Islamic banking: Some misconceptions

Islamic banking: Some misconceptions

Published : Wednesday, 01 May 2013

Khaled Mahmud Raihan  Financial Express

If you ask someone about Islamic banking, he will probably mumble something about religion. It is the universal belief of the common people that Islamic banks do not charge interest but use something else which is the same. This "something else", interestingly, is never defined. Unfortunately, this stereotyped image is also prevalent within the banking community as well due to overwhelmed interest-based banking in the economic system. In reality, the concept of Islamic banking cannot be defined so precisely. 

Islamic banking aims not to earn mere profit but to ensure welfare and distributive justice to the people. Islam upholds the principle that all wealth, including money, belongs to Allah and the wealth is to be used for the well-being of the society in general and human being in particular. Keeping this in view, Islamic banks operate on Shari'ah principles strictly avoiding interest, which is considered to be the root of all exploitation, in all its activities. Islamic banks make best endeavour to eliminate disparity and establish justice in the economy, trade, commerce and industry, build socio-economic infrastructure and create employment opportunities. 

The Almighty Allah revealed twelve verses in the holy Quran regarding interest (riba in Arabic) in four surahs. The clear prohibition of interest/usury is made in verse 275 of Surah Al-Bakara where Allah says "Those who devour usury will not stand except as stand one whom the Evil one by his touch hath driven to madness. That is because they say: 'Trade is like usury,' but Allah 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 Allah (to judge); but those who repeat (The offence) are companions of the Fire: They will abide therein (for ever)." [Translation by Abdullah Yusufali]

This prohibition of interest does not only have religious implication but also has economic justification. The underlining principle of traditional banking system is interest ('riba-al-nasia' in Arabic) which is derived from the core principle of finance, the 'time value of money'. The underlining assumption of time value of money is that every transaction is measured by time and money itself is used as commodity which is against the philosophy of creating money. However, Islamic Shari'ah does not permit to take or give additional amount of money or goods in exchange of time due to obvious reasons. Many modern economic scholars have identified economic demerits of interest because of its resultant effect of exploitation. Since interest-based mechanism is not directly related with real economy, it results to inflation and helps to accumulate wealth in the hands of few. 

Under the traditional paradigm, financial intermediation is carried out on the basis of lender-borrower relationships. On the contrary, in financial intermediation under Islamic paradigm, the relationship between depositors and bank is lender and partner while bank's relationship with the end user is an economic agent (sellers, buyers, lesser, partners etc.). The mode of operation can give a clear idea about how Islamic banking can ensure Shari'ah principles.

Mobilization of deposit: Unlike traditional banking system, depositors (sahib-al-maal in Arabic) keep their fund in the bank (mudarib in Arabic term) in the form of investment and earn share in profit (if there is any) along with the principal. However, principal is not guaranteed; losses, if any, are to be shared by all contributors to fund on proportional basis. Mudaraba depositors receive proportional profit from investment income earned from profit, rent, dividend etc. Non-investment income (commission, exchange, service charge, locker rent etc.) is not distributed among the mudaraba depositors. While calculating investable mudaraba deposits, a certain percentage is deducted as per the provision of the Banking Companies Act 1991. Total investable fund of the bank consists of equity, mudaraba deposits and other deposits. Mudaraba deposits get priority over other funds at the time of investment. Generally, Islamic banks distribute a certain portion of investment income (say 65 per cent) earned through deployment of mudaraba deposits among the mudaraba depositors while rest is kept as investment management fee including provision against investment loss. However, weightage depends on tenure of deposit, banking benefits and market scenario etc. 

There is a misconception in the banking community that Islamic banks actually give depositors 'interest' in the name of 'profit'. In reality, there is no room for such fixed interest/return as depositors' return are fully dependent on income generated from the deployment of investable mudaraba deposits. Islamic banks, however, for the convenience of the depositors, declare provisional rate of profits (which varies among the deposit schemes due to variation of weightage) based on previous experience of return on investment which is subject to adjustment at the year closing. Thus, unlike traditional banking, depositors' return is not fixed rather linked with real economic activities which ensure justice.

Application of fund: Islamic banks deploy their funds under different modes of financing as permitted by Shari'ah which include trade mechanism (bai in Arabic), partnership mechanism (Shirkat in Arabic), and leasing mechanism (Ijara in Arabic).

Trade mechanism takes place in three modes: Bai-Murabaha (sale on agreed upon profit), Bai-Muajjl (sale on deferred payment basis) and Bai-Salam (purchase of goods on deferred delivery basis) where the bank acts as an economic agent. Under the mechanism, financial flows are parallel to real flows and claims of the bank on the clients are not time variant. 

Partnership mechanism can also take place in two modes: mudaraba and musharaka. Under mudaraba mode of financing, bank (here called Sahib-al-maal) provides fund while client (here called mudarib) provides his expertise and management support for the enterprise. Any profit accrued is shared between the two parties on pre-agreed ratios while capital loss (without negligence on the part of the client) is fully borne by the bank. On the other hand, under musharaka mode of financing, both the bank and the client invest capital in a venture and share profit/loss at a pre-agreed ratio. Unlike traditional banking system, the banks involve in real economic activity. 

Under leasing agreement, bank receives rent from the lesser for use of assets owned by it. Hire Purchase under Shirkatal Melk (popularly known as HPSM) is a derivative product of leasing which is a synthesis of three contracts: Shirkat, Ijara and Sale. Under the mechanism, the bank and the client jointly provide capital (on pre-agreed ratio) to buy an asset and determines rent and selling price to make installment payment (includes rent and principal) by the client for subsequent transfer of ownership. In this mechanism financial flows are also tied to real flows. 

As discussed above, the superiority of Islamic banking derives from its involvement of real economic activity. During the 1950s Islamic banking concept was mere a textbook word and was limited to theoretical extravaganza. The sixties was actually the period of experimentation and Islamic banking started gaining momentum in the seventies. The eighties and nineties constitute the period of consolidation. And now it is coming up as the only just and welfare-oriented banking system of the modern world. Consequently, more than 300 Islamic banks and financial institutions have been established around the globe spread over more than 70 countries. Islamic banking system has been proved to be superior and more resilient during the global financial crisis due to their non-involvement in the toxic assets in the banking system and adherence to real assets in lending which is directly linked with economic development and prosperity of the country. By their inherent nature and objectives, Islamic banks focus on moral aspects of financing. Rapid growth of Islamic banking even in many non-Muslim countries in an environment of overwhelmingly dominated conventional finance reveals the superiority of Islamic banking. 

Despite the superiority of Islamic banking model and global experiences, the success and popularity of Islamic banks depends on compliance of Shari'ah and devotion of professionals towards its inherent objectives. Mere paper-based compliance does not ensure justice. It should also be remembered that the failure/non-performance of an Islamic bank is not driven by the flaw of the model itself but because of management who drives the bank. 

The views expressed in the article are the author's own and not necessarily the organisation he represents. The Author is an Assistant Vice President of IBBL and may be contacted at kmraihan@islamibankbd.com