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Chapter 4

PRACTICE OF INTEREST

FREE FINANCE AND ITS

SIGNIFICANCE

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Chapter 4

Practice of interest free finance and its significance

From the previous chapter it is clear that the current system of microfinance

has been facing a lot of problems including higher interest rate and interest free

microfinance has recently emerged as a tool for financial inclusion and poverty

alleviation. Interest free microfinance is the result of marriage between microfinance

and Islamic interest free banking. In this chapter an attempt is made to present the

background of interest free financial system, major practices of Islamic banking and

finance, advantages of interest free financial system over conventional interest based

system and finally modeling an interest free microfinance institution focusing on

poverty alleviation.

4.1 A Critical Analysis of Interest

Interest is the foundation of economic and financial system in contemporary

world. The entire financial system tied up with threads of interest. The relationship

between banks with its customers and central bank with financial institutions are on

the basis of interest. The monetary policies to regulate the economy are mainly based

on interest. Thus interest is the key tool used in modern economies to direct the

money and capital in to various fields. Therefore a change in the rate of interest

affects the entire financial system.

Most of the modern economists also considered interest as the strategic price

for capital. To them it is the nervous system of modern banking, the main tool for

management of monetary system, the effective saving factor and criterion to direct

investment allocation in to most efficient projects. According to them interest is

inevitable and unavoidable for the smooth functioning of the economy. Any attempt

to escape from this fate will, accordingly, be doomed to failure because the

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elimination of interest makes capital as free as air. The following part of this chapter

is an attempt to analyze the ethics and economics of interest.

Interest is the price paid to lenders for the use of their liquid money.

Economists have given different definitions to interest. Most prominent among them

is ‘Interest is the excess of money paid by the borrower to the lender over and above

the principal for the use of the lender’s liquid money over a certain period of time’.

Accepting this broad definition, the practice of interest can be traced back

approximately to four thousand years1.

4.1 a. Concept of Interest in ancient literature

From time immemorial scholars from different fields including theologians,

philosophers, social thinkers, philanthropists, and economists have been debating the

ethics of interest. The oldest known references to interest are found in ancient Indian

religious manuscripts. Jain (1929)2 provides an excellent summary of these. In the

earliest of such records derived from the Vedic texts of Ancient India (2000‐1400 BC)

the “usurer” (kusidin) is mentioned at several contexts and interpreted as any lender at

interest. Other detailed references to interest payment are found in the later Sutra texts

(700‐100BC), and in the Buddhist Jatakas (600‐400 BC). It is during this latter period

that the first sentiments of contempt against interest are expressed. Vasishta, a well

known Hindu law‐maker of that time, made a special law which forbade the higher

castes of Brahmans (priests) and Kshatriyas (warriors) from being usurers or lenders

at interest. Also, in the Jatakas, interest is referred to in a demeaning manner:

“hypocritical ascetics are accused of practicing it”. By the second century AD,

however, interest had become a more relative term, as is implied in the Laws of Manu

of that time: Stipulated interest beyond the legal rate was considered usurious way of

lending. From the time of Manu the concept interest got diluted and this dilution

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confined in the subsequent periods also. However interest confined to be condemned

in Indian society 3.

The Greek philosopher Aristotle rejected interest on the grounds that “money

is sterile”. Cato even compared it with homicide. Among the ancient western

philosophers who condemned interest, Plato, Cicero, Seneca and Plutarch got

prominence4. In 594 BC Solon cancelled all private and public debts when he

reformed the Athenian constitution. In 340 BC, Lex Genucia prohibited interest in the

Republican Rome. In Judaism interest was considered unfriendly and unfair act.

4.1 b. Interest and Christianity

The Bible specifies this in the following words. “If you lend money to any of

my people with you who is poor you shall be to him as a creditor, and you shall not

exact interest from him.” (Ex: 22:25) “He that hath not given this money upon usury;

nor taken reward against the innocent; He that doeth these things shall never fall”

(Psalm: 15) He that hath not given forth upon usury, neither hath taken any increase,

that hath withdrawn his hand from iniquity, hath executed true judgment between

,man and man” (Ezekiel: 18:8) The moral teachings of Jesus in this direction as

indicated by the following, are clear and unqualified: “Love your enemies and do

good; lend expect nothing in return” (Luke 6.35)5.

Building on the authority of Bible, the Roman Catholic Church forbade the

clergy from taking interest when Roman Empire became Christianized in 4th century.

In the eighth century under Charlemagne, they pressed further and declared interest to

be a criminal offence. This anti‐interest movement continued to gain momentum

during the early middle Ages and perhaps reached its zenith in 1311 when Pope

Clement V made the ban on usury absolute and declared all secular legislation in its

favor, null and void6.

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St. Thomas Aquinas was of the view that money was invented chiefly for the

purpose of exchange and that its principal use was its consumption and annihilation

whereby it is sunk in exchange. Hence it was unlawful to make payment for the use of

money lent.7 Zamir Iqbal, points out that prohibition of interest is not limited to Islam

but is also shared by Judaism and Christianity and the first interest free bank in

documented history Agibi Bank was established in pre-Islamic period circa 700 B.C.

in Babylonia. This bank functioned exclusively on an equity basis.8

4.1 c. Interest and Islam

The criticism of interest in Islam was well established during Prophet

Mohammed's life and reinforced by his teachings from the Holy Quran dating back to

around 600AD9. In Islam, the ruling against interest is very clear. Almighty God has

clearly stated in the Holy Quran, “Those who devour usury will not stand except as

stands one whom the Evil one by his touch hath driven to madness. That is because

they say "trade is like usury". But God hath permitted trade and forbidden usury.

Those who after receiving direction from their Lord, desist shall be pardoned for the

past; their case is for God (to judge); but those who repeat (the offense) are

companions of the fire they will abide therein (for ever)”10.

Prophet Muhammad strictly warned against interest. Prophet abolished all

interest, which the people owed to. He issued strong instructions that if they persisted

in demanding interests, war should be declared on them. He said, “All Interest on

loans taken during the period of ignorance (i.e. Pre‐Islamic era) stands abolished. And

I abolish all interest on loans advanced by my uncle Abbas”. “He who takes interest

and he who pays it and the scriber who writes the contracts of interest and he who

utilizes it will have the curse of God upon them”11.

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4.1 d. Origin of Interest based financial system

Towards the end of the sixteenth century in the face of strong movement in

favor of relaxing restrictions on interest, charging of a reasonable level of interest

generally became an acceptable practice. In 1545 King Henry VIII of England

changed his nation’s laws to allow some forms of interest. By the 1700’s charging

interest was accepted as a fair business practice. Since that time, most disagreements

about interest happened to be on the maximum rates that lenders should be permitted

to charge12.

4.1 e. Interest and modern economists

Many economists believe that the interest rate mechanism is not in practice an

effective tool for allocation of resources, particularly in the case of the amounts that

can be loaned for the purpose of investment. Indeed the opposite is the case. Some

studies find that Adam Smith, the father of modern economics was in favor of

controlling interest13. While he opposed a complete prohibition of interest, he

supported imposition of an interest rate ceiling.

The great twentieth century economist John Maynard Keynes in his General

theory defined interest as a price for demand for money and according to him rate of

interest is determined changes in liquidity preference and fixed supply of money. He

ignored the real factors like productivity in determining rate of interest. But he

revealed the inverse relationship between interest and speculative motive and agrees

the point that lower interest rate may make the capital more productive. In his own

words “the disquisitions of the schoolmen (on usury) were directed towards

elucidation of a formula which should allow the schedule of the marginal efficiency to

be high, whilst using rule and custom and the moral law to keep down the rate of

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interest, so that a wise Government is concerned to curb it by statute and custom and

even by invoking the sanctions of the Moral Law”14.

The famous economist Harrod (1956)15 opines that loans contracted to fight

unemployment, should carry no interest and suggests the creation of an independent

authority, “governing stabilization fund”, which will generate the necessary interest

free resources. It boils down to expansion of money supply through central bank

without any interest to it. Karl Marx16 rightly says “money exchanged for money, a

form that is incompatible with the nature of money. Therefore the usurer is most

highly hated” He quotes with approval of Martin Luther who gave good definition of

interest as can be whoever takes more or better than he gives, that is usury and is no

service.

The negative influence of interest rate on the process of capital formation and

its ineffectiveness in the treatment of inflationary and deflationary disorders are

considered as the most important causes of instability in the contemporary economies.

In the early 1980s the famous economist Milton Friedman asked, what caused the

unprecedented irrational performance of the American economy. He concluded that

the main cause was the equally irrational behavior of the interest rates17.

In an identical proposal made by Meade (1950)18, the name of the agency is

changed ‘Unemployment Assistance Board’ which will finance itself by new notes

issued by the bank of England on which no interest would be claimed. According to

Haberler,(1939)19 the theory of interest has for a long time been a weak spot in the

service of economics. According to Samuelson (1976)20 “for at least another 100

years we must pretend to ourselves and to everyone that fair is foul and foul is fair, for

foul is useful and fair is not. Avarice and usury and precaution must be our Gods for a

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little longer still”. He concedes that “at zero rate of interest we could reach a time of

golden age” (P 822)

J Enzler, W Conard and L Johnson (1981)21 have concluded field research

that, capital in contemporary economies has been seriously misallocated in various

sectors and various types of investment primarily because of interest rates. Interest is

an inferior tool. It misdirects the allocation of resources, prejudices as it is to large

scale projects on the unproven assumption that they are automatically credit worthy.

