstream Keynesian), decreasing profits or other real sector or exogenous shocks (as do Marx, Veblen, and Wolfson), it shows how an economy moves indigenously from a robust to a fragile system. The driving force for this transition seems 79

to be lenders risk or lenders expectations about the growth rate of the borrowing corporation. As long as it is positive, effective demand price of capital assets remains higher than the supply price of these assets. On the other hand, when expected growth becomes zero or negative, then not only does new investment come to a halt, but some of the existing investment financed on speculative and Ponzi bases is liquidated; because its net worth that was previously based on constant interest costs and expected escalation of asset prices is significantly reduced.

However, Minsky does not take any clear stand on the efficiency of secondary capital markets or on liquidity of financial assets in formation of his FIH. In general, he considers capital markets to be an efficient and useful component of capitalist finance but he occasionally blames them too for the onset of financial fragility, as is clear from the two quite different statements that follow.

The securities and exchange legislation may well be one of the most successful reform efforts of the New Deal era; without it, todays market oriented financial system would not be feasible (Minsky 1994).

The way markets price capital and financial assets reflects an heroic assumption that the unknowable can be known But once the randomness associated with uncertainty becomes manifest, the values sustained by this financial strategy become inappropriate. Then the necessity to adjust portfolios in a world which does not conform to expectations is likely to lead to the collapse of asset values (Minsky 1992). 80

Minskys omission of liquidity of financial assets from the core of his analysis becomes more telling if we consider his claim to have captured the substance of General Theory, along with what Keynes himself wrote in Book IV of General Theory.

Decisions to invest in private business of the old-fashioned type were, however, decisions largely irrevocable, not only for the community as a whole, but also for the individual. With the separation between ownership and management which prevails to day and with development of organized liquidity providing investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes adds greatly to the instability of the system.

2.19 Solvency Vs Liquidity

This theory bridges the gap between the mainstream view of assuming smooth functioning of financial markets, and Minskys tendency to put all the burden of investment fluctuations on the innovatory nature of financial markets. The argument is that while debt financing has some advantages over equity financing, it nevertheless involves the problem of informational asymmetry: a borrower has personalized information about the future of the underlying project that a lender cannot access without incurring significant costs. However, the net worth of borrowers can remedy this problem a great deal. Therefore, any level of debt that is contracted after securing a collateral and assuring the significant initial net worth of a borrower should not be worrisome.

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However, consequent upon exogenous shocks, a highly indebted corporation may face liquidity problems. In such a case, a subsidized lending or redistribution towards illiquid but otherwise solvent debtors can rebuild their net worth and solve the problem.

Thus, in contrast to the Arrow Debreu world underlying the Modigliani Miller theorem, in which only money mattes, this theory introduces credit, a broader concept than any measure of money supply, as the policy variable. But in contrast to Minskys FIH, this theory does not deem evolving financial relations to be the key to policy considerations. Furthermore, this theory does not support any direct or immediate effect of a liquidity crisis on the current investment and net worth of borrowers, rather a liquidity crisis, if not contained by a timely intervention policy, finds its way through multiplier and accelerator channels or through the so-called reverse wealth effect, that is, first a decrease in consumption and aggregate demand and then a decrease in effective demand.

2.20 A Business Cycle Model of Financial Crises

After reviewing various theories of financial crises by earlier and contemporary economists, Wolfson has developed his own theory: a business cycle model of financial crises. Without mentioning any specific reasons for the preference of debt over equity, the starting point of this model is the expansion phase of a business cycle, when there is increasing reliance on debt financing such that gradually ratios of short to long run debt,

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sequential to prior financing and unsecured to secured debt, increase. On the other hand, with time, actual profits do not keep pace with profit expectations that were formed at the time of contracting debt. Therefore, near the peak of a business those were formed at the time of contracting debt. Therefore, near the peak of a business cycle, corporations develop inelastic demand for more debt to service their existing debt and to meet their other committed payments. Banks, as lenders of last resort to corporate managers, try to accommodate increased demand for debt of their worthy and long time clients by cutting down business loans to new borrowers and by slashing their non-business loans. Banks also augment their sources by purchasing costly and volatile funds in money markets. As a result in this rather fragile and delicately poised situation, an unexpected event can cause a disruption. The surprise event could be a sudden application of an institutional constraint or an abrupt feeling of insecurity by lenders about their already loaned funds.

This model combines the main features of three different theories. One, in attributing to financial forces an important role in causing financial fragility it acknowledges the intellectual lead of Minsky, who claims that financial relations are main determinants of economic fluctuations. Two, the model also acknowledges the wisdom of earlier economists (for example, Marx, Veblen, Mitchell, Kaldor, Robinson, and Sraffa) who, without adopting the heroic assumption of profits equal investment, argue that current profits significantly affect the current demand for investment. Three, the model also incorporates, to some extent, the solvency vs liquidity thesis as it assumes that voluntary along with involuntary demand for further borrowing continues, unless

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banks initially oriented to accommodating this increase demand for further borrowing themselves face liquidity problems and thus become a target of bankruptcies prior to their clients, borrowing corporations, as mentioned by Bernanke and Campbell (1988). Furthermore, Wolfson shows how both possibilities regulatory restrictions (most favored by mainstream economists like Fisher and Bernanke) and sudden fear of lenders (most favored by Minsky) can create an unexpected event that can cause turmoil in an already rather fragile and delicately poised situation.

However, the important point of this mode for the purposes of this study is its emphasis on possible wrong expectations for the onset of financial fragility. It states that at the peak of a business cycle the financial condition of the corporate sector deteriorates because debt payment obligations increase at a faster rate than the ability to meet these payments, nor can the eventual occurrence of a surprise event that might disrupt financial relations be discounted.

