BASIC DEFICIENCY AND DEFECTS IN
ISLAMIC BANKS AND THE REMEDY

Note : It is a commentary on IDB-IRTI occasional paper no. 4 ‘Islamic Banking: Answers to some frequently asked questions’ authored by Dr.Munawar Iqbal, Dr.Mabid Ali Al-Jarhi and Dr.M.Umer Chapra. The comments relate mainly to the opinions and proposals which, though well-intentioned, are faulty and detrimental to the cause of elimination of interest. The comments are forthright made in right earnest and should be taken in that spirit. However, I offer my apologies if any comment hurts the feelings of any of the respected authors. Helpful response, queries and reasoned criticism will be gratefully received.

UNANSWERED QUESTIONS: Following challenging questions in a published article written by a highly placed bureaucrat in Pakistan trying to prove that Supreme Court order to eliminate interest cannot be implemented, remain unanswered.

(i)                 Is there any single bank in the Islamic or Non-Islamic world which is truly run on an interest-free basis?

(ii)               Can a Central Bank conduct its monetary policy without a norm of interest?

(iii)             Are not the practices of Islamic banks a queer blend of interest-based modes of finance carrying a façade of Islamic names?

(iv)             What are exactly the Islamic compliant instruments of finance? Can these instruments meet the myriad and diverse needs of modern trade, finance and banking?

(v)               When and where have these instruments been applied and with what degree of success?

(vi)             Does the Islamic Development Bank as the model Islamic bank operate on interest-free basis? If that is the case why did it offer to extend a loan to the government of Pakistan after nuclear detonation at an interest rate of 5% above LIBOR?

(vii)           By what mechanism can Islamic banks undertake financial intermediation

which is the primary function of all commercial banks throughout the world?

I have brought these questions to the attention of many Islamic economists pleading that these can be satisfactorily answered by inception of an interest-free lending instrument (TMCL) in Islamic banks. My several repeated appeals have remained un-replied. Whilst Islamic economists are keeping silent the advocates of interest have succeeded in getting one year extension in the period fixed in the Supreme Court order for eliminating interest and now they are trying to have the Supreme Court order set aside or shelved.

THE DEFICIENCY: The paper limits Islamic modes of finance to “carrying out of investment and / or the purchase of goods, services and assets”. These modes cannot meet the financial needs of very large number of cost-conscious privately owned firms keen on protecting their independence and ownership structure. Such firms form large source of productive manpower employment and they cannot be ignored. Their financial needs in Islamic financial system can be fulfilled only through interest-free lending. Hence to satisfy the financial needs of all sectors of the economy interest-free lending must be included in the Islamic modes of finance.

THE DEFECTS: For meeting their own short-term needs of liquidity Islamic banks take loans on interest from conventional banks and almost all Muslim governments also do the same. Muhammad Taqi Usmani who is chairman / member on Shariah Supervisory Boards of a dozen Islamic banks and financial Institutions, in his book ‘INTRODUCTION TO ISLAMIC FINANCE’ writes “The case of Islamic banking cannot be advanced unless a strong system of inter-bank transactions based on Islamic principles is developed. The lack of such a system forces the Islamic banks to turn to the conventional banks for their short-term needs of liquidity which the conventional banks do not provide without either an open or camouflaged Interest”.

The paper places modes of financing used by Islamic banks in two categories “advancing funds on a profit-and-loss sharing basis” and “financing the purchase / hire of goods (including assets) and services on a fixed-return basis”. The paper mentions “the share of profit-sharing modes in the total financing by Islamic banks is very small. Most of the financing is provided on a Murabahah basis”. Murabahah which is permissible in Shariah is a sales contract at a price markup between buyer and seller. In fake Murabahah transactions Islamic banks do not actually buy or sell and they simply provide finance to buyers in a round about manner through proxy buying and selling and use this mode only to legitimize fixed-return on capital which virtually is the same as interest earned by conventional banks. Following excerpts from an article written by Arshad Zaman and Asad Zaman published in April 2001 issue of ‘Islamic Economic Studies’ support this contention. “Thus in principle interest-based transactions have been replaced by those based on Murabahah, leasing and some Musharakah all of which are permissible under Shariah. Appearances are deceiving, however, and only the form of the transactions have changed with no change in the underlying transactions”. “Another issue of importance to consumers is the financing of loans… . These can easily be handled via the instrument of Murabahah… . There are virtually no differences between it and the conventional interest-based financing”.