As a result interest stimulates monopolistic tendencies. Moreover, surveys by J E

Meade and P W Andrews (1938)22 have confirmed that business men believe that the

interest rate mechanism is not an important factor in determining the level of

investment. In other words the demand for investment is inelastic in relation to the

rate of interest. There are two reasons for this. First of all the rate of interest

represents only a small proportion of the expenses of new investment projects.

Secondly many projects depend of self financing, which limits the effects of interest

as an implicit cost carried out by invested capital.

In a study on the American experience carried out by H Leibling (1980)23

found that a rise in interest rates was a serious hindrance to investment. During the

period studied (1970-1978), the total interest paid out amounted to one third on the

total return on capital which led to an erosion of the profitability of companies. As a

result the proportion of risk bearing capital (shares and loans) declined and capital

formation declined as well. This forced the American economy in to downward cycle

of reduced productivity leading to a diminished capacity to compensate for the higher

cost of borrowed capital causing in turn a further decline in both profitability and

average level of capital formation.

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In a study Abdul Hamid El Gazzali (1987)24 observes the limitation of interest

rate mechanism as a corrective measure for inflationary and deflationary pressure. At

the time of inflation the expected rate of return on investment is higher than the

increased interest rate in the economy. So the interest rate mechanism is insufficient

as a cost element to control inflation. In the case of deflation the limitation is more

obvious. There is sufficient incentive to borrow, but severe stagflation prevents for

realizing a gain over and above the cost of credit. In developing countries the situation

is worse because of the already limited efficiency of financial system. According to

him the problem here is not a monitory nature but structural one.

Fluctuations in the interest rates creating uncertainty in the investment

markets, which makes difficult to make long-term investment decisions with

confidence and reliability. H Simons (1948)25 attributes the famous world depression

in 1930s to the change in commercial confidence, arising from an unstable credit

system. He believes that the danger of economic disorder can, to a great extent, be

avoided if loans, particularly short term loans are eliminated, and if all investments

are self financed or financed by partnership. In this same context H Minskey (1975)26

emphasizes the fact that self financing of projects and rational investments of

undistributed profits gives rise to a strong financial system, while external financing

through borrowing exposes the system to instability.

Shaikh Mahmud Ahmad27 searched through several theories of interest,

developed since the time of Adam Smith, to show that there had been no satisfactory

explanation of existence of a fixed and predetermined rate of return to financial assets.

He went further; analyzing the writings of economists such as Keynes, Bohm Bowerk,

Cassels, and Samuelson, to argue that an objective assessment of these writings would

lead one to believe that all of these writers held a reasonably strong conviction that

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the existence of a fixed and predetermined rate of interest was an impediment to the

process of economic growth and development.

Mohsin S. Khan28, in his article notes that the abolition of interest-based

transactions is not a subject alien to even western economic thought. Several western

writers including Fisher, I., 100 % Money, (1945), Simons, H., Economic Policy for a

Free Society, (1948) and Friedman, M., 'The Monetary Theory and Policy of Henry

Simons,' in Friedman, M., (ed.), The Optimum Quantity of Money and Other Essays,

(1969), among others, have argued that the current (one-sided liability) interest-based

financial system is fundamentally unstable. Monetary economists insist that a zero

nominal interest rate is a necessary condition for optimal allocation of resources. They

argue that after switching from metallic to fiat money, adding one marginal unit of

real balance costs no real resources to the community. Therefore, imposing a positive

price on the use of money would lead traders to economize on the use of money, in

their pursuit to minimize their transaction costs. They would therefore use some real

resources instead of money. However, when the rate of interest is zero traders will

have no incentive to substitute real resources for money. More real resources can

therefore be directed to consumption and investment. In Simon’s view the basic flaw

in the traditional system is that, as a crisis developed and earnings fell, banks would

seek to contract loans to increase reserves. Each bank could do so, however, only at

the expense of other banks.

Abdel Hamid El Gazzali (1994)29 observes when interest rate was raised

during 1970s the ratio of gross national capital expenditure to gross national output in

western countries declined. Average international growth also declined. Weak

investment performance was the main factor contributing to the slow growth during

this period. This was the result of the erosion of profitability of projects because of

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high interest rates. Many economists are the opinion that not the rate of interest but

the rate of profit is the real decision factor which drives the production and growth in

all economies. Studies carried out within the American banking system corroborate

this conclusion by demonstrating the strong link between level of investment and

profits. R Turvey30 has confirmed that the rate of interest does not control the

economy, that the interest rate mechanism is unfit to regulate the investments

decisions and that it should be replaced by rate of price of real assets.

Hifzulrab31 presented an interesting calculation on interest and proves that the

inflation is the result of system of interest. An amount lent at 15% yearly compound

interest doubles in less than 5 years, it multiplies 10 fold every 16½ years, 1000 fold

every 49½ years and 1174313 fold every 100 years. Net output of the world does not

multiply even 10 fold in 100 years. Thus, net real rate of growth is below 2.4 %.

Therefore, even if capital worth 20 % of the total resources of the world could be

invested at 12% interest compounded yearly, the overall growth of the world’s

economy will not be enough even for clearing the interest. Thus, interest is killer for

the economy especially for the economy of indebted nations.

In another paper Hifzur Rab32 points out that If 100 gm of something is

borrowed at 10% interest, amount payable to clear this loan grows to equal weight of

earth in 695 years. Dues growing in this exponential pattern cannot be cleared unless

the unit of account is manipulated (depreciated). Normally economic transaction use

medium of exchange as unit of account implying that the system of interest cannot be

sustained without monetary manipulation.

One major reason to condemning interest is that it is an agent of economic

instability. An interest based system is inherently unstable due to lack of

synchronization between enterprise’s payment obligations to its financier and its

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expected receipts33. Gesell’s (1904)34 main objections to interest are that it is an

endemic factor in the instability of interest‐based economies, i.e. the cycles of boom

and bust, recession and recovery. Ahmad, arguing from an Islamic perspective, claims

“the greatest problem in the capitalist economy is that of the crises (and) interest plays

a peculiar part in bringing about the crises” (1958: 36)35. Even Keynes, the

campaigner for interest‐based monetary policy, admits the fact that “the rate of

interest is not self‐adjusting at the level best suited to the social advantage but

constantly tends to rise too high” (1936: 350)36. Kennedy (1995)37 is bolder,

suggesting that the compounded growth of interest may in fact cause inflation.

From the above words of famous economists and practitioners it is clear that

interest is not a good instrument to regulate the economy. Instead of interest different

instruments to assure high returns for capital and secure the stability and efficiency of

economy have been developed in the world years back. Now the interest free financial

instruments and institutions have developed as an apt alternative for interest based

financial system. The following portion of this chapter will give a brief picture about

the working of interest free system.

4.2 Treatment of money in modern economic system and its influence on interest

Money is a medium of exchange. It cannot be treated as a commodity. It has

no intrinsic value. Therefore it cannot be utilized in direct fulfillment of human needs

or traded to acquire extra earnings. It means money is neither considered as a

consumer good nor a productive good. If money is exchanged for money in

exceptional situations the payment of both sides must be equal. It should not be used

for the purpose of which it is not meant for, ie trading. Similarly money becomes

productive good only when it is converted in to capital or capital equipment. The

reward for capital is variable, hence charging fixed rate of interest as the reward for

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capital is injustice. The returns can only be shared among various parties involved in

the production process. On the other hand charging of interest will increase the cost of

production and lead to price rise and inflation. Thus interest on productive loan affects

the economy as a whole40.

The famous Islamic scholar Ghazali41 rightly remarked this nine centuries

back. He describes “and whoever effects the transactions of interest on money is, in

fact, discarding the blessing of Allah and is committing injustice, because money is

created for some other things, not for itself. So the one who has started trading in

money itself has made it an objective contrary to the original wisdom behind its

creation, because it is injustice to use money for a purpose other than what it was

created for. If it is allowed for him to trade in money itself money will become his

ultimate goal and will remain detained with him like hoarded money. And

imprisoning a ruler or restricting a postman from conveying messages is nothing but

injustice”

Money is only a medium of exchange and a measure of value is universally

accepted by almost all the economists of the world, but unfortunately a large number

of these economists failed to recognize the logical outcome of this concept, so as

clearly elaborated by Gazzali; that money should not be treated as a commodity meant

for being traded in. After holding that money is a commodity the modern economists

have plunged into a dilemma that was never resolved satisfactorily. The interest is

excess money charged over the lending of money and not the reward for capital as an

agent of production. Therefore it is injustice since it treats money as a commodity

which is not correct.

During the great depression of 1930s a committee was formed under the

chairmanship of Mr. Dennis Mundy42 to study about the depression. In its report the

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committee has discussed the root causes of the depression in national and

international trade and suggested different measures to overcome the problem. One of

the important recommendations of the committee 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 shouldn’t be traded as a commodity’.