A common point in all these arguments is that the non-contingent nature of a debt contract has been emphasized as a starting point for financial difficulties. In each theory, when a firm is over indebted there appears a sort of conflict of interests between lenders and borrowers, that is, a point at which borrowers become desperate for further borrowing whereas lenders want or have to liquidate their already loaned funds, let alone countenance further lending.

The common policy proposal is to increase policy intervention, though Fisher and 84

Bernanke favor relatively passive expansionary and lender of last resort type intervention, whereas Minsky favor relatively active regulatory and discount window type intervention.

2.21 Debt versus Equity Financing (Dr. Akacem & Dr. Gilliam)

This paper looks at Islamic banking as a model of equity finance. Debt financing by conventional banks has experienced crises both in the 1930s and more recently in the 1980s with the savings-and-loan (S & L) and banking crises in the United States. Initially the U.S. answer was to institute deposit insurance in order to eliminate or at least minimize bank runs. However, that has caused both banks and S & Ls to assume more risk at the cost of greater taxpayer exposure because they lacked the incentive to be risk averse. The current U.S. banking model of debt finance together with an implicitly unlimited deposit insurance results in the socializing of loss and the privatizing of gain.

While the U.S. banking system represents the debt-finance model, the Japanese financial structure presents an interesting combination of both this model and the Islamic equity-finance structure. The evidence shows that the growth of Japan's economy in the

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postwar period was greatly enhanced by the willingness of its banks to both lend money and assume equity stakes in the country's manufacturing and industrial sector.

2.22 Increased Financial Circulation

A credit created through debt is paid off if the underlying project generates at least enough income to pay off the whole debt, principal plus interest. If the underlying project does not generate this required minimum for any reason, then some arrangement has to be made to settle the remaining debt. This arrangement could be an extension in time to repay the remaining debt, or further lending to pay off the outstanding debt, or an exchange of existing debt instruments with some other kind of financial instruments. In any case, the borrower has to repay the previous debt plus his current debt payments from his future economic endeavors. This accumulation of future prospects of a borrowers, whether for his mistakes or just for his misfortunes in the past, may be burdensome for him and may hamper his economic pursuits as well.

In other words, in debt financing, dealing in outstanding debt as compared to dealing for new debt often becomes necessary, whereas this is not true in case of partnership or mudharba financing. A credit created for partnership or mudharaba is settled at the end of a single venture partnership or mudharaba. There remains no need to negotiate any financial arrangement on the basis of an existing credit, because in both partnership and mudharaba no only the rate of return but also the repayment of the

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original investment or principal are linked to the actual performance of the underlying project.

It is contended here that this dealing in outstanding debt is the starting point for financial circulation, even though many famous economists have pointed to some other reasons for this effect. For example, Merkham (1955) and Veblen (1954) attitude acceleration of financial circulation to financial monopoly on the part of a small group of financial experts, who deliberately increase financial cover of real economic activity for their vested interests. Marx calls it fictitious capital and attributes its birth to price volatility of existing stocks in secondary capital markets. Davidson (1978), along the lines of Keynes, attributes it to institutional biases towards financial capital.

2.23 Modern Commercial Banks Crises

As the modern banking system is interested based but, the economies which are following this system, do audits that the reason of decline in banking industry in the past few decades are, high rates of interest & increase in uncertainty.

For example the past few decades have been good ones for the American banking industry as figure 2.2 shows the importance of commercial banks as source of fund for borrowers has shrunk dramatically from peak of 35% total credit advanced in 1974 to around 22% in the early 1990s. Bank profits as % of GDP has also declined as figure 2.3 shows this trend. 87

% o f B a on fk G P D r o P f i t % T o t a l C r e d it A d v a n c 0e . 7d 4 0
0 . 6

a s

3 0
0 . 5

e r c ia l

n k s

2 0
0 . 4

1 0

0 . 3

0 1 9

6 0

0 . 2

1 9 6 5 Figure 2.2 B
7 0 1 9

1 9

7 01 9

7 51 9

8 01 9

8 5 9 1

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1 9

9 5

0 . 1 0 . 0 1 9

a n
7 5

k
1 9

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1 9 8 5

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9 5

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Figure 2.3 FREDRIC S. MISHKIN has mentioned in his book The Economics of money, banking, and financial markets two very important reason for this declining trend along with some other reasons that are 1. Increase in Interest rates The firms and individuals with the riskiest investment projects are those who are willing to rate go up because of increase in demand, good credit risks are less likely to want to borrow while bad credit risks are still willing to borrow. Because of the resulting increase in to made loan. It will cause decline in investment & aggregate economic activity. 2. Increase in uncertainty

A dramatic increase in uncertainty in financial market, due perhaps to the failure of prominent financial non financial institution leads to decline in lending, investment and business activities.

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2.24 Experiences in Pakistan

Though the constitution of Pakistan envisaged as early as 1949 that the State shall eliminate Riba as early as possible, the process of elimination of interest from the countrys banking system started only in 1977 when the Council of Islamic Ideology was entrusted by the President of Pakistan with the task of preparing a blue print for an interest free economic system. The council was assisted by a panel of countrys well known economists and bankers. This initial juridical groundwork was completed in 1980.

The action plan proposed by the council was a gradual transition causing minimum disruption in existing banking facilities available to the corporate sector and general public of the country. To start with, interest free counters besides conventional ones were opened in all branches of already nationalized banks of the country, and interest based transactions of other three semi autonomous financial institutions, National Investment Trust, House Building Finance Corporation, and Investment Corporation of Pakistan, were reorganized on interest free basis. Finally in 1985 all banks in the country stopped accepting any interest bearing deposits and provided a good part of their finances to their clients through any one mode out of twelve, specified by the State Bank for interest free financing. Though the transition was quite smooth and was mainly in accordance with the recommendations of the council, there ware still many loopholes and problems in the system.