The paper acclaims (i) “Islamic scholars and practical bankers took up the challenge and have made commendable progress in the last 25 years in providing a number of such instruments”. (ii) “Another manifestation of the success of Islamic banking is the fact that many conventional banks have also started using Islamic banking techniques in the conduct of their business, particularly in dealing either with Muslim clients or in predominantly Muslim regions”. However, borrowing on interest and earning profits akin to interest by Islamic banks show that the financing modes in their use bring prosperity to them and attract conventional bankers, having no ideological preference for Islamic ways, to open Islamic windows only to exploit religious sentiments of Muslims, but these modes cannot pave the way to Islamise the financial system. It is a matter of serious concern for committed practical bankers and hierarchy in IRTI who should either devise a new financial intermediation mechanism for getting the Islamic and conventional banks rid of interest or give serious consideration to accept the way shown by late Professor Sheikh Mahmud Ahmad. Upon my taking up the problem of shortcomings in Islamic banks personally with IDB President during Fourth International Conference on Islamic Economics and Banking held in UK in mid-August 2000 I received the following encouraging response from IDB: “REFERRING TO THE DOCUMENTS SUBMITTED TO H.E. THE PRESIDENT OF ISLAMIC DEVELOPMENT BANK (IDB) ABOUT YOUR OBSERVATION ON THE ISLAMIC BANKING MOVEMENT, WE APPRECIATE VERY MUCH YOUR GOOD EFFORTS AND INSIGHTS. THE ISLAMIC BANKS' OFFICE OF IDB WILL TRY TO DO ITS BEST TO COMMUNICATE TO THE ISLAMIC BANKS THE SHORTCOMINGS THAT YOU HAD MENTIONED IN YOUR DOCUMENT”.

Unfortunately further to the above advice, nothing appears to have been done by Islamic Economists and Bankers towards eliminating interest from the banking system.

DESCRIPTION OF ISLAMIC BANK given in the paper needs to be modified to include interest-free lending and borrowing in the scope of activities and to exclude fixed-return on capital akin to interest. Without these modifications Islamic banks cannot qualify to be Islamic nor can they meet the financial needs of all sectors of the economy.

THE REMEDY: Interest-free lending and borrowing can remedy the deficiency and defects in Islamic banks and eliminate interest from the banking system. Hence the need for an interest-free lending instrument. Wide spread practical use of Islamic concept of Qard Hasan i.e. interest-free lending for productive purposes is highly commendable and deserves to be encouraged as according to a Hadith reward for lending is eighteen times. There are several authentic examples in Islamic history of staunch Muslims investing loaned sums in trade. It is a gross misconception that Qard Hasan is meant only for the poor and disabled whose needs are fulfilled through zakah and sadaqaat in Islamic economic system. It is a pity that nowhere in the paper under discussion interest-free lending is mentioned although it is the most useful and commendable means for economic development. The paper mentions “Monetary economists insist that a zero nominal interest rate is a necessary condition for optimal allocation of resources”, “when this matter was investigated within general equilibrium modes it was found that a zero interest rate is both necessary and sufficient for allocative efficiency”, “those studies have shown that a system which is based on profit-sharing is not only viable, but also carries with it many advantages which make it superior to interest-based ones”. No doubt profit- sharing mode of financing is far superior to interest-based lending, but due to moral hazard profit-sharing on large scale has proved to be impracticable. In these circumstances it is necessary to put in use another zero interest rate mechanism i.e. interest-free lending as a mode of finance. Interest-based lending, though exploitative, has played a major role in the enormous economic development by providing finance freely and widely to industry, commerce and agriculture. Interest-free lending being commendable as a rewarding mode in Shariah will definitely bring economic development to an extent far greater than that brought by interest-based lending and what can be expected from wide spread use of profit-sharing which is permissible in Islam but not as rewarding as interest-free lending.