The famous economist James Robertson43 observes in his 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 this 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 worldwide 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 around the world are for purely

financial transactions, unlinked to transactions in the real economy”.

It means that the real reason for expansion of money and economic depression

is consideration of money as a commodity. Modern economists and Islamic scholars

are joining together in the common point. Imam Ghazali44 pointing out that, “interest

is prohibited because it prevents people from undertaking real economic activities.

This is because when a person having money is allowed to earn more money on the

basis of interest either in spot or in deferred transactions, it becomes easy for him to

earn without bothering himself to take pains in real economic activities. This leads to

hampering the real interests of the humanity because the interests of the humanity

cannot be safeguarded without real trade skills, industry and construction”.

In Islamic finance money is no more than a servant and used no more than a

medium and measure, on the other in conventional finance money itself becomes a

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commodity and object. Thus the historical role of money an intermediary for

exchange (commodity-money-commodity, C-M-C) gets transformed into money-

commodity-money (M-C-M) and ultimately ends up into M-M-M. According to

Professor Khurshid45 derivatives trade at the rate of 1.2 trillion a day is almost 50

times more than the daily physical international trade in goods and services. The

balloon of the financial economy is expanding at an alarming pace via speculation,

while the real economy is only crawling. For Islamic economists the real economic

progress and development consist in the expansion of the physical and human

aggregates of the economy via the creation of assets, products and services, and not

merely in the form of fiduciary expansion.

4.3 What is the alternative?

In conventional economics interest is the reward and price for capital as a

factor of production. That is the reason why interest is prevailed in modern financial

system. Islamic economics approaches the capital and interest in a positive way.

Interest itself cannot be treated as a reward for capital. Capital is rewarded according

to its productivity. The entrepreneur uses the capital as a tool for regulating the other

factors of production like land and labor. The profit is the reward of entrepreneur and

capital jointly. In Islamic economics capital and enterprise cannot be treated as

separate factors of production. Both are one and the same and treated as a single

factor of production. This reward is shared by savers, investors and intermediary

institutions like banks or microfinance institution. The important feature here is the

losses are also shared among the capital owners46.

Interest free institutions are those financial institutions which are financing

without interest. The concept of interest free ethical finance is introduced to the

financial sector by the Muslim world. So this is also known as Islamic finance. In

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Islamic finance there are alternative methods to mobilize savings and of investment.

Islamic banks and financial institutions are receiving deposits from the public as

shares and returning it after maturity with a part of profit earned from investments.

These institutions are providing capital to the unemployed and needy entrepreneurs

and strictly monitoring the working of these institutions. Providing interest free

consumer loans are another important function of interest free establishments. In the

following pages of this chapter, we shall discuss the concept, ideology and working of

interest free institutions and their present position in different nations.

4.4 Theoretical background of Islamic banking and finance

Islam is not merely a religion; it provides a complete code catering for all

fields of human existence, individual and social, material and moral, economic and

political, legal and cultural, national and international.47 It is a comprehensive way of

life, religious and secular; it is a set of beliefs and a way of worship; it is a vast and

integrated system of laws; it is a culture and civilization; it is an economic system and

commercial norm; it is a polity and method of governance; it is a society and a family

conduct; it is a spiritual and human totality; thus worldly and other worldly.48

The recent surge of religious consciousness amongst the Muslims has

provided the drive towards implementing and adopting Islamic principles in financial

transactions. In other words, an outcome of this revival is the emergence of a new

discipline, i.e. Islamic Finance. This discipline is based on the knowledge and

application of the injunctions and norms of Shari`ah which prevent injustice in the

acquisition, management and disposal of material sources. Among the most important

teachings of Islam for establishing justice and eliminating exploitation in business

transactions, is the prohibition of all sources of unjustified enrichment and the

prohibition of dealing in transactions that contain excessive risk or

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speculation.(Siddiqi)50 Islamic scholars have deduced from the Shari`ah three

principles which distinguish Islamic finance from its conventional counterpart. These

are briefly as follows:

4.4 a. The Prohibition of interest/usury

The prohibition of riba or interest/usury is clearly the most significant

principle of Islamic Finance. Riba translates literally from Arabic as “an increase,

growth or accumulation”. In Islam, lending money should not generate unjustified

income. Riba represents, in the Islamic economic system, a prominent source of

unjustified advantage.

4.4 b. Profit and Loss Sharing (PLS)

PLS financing is a form of partnership, where partners share profits and losses

on the basis of their capital share and effort. Unlike interest-based financing, there is

no guaranteed rate of return. Islam supports the view that the Muslims do not act as

nominal creditors in any investment, but are actual partners in the business. It is

comprised of equity-based financing.

4.4 c. Gharar or uncertainty and Speculation

Any transaction that involves Gharar is prohibited. Parties to a contract must

have actual knowledge of the ‘subject matter’ of the contract and its implications. An

example of Gharar is an agreement to sell goods which have been already lost.

4.5 Financing Techniques of interest free institutions

Interest free financial institutions around the world have devised many

financial techniques that are basically derived from Islamic law of contract. Following

section gives a brief account of the interest free financial techniques adopted by

worldwide. These can be grouped under three broad categories. After a discussion

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about main contractual form some accessory contracts which facilitate the functioning

of interest free financial institution are also mentioned.

4.5 a. Participatory financing

1. Mudarabah (Trusteeship Financing)

Mudaraba is an agreement between two parties; one provides the capital and

the other known as fund manager (mudarib) uses his entrepreneurial capabilities and

manages the fund and the project. The profit arising from the project is distributed

according to a predetermined formula. Any losses accruing are born by the provider

of the capital. The provider of the capital has no control over the management of the

project.

Chart 4.1

Structure of mudarab financing

Source: Mohammed Obaidullah (2008) Islamic financial services, IDB, IRTI, Jedda

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Trusteeship financing (mudaraba) is a contract between at least two parties in

which the bank as the investor supplies the entire capital of the business forming a

relationship between the supplier of capital and the user of capital. Very important

feature of this type of contract is bearing of the liability to loss to the financier only;

the working party i.e. the user of the capital bears no part of the loss accruing to the

capital extended by the financier. His only loss will be his labor, which will get no

reward. The basic structure of mudaraba financing is illustrated in chart 4.1

Steps in mudaraba transactions

1) Bank and client decided to implement a business after the discussion; bank

provides funds to client towards capital investment.

2) Client sets up the business and manages its operations. Bank keeps

observation on acc.

3) Business generates positive or negative returns.

4) If profits is positive shared between client and bank as per a pre agreed ratio.

5) If profits are negative borne by bank;

2 Musharakah (Joint venture Partnership)

Musharaka is a partnership between two parties who both provide capital towards

the financing of a project. Profits are sharing on a pre agreed ratio, but losses are

shared on the basis of equity participation. Both or any of the party may carry

management of the project.

In this case the bank and the customer jointly contribute capital. They also

contribute managerial expertise and other essential services at agreed proportions. An

individual partner does not become liable for the losses caused by others. The

structure of a musharaka transaction of a bank is as follows.

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Chart 4.2

Structure of musharaka partnership

Source: Mohammed Obaidullah (2008) Islamic financial services, IDB, IRTI, Jeddah

Steps for musharaka partnership are

1. Client and Bank discuss business plan and jointly contribute to capital of the

venture;

2. Client and Bank jointly set up the business venture and manage its operations

jointly.

3. Profits if positive, are shared as per a pre-agreed ratio;

4. Profits if negative are shared in proportion to capital contributions

3 Diminishing Musharaka:

A diminishing musharaka is a recent innovation. Musharaka aims to involve

bank as a permanent partner in the venture. This may not be a desirable idea for a

financial institution. In a diminishing musharaka, the bank's share in the equity is

diminished each year through partial return of capital. The bank receives periodic

profits based on its reduced equity share that remains invested during the period. The

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share of the client in the capital steadily increases over time, ultimately resulting in

complete ownership of the venture. Steps in diminishing musharaka are as follows.

Chart 4.3

Structure of diminishing musharaka

Source: Mohammed Obaidullah (2008), Islamic financial services, IRTI, IDB, Jeddah

The steps for musharaka are

1) Client and bank jointly contribute to capital of the venture.

2) Client and bank jointly set up the business venture and manage its operations,

3) Profits if positive are shared between client and bank as per a pre agreed ratio.

4) The profit share of client flows into bank too, towards partial redemption of

the latter’s capital contribution.

5) Profits if negative are shared between client and bank in proportion to their

respective capital contributions.

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4.5 b. Contracts of Exchange

1. Murabahah (Cost plus sale)

Murabahah is a contract of sale between the financial institution and its client

for the sale of goods at a price which includes a profit margin agreed by both the

parties. As a financing technique it involves the purchase of goods by the bank as

requested by its client. The goods are then resold to the client with a markup which is

determined by mutual consent. Usually price is received in specified installments. In a

murabaha, both parties to the transaction must know the cost and the profit or mark-

up charged by the bank.