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CHAPTER 3

RESEARCH METHODOLOGY AND DESIGN

The following chapter presents the detail of the research approach adopted, methods and instruments exploited and the techniques used for analysis. First of all the problem is identified. Then related data is collected and then the collected data is analyzed & interpreted and finally conclusions have been made.

3.1

Type of the Study

This study is basically descriptive in nature, and this would explore & review the research done on Islamic banking by different researchers and scholars.

This study would describe mainly what Islamic banking is all about, its instruments, principles, viability, riskyness as compared to conventional banking system, and difference between the two systems.

3.2

Methods of Study

This study utilized the descriptive technique because its main objective is to find out what exists and what is about a certain existing problems. Different theories were

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compared and contrasted with one another to know the causes of existing problem and to get final conclusions.

The information regarding the Islamic banks has been collected from Secondary Data. Different books by famous scholars and researchers are reviewed and most of data is collected from net after the detailed discussion with the supervisor.

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CHAPTER 4

INTERPRETATION AND ANALYSIS OF DATA

Basically in this chapter the collected data is analyzed and interpreted. As this is descriptive research so this section will only give the answers of the research questions given in first chapter in the light of the research done previously in the same area.

The findings of the studies are as follows:

1. What is Islamic banking system with respect to its principles and instruments?

Islamic banking, an alternate to interest based banking is not banking in the traditional sense of the word. It derives its inspirations and guidance from the religious edicts of Islam and has to conduct its operations strictly in accordance with the directives

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of Shariah.

It is, therefore, not merely refraining from interest based transactions but the objective is to make a positive contribution to the fulfillment of socio-economic objectives of the society in all spheres, including trade industry, agriculture, science, technology, employment, benevolent sector and the environment, with special focus on the human factor.

An Islamic bank is a financial and social institution which identifies itself with the principles of Shariah, as laid down by the Holy Qurans and Sunnah, as regards its objectives, principles, practices and operations. An Islamic bank does not normally lend money except the interest-free loan which is termed as Qard Hasan. Islamic bank is a partner in trade, industry and agriculture for production and development financing. This, therefore, implies that an Islamic bank should also share in the risk with the entrepreneur which is in sharp contrast with interest-based bank. Islamic banking implies zero rate of interest but no zero rate of return as Islamic banks do not deal in money but deal with money.

Islamic banks are required to pay Zakat (poors due) @2.5% of their capital and profits each year for the poor and needy. It will also be observed that by their very nature of operations, Islamic banks have to be more cautious and more efficient, as they transact business on profit and loss sharing. They are subject to the supervision and control of the Central Bank as is the case with other interest-based banks. Further, in addition to 94

internal and external audit, Islamic banks are also generally subject to supervision by an Islamic Religious Board. The Islamic banks obtain their inspiration from ethical values of Islam and do not deal in business declared illegal like alcohol, drugs and gambling, etc.

It can, therefore, be concluded that Islamic banks, in essence, are development institutions, which are established according to the objectives of Islamic economics. Islamic banks, therefore, not only refrain from involving themselves in interest transactions, but also adhere to the Islamic principles of social justice. These banks, therefore, introduce systems, procedures, practices and products, which contribute to the attainment of the socio-economic objectives prescribed by Islam.

The investors and depositors are thus able to participate in the development and production process for the benefit of the community as a whole, as well as have a share in the profits of the institutions with which funds are placed or invested. Islamic banks like other conventional banks publish audited balance sheets and profit and loss accounts. They are owned by shareholders who expect sufficient dividends on their holdings. The depositors of Islamic banks, on the other hand, hope to get higher returns on their investments with these banks. The higher returns announced by a bank would obviously attract more funds from depositors and investors.

The real aims and objectives of establishing Islamic banks are to put the Islamic economic system into practice through banking and financial institutions. These banks operate within the framework of Shariah and their systems and procedures are tailored to 95

meet the challenges posed by the present complex and competitive market. At present, there are bout 100 Islamic banks and financial institutions in different parts of the world.

Principles and Instruments

Different writers explained the principles and instrument of Islamic banking in different way but the basic idea is same, both principles and instrument are described in details in literature review, so here they are summed up briefly.

The board principles of Islamic banking system are:

a)

Any predetermined payment over and above the actual amount of principal is prohibited.

b)

The lender must share in the profits or losses arising out of the enterprise for which the money was lent.

c)

Making money from money is not islamically acceptable.

d)

Gharar (Uncertainty, Risk or Speculation) is also prohibited.

e)

Investments should only support practices or products that are not forbidden in Islam.

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(For details look at section 2.8)

The instruments of Islamic banking system are: Mudharabah, Musharakah, Murabahah, Al-Bai Bithaman Ajil, Al-Ijarah, Al-Tijarah, Qarad Hasan, Al-wakalah and Wadiah.

a) Mudharabah

This is basically an agreement between a lender and an entrepreneur, in which the lender agrees to finance the entrepreneurs project on a profit sharing basis according to a pre-determined ratio agreed on in the negotiation between the two parties. The lender will bear any loss incurred.

b) Musharakah

This is a partnership for a specific business activity with the aim of making profit, whereby the lender not only provides the capital but also may also participate in the management. As in the case of Mudharabah, all parties agree, through negotiation, on the ratio of distribution of profits generated from the business activity, which need not coincide with the ratio of participation in the financing of the activity. However, in the event of a loss, all parties bear the loss in proportion to their shares in the financing.

c) Murabah

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This is basically the sale of goods at a price covering the purchase price plus the profit margin agreed on by both parties concerned, which transforms a traditional lending activity into a sale and purchase agreement, under which the lender buys the goods wanted by the borrower for resale to the borrower at a higher price agreed on by both parties.