PLANNED GRADUALISM: The paper claims “gradualism in implementing the Shariah injunctions is well-recognised”. It is a misconception because each and every Divine command was fully implemented immediately upon revelation. There is not a single instance of any sinful act being permitted to persist for any duration. The juristic rule quoted in the paper “what cannot be attained in its entirety should not be left entirely” applies to attainment of good and not to shedding of evil. Allah’s laws are all for the good of mankind at all times and in all circumstances. It is inconceivable that elimination of interest even if it is done abruptly could bring any harm because Allah assures in Quraan “those who act upon My instructions will have nothing to fear nor will they be sorry”. It is therefore wrong to contend as is done in the paper that “it is not advisable to carry out transformation from a conventional to an interest-free banking system abruptly, as this may subject the banking system as well as the rest of the economy to needless shocks”. The paper does not specify what are those needless shocks to the economy and banking system which need to be avoided at the cost of earning Allah’s wrath by maintaining interest in the banking system.

Gradualism is understandable and can be acceptable for transforming the whole economic system to Islamic System. However, gradualism in eliminating interest cannot be acceptable in any circumstances because giving up of interest is condition of Iman and Quraan declares war from Allah and His Rasool saws against perpetrators. Interest must, therefore, be eliminated forthwith and not gradually. No doubt “every system has its own institutional requirements” but these come into being through constant evolving process which goes on side by side with the expansion and development of the system. However, elimination of interest must not be delayed on any account.

HYPOTHETICAL PLAN TO APPLY THE ISLAMIC MONETARY SYSTEM AS PER TABLE 5 IN THE PAPER indicates universal + Islamic banking in the first two-year phase, no commercial banking during the second two-year phase and only Islamic banking in the third two-year phase. The plan states “Obviously, switching to universal banking and adapting to Islamic banking must be done within a specified time limit. A period of four years, extending to the end of the second phase would be reasonable”. The plan suggests a period of four years for adapting to Islamic banking without defining actual practical steps for achieving these objectives. The plan implies that interest will persist for at least four years from the day any establishment decides to implement Allah’s Will or in other words it will take four years to bow to Allah! Allah’s laws are enforceable at all times and in all circumstances. The paper does not indicate what are the obstacles in the way of eliminating interest removal of which will require as long a period as four years. The obstacles if any in eliminating interest will be either imaginary or man-made as there can be no real obstacle in the way of eliminating interest forthwith as Allah declares in Quraan “He has not produced any obstacle for you in (the way to follow the edicts of) the religion” and also “whosoever fears Allah, He makes for him way out (of difficulties) and provides to him from (sources) which he cannot imagine and whosoever depends on Allah sufficient is He for him”.

DOCTRINE OF NECESSITY AND INTEREST-BASED FOREIGN BORROWING: The paper suggests “interest-based foreign borrowing can only be resorted to in case of compelling need for development purposes which amounts to ‘necessity’ as determined by the Ulama”. Doctrine of necessity can be invoked only in cases where Allah Himself has allowed some concession like eating pork for saving life. It cannot be invoked for continuing interest for which Allah has not allowed any concession whatsoever. Ulama cannot permit what Allah has prohibited. For Muslims nothing can be more compelling a need than desisting from committing a planned sinful act amounting to rebellion against Allah and His Rasool saws. Islamic countries can get rid of interest-based foreign borrowing by setting up a Central Depository-cum-lender of last resort for receiving deposits from Islamic banks and countries having surplus funds and advancing loans to other Islamic countries and banks needing funds for development. Central Depository will use same interest-free lending and borrowing mechanism as suggested for Islamic banks. The Central Depository will invest surplus available funds in profitable Islamic modes of business.

PUBLIC DEBT: The paper suggests “in the first phase the country must seek debt-relief (debt forgiveness as well as rescheduling) through active and energetic contacts with donors’ forums. The fact that it is embarking on serious and rigorous financial and structural adjustment program would go a long way in persuading donors to provide debt-relief”. So-called donors are in fact lenders of money on interest and they are no friends of the borrowers. Their recent behavior clearly shows that they want to dictate the borrowing countries. It is a mistake to expect them to do anything to help the borrowers to come out of the debt morass and become independent of them. Instead of begging for debt forgiveness or debt rescheduling Islamic countries must build self-sufficient interest-free financial system capable of clearing current debts and providing interest-free loans in times of need. These objectives can be very well achieved by utilizing interest-free lending and borrowing mechanism as suggested for Islamic banks.