Chart 4.4

Structure of murabahah financing

Source: Mohammed Obaidullah (2008), Islamic financial services, IDB, IRTI, Jeddah

Steps of murabahah contract are

1) Client identifies and approaches Vendor or supplier of the commodity that he/

she needs, collects all relevant information;

2) Client approaches Bank for murabaha finance and promises to buy the

commodity from the Bank

3) Bank makes payment of base price to Vendor;

4) Vendor transfers ownership of commodity to Bank;

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5) Bank sells the commodity, transfers ownership to Client at marked-up price;

6) Client pays marked-up price in full or in parts over future time period

2. Ijarah (Leasing)

Ijara is a contract under which a bank buys and leases out for rental fee

equipment required by its client. The lease period and the rental fees are agreed in

advance. In ijara, the bank continues to be the owner throughout the ijara period

while the client receives the benefits of ownership or the benefits of using the asset.

As such, risks associated with ownership of the asset remain with the bank.

Chart 4.5

Structure of Ijarah contract

Source: Mohammed Obaidullah (2008), Islamic financial services, IRTI, IDB, Jeddah

Steps of ijarah contract are as follows

1) Client identifies and approaches Vendor of the asset that he/ she needs, collects

all relevant information;

2) Client approaches Bank for ijara of the asset and promises to take the asset on

lease from the Bank upon purchase;

3) Bank makes payment of price to Vendor;

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4) Vendor transfers ownership of asset to Bank;

5) Bank leases the asset, transfers possession and right of specified use to Client;

6) Client pays ijara rentals over future time period.

7) Asset reverts back to Bank.

3 Ijara-wa-iqtina

This is a contract similar to Ijarah with a commitment from the client to buy

the equipment at a pre agreed price at the end of the lease. In this case payment of the

client includes rent plus part of the costs of the equipment. The contract is starting

with a combination of ijara with partnership (based on musharaka or mudaraba). In

this structure, the bank and its client enter into a partnership specifically formed to

finance the acquisition of the property that the client is interested in. The bank and the

client contribute to the equity of the partnership in a certain ratio. The bank acts as the

agent-manager of the partnership. The partnership then purchases the property and

leases the same to the client against known periodic rentals. The proportion of rental

accruing to client is used to redeem part of the bank’s stake in the property. This

results in a decrease in the bank’s stake over time. Eventually, the bank’s stake in the

property reduces to zero and the client becomes the full owner of the property.

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Chart 4.6

Structure of Ijara waiqthina

Source: Mohammed Obaidullah (2008) Islamic financial services, IRTI, IDB, Jeddah

Steps of ijarah contract are as follows

1) Bank forms a partnership with the Client based on musharaka; Client promises

to take on lease the property to be purchased by the Musharaka against

predetermined rentals for a definite time period; Bank may appoint itself as

agent-manager of the partnership; subsequent activities are undertaken in this

capacity;

2) Bank on behalf of the Musharaka purchases the property;

3) Property is taken on lease by Client; generates rental income over future time

periods;

4) Bank apportions the rentals among both parties; one portion flows back to bank

as its share in rental income;

5) Another portion – the share of the Client in rental income is used to redeem part

of Bank’s stake in partnership; Bank transfers ownership of asset to Client when

its stake is reduced to zero.

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4. Salam (forward sale)

The contract for sale of goods where the price of the said item is paid in

advance is known as salam (forward sale). In this system a buyer pays in advance for

a specified quantity and quality of a commodity, deliverable on a specific date, at an

agreed price. This financing technique is similar to a future or forward-purchase

contract and is particularly applicable to seasonal agricultural purchases.

Chart 4.7

Structure of salam contract

Source: Mohamed Ayub,(2007) Understanding Islamic finance, John Wiley & SonsLtd, England.

The steps of salam contract as follows.

1. The bank will purchase the item from client with full prepayment of the price and

delivery on an agreed specified date.

2. The customer (seller) will deliver the commodity at the agreed time and place.

3. The bank will sell the commodity to any third party by way of any alternatives

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5 Istisna: (Manufacturing contract)

The contract of acquisition of goods by specification or order, where the price is

paid progressively in accordance with the progress of a job completion is isthisna

contract. This is practiced for purchase of an item that is yet to be completed or

produced. For example, a house to be constructed where payments are made to the

developer or the builder according to the stage of work completed. Important

restrictions are (a) the subject matter of the contract is always a made-to-order item,

(b) the delivery date need not be fixed in advance, (c) full advance payment is not

required and (d) the Istisna contract can be canceled but only before the seller

commences manufacture of the agreed item(s).

Chart 4.8

Structure of isthisnah

Source: Mohammed Obaidullah (2008) Islamic financial services IRTI, IDB, Jeddah.

The steps for isthisna contract are the following

1. Client asks Bank to develop or construct or manufacture an asset with clear

specifications;

2. Bank asks Manufacturer to develop or construct or manufacture asset with same

specifications

3. Manufacturer develops or constructs or manufactures asset, receives progress

payments from Bank as per agreed terms during different stages of manufacturing;

4. Manufacturer gives delivery of asset to Bank;

5. Bank gives delivery of asset to Client;

6. Client pays in full or in parts over agreed period of time.

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4.5 c. Zero return financing

1. Qard Hasan (Interest free loan):

Qard Hasan means an interest-free loan, given by the Islamic bank to the needy

people in a society. The practice of dealing with this sort of investment differs from

bank to bank. Qard Hasan is normally given to needy students, small producers,

farmers, entrepreneurs and economically weaker sections of the society, who are not

in a position to obtain loan or any financial assistance from any other institutional

sources. The main aim of this loan is to help needy people in a society in order to,

make them self-sufficient and to raise their income and standards of living.

4.6 Advantages of interest free finance over conventional finance

Modern banking and financial system have the history of more than five

centuries. But interest free Islamic financial system developed only after second half

of the 20th century. Within a short period of time a number of studies were conducted

on interest free financial system. Some of these studies focused on short comings of

interest based system and Islamic financial system as a viable solution for these

shortcomings. The following part of the study is an attempt to examine the merits of

interest free financial system in relation to its interest ridden counterpart.

Justifying the rationale of interest free banking, Professor Khurshid51 notes,

“The central issue is that the contemporary financial system is exploitative, unjust,

discriminatory, unstable and crises generating. There is no denying the fact some

positive contributions that have been made by the banking and financial system

towards the promotion of economic development and global capitalism. But when a

balance sheet of achievements and failures is made, its failures outweigh and

outnumber”. He further says that in Islamic system of banking money does not beget

money rather used as a facilitator for the greater production of goods and services,

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resulting not merely in increasing the number of billionaires but producing real well-

being for the people.

4.6 a. Efficiency in financial system

Financial efficiency measures proper availability and conveyance of saving

and investment products in the economy. The important function of banks and other

financial institutions are intermediating between savers and investors. Through proper

channeling of financial resources from first party, to entrepreneurs who need financial

resources facilitates efficient allocation of resources in an economy.

When discussing this Al-Jarhi52, observes that by reducing the cost of funds

with absence of interest the Islamic banking products maximize the allocation

efficiency. Many modern economists point out the bad consequence of interest on

allocative efficiency. The champion of monetary policy JM Keynes53 illustrates the

inverse relation between rate of interest and marginal efficiency of capital. At zero

rate of interest the cost of funds invested becomes minimum and therefore maximum

allocation of resources is possible. It may lead to optimum allocation of resources in

the economy. In all the economies where interest exists resource utilization is

suboptimal. Therefore full employment remains only as a dream in these societies.

That is why Prof. Samuelson54 comments “at zero rate of interest the economy attains

a golden age”.

Conventional banks lend money to earn interest while Islamic banks provide

finance to share profit. This fundamental difference leads to many other important

differences between the functioning of the both. Conventional banks ensure that the

loan is paid back together with interest. For the same they gave importance to secured

collateral, and not much interested in the kind of economic activity, or the

profitability of the projects financed or any other moral concern, for which the loan is

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sought. Thus, the conventional bank grants higher preference to the credit worthiness

of the borrowers than the viability of the project to be financed or the ability or the

idea of the entrepreneur. Islamic economists56 argue that this method of financing is

the primary cause of miss allocation of the economy’s resources. In Islamic finance

focus would be given to profitability of financial projects when resources are

allocated. This type of finance has the potential to divert resources to the most

productive investments. This will increase the efficiency in the productive sectors.

John Tamlinson58 an American merchant banker argues that the conversion of

the economic system from debt based to equity based will lead to increasing

achievement of stability and efficiency. “Converting debt to equity is not a panacea

for all economic ills. It can however, produce many positive benefits. These benefits

will not necessarily follow automatically from conversion. Concentrated effort will be

required to ensure they do. Without conversion they will not happen at all”.

4.6 b The Stability

Stability of the financial system is important to assure the growth and

development of the economy. Researchers have studied the reason for instability in

the modern economic system. Many western scholars are arguing that interest is one

of the most destabilizing factors in the economy. Milton Friedman has considered

erratic behavior in interest as one of the most disturbing phenomena while Mr.

Iacocoa59, the chairmen of the Chrysler Corporation, observes that interest rates have

been so volatile that no one can plan for the future. In fact the erratic behavior in

interest rates has largely been responsible for unequal movement of financial

resources between the savers and the users which has brought a high level of

instability in the financial market. According to Chapra,(1995)60 “The high degree of

interest rate volatility has injected great uncertainty into the investment market which

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has had the effect of driving borrowers and lenders alike from the longer end of the

debt market into the shorter end, thus fundamentally altering the investment decisions

of businessmen”.