d) Al-Bai Bithaman Ajil

This is a variant of the concept of Murabah, whereby the borrower is allowed to defer settlement of the payment for the goods purchased within the period, and in the manner, determined and agreed on by both parties.

e) Al-Ijarah

This is the Shariahs concept of leasing finance whereby the bank purchases the asset required by the customer and then leases the asset to the customer for a given period, the lease rental and other terms and conditions having been agreed on by both parties. Al-Takjir: This is a variant of the concept of Al-Ijarah which, however, provides for the acquisition of the leased asset by the lessee.

f) Qard Hasan

This is a benevolent loan which obliges a borrower to repay the lender the

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principal sum borrowed on maturity of the loan. However, the borrower has the discretion to reward the lender for his/her loan by paying any sum over and above the amount of the principal.

g) Al-Wakalah

This is an agreement between a customer and his/her bank in which the former appoints the latter as his/her agent in undertaking a certain transaction on his/her behalf.

h) Al-Kafalah

This is an agreement between a customer and the bank whereby the later guarantees the fulfillment of the obligation of the former to a third party.

i) Wadiah

This is an agreement to deposit an asset, excluding immovable fixed assets, in the custody of another party who is not the owner, or any such asset deposited with a nonowner for custody.

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2.

How Islamic banking system is different from conventional one?

Islamic Bank system & conventional Bank system can be compared by identifying similarities and differences between both of the banks.

a)

Similarities

Both are governed by the general rules of the regularity authority covering establishment, control and general operations.

Both operate within the context of professional efficiency cost effectiveness and lost / benefit.

Both are directed towards useful employment of resources for the society.

Both are usually established as shareholding companies.

Both types of banks give incentive to increase the level of savings in the country.

Provide training facilities to their employees.

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Motive of profit maximization is same for both banks.

Both banks try to maximize the utility of their customers to attract and increase their client.

Both banks increase investment modes of financing.

Both try to prevent the crisis & stabilize the economy.

Both provide the security services like lockers for the ornament etc, to their customers.

Providing loan to customers is the main function of both banks, despite their difference in operation.

Both promote business activities in a country.

b)

Differences

Islamic bank has a different moral basis i.e. jurisprudence (Shariah)

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Consequently, targets, objectives and mode of operations are different.

Islamic bank is universal comprehensive bank where as in conventional framework, there is commercial, investment, merchant or specialized bank.

Structures of assets and liabilities i.e. sources and uses of funds are different and consequently the earnings and expenses structures are different.

In Islamic Banking, Bank play a role of a trader or an entrepreneur but in conventional banking system, bank just play a role of issuing loans to customers, Modern Banks issue loans and they are not very much interested in what the borrower will do with that money. Thats why, there is always a risk of not getting back the loan but it is not so in Islamic banking. As it provide Finance on participatory basis or it directly links Finance to the economic activity so in this case both the lender and borrower has to share risk equally. It also increased the scope of economic activity in economy.

In conventional banking system interest rate is involved on the other hand in Islamic banking system involved partnership, so the advances of Islamic banks are contingent on profit & loss sharing basis. Interest based system encourage instability in the economy because there is a chance of high inflation etc, but on the other hand Islamic banking system encourages a

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stability in the economy

Islamic banking system increases the investment. In conventional banking system, higher the level of interest the lower the level of investment and vice versa. Thus financing the business on the basis of profit and loss sharing instead of interest will increase level of productive investment.

Today all costs for example those occurred due to time log in a deferred payment, default risk and the inflation rate are covered under the interest rate and margins added to it. Such costs are likely to appear in an Islamic Riba free framework too, but the media through which there costs will be met is different.

At present, commercial banks are mostly financing to the large size or medium to large size projects but in Islamic framework it is not so. The management of Islamic banking system has to give incentive to increase small and medium size investment to generate revenue and profits so they give incentives to small and medium size entrepreneurs and in turn the prospects for mudarabah and Musharaka will increase.

It is important to appreciate the high interest rates penalize entrepreneurs, as the cost of borrowed funds goes up. The low interest rate on the other hand, hurts the savers who place funds with interest based institutions, as the net 103

interest rate further go down and even may become negative due to inflation. There is injustice in both situations in conventional financing system. The Islamic system of financing may not eliminate or change the level of these uncertainties in all cases and at all times, but would definitely redistribute the consequences of these uncertainties over all the concerned parties in a just manner.

Because of the Shariah restrictions and the prohibition of usury the detailed relationship to the Regulatory Authority is different.

Target customers are partly different.

In a conventional interest-based banking system the revenue of a bank arises from market imperfection as well as fees and commissions while in an Islamic-based banking system the revenue is generated by fees and commissions (administered prices).

In Islam, there is a clear difference between lending and investing, lending can be done only on the basis of zero interest and capital guarantee, and investing only on the basis of mudaraba (profit-and-loss-sharing). Conventional banking does not, and need not, make this differentiation. But an Islamic bank has to take this into consideration in devising a system to cater to the

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Muslims. Therefore such a system has to provide for two sub-systems, one to cater to those who would lend and another for those who wish to invest.

3.

What are the advantages of Islamic banking system, and what is its future?

