ISLAMIC banking has been defined as banking in consonance with the ethos and value system of Islam and governed, in addition to the conventional good governance and risk management rules, by the principles laid down by Islamic Shariah. Interest-free banking is a narrow concept denoting a number of banking instruments or operations, which avoid interest. Islamic banking is expected not only to avoid interest-based transactions, prohibited in the Islamic Shariah, but also to avoid unethical practices and participate actively in achieving the goals and objectives of an Islamic economy.
Islamic Shariah prohibits 'interest' but it does not prohibit all gains on capital. It is only the increase stipulated or sought over the principal of a loan or debt that is prohibited. Islamic principles simply require that performance of capital should also be considered while rewarding the capital. The prohibition of a risk-free return and permission of trading, as enshrined in the Verse 2:275 of the Holy Quran, makes the financial activities in an Islamic set-up real asset-backed with ability to cause 'value addition'. Islamic banking system is based on risk-sharing, owning and handling of physical goods, involvement in the process of trading, leasing and construction contracts using various Islamic modes of finance. Islamic banks deal with asset management for the purpose of income generation. They will have to prudently handle the unique risks involved in management of assets by adherence to best practices of corporate governance. Once the banks have stable stream of 'halal' income, depositors will also receive stable and halal income. The forms of businesses allowed by Islam at the time the Holy Quran was revealed included joint ventures based on sharing of risks and profits and provision of services through trading, both cash and credit, and leasing activities.
In the Verse 2:275 of the Holy Quran, Allah, the Almighty, did not deny the apparent similarity between trade profit in credit sale and Riba in loaning, but resolutely informed that Allah has permitted trade and prohibited Riba. Profit has been recognised as 'reward' for capital and Islam permits gainful deployment of surplus resources for enhancement of their value.
However, along with the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to be permissible, should be associated with goods, services or benefits. At macro level, this feature of Islamic finance can be helpful in creating better discipline in conduct of fiscal and monetary policies.
Besides trading, Islam allows leasing of assets and getting rentals against the usufruct taken by the lessee. All such things or assets corpus which is not consumed with their use can be leased out against fixed rentals. The ownership in leased assets remains with the lessor who assumes risks and gets rewards of his ownership.
Modern banking system was introduced in the Muslim countries at a time when they were politically and economically at low ebb, in the late 19th century. The main banks in the home countries of the imperial powers established local branches in the capitals of the subject countries and they catered mainly to the import-export requirements of the foreign businesses. The banks were generally confined to the capital cities and the local population remained largely untouched by the banking system. The local trading community avoided the "foreign" banks for both nationalistic as well as religious reasons.
However, as time went on it became difficult to engage in trade and other activities without making use of commercial banks. Even then many confined their involvement to transaction activities such as current accounts and money transfers. Borrowing from the banks and depositing their savings with the bank, were strictly avoided in order to keep away from dealing in interest which is prohibited by religion. With the passage of time, however, and other socio-economic forces demanding more involvement in national economic and financial activities, avoiding the interaction with the banks became impossible.
Local banks were established on the same lines as the interest-based foreign banks for want of another system and they began to expand within the country bringing the banking system to more local people. As countries became independent, the need to engage in banking activities became unavoidable and urgent. Governments, businesses and individuals began to transact business with the banks, with or without liking it.
This state of affairs drew the attention and concern of Muslim intellectuals. The story of interest-free or Islamic banking begins here. Interest-free banking seems to be of very recent origin. The earliest references to the reorganisation of banking on the basis of profit sharing rather than interest are found in the writings of Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties, followed by a more elaborate exposition by Mawdudi in 1950 (1961). Muhammad Hamidullah's 1944, 1955, 1957 and 1962 writings too should be included in this category. They have all recognised the need for commercial banks and the evil of interest in that enterprise, and have proposed a banking system based on the concept of Mudarabha - profit and loss sharing.
In the next two decades, interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period.
The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors.
Early 1970s saw the institutional involvement. Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, First International Conference on Islamic Economics in Mecca in 1976, International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process.
The first private interest-free bank, the Dubai Islamic Bank, was also set up in 1975 by a group of Muslim businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and Sudan. In the same year the Kuwaiti government set up the Kuwait Finance House. However, small scale interest-free banks with limited scope have been tried before -- one in Malaysia, in the mid-forties, and another in Pakistan, in the late-fifties. Neither of them survived.
In 1962 the Malaysian government set up the "Pilgrim's Management Fund" to help prospective pilgrims to save and profit. The savings bank established in 1963 at Mit-Ghamr in Egypt was very popular and prospered initially and then closed down for various reasons. However, this experiment led to the creation of the Nasser Social Bank in 1972. Though the bank is still active, its objectives are more social than commercial. In the ten years since the establishment of the first private commercial bank in Dubai, more than 50 interest-free banks have come into being.
Though nearly all of the Islamic banks are in Muslim countries, there are some in Western Europe as well: in Denmark, Luxembourg, Switzerland and the UK. Many banks were established in 1983 and 1984. The numbers have declined considerably in the following years. In most countries the establishment of interest-free banking had been by private initiative and was confined to that particular bank.
In Iran and Pakistan, however, it was set up at the initiative of the by government and covered all banks in the country. The governments in both these countries took steps in 1981 to introduce interest-free banking. In Pakistan, effective from January 1981, all domestic commercial banks were permitted to accept deposits on the basis of profit-and-loss sharing (PLS). New steps were introduced on January 01, 1985 to formally transform the banking system over the next six months to one based on no interest.
From July 01, 1985 no banks could accept any interest bearing deposits, and all existing deposits became subject to PLS rules. Yet some operations were still allowed to continue on the old basis. In Iran, certain administrative steps were taken in February 1981 to eliminate interest from banking operations.
Interest on all assets was replaced by a four per cent maximum service charge and by a four to eight per cent 'profit' rate, depending on the type of economic activity. Interest on deposits was also converted into a 'guaranteed minimum profit.' In August 1983, the Usury-free Banking Law was introduced and a 14-month change over period began in January 1984. The whole system was converted to an interest-free one in March 1985.
The subject matter of writings and conferences in the 1980s changed from the concepts and possibilities of interest-free banking to the evaluation of their performance and their impact on the rest of the economy and the world. Their very titles bear testimony to this and the places indicate the world-wide interest in the subject. Conference on Islamic Banking: Its impact on world financial and commercial practices held in London in September 1984, Workshop on Industrial Financing Activities of Islamic Banks held in Vienna in June 1986, International Conference on Islamic Banking held in Tehran in June 1986, International Conference on Islamic Banking and Finance: Current issues and future prospects held in Washington, D.C. in September 1986, Islamic Banking Conference held in Geneva in October 1986, and Conference 'Into the 1990's with Islamic Banking' held in London in 1988 -- all belong to this category.
The most recent one is the workshop on the Elimination of Riba from the Economy held in Islamabad in April 1992. Several articles, books and PhD theses have been written on Islamic banking during this period. Special mention must be made of the work by M. Akram Khan in preparing annotated bibliographies of all published and some unpublished works on Islamic Economics including Islamic Banking. It is very useful to students of Islamic Economics and Banking, especially since both English and Urdu works are included (1983, 1991, 1992). M.N. Siddiqi's bibliographies include early works in Arabic, English and Urdu (1980, 1988). (To be continued)
The writer is Senior Vice President, Research Planning and Development Division of Islami Bank Bangladesh Limited