Use of Trade and Lease as Financing Modes in Islamic Banking Salman Ahmed Shaikh Respected scholar, Dr.

Muhammad Ayub sahab recently wrote a rejoinder on my article Difference between Interest and Trade: Weakening Justifications. Being a criticism on my viewpoint, it was supposed to mention what I wrote and then, the author could have provided his own analysis. But, apart from one instance, the rejoinder did not mention my own words and even when it did on one particular instance; it was a complete misrepresentation of my viewpoint. The author seems to have largely constructed his own arguments and then provided answers to them. Below is an excerpt which the rejoinder quoted and discussed from my article: Secondly, how strange it would be to assume that Allah would punish taker of Riba so severely, while from the economic standpoint, the one who undertakes a credit sale transaction which resembles Riba would have earned the same level of profit or in fact more with higher banking spreads. Author of the rejoinder assumed and understood from this that I am basically of the view that perhaps there is an incomplete rationale and explanation behind prohibition of Riba and that there is an inherent blur between lending for interest and trade for profit in my viewpoint. I have noted down before my criticism on Islamic Finance practices and when I wrote that above mentioned sentence, it was basically questioning the contemporary practices which have made the distinction between trade for profit and lending for interest blurred in my view. I would mention specific examples of how this is happening in Islamic Finance in this article and my future writings, insha Allah. Below, I write my response to the various parts of the rejoinder which also require my viewpoint or clarification. Dr. Muhammad Ayub Sahab wrote: There should be no doubt that interest is prohibited because of its economic evils. The related command of Allah SWT is based on the logic that Riba breads distributive injustice leading to destruction of human society. This is my basic premise. In fact, it was me who was using this line of reasoning. Indeed, Maulana Mufti Muhammad Shafi Usmani sahab, Maulana Abul Ala Maududi, Maulana Amin Ahsan Islahi and many contemporary and earlier scholars have used the same line of reasoning. What is the economic evil of interest? Dr. Muhammad Ayub sahab himself mentions that it is distributive injustice. Let us see whether Islamic banks do anything different from economic standpoint before we delve deeper on discussing the Islamic Fiqh basis of current Islamic Finance practices. In Pakistan, Islamic Banks banking spread is 8.80 percent as compared with 6.90 percent for the overall industry (Source: SBP Islamic Banking Bulletin, Apr-Jun 2011). So, on average, Islamic banks are costlier than conventional banks. Financing the same asset, a customer pays more to an Islamic bank than to a conventional bank. Also, on average, they share lesser profits with their depositors. Reportedly, Islamic banks finance limited number of small and medium enterprises. Islamic banks have not ventured into microfinance despite of surplus liquidity at their disposal, maintaining low advance to deposit ratio and some having very successful profitable operations. Islamic banks hardly have branches in rural areas. While maintaining highest banking spreads (at 8.80%) among the major countries of the world, all economic arguments for Islamic Finance merits are also equally supportive to conventional banking. Then, Dr. Muhammad Ayub Sahab wrote:

Mr. Salman should have indicated the names of those scholars who argue that Riba is prohibited solely because it is Gods order and there is no rationale behind that; I could have mentioned it then as well. In light of not making it controversial and bringing sensitivities to the matter, I avoided mentioning names. First of all, this comment and language used is an example of how one can misrepresent the others viewpoint. Below, I quote my exact words which I wrote: Respected mainstream scholars behind Islamic Finance movement while explaining verse 275 of Al-Baqarah opine that if this and similar injunctions do not become clear to the human mind, it should not become a reason for argument and disbelief. However, if one reads the verse 275 of Al-Baqarah, it seems that Allah is criticizing using the very argument that no sane person can equate trade with Riba. Please see Tafseer Asaan Tarjuma-e-Quran of verse 275 by respected scholar, Mufti Muhammad Taqi Usmani Sahab, Volume 1, page 172. Also, please see Muarif-ul-Quran by respected scholar Mufti Muhammad Shafi Usmani Sahab, Volume 1, page 684. It is to be noted that these esteemed and respected scholars had also explained at various places the rationale behind prohibition of Riba. But, Muarif-ul-Quran does not mention that the word Bai in verse 275 of Al-Baqarah refers to credit sale only. Maulana Taqi Usmani sahab however has explained this context which I referred to in my article in his Tafseer as well as in his book Ghair Soodi Bainkari. Then, Dr. Muhammad Ayub sahab wrote: No scholar defends such trade practices of Islamic banks in which essentials of Bai are ignored (like Tawarruq and baial Inah); all advise that Islamic banks should involve in real sector trading, taking business risk, adding value