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This section examines Islamic banking from several sides, including efficiency, stability, moral hazard, role in economic development, integrity, equity and sustainability. All these are the characteristics of Islamic banks which help in proving that Islamic banking system is less prone to business cycles which is the main advantage of Islamic banking system, along with this these characteristics give many advantages to the economy of a country and the bank itself.

a) Efficiency

As the modern banking system is interested based but, the economies which are following this system, do admit that the reason of decline in banking industry in the past few decades are, high rates of interest & increase in uncertainty. As fredric s. Mishkin has mentioned in his book (see literature review) .At the macroeconomic level, Islamic banks avoids the use of interest-based lending. The rate of interest is replaced by the rate of profit on equity and profit-sharing finance, by markups on credit-purchase finance and by rental rates on leasing finance. While the time-value of money is maintained, there is no need to handle the complicated questions of how to bring the rate of interest down to zero in order to reach the optimal allocation of resources. While, Conventional banks allocates financial resources with paramount regard for borrower's ability to repay loan principal and interest. In modes of Islamic finance that are based on equity and profit sharing, focus would be on the profitability and rate of return of the concerned investment. This type of finance has the potential of directing financial resources to the most productive

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investments. This would increase the efficiency of the financing process and reinforce efficiency in the real sectors.

b) Stability

A conventional bank has on the one hand liabilities that include demand, time and saving deposits, which the bank guarantees. On the other hand, it has assets that are mostly composed of debt instruments each of which has a quality that depends on the ability of the corresponding debtor to repay. Default on the asset side, if it happens in significant proportion, would imply inability to meet the bank's obligations on the liability side. Such default can be expected at times of crises, be it of macroeconomic nature or caused by circumstances specific to the bank. A bank operating according to Islamic rules of finance has liabilities of different nature. Only demand deposits are guaranteed. Meanwhile, investment deposits are placed on profit-and-loss-sharing basis. When such bank faces macroeconomic or specific crises, investment depositors automatically share the risk. The bank is less likely to fall and a bank run is less probable. It can therefore be said that an Islamic banking system is relatively more stable when compared to conventional banking.

c) Morality hazard and selection

It is mentioned above that Islamic banks hold equity and trade in goods and services as they operate as universal rather than commercial banks. Universal banks are 107

defined as "large-scale banks that operate extensive networks of branches, provide many different services, hold several claims on firms (including equity and debt), and participate directly in the corporate governance of the firms that rely on the banks as sources of funding or as securities underwriters" (Calomiris, 2000).

A bank can be exposed to moral hazard when the firm obtaining finance uses the funds for purposes other than those for which finance was advanced. This could lead to business failure and inability to repay on part of the debtor firm. The bank would be exposed to adverse selection when it fails to choose the finance applicants who are most likely to perform. Obviously, adverse selection can be avoided by careful screening of finance applicants. When a bank provides equity and debt finance simultaneously, it will have more access to information than when only debt finance is provided. It can therefore be concluded that screening would be more effective and adverse selection less probable with universal banking. Reducing possibilities of moral hazard requires monitoring the firm that obtains finance. Banking theory indicates that universal banking would be exposed to lower levels of moral hazard and adverse selection.

d) Economic development

Given the characteristics of Islamic banks mentioned above, particularly the fact that Islamic banks operate according to the rules of universal rather than commercial banking, it can be conclude that the practice of universal banking by Islamic banks put their financing activities right in the center of the development process. Bankers in this 108

case become both partners and financiers of entrepreneurial efforts to develop the economy.

e) Integrity

Risk is known to be one of the most important ingredients of making investment. Those who finance investment share a good part of the risk involved with those who carry out actual investment activities. Conventional banks leave risk to be borne by specialists. Banks provide investors with loans guaranteed by collateral. In this fashion, they keep themselves apart from certain kinds of risk, like those attached to production, marketing and distribution, and limit their exposure to risk related to collateral only.

Islamic banks allow savers who deposit their funds to share with banks the risks associated with choosing the right investment and how successful it would be. Banks advancing funds share risk with those receiving finance, including producers, traders etc. Islamic bank with proper corporate governance allows depositors some influence on banks investment decisions and allows a share in the decision-making process. Thus the risk as well as decision-making is spread over a much larger number and wider variety of concerned people. Risk sharing is balanced by sharing in decision-making. This allows for wider involvement in economic activities, so that people will eventually feel they are partners rather than spectators. The benefit of wider involvement goes beyond the mere feeling of involvement. It adds to the stability of banks. Holders of investment deposits with banks share in both the profits and losses. 109

When a bank faced the unlikely event of an overall loss over the placement of its investment pool, its depositors shoulder their proportional share of the loss. Individual banks as well as the banking system as a whole would therefore be less likely to break down.

f) Equity

Islamic financial institutions and Islamic banks must be viewed as basically private profit-seeking business enterprises that operate according to the market mechanism. By themselves, they cannot reduce or eradicate poverty. However, if given the right tools, they can contribute to the efforts taken by the whole society in that regard. Islam prescribes a tax-subsidy approach to reducing poverty. A levy called Zakah is paid out by the wealthy (those whose wealth exceeds a certain minimum level) in proportion to their Property. Zakah collection would be expected to be carried out mostly by nongovernmental and sometimes by governmental organizations. Islamic banks can help by acting as custodians and in the disbursement of the proceeds. In addition, non-banking financial institutions can also take part in collecting Zakah, using Islamic banks as depositories, and invest the proceeds allocated to the poor in special accounts with Islamic financial institutions, to which they would also add a proportion of Zakah due on their shareholders equity.

Income maintenance is provided within narrow limits to those incapable of work and wealth maintenance is provided to the rest of the poor. The latter policy entails giving 110

the poor productive assets, which they can use to produce goods and services and sell them for profit. This method of poverty reduction can be closely intertwined with that of economic development, as redistribution is mostly directed towards making the poor more productive, which in turn contributes to economic development. Income maintenance would involve regular (monthly) payments to the needy. Wealth maintenance, meanwhile, involves transferring to the poor a combination of productive resources, which would be capable of generating sufficient income to maintain at least one household. As to income maintenance, Islamic banks can credit the accounts of the prescribed poor with monthly payments. Wealth maintenance can be implemented through the establishment of micro enterprises that would be owned and operated by the poor. While, the titles to such enterprises are transferred to the poor, certain measures must be taken to insure that the new businesses would not be immaturely liquidated to finance consumption outlays for their owners. The experience of Islamic banking in project financing should come in handy in eradicating poverty and increasing equity through proper use of Zakah proceeds.

