Islamic Banking A Derivative of Islamic Economics

Islam has a particular worldview and value system and gives specific guidance and instructions encompassing almost all aspects of life, including economic life of man. The Islamic system of life is an organic whole. However, based on instructions and guidance relating to different aspects of life it is possible to describe various sub-systems of this unitary system. Hence there is a scope to talk in terms of economic system – or sub-system – of Islam.

A dominant view of economists is that economics is a study related to scarcity of resources that have alternative uses. From Islamic viewpoint the notion that resources are scarce is not acceptable in the absolute sense because Allah, the Creator, has provided resources in just, if not abundant, quantities. The scarcity arises on account of the unrestricted claims on the resources and the failure of human beings in their equitable distribution. Islamic economics aims at this distribution of resources ensuring well-beings (falah) and good lives (hayat-e-tayyiba) of human beings. In conventional economics it is said that human society produces on the bases of four factors of production namely land, labour, capital and entrepreneur and these four factors are paid back in the form of rent, salary, interest and profit. Islamic economics, on the contrary, negates the justification of interest as a payment against capital. Provision of capital is the responsibility of the entrepreneur and so there is no justification of payment of any additional payment of interest over and above the profit. Profit, in Islamic system, takes care of all that the entrepreneur does, including arrangement of capital.

One aspect of man’s economic life that has grown tremendously in the last couple of centuries relates to banking. Although banking is simply a small segment of economic activities that is relevant only at its transaction and service levels, the pace of growth in this field has been so much fast and the outcomes so much cumbersome that this segment of economics has taken the centre stage. Banks provide valuable services for economic life of man, inter alia: Financial services like transfer of funds, and safe deposits of money and valuables; pooling small deposits and financing wide range of projects; meeting maturity and liquidity requirements of both individuals and corporate sectors; spreading risks of the economy through its portfolio management; and, screening financial viabilities and technical feasibilities of projects, including their internal savings vis-a-vis debt-servicing position, and monitoring their performance, etc.

The rapid growth in the banking sector occurred mostly in the last three millenniums. This coincided with the scientific and technological developments in the western hemisphere. Ironically, this period saw a relative slump, if not de-growth, in the eastern countries, particularly Muslim populated countries. The East lagged in almost all walks of life, including economics, and including, of course, the banking sector. Most of the scientific and technological advancements, whether in East or West, are assets for mankind and everyone enjoys their fruits. But the same is not true in the case of all the developments in the banking sector because these have been based on the concept of interest that is basically not in conformity with the Islamic ideals and is harmful for mankind.

The response of Muslim intellectuals, particularly ulema and economists, towards this unwelcome growth of interest-based economic activities was slow and belated. However they did come up with their analysis of the situation and presented their solution to the malice. Noteworthy developments in the field of Islamic banking started about more than 40 years ago and it has been gaining momentum since then. Now it has reached a level where the world is now not only noticing but is also debating, analysing and participating in the movement. However, a note of caution is to be mentioned here that all the developments in the name of Islamic banking have not been desirable as many loopholes and shortcoming have been mentioned and the experts are talking in terms of course correction. This note of caution is required because everything that is given the nomenclature ‘Islamic’ may not be truly Islamic and the misnomer may become obvious at various stages.

Shari’ahscholars started writing on the ills of interest-based system of economics and the need and possibilities of reverting the trend in favour of the Islamic system, where riba/interest will have no place, from the late thirties of the 20th century. For example, series of articles written by Syed Abul Ala Maududi from 1936 to 1960 were published in book forms under the titles Islamic Economics and Riba after 1960. Although we find certain apologetic writings justifying bank interest on the opinion that it is not riba. But the opinion got buried under the pile of forceful writings of Shari’ah scholars and Muslim economists and the Muslims mass opinion sided with the conviction that bank interest is nothing short of riba. Muslim economists took clue from Shari’ah scholars and they came out with the blueprints of how to form a bank without interest. For example, Dr. Mohammad Nijatullah Siddiqi’s book Interest Free Banking was published in 1968.

The practical shape of these writings in form of Islamic Finance and Islamic Banking was experimented in Malaysia and Egypt. Malaysia became independent in 1956 and within a couple of years thereafter Tabbung Hajji started functioning. Individual recurring savings by Muslims for the purpose of performing Hajj pilgrimage were mobilised and invested in accordance with Shari’ah. This made the pilgrimage easier because profit earned on such savings lessened the total savings required for the purpose. Further, this concept popularised the concept of Shari’ah-compliant investment. This successful venture in Malaysia remained outside the view of the world. It was noticed in 1981 at the time when proposal for formation of the Islamic Bank of Malaysia was under the consideration of the Islamic Development Bank, Jeddah.