Al Jarhi61 pointed out the reason for instability in the banking sector. In the

case of conventional banks there are liabilities of different nature including demand

time and saving deposits which are guaranteed full payment by the bank. On the other

hand the assets are debt instruments of different nature; its quality depends on the

ability of the debtor to repay. Defaults on massive scale on the asset side would imply

inability of the financial institution to meet the obligation on the liability side. Such

defaults may arise at the time of crisis and lead to bank run in most of the cases. The

recent crisis in US and other western nations had lead the collapse of hundreds of

banks because of this trend.

Mohsin Khan (1986)63 and Abbas Mirakhor (1987)64 of IMF have proved that

banking contracts as found in Islamic form of banking are more stable than the

contracts found in conventional banking. A bank functioning of Islamic nature is

guaranteeing only demand deposits. Investment deposits are placed on profit and loss

sharing basis. When such bank facing crisis investment depositors automatically

sharing losses. The bank is less likely to fall and bank run is less probable. Therefore

the Islamic banking system is more stable than conventional system.

Several of the Western economists65 too have endorsed the view that equity

based system is more stable as compared to the interest based and blamed interest for

their economic woes. Sundarrajan and Luca (2002)66 have pointed out in their study

that owing to the structure of their balance sheet and the use of profit and loss

arrangements, Islamic banks are better poised than conventional banks to absorb

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external shocks. Solvency risks are typically lower in Islamic banks than in

conventional banks.

Another source of instability in the financial market is selling of debt. Bonds

are easily traded debt instruments in the financial market. In conventional finance

present money is traded in an integrated debt market against future money, which

takes the shape of commitments to pay specified amount at specified future dates or

bonds. Bond markets provide an easy and automatic mechanism through which short

term funds flow at will from one country to another. Much of those flows follow

factors that are only nebulously related to economic fundamentals. They bring an

important element of instability in to national economies. They threaten the world

economy with the spread of instability that might start in one single market and come

to all through contagion. The integrated debt market has grown immense in size as

well as in scale of integration that now encompasses the whole world economy. Many

experiences proved the role of this debt market are source of both domestic instability

and contagion67.

In contrast, in Islamic finance debt is created through selling of goods and

services on credit. Debt instruments are not readily tradable. We can visualize the

existence of a debt market for each commodity and service in which the demand and

supply to buy it on credit determines a markup rate. Such credit instruments would be

fully segmented. There is no room for sudden or mass movements of funds from one

country to another. So possibility of instability and contagion is less probable in

Islamic finance.

Siddiqi68 wrote, “You exchange money either for goods and services, or for

money or for debt. In the Islamic framework we have no problems with the first, the

second, exchange of money for money is severely constrained, and the third is almost

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eliminated. Islamic law allows cash for debt only at par, which leaves no room for a

market in which debt could be sold for cash.”

Patrikis (1996)69 argues on the charges of separating financial economy from

the real one and banking from the commerce that, this policy is grounded upon a

mixture of safety and soundness concerns and a broader public policy concern about

fair and equal access to credit and control over society's resources by banks”. On the

other Islamic economists charge that separation of commerce and banking is the result

of interest mechanism which in turn has been responsible for disproportionate and

independent growth of financial economy to such a state where these debt instruments

are themselves treated and traded like a commodity.

Rogoff (2011)70 suggested that conventional banking can learn from Islamic

alternative system to improve stability. Islamic banks generally escaped the worst

effects of the 2008 financial crisis, because they were not exposed to subprime and

toxic assets, and had maintained their close connection to the real sector. Hence, it is

suggested that conventional banking can learn from the alternative systems offered by

Islamic finance, which is less skewed toward debt instruments, uses equity for greater

risk sharing, and limits the mismatch of short-term demand deposits with long-term

loan contracts

Mohieldin (1995)71 explains the reason for not affecting crisis to Islamic banks

in the following words. “As business partners, financial institutions are more likely to

assist borrowers in working through bad times, thus lowering the pressure to sell

assets at “fire-sale” prices. This protects the system against a general fall in asset

prices and reduces the probability of cascading defaults. The sharing of losses reduces

the probability of contagion to the rest of the financial system. Moreover, Islamic

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finance protects the exchange/transaction role of a banking system by limiting the risk

on deposit balances.”

4.6 c. The Justice

The contemporary financial system is inequitable and it is against justice. The

inequitable allocation of financing in the conventional banking system is now widely

recognized by western scholars also. According to Arne Bigsten72, “the distribution of

capital is even more unequal than that of land” and “the banking system tends to

reinforce the unequal distribution of capital”. Chapra’s73 argument is that the present

interest based banking system is inherently biased in favor of rich as they are the

people who could offer sufficient collateral required for finances. Has this not been

the case finances would have gone on the merit of the project, which would have been

more equitable and just for the society as a whole. To stress his point Chapra quotes

some other western economists and Morgan Guarantee Trust of the US, which

admitted that the present banking system, has failed to “finance either maturing

smaller companies or venture capitalist”

In interest based finance efficient entrepreneurs who are unable to provide

collaterals are fail to get credit at the cost of relatively rich entrepreneurs who are

granted credit. Since those who are granted credit has to pay a fixed interest

irrespective of the actual outcome of the project. Since there is no monitoring of the

funds available to the entrepreneurs there are very likely chances that, to ensure their

own profit plus the cost to be paid to the bank, many a times entrepreneurs would try

to adopt various methods that are actually not in conformity with the societal

objectives and lead to various speculative and other harmful activities. Professor

Siddiqi74 in his speech at the Harvard has rightly pointed out, “At the top of the list is

the opportunity the current (Conventional) system provides for money to be

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exchanged for more money, making the moneyed richer. Next in importance is the

immense scope for gambling-like speculation provided by the huge volumes of debt-

based securities in a system that permits sales on margin, short selling and other

exotic money games. Last but not the least is the philosophy that regards profit

maximization as the only legitimate concern of the investment managers to the

neglect of all the other ingredients of human weal.”

4.6 d. Growth

Islamic banks and financial institutions are considering only the viability of

the project instead of wealth of the borrowers. It is more concerned about the

entrepreneurial capabilities, honesty, and truth fullness of the borrowers. In other

words Islamic bank is financing to worthy projects rather than those who are famous

for the assets. Inbuilt monitoring coupled with other Islamic prohibitions like

speculation; gamble and other kinds of frauds (Gharar) and cheating ensure that the

funds of Islamic banks are utilized for the overall benefit of the community.

All these will enhance the entrepreneurial capabilities of the society as a whole

and led to overall growth of the economy unlike the commercial way of financing,

which helps in producing a class of elites out of the funds of the masses. Islamic

economists affirm that the projects that are chosen for their viability will naturally be

more growth oriented than those that are chosen because they are proposed by rich

borrowers.

4.6 e. Systematic integrity

Al Jarhi75 likened conventional finance to a spectator’s game where few

skilled players stay in the playground and a big crowd is watching from outside.

Every person has saving with bank secured their repayment and fixed rate of return in

the form of interest. Banks and other financial institutions also place their money with

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few entrepreneurs and guaranteeing repayment with interest. These people are not

ready to share risk as take part in business activities. All risks are borne by few

entrepreneurs only. If the productive or business sector collapsed due to any natural

reasons only the entrepreneurs suffer the losses. Banks and financial institutions

provide investors with loans guaranteed by collateral. It will reduce integrity among

the business people and may affect the productivity of the nation.

On the other hand Islamic finance, meanwhile, is similar to participatory

sports, where everyone is playing and no one is concerned with mere watching. 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. We can therefore notice that 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 famous scholar on Islamic economics Al Ghazzali76 rightly remarks

“interest is prohibited because it prevents people from undertaking real economic

activities. This is because when a person having money is allowed to earn more

money on the basis of interest, either in spot or in deferred transactions, it becomes

easy for him to earn without bothering himself to take pains in real economic

activities. This leads to hampering the real interests of the humanity because the

interests of the humanity cannot be safeguarded without real trade skills, industry and

construction”

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4.6 f. Equity

Interest based borrowings have resulted in glaring inequalities in the system of

distribution. The injustice brought by productive loans is highly horrible to the society

as compared to the injustice on the consumption loans which is confined to the

personal sufferings of the borrowers. In an interest based system majority of loans

from financial institutions are availed by the richer sections. This money is invested in

productive sectors or advanced for further loan. Profit from the enterprises is

appropriated by themselves and only a meager share in the form of interest come to

the bank. Thus there is a grave injustice due to the fact that 10% of contributors get

90% of return while 90% of contributors get 10% return. Even this 10% return is

faded away due to upward rise in prices due to interest. The interest paid by the

entrepreneurs included in the cost of production and bounce back to the consumers in

the way of increased prices. The net result is that the depositors actually gain nothing

from the interest oriented productive ventures. While deposit comes from a broader

cross section of the population, their benefit goes mainly to the rich77.

Interest causes a continuous flow of economic resources from the

entrepreneurs to the financiers. This happens when the rate of profit is less than the

actual interest rate. In the case of loss making ventures also the financier gets back the

principal plus part of the value added as interest. Any way the net position of the

financiers must improve. In the long run there are bound to be such periods in which a

net transfer takes place from already existing wealth of the entrepreneur borrowers to

the lenders. Wealth is made always to bring more wealth. It means a redistribution of

existing wealth of the society in favor of the owners of money capital. It may lead to

the distribution of wealth that becomes more and more inequitable as time passes.