Conventional lending gives utmost attention to the ability to repay loans. To ascertain such ability, it depends overwhelmingly on the provisions of collaterals and guarantees. Thus those already rich would have most access to finance. In contrast, Islamic banks provide funds on equity or profit-sharing basis would be more concerned about profitability and rate of return and less concerned about collateral as the primary consideration. Those who are not wealthy, but have worthy investment projects, would

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have more access to finance. So this characteristic is another advantage of Islamic banking and society itself.

g) Sustainability

Conventional debt has certain characteristics that could place debtors in difficulties if circumstances do not allow them to repay in time. Interest is usually calculated on the outstanding balance of debt, usually compounded annually and sometimes at shorter intervals. Delinquent debtors are often subjected to penalty rates of interest, which are higher than regular rates. It is not uncommon to find borrowers who end up paying debt service that is many folds the original principal they borrowed. This is particularly symptomatic of developing countries debt, as they continue to face debt problems that sometimes reach crisis levels. Creditor countries and institutions have often sought to find ways and mechanisms to provide debt relief to debtor countries. Despite continuous efforts, the debt problems faced by developing countries seem to be everpresent. Thus it can be concluded that interest based banking and finance lacks a great deal of sustainability. Creditors have to stop every few years to give debtors relief in terms of rescheduling and forgiveness.

Unconventional debt created through Islamic banks has characteristics with which debt crises are less likely to rise. Particularly, the total value of debt, the total value of 112

debt can be repaid in installments, without increase in its total value, as there is no compounded interest to pay on outstanding balance. When debtors face unavoidable circumstances that would make them temporarily insolvent, they are often granted grace periods to help them bring their finances back to order. No penalty fees can be levied in this case. In other words, debt rescheduling, when justifiable, would be granted at no extra cost to borrowers. Therefore, it can be concluded that Islamic banking and finance is sustainable and less liable in itself to cause undue hardship to debtors.

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4.

Why Islamic banking is more viable than conventional banking system?

From the characteristics and the advantages of Islamic banking given in the previous section, it can be easily concluded that Islamic banking is more viable than conventional banking system. The main reasons for its viability are:

a. Islamic banks have some definite edge over conventional banks because their capital is secure. While, the capital of the conventional banks is at risk, due to high leverage with their liabilities. The investments and deposits in an Islamic bank are not the liability of the bank and can, at best, be termed as a contingent liability as these funds are in trust with the

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bank. The liability of the Islamic bank arises only when gross negligence is proved in carrying out the trust functions as distinct from business losses. Islamic banks are, therefore, highly leveraged institutions, unless of course their current account balances are several times their paid up capital and reserves.

b. Secondly, the main selling point of Islamic banking, at least in theory, is that, unlike conventional banking, it is concerned about the viability of the project and the profitability of the operation but not the size of the collateral. Good projects which might be turned down by conventional banks for lack of collateral would be financed by Islamic banks on a profit-sharing basis. It is especially in this sense that Islamic banks can play a catalytic role in stimulating economic development. In many developing countries, of course, development banks are supposed to perform this function. Islamic banks are expected to be more enterprising than their conventional counterparts. In practice, however, Islamic banks have been concentrating on short-term trade finance which is the least risky.

c. Thirdly, it is less cyclical as compared to conventional banking system because of interest free trend as high interest is considered the basic cause of business cycles in any economy.

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d. As Islamic banks do not have to pay fixed amount to borrowers, they need not to keep additional liquidity with them. Thus they can lend more as compared to conventional banks because they do not have to keep excess money with them.

CHAPTER 5

SUMMARY, CONCLUSION AND RECOMMENDATIONS

This chapter consists of the conclusion and recommendations of the addressed problem.

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5.1

Conclusion

Findings and conclusion are in fact the summary of chapter 4.

Theoretically speaking, there is no concept of loans and credits in Islam for financing trade, industry and agriculture except Qard Hasan and where profit and loss sharing is not feasible like interest-free loans by the federal government to provincial governments for their developmental needs. Islamic banks, therefore, involve themselves in financing (short, medium and long term) for the working capital requirements, and also contribute to the capital of an enterprise by participating in its equity. These financings are on profit and loss sharing basis. Islamic banks also mobilize resources on profit and loss sharing basis as distinct from interest payments to depositors on predetermined rates.

Islamic banking is a part of over-all value system of Islam. It is, therefore, imperative that simultaneously genuine efforts are made to ensure that the people are imbued with honesty of purpose and their actions conform to Islamic values. The basic values that Islam seeks to establish are: (a) Freedom (b) Brotherhood (c) Equality (d) Justice (e) Trust i.e. treating the God given capabilities and resources as trust. (f) Honest Consciousness i.e. sense of responsibility and care for ones obligations.

In a system based on profit and loss sharing, it is to the advantage of banks and financial institutions to invest in those projects where higher rates of profits are anticipated. The financing by Islamic banks under this system is done within the 117

framework and keeping in view the social considerations, the requirements of priority sector and the safety of funds. The Islamic banking system, therefore, induces savings and capital formation and lead to optimum allocation of resources.