NOVEL IDEA OF PRACTICAL APPLICATION OF QARD HASAN IN BANKING was presented by late Professor Sheikh Mahmud Ahmad applauded in Supreme Court of Pakistan judgment in Riba case as “our country’s most outstanding economist and researcher and a leading thinker--had devoted considerable part of his life in the study of the theory of interest”. He devised interest-free lending instrument which he named as Time Multiple Counter Loan - TMCL consisting of two simultaneously exchanged interest-free loans between two parties such that the multiple of the amount and period of one loan equals the multiple of the amount and period of the other loan. It facilitates interest-free loaning of large sums against counter-loans of smaller sums advanced for proportionately longer periods. For example an entrepreneur requiring a loan of $10.0 Million for one year can get interest-free loan of $10.0 Million (against collateral as usual) for one year by advancing an interest-free counter loan of $1.0 Million to the bank for 10 years. Thus TMCL fulfills the client’s need of funds for the required period and also enables the bank to earn profit from long-term investment of counter-loan money. Whatever gain or loss the bank earns comes from investment of counter-loan amounts which are actually borrowed sums and in Islam there is no bar on earning profit by investing borrowed sums. In interest-based loaning the lender always gains because he earns interest whereas the borrower may gain or lose from investment of the borrowed sum. Therefore interest-based loaning is inequitable and unjust. In TMCL transaction none of the two parties is a definite gainer and each one of them may gain or lose by investing the loan taken from the other party. Hence TMCL transaction is equitable and just. In TMCL transaction each party does good to the other party and as such TMCL-based loaning conforms with the Quraanic precept Hal jaza-ul-ihsaan illa al-ihsaan and the noble teaching of our Prophet saws that a favour done to any one should be reciprocated.

As TMCL can perform Islamically all legitimate financial intermediation functions which are performed by interest, it can instantly and effectively replace interest without any disruption in the banking system. After switching over to TMCL-based loaning system the banks will continue to function as usual with the basic change that no interest will be paid or charged. All loans will be advanced against counter-loans and all transactions involving credit will be executed on TMCL-basis. Banks will continue to receive deposits and issue cheque books as usual. Account holders will have the option to keep their money in investment or demand deposit accounts. Investment account holders will share profit/loss with the bank on daily product basis. Banks will earn profits by investing counter-loan amounts and surplus deposits in Shariah-compliant modes like stock exchange, real property, musharakah, mudarabah, etc. Outstanding interest-based loans will be converted into TMCL-based transactions. Each borrower will repay only the principal amount of loan on due date or earlier and instead of paying interest the borrower will advance to the bank a counter-loan of the same amount as he took in loan and for the same period for which he availed the loan. Alternatively the bank and the borrower may mutually agree to a different amount of counter-loan for proportionately longer or shorter period on TMCL-basis. Interest-bearing bills and bonds will be encashed at their face value and the holders will receive appropriate counter-loan on TMCL-basis from the issuer.

In the interest-free regime there will be no role of interest-based treasury bills and bonds etc. and all such documents will cease to be issued and no function involving interest will be undertaken by the Central Bank. Other functions not involving interest will be performed as usual. The Central Bank will set up a framework of Central Depository-cum-lender of last resort for mobilizing surplus funds of banks and federal and provincial governments and autonomous bodies and advancing interest-free loans to them in times of need. The Central Depository will receive deposits and advance interest-free loans on TMCL basis. For example, if a bank has a surplus of Rs. 5.0M for 1 month, it may deposit this sum for 1 month with the Central Depository and obtain an interest-free loan of Rs. 0.5M for 10 months. If a bank is short of liquidity and requires Rs. 10.0M for 1 week, it will obtain from the Central Depository an interest-free loan of Rs. 10.0M for 1 week by depositing Rs. 1.0M with the Central Depository for 10 weeks. Central Depository will also earn profits by investing surplus funds in Shariah-compliant businesses.

Adoption of TMCL as loaning instrument by Islamic banks will bring the following benefits to Islamic banks and the Muslim ummah as a whole.

1.      It will open for Islamic banks the vast field of loaning to reliable and capable cost conscious entrepreneurs who want to remain independent and in full control of their enterprises and do not accept any sharing of profit or outside interference. Without providing loans to this big class of loan seekers, Islamic banks will not be able to compete with western banks who have started capturing business in Islamic investment field.

2.      It will facilitate inter-bank interest-free loan transactions and Islamic banks will not have to turn to western banks for meeting their short-term needs of liquidity.