and thus earn profit; Bai Inah and Tawarruq are still practiced in many parts of the world by Islamic financial institutions and there are scholars who justify it. Saying no scholar is not true representation of reality nor the viewpoint of all scholars. With surplus liquidity at their disposal, Islamic banks could have provided financing using preferable equity modes to facilitate new IPOs in the market and hence encourage equity financing to be used in economy and especially if it is deemed preferable by them. But, what Islamic banks are doing with their surplus liquidity makes one very uncomfortable. Islamic banks currently in Pakistan use their excess liquidity to provide funds to the conventional banks who by way of this provide interest based loans to the people. Is this the kind of economy Islamic scholars and practitioners are promoting and had in mind? It is interesting that the author mentions that Islamic banks should take business risk. This was the same question I raised in my article. Unilateral undertaking which is legally binding as well enables the bank to completely avoid the price and market risk in Islamic banking. My basic point in the article is to question where the bank takes the risk. It locks the price and by way of unilateral undertaking which is legally enforceable, it also binds the customer and that is all done before the bank even thinks about purchasing the asset, let alone having an inventory of tradable assets. Fact of the matter is that bank does not commit a single penny unless it has taken a unilateral undertaking from the customer which is legally enforceable and binding on the customer and through this, the bank gets the customer to agree to the quoted rentals or markup price (calculated from the same present value formula).

At one place, the author writes: There is not a little difference between interest and trading activity as he mentions; This is complete misrepresentation of my viewpoint. I said and meant completely the opposite. Rather than arguing that there is little difference between interest and profit, I wrote: Explaining the verse 275 of Al-Baqarah, some respected scholars argue that the verse was revealed to clarify the difference between credit sale (of the type which is used today in Islamic banking) and Riba. There is a huge difference between interest based economic activity and trade. If there had been a little difference, Allah would have given the reason for its prohibition in place of the verse in which Allah has declared the advocate of interest as the one who has become mad by the touch of the evil (AlBaqarah: 275). Rather than being derisive here, arguments against interest should have been given by Quran. But, it was not needed because the people understood what interest was and what was trade. I do not know how one can misunderstand this. What I was basically trying to highlight is the huge difference that exist between trade for profit and lending for interest. That difference as in the words of the author of the rejoinder includes taking on business risks or entrepreneurial risk. When I wrote the above lines, I was questioning the status of current Islamic banking practices in which this risk seems to be completely avoided. Then, Dr. Muhammad Ayub sahab wrote: Islamic banks have to take the price risk and the market / commodity risk for valid profit; otherwise, their incomes / profit margins have to go out of their P/L account. This is the same line of reasoning which I have used. My basic question about Islamic banking practices is that how the Islamic bank takes on price and market/commodity risk. Islamic bank gets the customer sign an undertaking unilaterally. If the customer does not give that undertaking, his request for finance is not accepted and processed further. The question is that what that undertaking includes? By way of this undertaking, the customer is made obliged to buy the asset from the bank and agree to a particular price stated in the payment schedule. That payment schedule calculates the markup price using the same present value formula and while amortizing the particular cost for bank, it includes all the costs, like insurance cost etc. As a matter of fact, all ownership related costs are also paid indirectly by the customer through transfer pricing and the payment schedule represents higher price for higher time to maturity i.e. more delayed the payment, more will be the price. However, there is no rollover and no price adjustment allowed which is a good feature, but not a sufficient one to answer the question of risk taking by the Islamic bank. Author of the rejoinder has explained at length as to how higher price in credit sale was permissible and was practiced in Arab in those times. He also quoted various noted scholars in support of his viewpoint. But, the question that I tried to raise in my article is that where the Islamic bank takes on risk. As a matter of fact, Islamic bank does not commit a single penny unless the customer signs the unilateral undertaking, and by way of unilateral undertaking, the customer is bound to purchase the asset and pay bank markup price of the asset (calculated using KIBOR/LIBOR as a discount rate and using present value formula). Only when the customer agrees to provide that undertaking, will the bank think of purchasing the asset.