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This is what has been happening since interest became the kingpin of the

capitalist system of banking and finance roughly over the last four centuries. While

absolute poverty declined and the lot of the poor improved, relative poverty increased

and the gap between rich and the poor widened both within nation and between

nations78. A sharing arrangement between entrepreneurs and their financiers rules out

any net transfer of existing wealth from the former to the latter. Any addition to

financier’s wealth would in a sharing arrangement come out of the new wealth created

as a result of the productive employment of their capital by the entrepreneurs.

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 finance providing 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 have more access to finance.

4.6 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

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to debtor countries. Despite continuous efforts, the debt problems faced by

developing countries seem to be ever-present. The system has demonstrated

unsustainability several times.

Debt created through Interest free finance has characteristics with which debt

crises are less likely to rise. Particularly, the total value of debt, which includes the

spot value of commodities purchased on credit as well as an implicit mark-up, is set

from the very beginning. The total value of 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, we can conclude that Islamic finance is sustainable and less liable in itself

to cause undue hardship to debtors.

One important reason for defaults in the debt from conventional institutions is

it cannot use for its prescribed purpose. Under the rules of conventional finance,

creditors assume that the use of the loans they extend would strengthen the ability of

debtors to meet their future obligations. However, conventional loans are usually

offered without ways or mechanisms to assure their use for certain purposes. In

contrast, Islamic debt is created through the finance of acquiring goods and services

on credit. In other words, the loan is used from the very beginning for its prescribed

purpose. Default resulting from improper use of borrowed funds would therefore be

most unlikely.

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As Interest free finance provided to finance investment is asset-based, i.e., it is

used to acquire real assets; it is much less likely to lead to debt crises. Such type of

asset-based finance, directly contributes to the ability of the economy to meet its

internal and external financial obligations. This is certainly a welcome effect.

4.7 Current position of Interest free finance

From previous discussions we got an idea about consequences of interest based

financial system on the economy and society as a whole. Interest free finance is the

growing alternative in almost all parts of the world to correct this. Global Islamic

banking report by Deutsche Bank in November 201179 explains the size and growth of

this sector in the following words. “Global Islamic financial assets have increased

significantly over the past three decades, reaching about US$1 trillion in 2010 (chart

4.9), up from about US$5 billion in the late 1980s. Banking assets account for the

bulk of this increase, complemented by Sukuk and assets under management (AUM).

Banking assets have been growing rapidly for several decades and rose from about

US$386 billion in 2006 to US$939 billion in 2010 (chart 4.9). Preliminary estimates

suggest that they climbed further to about US$1.1 trillion in 2011. In recent years,

growth in Islamic financial assets has generally outperformed conventional financial

instruments, particularly following the onset of the financial crisis that has been

gripping the world since 2008”.

Chart 4.9Global Islamic finance industry assets

Source: Deusche Bank 2011; International Islamic financial markets database March2012 and Earnest &Young 2011

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Islamic finance institutions are not only concentrated in Muslim countries but

major secular countries are also promoting the development of this new industry. It

is reported that Islamic finance sector has grown up to 715 banks worldwide with $1.4

trillion assets in 2011. Secular countries include UK, Japan, Canada and Singapore is

promoting Islamic finance. UK has 25 and US has 20 Islamic financial institutions

and UK is now going to become hub of Islamic finance industry in western world.

Islamic Banking has gained much attention after the Financial Crisis. That is it has not

affected the Islamic Banking sectors due to its mode of operation. And hence all the

countries are studying about Islamic Banking and are on the verge of introducing

Islamic Banking in the country80.

The global market in Sukuk (profit sharing bonds) has expanded rapidly

during this period. Sukuk, or Islamic bonds, are certificates of ownership that are

based on the concept of joint ownership of an asset by several financiers, giving it

features more like securitized equity- type financing. After dipping with the start of

the global financial crisis in 2008, the total volume of issuances more than doubled to

reach roughly the equivalent of US$48 billion in 2010 (chart 4.10). Although the

Sukuk market is small compared to conventional fixed-income or securitized products,

the weaker performance of conventional instruments during the crisis is combining

with a greater recognition by issuers that Sukuk are a feasible alternative to boost

market appetite81.

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Chart 4.10

Global Sukuk Issuance

Source: Islamic finance information service October 2011

We can find from the statements below that Islamic Banking is not just for the

Muslim society alone. The New Financial Dawn82 reported that in Malaysia, more

than 40% of the investors & 60% borrowers are non-Muslims, mostly Chinese, in

Islamic banks. One in five applicants for some of the Islamic products are non-

Muslims in Islamic Bank of Britain. In Kenya, a predominately non-Muslims

country, banks such as Gulf African Bank have indicated that as much as 20% of their

customer base is Non-Muslims. Similarly the unbanked population is also declining,

as access to finance is made more convenient. Many of the Underlying principles

investment strategies and objectives in the Ave Maria Catholic Values Fund are

strikingly similar to those of Islamic alternatives83. We can conclude from the above

details that Islamic Banking is developing day by day and its scope is very huge

especially in the modern scenario.

Islamic financial instruments are currently available in at least 70 countries,

with widely varying shares of banking services compared to conventional equivalents.

The recent financial crisis affected the asset quality of conventional banks adversely.

In contrast, as shown in recent research, Islamic banks had higher asset quality, were

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better capitalized, and more likely to continue their financial intermediation role

during the crisis than their conventional counterparts84.

The growth of Islamic banks has been significant during the past five years.

For example in Qatar, the assets of Islamic banks expanded by 43 percent during

2006– 10, substantially faster than the growth in assets of conventional banks, and

constituted around 23 percent of the country’s total banking assets in 2010.

Chart 4.11

Growth of Islamic banking and conventional banking;

Assets in selected countries 2006-10

Source: Deutche Bank 2011, 10

Islamic mutual funds come in different flavours, dominated by equity, leasing,

and commodity funds. The growth of such AUM has slowed since 2008, after

expanding by more than 20 percent a year in the first half of the decade. The sector

remains dynamic, however, with the number of Islamic funds reaching 699 in mid-

2011, compared with 608 in 200985.

In addition to banking, AUM, and capital markets, there is a very vibrant

industry of Shariah-compliant financing in other asset classes such as venture capital,

private equity, and project finance. Several major infrastructure projects are being

financed through Shariah-compliant modes of financing. It is worth noting that the

World Bank Group has sought to support Islamic finance through a variety of

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initiatives, ranging from academic research to execution of transactions. Engagement

on technical assistance, advice, and outreach has cantered on collaboration with

standard-setting institutions like the Accounting and Auditing Organization for

Islamic Financial Institutions (AAIOFI) and the Islamic Financial Services Board

(IFSB), as well as work at the country level. The World Bank Group has also tapped

Islamic financial markets86.

Islamic microfinance is also in a same position of growth. In a 2007 global

survey on Islamic microfinance, CGAP87 collected information on over 125

institutions and contacted experts from 19 Muslim countries. The survey and a

synthesis of other available data revealed that Islamic microfinance has a total

estimated global outreach of 380,000 customers and accounts for only an estimated

one-half of one percent of total microfinance outreach.

Obaidullah (2008)88 give a detailed picture of global outreach of interest free

microfinance. He observes that Islamic microfinance institutions display wide

variations in the models, instruments and operational mechanisms. While, in terms of

reach, penetration and financial prowess, Islamic microfinance institutions lag far

behind their conventional counterparts they certainly score better in terms of richness

and variety. Islamic microfinance institutions similar to conventional microfinance

institutions, use group financing as a substitute to collateral, have a high concentration

of women beneficiaries and aim at alleviation of poverty in all its forms. He listing

successfully functioning interest free microfinance institutions from different parts of

the world.

4.8 Similarities between Islamic Finance and Conventional Micro-Financing

The forgoing discussion has given a clear picture about the functioning of the

Islamic financial institutions and the merits of Islamic finance over interest ridden

finance. In the third chapter we have noted the functioning of micro finance

institutions and their advantages. It may be mentioned that Islamic finance and

conventional micro finance are the approaches which developed almost at the same

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time with same objectives. We have already demonstrated that interest based

microfinance has failed to function as an effective tool for poverty alleviation and

economic empowerment. However these two approaches have several things in

common.

The important among them are listed as under.

1) The objective of both is economic development, social upliftment and fighting

poverty

2) Both aims at financial inclusion by extending finance to those excluded from

the mainstream financial sector

3) Both advocate innovative means of finance to the poor to combat financial

exclusion

4) Strive for ensuring fair access to capital and catering to the excluded and the

under-served

5) Both recognize that financial exclusion is a vicious cycle that could be tackled

through entrepreneurship and risk sharing

6) Promote equitable economic development by empowering the poor

7) Appreciate the potential of the excluded as being disadvantaged does not

necessarily suggest lack of ability or talent to break this vicious cycle.

Different from the above, micro-financing and Islamic finance have some

fundamental differences regarding the financing modes employed, as well as their

strategic objectives. Some of these differences are listed below.

