Islamic Banking & Interest Free Banking

Lecture Objectives

•What are misgivings about Islamic Banking?

•To be able to define Islamic banking.•To draw difference between conventional

banking and Islamic banking.•To define different types of Islamic modes

of financing.• Some basic modes of Islamic financing.

Interest-Free Banking---Some misgiving Clarified• The first misgiving which has been expressed is whether

bank interest is that interest at all which is prohibited by Islam.

• The second misgiving which has been often expressed is that interest is the kingpin of the modern banking system.

• The third misgiving is how the profit sharing system could work when so many firms and individuals in business either do not maintain accounts due to the high level of illiteracy.

Interest-Free Banking---Some misgiving Clarified• The fourth misgiving and a very serious one, is that a

system based on profit & loss sharing may lead to collapse of the banking system as banks will have to share in losses also.

• The fifth misgiving which has been expressed in some quarters is that profit & loss sharing system will make the banking system less liquid and hence there will be a great risk of banks to meet the withdrawals of funds.

• Finally, the sixth one it has been pointed out that interest free banking amounts to capital being provided free while capital has a scarcity value.

Implication of interest free Banking

•Introduction▫Islam prohibits “ interest”▫“Riba” means “ Interest”▫In force in Pakistan & Iran▫Islam believes in profit & loss sharing or

participation, conceptually & logically▫All funds in the form of equity▫No capital fund in the form of debt▫Capital & Enterprise combined together▫Constitute the factor of production & profit

would be its reward

Islamic Banking• 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, the more general term 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. Source: http://www.sbp.org.pk/ibd/faqs.asp#q1 dated: 12/07/12

Concepts & Models of Islamic Banking: An Assessment

• The concept of Islamic Banking▫ Intermediary between Savers & Investors▫ Creates credit▫ Interest ( Riba)▫ Transactions based on interest are severely condemned in the

holy Quran & Sunnah( pg:62,63)• Undesirable Features of an interest- based banking system

▫ Transactions based on interest violate the equity aspect of economic organization

▫ Loss situation leads to a number of bankruptcies resulting in loss of productive potential & unemployment

▫ The interest system dampens investment activity because it adds to the costs of investment

▫ The interest –based system discourages innovation, particularly on the part of small-scale enterprises

▫ Under interest-based system banks are only interested in recovering their capital along with the interest

Concepts & Models of Islamic Banking: An Assessment•Alternatives

▫First to decree that no return would be paid on any type of deposits in banks & all loans & advances will be provided on an interest free basis

▫Second is that banking should be conducted on the basis of profit/loss sharing

•Fundamental features of a profit /loss sharing arrangements are▫Islamic Literature on Fiqh Muamla-ul-Malia▫Mudarbah or Qirad or Muqaradeh ▫Sharakah

Concepts & Models of Islamic Banking: An Assessment

• Some techniques which are not prohibited in Islam▫ Bai Muajjal (Cost-plus trade Financing)▫ Ijara ( Lease or Hire)▫ Ijara wa Iqtina ( Hire-Purchase)▫ Bai-Salam

• Models of Islamic Banking

Some Aspects of Interest Free Banking

• Introduction• Capital, Capitalistic & Capitalism

▫ A misconception▫ Capital Formation▫ Capitalists▫ Deposit Holders▫ Correcting the misconception▫ Interest & Profit Distinguished▫ Interest free Economy▫ Ensuring Justice in an interest-based system▫ Ensuring justice under popular version of interest-free system▫ Lack of Participatory managerial rights▫ Disclosure of operating results▫ Inflationary risks▫ Rate of Return of Capital

Some Aspects of Interest Free Banking•Impact on Banking

▫Pattern of Credit allocation▫Deposit Mobilization▫Income accounting

•Conclusion

Islamic Banking in PakistanIslamic Banking in Pakistan

Islamic Banking Means such a bank where all the financial, trade, business matters are done according to the Islamic Rules & Regulations and it is free from Interest.

At the time of independence Muslims had thought to root out Riba (Interest) in financial matters in this Islamic State.

1947 to 1960:No possible decision could be taken in this era to

eliminate interest from the Banking World. 1960 to 1977: In this era, the Council of Islamic Ideology (CII) put a lot of

reports in front of Government to guide the Govt. that Interest is prohibited in Islam.

• 1977 to 1980: the Council of Islamic Ideology (CII) and State Bank of

Pakistan took some steps to remove interest from the economy. The steps are:

In Feb, 1979 financial institutions which are (ICP, NIT, HBFC) were targeted for elimination of interest

Islamic Banking in PakistanIslamic Banking in Pakistan• On July 1, 1981 Govt. directed to all the

commercial banks to open profit and loss sharing deposit counters

• In 1980, Mudarbah Ordinance took place.• On July 1, 1984, the SBP directed all the

commercial banks.• On January 1,1985, the SBP asked the

commercial banks to not accept interest bearing deposit.

Basic Principles of Islamic FinanceBasic Principles of Islamic Finance

• Riba is prohibited. • Faith Based: Islamic banking is on faith based

system.• Un-Islamic activities are not allowed in trading

and business.• Socially beneficial business is allowed to be

invested in the businesses. • Discloser of means• Bank is partner in business

Main Instruments of Islamic Main Instruments of Islamic FinanceFinance• Participation Term Certificate:

It was designed to replace debenture financing. A company is authorized under the companies ordinance to issue Participation Term Certificates (PTCs) for balancing, modernization and expansion of the existing industrial units.

•Musharika: It is the most efficient and effective non interest based instrument to meet the working capital requirements of a business Musharika is an arrangement in which the banks and their clients agree to join in temporary participation for carrying on a business within an agreed period of time.

Main Instruments of Islamic Main Instruments of Islamic FinanceFinance

•Features of Musharika:▫Short term financing▫Overdraft facility▫Management▫Sharing of Profit▫Sharing of Loss▫Security

Main Instruments of Islamic Main Instruments of Islamic FinanceFinance

•Modaraba: it is another important from of Islamic financing. Modaraba means a business in which the subscriber participates with money and the manager (Modarab) with the knowledge and skill. Modaraba is an effective method for raising large amounts of resources.

Main Instruments of Islamic FinanceMain Instruments of Islamic Finance

• Features of Mudarbah:▫ Registration▫ Types▫ Public or Private Sector▫ Separate Business▫ Paid up Capital ▫ Religious Capital▫ Religious Board▫ Regulatory Control

• Promoters should be knowledgeable• Resource mobilization• Operations

Mudarbah Business Activities:• Financing Operations• Resource Mobilization• Others

Main Instruments of Islamic Main Instruments of Islamic FinanceFinance

• Leasing: It is also a minor instrument of Islamic financing. A leasing is arrangement whereby an asset owner called lessor confers the right of use of asset to the lessee (one to whom lease is meant) for a specific period of time. In leasing the ownership of the property or asset remains with the lessor.