The Theory Of Islamic Banking (2/5)

1. The Concept and Models of Islamic Banking

The theoretical work on the concept of Islamic banking has proceeded on the basis that guidance for all institutionalized developments in an Islamic society should be derived from the principles of shari'ah. The form and content of Islamic banking practices have, therefore, to be derived from the teachings of Islam. Scholars in search of a new form of banking which should steer clear of interest noted that though banks did not exist in the early Islamic period, the practice of financial resources of one party being used by another party in the conduct of business, trade or industry was fairly widespread. In the pre-Islamic period, all financial resources were mobilized on the basis of either interest or some sort of profit/loss sharing arrangements. Islam prohibited all dealings based on interest but allowed the continuance of the system of profit/loss sharing. The two forms of profit/loss sharing which were predominantly in use in the pre-Islamic period are known as mudarabah and musharakah. In mudarabah, one party provides the capital while the business is managed by the other party. Profit is shared in pre-agreed ratios and loss, if any, unless caused by the negligence or violation of the terms of the agreement, is borne by the provider of capital. In musharakah, partners pool their capital to undertake business. All providers of capital are entitled to participate in management but are not necessarily required to do so. Profit is distributed among the partners in pre-agreed ratios while loss is borne by each partner strictly in proportion to the respective capital contribution. The jurists of the early Islamic period closely examined the features of mudarabah and musharakah as found in the pre-Islamic period and built a corpus of juridical opinion in regard to the attributes that must be possessed by these two types of financial arrangements to make them fully compatible with the ethos of the value system of Islam. The wealth of fiqh literature on the subject has been of invaluable help in devising models of Islamic banking capable of functioning on truly Islamic lines in the modern age.

In developing models of Islamic banking, scholars of recent times have tried to follow as closely as possible the precepts of the highly respected jurists of the early Islamic period. However, in matters on which the Qur'an and the Sunnah provide no specific injunctions they have, where necessary, departed from some of the opinions of fuqaha of the early Islamic period in order to find practical solutions to modern day problems. This is fully in consonance with the objectives of the shari'ah and aids the growth of Islamic jurisprudence to meet the challenges of the modern age.

The efforts of Muslim scholars in developing models of banking within the parameters of Islamic teachings had led to a variety of proposals. It is not intended to survey here the various individual contributions in the field; a good review of several such contributions is available elsewhere[1] it will suffice, for purposes of this paper, to note the salient features of these models.

The hard core of almost all Islamic banking models developed so far is a two-tier mudarabah contract, the first among the depositors and the bank, and the second between the bank and the parties to whom finance is provided. The earliest contributions on the subject were of the nature of summary proposals and had very few details. With the passage of time, increased attention has been given to the details of the operating procedures of Islamic banking, imparting greater degree of realism to the theoretical models.

The earlier Islamic banking models envisaged three main sources of funds for Islamic banks and four principal uses of these funds. The three sources of funds were identified as:

(i)          The bank's share capital

(ii)          Mudarabah deposits, and

(iii)         Demand deposits.

The four principal uses of these funds were identified as:

(i)          Mudarabah financing

(ii)          Financing on the basis of the principles of musharakah

(iii)        Purchase of ordinary shares of commercial or industrial enterprises as well as any investment certificates issued in the private or public sector on profit/loss sharing basis, and

(iv)        Qard al-hasanah.

Later models took cognizance of the fact that Islamic banks may need to branch into certain other activities to deploy their funds. The theoreticians noted that in the actual practice of Islamic banking, a number of Islamic banks which had started operating in the seventies in different countries did not confine their activities to only the four modes of finance envisaged in the earlier theoretical models. The shari'ah experts associated with the working of these banks saw no objection to banks engaging in activities like murabahah) a contract in which a client wishing to purchase equipment or goods requests the bank to purchase the items and sell them to him at cost plus a declared profit, (bai muajjal) a trade deal in which the seller allows the buyer to pay the price of a commodity at a future date in lump sum or installments, (ijara) leasing, (ijara wa iqtina) hire purchase) and bai salam) advance cash purchases of products).

Similarly, banks could also engage in actual conduct of business either on their own or through their wholly owned subsidiaries. The later models of Islamic banking make specific mention of such activities. This represents a concrete example of the interaction between the theory and practice of Islamic banking.