3.      It will facilitate setting up of a central depository for mobilizing surplus funds of Islamic banks and governments on TMCL-basis and advancing to them in times of need TMCL-based interest-free loans.

It will facilitate utilization of the financial resources of the Muslim ummah in developing Muslim countries through the Central Depository, instead of being diverted to western financial markets.

UNJUSTIFIED BIAS AGAINST TMCL: Unfortunately mainstream thinking among Islamic economists and bankers mistakenly favours gradual elimination of interest whereas use of TMCL can eliminate interest forthwith and perhaps that is why they do not treat inception of TMCL in banking with the vigour and rigour it deserves. Following are three specific examples of unjustified bias against TMCL.

In his book ‘Towards a Just Monetary System’ Dr.M.Umar Chapra writes “The method of Time Multiple Counter Loans could be adapted for small-scale financing particularly within the framework of co-operative institutions. For commercial banks, it would be of limited applicability”. He does not give any reason for putting limitations on the use of TMCL which can perform all functions as are performed by interest in the modern banking system.

‘The Blue-print Of Islamic Financial System Including Strategy For Elimination Of Riba’ published by International Institute Of Islamic Economics, International Islamic University, Islamabad includes short comment on TMCL: “One may argue that TMCL instrument offers an ingenious solution to the problems of Riba, gharar and having two mutually exclusive conditions in one contract. But its viability is questionable for several reasons. Some of these are as follows. Counter loans would be liability of the banks. Therefore, while the sum generated might be used to meet their operating expenses it would not be distributable as profits among their share holders or depositors who provide funds on partnership basis. This will compel the banks to turn to trading, leasing and other profitable options. It is also possible that clients may use loans from banks, whether directly or indirectly, to give, the counter-loans. This, in turn, casts further doubts on the usefulness of the TMCL option. Last but not the least, a recourse to TMCL is not advisable because the ensuing credit expansion is likely to fuel inflation.”

Obviously the above cursory remarks on TMCL have been made without taking into account the following important points. The sum generated by counter-loans will be invested in long-term profitable business. The profits earned by the banks will be shared with the depositors in investment accounts. There is no harm in the banks turning to shariah-compliant trading modes as is done by all Islamic banks. Every loan will be advanced against collateral and will have to be returned on due date. There is no reason why any sensible person will use the loan from bank to give counter –loans for further loans instead of utilizing it in meeting his business requirements. Credit expansion will be controlled by raising or lowering the time multiple ratio in TMCL just as it is controlled in the present system by raising or lowering interest rate.

During question and answer hour at the end of a session at Fourth International Conference on Islamic Economics and Banking I raised the question as to why TMCL was not used for getting Islamic banks rid of interest and enhancing economic co-operation among Islamic countries. Dr.Najatullah Siddiqui answered every other question raised by the audience but he completely ignored my question and did not say a word about it.

SUCCESS, FAILURE AND THE RISK: Islamic scholars and economists won the battle against interest and Supreme Court of Pakistan settled once for all in Dec 1999 that interest is Riba and ordered its elimination by 30^th June 2001. Soon after the Supreme Court Order was passed advocates of interest began striving to render the order ineffective. UBL filed a review petition in the Supreme Court which came up for hearing in June 2001 at which time UBL succeeded in getting one year extension in the date for elimination of interest on the plea that there was no viable interest-free banking plan available to replace the existing system. Eight months have passed since the extension was granted and still the above plea remains un-repelled. If on the next hearing of UBL review petition, any day before 30^th June 2002, a viable interest-free banking plan to replace the existing system is not presented, then there is grave risk of Supreme Court Order being set aside or shelved. If, God forbid, it so happens it will be highly tragic as it would bring to naught more than half a century’s strenuous efforts of dedicated Muslims to get the curse of interest banished from the country.

APPEAL AND PRAYER: To avert the tragedy of Supreme Court Order being shelved, Islamic economists are urgently required to either present their own viable interest-free banking plan or actively support the proposal to replace interest by TMCL in the banking system. I earnestly request them to rise to the occasion and do whatever they can to frustrate the efforts of advocates of interest. I wish and pray that Islamic economists will not let it be said that champions of Islamic economic system did not prove equal to the task to show practicable way to implement Allah’s Law to eliminate interest and the way for Islamic countries to retain / gain economic independence. Wassalam.

contact writer at aw_khan@hotmail.com