Islamic banks operating on profit and loss sharing basis are definitely in a stronger position to absorb the shocks to their assets position (banks financing), as the losses are simultaneously absorbed by the changes in the value of deposits placed with the banks. The nominal value of deposits of Islamic banks is not guaranteed like investment in shares of a bank or for that matter of a joint stock company. The real value of Assets and Liabilities (Uses of Funds and Sources of Funds) of Islamic banks is, therefore, equal at any point of time. It is, however, to be ensured through prudent and professional banking practices, procedures and systems that the losses in the financing portfolio are as low as possible and that highest possible returns are paid to the depositors and investors.

It emerges from all this that Islamic banking has following distinguishing features: (a) Islamic banks deal with money and do not deal in money, (b) it is interestfree, (c) Lending and investing are treated differently; loans are interest-free but carry a service charge, while investing is on a profit-and-loss-sharing (mudaraba) basis, (d) it is multi-purpose and not purely commercial, (e) it is strongly equity-oriented, and (f) Value erosion of capital due to inflation is compensated.

Theoretically and empirically, it is not difficult for specialists in economics and 118

finance to find Islamic banking in not only viable and acceptable, but also efficient and significantly effective. It is not therefore surprising to see large multinational banks and institutions are providing Islamic financial services to their customers in significant amounts. As an innovation, Islamic banking has been practiced for more than a quarter of a century.

Theories reviewed in chapter 2 show that interest is the basic cause of business cycles and financial instability, these theories also prove the bad effects of the interest on resources, production, distribution, and on the economy as whole. On the other hand theories presented by Fisher, Minskyetc show the bad effects of debt, Similarly the research and work of many researchers and scholars like Lloyd Metzler, Mohsin Khan, Nejatullah Siddiqietc have also proved that Islamic banking system is more stable than conventional banking systems. The problem statement of this research was why some of conventional banks moving towards Islamic banking system, findings of all these theories and answers of all research questions discussed previously clearly show that Islamic banking system is more stable, secure, sustainable, less cyclical in nature and better for economy, thats why Islamic banking system is becoming more popular and many of conventional banks are moving towards Islamic banking system.

Islamic banks share with their conventional counterparts similar specialization and business interests. Differences that exist between their modes of operations afford them excellent opportunities to cooperate and collaborate. Areas like joint financing and

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financial market operations can be the stage of daily collaboration. As conventional banks have been first in the field, they can be a valuable source for professional techniques and standards. In other words, Islamic banks have a lot to learn from conventional banks in this regard. Islamic banks, being aware of their innovative methods, have toiled to develop the new modes of finance. That included a lot of work to formulate new contractual arrangements on both their asset and liability sides. In addition, they have been able to acquire a niche that conventional banks do not have. The latter can participate and make use of such new and innovative techniques that would help them better serve their customers.

Although, Islamic banking system is more viable than conventional banking system it has some challenges also, like: The well-known fiscal prejudice against profit and in favor of interest is just an example, where interest payments are partially or fully tax exempt, and profit gets no such advantage. Similarly New instruments are needed, a uniform regulatory environment and legal framework have yet to be developed. The total implementation and success of Islamic banking in a country needs re-shaping the society, re-structuring of the economic system and re-framing of the laws according to the dictates of Islam. Islamic banks also face a challenge of developing innovative services and products for mobilizing deposits and utilizing them effectively and efficiently for financing under profit and loss sharing system. Islamic banks like all other modern conventional banks under interest-based system have to remain competitive and tailor their services and products according to the needs and requirements of their clients,

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ensuring that the products designed by them remain within the framework of Shariah. International operations would have to be continued on interest basis till such time, that a suitable and mutually acceptable alternate is found. This will, however, depend upon the success of Islamic banking on the domestic fronts in a large majority of Muslim countries of the world. While taking steps to enforce Islamic banking, it will have to be seen that interest is eliminated in such a way that it does not abruptly disturb the basic structure of the economy. It has also to be ensured that initially the confidence of the people is developed and strengthened in the new system. This approach would also provide an opportunity to refine the newly formed laws to support the Islamic system of banking in the light of experiences gained during the process. The development of an interbank market is another challenge. With the establishment of the Islamic Fiqh Academy (IFA) in Jeddah and wide spread growth of specialized training centers dedicated to train people in Islamic Finance and banking practices, and a series of International conferences, the challenges are being addressed with vigor. With the forced opening up of the economy and gradual removal of barriers, Governments and regulatory bodies, too, are cooperating in making Islamic banking a part of mainstream banking. In the years to come, as Islamic banking breaks new ground and expands into new areas, there is sure to be an increased effort in broadening its principles and scope.

5.2

Recommendations

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It, however, appears that although tremendous efforts for Islamization of banking system and for streamlining and enhancing the scope of the activities of Islamic banks are being made in many Muslim countries, but effective steps for reformation of the societies in the respective countries are not being taken up with the same zeal and enthusiasm. This is an essential prerequisite for the success of Islamic banking and deserves serious considerations by all those who are involved in the process of Islamic banking.

The following are the suggestions for future growth and success of Islamic banks. Which be successful and produce full dividends, if the society in which it operates, is geared on Islamic principles. It is, therefore, of utmost importance that sincere and effective efforts are simultaneously made to transform the existing societies, in the Muslim countries, into truly Islamic societies.

1. A basic tenet of commercial banking is capital guarantee. The capital entrusted to the bank by a depositor must be returned to him in full. Conventional banking system fully complies with this requirement. While Islamic banking as practised today does not provide capital guarantee in all its deposit accounts. In many countries, this is one of the two main objections to permitting the establishment of Islamic banks. There is no objection to paying zero interest on deposits. Thus, by paying zero interest and guaranteeing capital, the proposed system satisfies both the riba-prohibition rule of Islam and the capital guarantee requirement of conventional Banking Acts. This enables it to obtain permission to set up and

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operate as a deposit bank in all countries of the world, while obeying the ribaprohibition rule and qualifying to be an Islamic bank.