1) Micro-financing mostly in practice is interest-based financing which is

fundamentally different from the modes of finance employed by Islamic banks.

2) Profit maximization is not a goal for microfinance institutions. Islamic banks

on the other hand are private institutions and, like any other private entity,

shareholder wealth maximization is their most basic objective.

3) Funding sources are also different as Islamic banks’ capital is contributed by

private individuals who are mainly motivated by profit maximization. The

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major source of funding of conventional micro-financing institutions is from

international donors and philanthropists.

It is examined the similarities and the differences between conventional

microfinance institutions and Islamic banks, it is clear that although the two share a

lot in common, there are some stark differences. This would make us question the

practicality of the proposal that Islamic banks should directly bridge the gap vacated

by conventional micro-finance in tackling financial exclusion. Islamic micro-

financing has been suggested by many scholars as one of the most practical ways of

responding to the financial services needs of poor. As Shari’a compliant micro-

financing is one of the most popular solutions proposed by the critics of current

practices, it will devote the following part to the subject of Islamic micro-financing as

a tool for combating financial exclusion.

4.9 Modeling of an interest free microfinance

The mission of a microfinance institution is poverty alleviation and economic

empowerment. For the fulfilment of this mission the microfinance should emphasizes

access and not cost. Obaidullah (2008)89, an expert in Islamic microfinance argue that

in the first stage the microfinance institution should be a charity based (donor aided)

institution. It focuses on financial services among poorest of the poor. Sustainability

of the institution may be considered only after a shift from a charity-based approach

to a market-based for-profits approach. In this stage importance should be given to

efficiency and transparency and restrict use of donor funds. Donor funds have played

a major role in the birth and subsequent growth of the global microfinance industry.

Initial capital of many NGOs is provided by donations from international donor

organizations. Many NGOs are depends on donor funds to meet the deficits. A

microfinance institution will become sustainable only when avoiding dependence on

donor funds. But an interest free non profit microfinance institution may always

depends on donor funds or grants in different forms.

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Obaidullah (2008)90 illustrates a brief sketch about the working of an interest

free nonprofit microfinance institution. The sources of funds for IMFI are many and

varied. Some of the popular sources are including Compulsory donation (zakat or

Almsgiving), Charitable giving (sadaqa), charitable endowments (awqaf) and

benevolence loan (qard-hassan). Zakat is one of the compulsory payment for rich

Muslims while the others are discretionary and entail all forms of philanthropic

giving such as donations, gifts, charitable spending. When these are expected to

continue over long period of time they are called awqaf (charitable endowments).

Qard hasan implies loans that are free from any benefit or return to the lender and is

more commonly referred to as zero return loan.

4.9 a. Charity (non-Profit) model of microfinance

Chart 4.12

Model of microfinance charity based

Source: Obaidullah (2008)

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The model may be described in terms of activities as follows:

1) Microfinance Institution creates a Zakah (compulsory charity) fund.

2) Mobilising Waqf (charitable endowments) of physical assets as well as

monetary assets. The physical assets are used to facilitate education and skills

training.

3) Program carefully identifies the poorest of the poor and financing for the

improvement of living condition from zakah funds.

4) Program provides skills training to economically inactive, utilizing

community-held physical assets under waqf;

5) Beneficiaries graduate with improved skills and managerial ability;

6) Beneficiaries are formed into SHGs;

7) Financing is provided on the basis of qard hasan (benevolent loan) to the

group;

8) Group members pay back and in turn, are provided higher levels of financing;

9) Actual defaulting accounts are paid off with zakah funds; this is indeed the

distinct feature of this model

10) Group members are encouraged to save under appropriate micro savings

schemes;

Obaidullah (2008)91 discusses three major non-profit modes of Islamic

microfinance – zakah, awqaf and qard hasan means compulsory charity, charitable

endowments and benevolent loans. By incorporating these techniques develop a

model of microfinance. This is a model that uses for non-profit modes only. The

model is presented in Figure 4.12.

It was pointed out in second and third chapters that main drawback of

conventional microfinance is it cannot provide services to poorest of the poor. The

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main reasons specified by many writers that lack of education and skill, absence of

any type of assets etc. Charity based Islamic microfinance is targeting this group of

people first. By using funds from donations and grants in different modes various

services are provided. They cannot need loans first; but fulfilment of livelihood

means. For the same different type of activities like supplying of necessary goods,

availing medical care, educational promotions are implemented. And to promote this

group to economically active poor, skill training are also given. In the next stage

SHGs are forming among them and regular microfinance services like savings, credits

and insurance are provided.

In a secular set up like India not only the members from Muslim community

but also others wants to introduce interest free micro finance. By using this model it is

possible to develop such microfinance. Instead of Islamic terminologies like zakah,

waqf and qard hasana it is possible to develop seed money by receiving donations

from likely minded peoples and public. By using this initial fund try to avail welfare

measures, education and training programmes and other measures to make them

economically active. Then by forming SHGs and collecting thrifts develop a fund and

provide interest free loans. When this system develops other products of microfinance

also is introduced.

Meeting of expenses of microfinance institution is a question to all interest

free microfinance. When commercial microfinance institutions become sustainable by

earning through collection of interest and other means, interest free microfinance on

non profit basis has no such option. Many institutions are collecting a nominal service

charge but it is only for office stationary expenses. But most prominent non profit

microfinance institutions are depends widely on volunteer ship to reduce cost. These

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types of NGOs have very few paid staff at the management and executive level; and

its local level activities are managed by volunteers.

4.9 b. Profit based model of microfinance

Profit based model of interest free microfinance is combining charity based

and participatory modes. After developing poorest of the poor to economically active

poor participatory methods are using. The model is presented in Figure 2 below.

Chart 4.13

Profit based model of microfinance

Source: Obaidullah (2008)

189

The model may be described in terms of activities as follows:

1. Microfinance institution creates a Zakah fund.

2. Program facilitates Waqf of physical assets as well as monetary assets. The

physical assets are used to facilitate education and skills training

3. Program carefully identifies the poorest of the poor and financing for the

improvement of living condition from zakah funds.

4. Program provides skills training to economically inactive, utilizing

community-held physical assets under waqf;

5. Beneficiaries graduate with improved skills and managerial ability;

6. Beneficiaries are formed into SHGs;

7. Financing is provided using participatory and debt based modes, such as,

ijara, salam, istisna or isthijrar or equity based modes, such as, mudaraba or

musharaka or declining musharaka;

8. Group members pay back their debt; and/or perform and meet the expectations

of equity providers and, in turn, are provided higher levels of financing;

9. Actual defaulting accounts are paid off with zakah funds;

10. Group members are encouraged to save under appropriate micro savings

schemes;

Islamic Microfinance includes not only non profit modes but also for profit

modes. When poorest of the poor got the services of interest free loans and other

services of non profit modes only, the “economically active” category of poor may be

provided finance using for-profit modes as well. Such groups do not belong to the

extremely poor or the destitute category and are in a position to create wealth. These

types of financing provide financial sustainability to Islamic Microfinance Institutions

(IMFI). The instruments used for mainstream financial institutions are the same for

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microfinance with minor modifications wherever needed. By applying these modes to

economically active poor the beneficiary’s income will increase and at the same time

the IMFI received a part of income created by the client.

4.10 Instruments used in for profit model

4.10 a. Micro-Savings

Poor need a range of microfinance services, such as, micro-savings, micro-

credit, micro equity, micro-insurance and micro-remittance. Micro-savings are an

important financial service for financially excluded. Poor people want deposit

services that allow for small balances and transactions. There are different options for

saving in Islamic finance. Those are wadia (Trust account), qard hasan (benevolent

loan) and mudaraba (trusteeship partnership). All these products must be free from

elements of interest and uncertainty.

Wadia means trust deposits. Under wadia mechanism, the deposits are held as

trust deposits and microfinance institution is utilized at its own risk. Any profit or loss

resulting from the investment of these funds accrues entirely to the microfinance

institution. There is no special condition for withdrawal.

Another form of deposits is benevolent loan (qard hasan) by the depositor to

the microfinance institution. The institution utilise this deposits at its own risk. As a

depositor the lender is not entitled to any return as interest or profit. The saving

products under wadia and qard are not allowing any excess over and above the

principal to the depositors.

Different from above savings under trusteeship partnership (mudaraba) is

allowing share of profit to the depositor. Here the depositor authorizes the

microfinance institution as an entrepreneur (mudarib) for the purpose of investing the

funds. If the profit is positive, are shared between depositor and microfinance

191

institution as per a pre agreed ratio. When profit is negative, it is absorbed by

depositor. There is freedom to withdraw deposits in this mechanism only with pre

agreed basis.

When the savings are remunerated on the basis of revenue-sharing rather than

profit-sharing, the underlying mechanism is not a classical mudaraba but an agency

contract known as wakala. In this contract the depositor appoints the microfinance

institution to manage its funds.

4.10 b. Micro-Credit

Micro credit is the important service of a microfinance institution. The

alternative to interest-based conventional loan the Islamic microfinance has products

of different nature. The operational features of these products we have already

discussed. Those classified in to contracts of exchange and contracts of charity.