By monetizing its funds using asset backed financing provision, the Islamic bank all of a sudden becomes seller of every Halal type of asset without bearing any market/price risk and without managing and keeping any sort of an inventory or warehouse. Islamic bank becomes the seller of all of the millions of different types of Halal goods, from laptop to refrigerators to caterpillar equipments; it can sell them all to you. Not only this, if you want to rent a house at any place in the city, you can just pinpoint, Islamic bank would provide you the house on lease. Is doing several hundred types of businesses at the same time ever done in history by a single institution and is that as easy as it seems? No, but business of banking is. If Islamic bank is the seller of all different types of Halal goods, why not we buy everything from the bank? Some of us may think it will be cheaper as well. Let us see what happens if we lease car from an Islamic bank. The rent will be more if we were to lease for a short period than for a long period. Why is that so? Islamic bank basically amortizes all its costs through rentals. It is acting as a financial broker looking to amortize an investment made. For the same asset or property, bank will charge higher rentals for short term lease and lower for long term lease. It is because bank is willing to amortize all costs and not acting anything else than being a financial broker. Islamic banks being financial intermediaries are using the same benchmark for pricing. They are already not charged GST on their sale of assets to clients in second leg of transaction and the Government by not levying GST regard an Islamic bank as a financial intermediary and not as a trading house. Most definitely, trade for profit and lending for interest has a sea in between. They are different from all perspectives, legal, economic, from their social and even psychological implications and effects. But, when Islamic banks use the concept of trade and lease, they use it in such a specific way that questions arise about the substance behind these transactions. Indeed, as this article argues, it seems that Islamic bank does not in a practical sense; take on market/price risk meaningfully. It is very important to appreciate that the viewpoint of scholars quoted by the author of the rejoinder was not involving any financial intermediary doing the transactions principally. It is very important to understand this next point. If a genuine and established trader or seller sells on cash as well as on credit and has been in the business taking on price and market risk of the business in its normal course and charges a higher selling price in some of the credit transactions, he still takes on all relevant risks required of being the trader. What an Islamic bank does is to take only this permissibility of charging higher price in credit transactions as a support for its operations, monetize the asset and purchase it only when the customer signs an undertaking which enables the bank to earn the level of profit which is not representative and reflective of average profits on the sale of such assets, but earn a level of profit which the conventional bank earns. This is ensured by making KIBOR/LIBOR as a benchmark and lamentably, this is not the end of the story. Since Islamic banks banking spreads are 8.80% and higher than 6.90% for conventional banks in Pakistan, Islamic banks earn even more profits from their clients and share lesser with their depositors on average. What I questioned before is the practice of Islamic banks and not the validity of trade and lease as permissible or not in Islam. Apart from Murabaha Muajjal in which the Fiqh basis can be questioned and has been questioned by noted scholars as well, let us just consider Ijarah, Salam and Istisna for the clarification of my viewpoint. These contracts are understood and approved by a majority and these contracts had been mentioned in several Ahadith as well. I have same question that how an Islamic bank takes on business risk in them. In Salam, before paying the Salam price, if a unilateral undertaking is taken from a third party for a parallel Salam or in Istisna, if the client is made the agent and sometimes a guarantee is also taken from him to