2. All relevant laws in Muslim countries who have established or are in the process of establishing Islamic banks should be reviewed so as to bring them in conformity with the Shariah. Necessary laws also need to be framed for providing legal cover to the transactions, services and products developed under the Islamic banking system.

3. The research and training centers for Islamic banking established in various Muslim countries should pass on their findings to their Muslim countries to assist them in establishing new Islamic banks and enhancing their existing capabilities.

4. Muslim scholars, bankers and economists should explain, to their counterparts in Western / American countries as also to various international financial and monetary agencies like The World Bank and International Monetary Fund, the salient features of Islamic banking. It should also be a good idea to invite their suggestions for achieving the objective of socio-economic justice, in the context of Islamic baking.

5. There is an urgent need for more extensive cooperation among Islamic banks throughout the world. There should, therefore, be more organized and systematic meetings, seminars, conferences and workshops to exchange experiences and 123

expertise and to foster closer cooperation in all spheres of operations.

6. Muslim countries, who have established Islamic banks, should transact the imports and exports business between them on Islamic principles. This would lead to handling more and more international transactions under interest-free system and would provide a model for other conventional banks to deal with Islamic banks on interest-free basis. This will also help in developing the much needed International Islamic Financial Markets.

7. The central banks of Muslim countries should prepare themselves more vigorously for fulfilling their new and enhanced responsibilities under Islamic banking system. In addition to their normal functions of supervising the operations of banks and the quality of their financing portfolio, central banks should also regulate the ratios of profit sharing, by prescribing a range within which, the banks would be free to deal with their clients under the Islamic system.

8. Islamic Development Bank has to adopt a very innovative approach to gear themselves for assuming a global role on the footprints of The World Bank. It has accordingly to establish a number of affiliates and subsidiaries for carrying out the multi dimensional functions and responsibilities, under the Islamic banking system.

9. A Monitoring commission for Islamic banks should be constituted by all Muslim 124

countries. Prominent Muslim scholars of all school of thought, economists, jurists and bankers should be the members of this commission. The commission should have a number of committees to deal with various issues of Islamic banking and should be entrusted with responsibilities mainly the following:

a)

Developing by Ijma (a secondary source of Islamic jurisprudence through the process of consensus of opinion) a uniform banking code with in the prescribed regulatory framework of Shariah. This banking code would provide legal certainty had would also develop uniform banking practices to be adopted by Islamic banks.

b)

Ensuring that all the existing modes of financing are appropriately amended, wherever necessary, so that they are bought within the purview of Shariah.

c)

Developing of uniform accounting systems and standards for providing consistency in accounting treatment of various operations and products of Islamic banks.

d)

Designing new and innovation services and products for financing on profit and loss sharing basis.

e)

Standardization of the systems, procedures, charge forms and other

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documents for handling various banking transactions under Islamic banking system.

f)

Providing solution to any problem or guidance on any matter referred to it, by any bank.

10. Finally, conclusion is that, being a Muslim we should discontinued the interest based Financial and banking system. So that we may be saved from the punishment of Riba" described in Quran and Hadith. E.g.

The Prophet peace be upon him said as follows on the night of ascendance to The Heavens, I passed by a group of people who had tummies as big as houses, filled with snakes that could be seen from outside. I asked The Arch-Angel Jibrael as to who they were. He said that they were the people who ate Riba. And the earlier it is realized better it would be for all.

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REFERENCES

Bank patronage factors of muslim and non-muslim customers, international journal of bank marketing, vol 12.pp 12-40.

Al Rajhi Banking & Investment Corporation Magazine, written by Colin Willis, treasurer.

Accounting needs of Islamic Banking, Abdul Wassay History of Islamic Banking, Haqiqi & Prof. Felix Pomeranz.

Principle of Islamic Banking, 10th issue of Nida'ul Islam Magazine, November-December 1995, source: msa-usc.

What

is

Islamic

Banking

(http://www.islamic-

banking.com/ibanking/whatib.php). Mishkin, S. Fredevic (1995) the Economic of Money, Banking and Financial Markets. Siddiqi, Muhammad Najatullah (1983) Banking without Interest. Leiscester: the Islamic founded on, UK. Siddiqui, H. Asrar (1975) Practice and Law of Banking in Pakistan. International Institute of Islamic Economics IIUI (1999) Islamabad. Siddiqui, Shahid Hasan. Islamic Banking Karachi: Royal Book Company. Khan, Mohammad Ikram. (1992) Islamic Banking in Pakistan. Lahore: All 127

Pakistan Islamic Education Congress. Khan, Abdul Wadood. (1999) Interest Free Banking. Lahore. Khawaja, Abdul Haleem (1994) Economic Theory Lahore: Naveed Publications. www.alrajhibank.com.sa/islamicebanks.html commercial banking in the presence of inflation by Abdul Gafoor. mudaraba-based investment and finance, Abdul Gafoor. http://www.islamicconferences.com http://www.islamicbanking-finance.com http://www.islamic-banking.com Islamic banking, Abdul Gafoor. http://www.islamic-finance.net http://www.albaraka.com/islamicinfo/islamicbooks/instruments/table.html http://www.worldbank.org/fandd/english/0697/articles/0140697.htm islamic-economics.com riba-free-economy.com

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interest-free commercial banking, Abdul Gafoor. islamic-economy.com riba-free-banking.com www.rhbbank.com/islamic/index.shtm www.gdrc.org/icm/islamic-banking.html www.islamicbankingnetwork.com www.library.northwestern.edu/govpub/resource/internat/foreign.html www.fordham.edu/halsall/mod/modsbook35.html www.lib.upm.edu.my/iisib.html www.my-muslim.com/dir/business_and_economy

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