While delineating the operating procedures of Islamic banks, the theoretical models of Islamic banking have given special attention to the principles governing the allocation of profits between the banks and the mudarabah deposit holders and between the banks and the users of bank funds under profit/loss sharing arrangements. In most of the earliest models, shareholders' equity and mudarabah deposits were deemed to be the only two remunerable liabilities of an Islamic bank, and holders of mudarabah deposits were treated as one homogeneous group. The profit sharing arrangements between these two broad groups of providers of capital were envisaged along the following lines:

a)           The aggregate profit earned by the bank on the total capital will be divided over it. After such a division, an agreed proportion of the profit will be kept by the bank and the rest will be given to the holders of mudarabah deposits. The proportion of profit division will be determined with the mutual consent of the two parties concerned.

b)           If the bank suffers a loss, the loss will be shared between the two parties in strict proportion to the capital supplied by each party.

c)           The maximum incidence of loss to a mudarabah deposit holder in a loss situation will be limited to the amount of his deposit.

In later contributions to the literature on Islamic banking, it was recognized that profit sharing arrangements among the remunerable liabilities of an Islamic bank could take more complex forms while still remaining within the shari'ah parameters. It was felt that there was a strong case for some flexibility in profit sharing ratios depending upon the degree of risk to which various types of remunerable liabilities were exposed.

The mudarabah deposits of a longer maturity could be given an edge over deposits of shorter maturity in the profit sharing arrangements. Similarly a distinction could be made between the providers of redeemable capital and non-redeemable capital, with provision of larger return to providers of non-redeemable capital.

As for the profit sharing arrangements between the bank and the users of bank funds, Islamic banking models stick to the basic principle laid down in the shari'ah that profit earned from mudarabah business will be distributed between the provider of funds (the bank) and the user of bank funds on the basis of proportions settled in advance. No fixed amount can be settled for any party. Loss, if any, unless caused by negligence or violation of the terms of the contract by the user of bank funds, will be borne by the provider of funds. For the purpose of profit/loss sharing in musharakah business, the respective capital contributions of parties, utilized for varying periods, would be brought to a common denomination by multiplying the amounts with the number of days during which each particular item such as equity capital of a firm, its current cash surpluses, suppliers' credit as well as the finance provided by the bank were actually deployed in the business. In other words, the calculation of the respective capital contributions of the parties would be made on a daily product basis.

A prominent feature of Islamic banking models is the relegation of loans and advances to a very minor role whereas they play a dominant role in the assets structure of the interest based banks. This is for the simple reason that no return is allowed on loans and advances in the Islamic system whereas in the conventional system they are high return assets. The use of lending is confined mainly to help meet the needs of those who are unable to secure financing facility in any other way.

While profit/loss sharing is the central feature of almost all the Islamic banking models developed so far, differing viewpoints have been expressed by various writers on certain aspects of the working of Islamic banks. The more important of these are indicated below:

a)           It has been suggested that Islamic banks should draw a sharp distinction between money deposited as demand deposits and money deposited in mudarabah accounts. Demand deposits should be backed by 100 percent reserve as they are of the nature of an amanah) safe keeping[2] (This view is not shared by others who regard demand deposits as qard al-hasanah deposits whose repayment in full on demand is guaranteed by the bank but these can be used by the bank in its financing operations.

b)           Some writers are of the view that Islamic banks should not resort to credit creation[3]. They feel that credit creation enables banks to reap unjustified profits which go to enrich a limited class of population. Others see no objection to credit creation by the Islamic banks and are of the view that means can be found to ensure that the benefits from the totality of banking operations are equitably distributed.

c)           Some writers are of the view that for Islamic banks to really work in the Islamic spirit it is necessary that they should be small localized institutions.[4] They feel that Islamic banks should be a decentralized chain of institutions sharing the features of a local bank, cooperative society and a social service organization. Others do not go to this extreme but seem to be against big sized banks to prevent them from exercising undue power.[5] Most other writers are of the view that Islamic banking can be practiced according to its underlying spirit irrespective of the size of the banks.

d)           Some writers have suggested that Islamic banks should be required to earmark a certain part of their demand deposits for providing interest-free loans to the government to enable it to finance socially beneficial projects for which the required financing cannot be secured on profit sharing basis [6]. The rationale for this is that since the funds available to a bank through demand deposits belong to the public and the banks do not pay any return on these deposits, a part of these should be utilized for meeting the financial needs of the government. Similarly it has been suggested that a part of demand deposits may be utilized for making interest free loans for meeting genuine consumption requirements of the people[7]. Others are of the view that provision of interest free loans to the government should be undertaken by the central bank of the country rather than the commercial banks. A number of writers have expressed the view that commercial banks should not be involved in financing the consumption requirements of the people. They think that zakat funds should be used for meeting the consumption requirements of the really needy persons while others should be motivated to set up cooperative self-help bodies to finance the consumption requirements of individual members as the need arises.

(Continued)