provide surety that the third party will provide payment on time in credit sale of Istisna commodity, where the Islamic bank is taking on the business risk? Due to constraint of space, let me try to explain it by quoting just one example, the exact words of a noted scholar Dr. Rafic Yunus Al Mari who also has this similar concern and question. In his paper The Binding Unilateral Promise (wad) in Islamic Banking Operations: Is it Permissible for a Unilateral Promise (wad) to be Binding as an Alternative to a Proscribed Contract? published in Journal of King Abdul Aziz University: Islamic Econ., Vol. 15, pp. 29-33 (1422 A.H / 2002 A.D), he writes: Some modern jurists have moved such a unilateral promise (wad) from the category of voluntary offer (tabarrut) to that of commutative contracts, (muawadt), so as to replace the contract. That is because these proponents have found that (Murabaha, i.e., a resale contract with specification of gain (cost plus original price) is not permissible, since it falls under the sale of goods that are not in one's possession (the goods are not in the bank's possession). So, they replaced the contract with the unilateral promise (wad), that is to say, they made the contract a unilateral promise (wad). Had they stopped at that point, and had the unilateral promise (wad) remained non-binding, there would not have arisen any problems; but, in fact, they went on to say, and herein lies the gravity of their position: we will make the unilateral promise (wad) bindingand so they went a long way in elaborating, amplifying, dissecting, and subcategorizing, until they filled people with the fear of not fulfilling a unilateral promise (wad) so much so that the binding unilateral promise (wad), which for them is permissible, came to replace the contract which is proscribed by Islamic law. Is this admissible? And is there any difference in this case between the contract and the binding unilateral promise (wad)? Dr. Yunus Al Masri further writes: The consequence of such a direction in adopting rulings is, in my view, to make Islamic banking operations conform to traditional banking transactions and render them even more complicated, obscure, and costly. Then, in conclusion, Dr. Yunus Al Masri writes: In summary, it is inadmissible for the unilateral promise (wad) as an alternative to a proscribed contract, such as selling goods that are not in ones possession, to be binding, because a binding unilateral promise (wad) is analogous to a contract. Any views for making it binding upon both or either parties, explicitly or implicitly, by virtue of a Memorandum of Understanding (MOU), a sideline agreement, or any other circumvention, are not founded on any legitimate basis. Let us now finally see what the respected scholar Maulana Mufti Muhammad Taqi Usmani sahab wrote in some of his recent writings. In his article, New Steps in Islamic Finance, the respected scholar writes: One must not forget that these instruments are not modes of financing in their origin. They are in fact some forms of trade that have been modified to serve the purpose of financing at initial stage as secondary and transitory measures. Since they are modified versions of certain forms of trade, they are subject to strict conditions and cannot be used as alternatives for interest-based transactions in all respects. And since they are secondary and transitory measures, they cannot be taken as final goal of Islamic Finance on which Islamic Financial Institutions should sit content for all times to come. It is a matter of concern for a student of Islamic finance, like me, that both

these points are increasingly neglected by the players in the field, and especially by the new-comers in the industry. In his book, Introduction to Islamic Finance, the respected scholar, Maulana Mufti Muhammad Taqi Usmani sahab writes: It should never be overlooked that, originally, Murabaha is not a mode of financing. It is only a device to escape from interest and not an ideal instrument for carrying out the real economic objectives of Islam. Therefore, this instrument should be used as a transitory step taken in the process of the Islamization of the economy, and its use should be restricted only to those cases where Mudarabah or Musharakah are not practicable. (p. 72) I shall make it clear that this article was not meant to discredit the contributions of scholars and committed Islamic bankers or to declare Islamic banking as unislamic. I am no authority to do that or had this in mind. I have noted down some of my reservations and questions and we need to move forward towards achieving the egalitarian objectives of an Islamic economic order and may Allah accept all of our efforts in this regard. Ameen. Summa Ameen. ---(Salman Ahmed Shaikh is a researcher in Islamic Economics. He is author of "Proposal for a New Economic Framework Based on Islamic Principles". He has also written 20 papers and more than 60 articles on Islamic Economics. He can be contacted at salmanahmed_hyd@hotmail.com)