The experiment in Egypt remained under full public view from day one and perhaps one of the reasons of its failure in latter years was the expectation or concern it unnecessarily generated. One visionary cum activist Ahmad Najjar established a saving cum investment venture in a small town of Egypt named Mit Ghamr in 1963. Later he opened several such ventures in many small towns of Egypt. This experiment could not last long. It failed owing to various reasons, including the lack of home works done before their commencements. However, the Mit Ghamr experience, despite failure, served as a beginning of the Islamic banking movement. An experience based on the concept of a cooperative bank was done in Karachi in 1965. The government of Egypt started the Nasser Social Bank on the principles of Islamic banking in the year 1971. A number of Islamic-oriented financial institutions came up in different parts of the world after mid 1970s. A landmark in the history of Islamic finance was the establishment of Dubai Islamic Bank in 1975. At this stage the new development was noticed by the Federal Reserve Bank, USA, Bank of England, World Bank, Harvard University and London School of Economics. Thereafter there has been no looking back in the development of Islamic banking in the one hand, and analysis and research of the outcomes of the movement by the academia of the world, on the other. Hundreds of books have been written on the subject and scores of research materials, articles, dissertations submitted in the western universities, have been published. Much water has flown since.

Islamic banks over the years have developed a number of financial instruments for their functioning. These financial instruments represent the types of contracts that Islamic banks enter into with their clientele. An understanding of these instruments and contracts is useful in comprehending the functions of Islamic banks. These instruments broadly fall under three groups: Profit Sharing based instruments: Trade based instruments and sukuk. The last mentioned item is a relatively new development and is being debated heatedly and applied vigorously.

Profits sharing based financial instruments include musharka, mudarba, muzariah and nusaqat. Musharka is a partnership contract where all the partners are active in the business. Mudarbah is in the nature of sleeping partnership wherein one or more of the partners is/are dormant. Muzariah may be understood as a partnership in share cropping and musaqat is the musharka as applied to horticulture. Profits sharing based financial instruments are also known as Primary modes of finance.

Trade based financial or secondary modes of instruments include murabaha, bay’muajjal, salam, istisna, ijara, and ijara wa iqtina. Murabaha is a cost-plus agreement where the purchaser pays back with an agreed mark-up. The cost-plus or the mark-up has to be known to both by the seller and the purchaser. Bay Muajjal is a sale on credit or deferred payment basis. Here the seller is not obliged to reveal his cost and he does not have to share his profit element in the deal. Salam is the opposite of bay muajjal where price is paid in advance for a future dated delivery. Istisna is the case of salam applied to manufacturing activities. Ijara and ijara wa istiqna are leasing agreements.

The secondary modes of finance may look akin to interest-based deals. Hence there is a need to understand the basic difference between the two. Secondary modes are basically sale or lease agreements as against outright borrowing in interest-based deals. Price, not the rate of interest, is stipulated in the secondary modes of agreements of Islamic banking. That is why price once fixed cannot be changed even in the case of delay or default in payment.

Sukuk or Islamic bonds are recent form of Islamic financial instruments. They have become popular in a short span of time and a lot of funds are being earmarked for this financial instrument. For example, Dubai Islamic Bank announced sukuk of 750 million US dollar (Dh2.7 billion) for utilisation to part-finance the development of Dubai International Airport. Sukuk are certificates of equal value representing undivided shares of ownership of an asset. It takes place when a set of investors pool their wealth to invest in accordance with Shari’ah. Sukuk holders have ownership rights over the assets for which the investment has been done. The asset is then used for earning profits which are distributed among the sukuk holders in the ratio of the value of their respective certificate. It is obvious that an Islamic bond, that is sukuk, can be issued only when the assets to be so financed have earning capability. Finally, what makes sukuk attractive is that it can be traded as it represents undivided shares in the ownership (equity) of the assets.

It is estimated that the Islamic fund that is invested in Islamic banks has been growing annually by 10 to 15 per cent and its present worth is not less than $200 billion. The growth has been fast and steady in Gulf Cooperation Council (GCC) countries. However, Islamic banks have done extremely well in poor countries like Sudan and Bangladesh, developing countries like Turkey and Malaysia and have further openings in western countries. The Malaysian experiment has proved that Islamic banks attract non-Muslims too. The Buddhist and Christian Chinese business men are a strong clientele of Islamic banks in Malaysia.

However Islamic banking is facing many challenges. The most important aspect is that the actual growth of the banking is not in line with the theory of Islamic banking originally presented. It was opined by Shari’ah scholars and Muslim economists that the major part of business will come from the primary mode of finance. But the development is just contrary. It was propounded that Islamic banking will encourage equity finance and instrument like mudarbah and musharka will flourish. But in actual practice the instrument through which funding is being done is overwhelmingly in the secondary modes like murabaha. This is simply dichotomy. There is an opinion that the Islamic banking industry today is in a mad rush to mimic debt instruments of conventional banking with slight adjustment to make these look like Islamic. That is why experts feel the need of course correction.