These products are developed by mainstream Islamic financial institutions. Contracts

of exchange are murabaha, ijara, ijara wa iqthina, isthisna and salam. The main

contract of charity is qard hasana loans. The partnership contracts are using for equity

financing and not for credit. The important micro credit products are discussed briefly

as under.

1) Micro Murabaha (Cost-Plus Sale)

Under this model, the microfinance institution selling durable consumption

goods or producer goods like vehicles, machineries etc. to the clients on deferred

payment basis. Here the MFI is fixing the price with the cost plus a markup for

covering administrative costs. The borrower often pays for the goods in equal

installments or paying in lump sum within a specified period of time. Interest free

microfinance institutions working in India as well as abroad are operating this model.

In a murabaha, both parties in the transaction must know the cost and the profit or

192

mark-up. Where the seller does not disclose the cost and profit thereon, the

transaction is called musawama.

2) Micro-Leasing (Ijara)

Ijara implies leasing or hiring of a physical asset. It is a popular debt-based

product in which the IMFI assumes the role of a lessor and allows its client to use a

particular asset that it owns. Producers, farmers and households needed different types

of equipments and machineries. But they have no capability to purchase the same. All

kinds of income-generating equipment or physical asset, such as, tools and machines

to manufacture commodities, rickshaws and boats to transport, carts to sell

merchandize and low-cost houses may be financed through this mode. Here the

clients are paying rent to the institution.

3) Deferred delivery sale (Bai-salam)

Salam is a deferred delivery contract. It is essentially a forward agreement

where delivery occurs at a future date in exchange for spot payment of price. This

mechanism is originally designed as a financing mechanism for small farmers and

traders. Under a salam agreement, a farmer or a trader in need of short-term funds

sells its output or merchandize to the IMFI on a deferred delivery basis. It receives

full price of the merchandize on the spot that serves its financing need at present. At a

pre-agreed future date, it delivers the merchandize to the IMFI. The IMFI sells the

merchandize in the market at the prevailing price. Since the spot price that the IMFI

pays is pegged lower than the expected future price, the transaction should result in a

profit for the IMFI.

4) Manufacture contract (Bai-Istisna)

Bai-Istisna is a contract of manufacture. A seller under an istisna agreement

undertakes to develop or manufacture a commodity with clear specifications for an

193

agreed price and deliver after an agreed period of time. The unique feature of istisna

is that nothing is exchanged on spot or at the time of contracting. The buyer makes

payment of price in parts over the agreed time period or in full at the end of the time

period. In an istisna, the seller and the manufacturer may be different entities. This

allows an IMFI to engage in istisna by assigning the job of development, manufacture

or construction to a third party under a parallel istisna arrangement.

5) Qard hasana

In this system microfinance institution is providing micro credit on interest

free basis. Funds are transferring without receiving any return to meet urgent needs of

the client. For meeting the working expenses service charge is collecting from the

borrowers. There is lots of interest free microfinance institutions are working in

different countries by using this model only.

The above mentioned modes create debt and may be used as an instrument of

microcredit. There is a possibility of default here. Islamic modes do not admit the

possibility of any payment in excess of the original amount of debt in any cases. But

scholars generally permit the IMFI to impose a penalty on the defaulting client to act

as a deterrent against wilful default, but such penalty must be donated to a charity. It

cannot be treated as an earned income for the IMFI as this would tantamount to

interest.

4.10 c. Micro-Equity

Interest free Islamic MFIs may consider various partnership based modes or

equity based modes for microfinance. Three modes commonly discussed in this

context are mudaraba and musharaka and diminishing musharaka. The former

involves a combination of entrepreneurship and capital while the latter involves a

partnership in entrepreneurship and capital. Diminishing musharaka is lead to

194

complete ownership of asset or project by the micro entrepreneur. The operational

features of these instruments are already discussed in the first part of this chapter.

These equity-based products are unique to Islamic microfinance and in some sense,

account for its superiority over conventional microfinance on grounds of ethics and

efficiency.

4.10 d. Other Services

Major financial techniques in Islamic microfinance have already discussed.

All these techniques are used in for-profit models. But non profit models are

practicing only those techniques which promote welfare of the people. For-profit

microfinance simultaneously operates these two types of products. As a financial

entity there are lot of scope to microfinance institutions to perform various types of

services to the beneficiaries. Few of them are fee based products while others are

service charge based. By inculcating all the activities under an umbrella of

microfinance institution it may become more effective for poverty alleviation and

socio economic upliftment. Islamic finance has lot of such like products and practices

to apply microfinance field. In the following part a brief discussion on some accessory

contracts and few new types of techniques are discussed.

1) Ar-rahn (pledging)

When People needs money for urgent transaction purposes one of the ways to

seek it is from financial institutions by pledging gold. Conventional financial

institutions are charging interest for the same. But lots of interest free financial

institutions are working in different countries on interest free basis and they are

serving the same function. Ar rahn means simply gold loan. A service charge is

receiving from the beneficiaries for meeting the operational expenses.

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2) Hybrid products

Many interest free microfinance institutions are developed hybrid products for

providing service to different types of beneficiaries. Important among them is

salam+murabaha financing in agricultural sector. This model is practicing in Srilanka

to develop paddy cultivation. Here agricultural inputs are selling to the paddy

cultivators on murabaha basis. To assure the reasonable price and demand the output

is purchased by MFI on salam basis. Here Paddy cultivation is promoting through this

hybrid model.

Another hybrid model is Murabaha+Ijara. Here input is selling on murabaha

basis and machineries are provided by ijara basis. For the promotion of agricultural

production and resultant employment microfinance institutions are developing this

model and practicing in different countries.

3) Micro thakaful (insurance)

In Islamic finance thakaful means insurance. Microfinance includes insurance

also. Scholars developed a particular type of insurance to fit rural poor on sharia

compliant basis. This is known as micro insurance. Small premium from the thrifts of

members of MFIs are collecting and insuring the micro enterprise or any other assets.

The cost of risks is taken from common funds of the clients. This type of insurance is

practicing different institutions.

4) Kafala (Suretyship)

Kafalah means to add an obligation to an existing obligation in respect of a

demand for something. This may relate to a person, finance or act (performance). In

simple language it is a bail. In microfinance instead of physical collateral SHGs and

other models widely depends on mutual bails. If a delay is happens in the payment by

principal debtor a delay also granted to surety.

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5) Hiwalah (Transfer of debt)

Hiwalah means transferring a debt from one debtor (transferor) to another

(transferee). Once the transferee has accepted the transfer of debt, the transferor

would be released from any obligation. In many occasions the transfer of debt is

occurred in micro finance activities.

6) Hibah (Gift)

Gift contract is defined as a voluntary contract that results in uncompensated

ownership transfer between living individuals. There are two categories of gifts:

presents given to please the recipient, and charities given to please God. The

properties may be known or unknown, but they must be conventionally given as gift.

The use of property transfer in those definitions is stipulated to exclude loans, as well

as the transfer of non-valued properties. In the case of poverty alleviation and

economic and social upliftment microfinance institutions sometimes depends on gifts

to mobilize resources.

7) Bai’al istijrar (Supply contract)

Istijrar is not a specific mode; it is rather a repeat sale purchase arrangement of

normal sale in which a seller agrees to sell various units of a commodity from time to

time. The seller may also deliver the commodity agreed upon once in a number of

consignments and the price may be determined in advance, with every consignment or

after the delivery of all consignments. The terms and conditions of repeat sale may be

of any normal cash or credit sale. An agreement may take place between the buyer

and the supplier, whereby the supplier agrees to supply a particular product on an

ongoing basis, for example monthly, at an agreed price and on the basis of an agreed

mode of payment. While interest free microfinance institutions are mostly depends on

197

financing in the form of raw materials, consumer durables or productive equipments it

needs this type of contract.

8) Ju‘alah (reward)

Ju’alah is a contract in which one party undertakes to give a specific reward to

anyone who may be able to realize a specific or uncertain required result. Ju‘alah may

be used by Islamic microfinance and banks for recovery of overdue debts and certain

other services whereby the subject of the required work cannot be minutely specified.

9) Wakalah (Agency)

It is defined wakalah legally as the delegation of one person (the principal) for

another (the agent) to take his place in a known and permissible dealing. In this

regard, the wakil (agent) deals in the other’s property and preserves it. Islamic

microfinance may act as agent for beneficiaries or the institution may appoint other

institution or individuals as agent to fulfill certain services.

10) Ujrat (Fee)

Ujrat means fee. The poor also need many other services besides savings and

financing, such as, remittance. These services may be easily provided by an IMFI in a

fee (ujrat) based framework. In order that these services are provided in interest free

manner, scholars insist that the amount of fee permitted.

The discussion in this chapter makes it clear that conventional interest based

financial system has many drawbacks. It also gave a brief idea about theoretical

framework of interest free microfinance institution. Interest free microfinance is not

only a concept now but is practicing in different parts of the world including in our

state. As a viable alternative to interest based system, interest free Islamic financial

techniques are practicing in different countries. In the microfinance sector also have

lot of such initiatives. It is reported that many positive results of Islamic microfinance

198

on poverty alleviation in different countries. The next two chapters of this study are

examining the impact of these ventures on its beneficiaries in Kerala.

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