The Theory Of Islamic Banking (3/5)

The literature on Islamic banking does not deal only with the mechanics of Islamic  banking. It delves deep into the philosophy of Islamic banking. It has been pointed out that the monetary and banking system of a country does not operate in an ideological vacuum. It is an integral part of its parent ideology. Its operating procedures have to be fashioned in accordance with the requirements of a particular ideology. Judged in this perspective, the task of the replacement of conventional banking by Islamic banking does not consist of a mere mechanical replacement of interest by noninterest modes of financing. These modes have to be chosen keeping in view the religious prescriptions as well as the ideological orientation of an Islamic society. Further, the financing activities of Islamic banks have to be directed towards achieving the Islamic socioeconomic objectives. These objectives briefly are promotion of a pattern of growth best suited to eradication of poverty, equitable distribution of income and wealth and sufficient opportunities for gainful employment.

An important policy issue that has been discussed extensively in the above context is whether keeping in view the Islamic teachings and Islamic socioeconomic objectives, the Islamic banks should have a preference pattern with respect to various modes of financing which are permissible in shari'ah .It has been forcefully argued by a number of writers that the real substitute of interest in an Islamic financial system is the mode of profit/loss sharing along with qard al-hasanah while the other techniques like murabahah, bai muajjal, ijara and ijara wa iqtina cannot be of equal significance in achieving Islamic socioeconomic objectives [1]. The reasoning employed is as follows. The interest system is disallowed by Islam because intrinsically it is a highly inequitable system. The feature that makes the interest system inequitable is that the provider of capital funds is assured a fixed return while all the risk is borne by the user of these capital funds. Justice, which is the hallmark of the Islamic system, demands that the provider of capital funds should share the risk with the entrepreneur if he wishes to earn profit. It follows, therefore, that financing techniques like murabahah, bai muajjal, ijara and ijara wa iqtina, which involve a pre-determined return on capital, cannot be regarded as commendable substitutes for interest, and should only be used when absolutely needed.

These writings have also emphasized that Islamic banking is expected not only to avoid transactions based on interest, but also to participate actively in achieving Islamic socioeconomic objectives of eradication of poverty, achievement of an equitable pattern of income distribution and generation of maximum employment opportunities. It has been argued that these objectives can best be achieved through the profit/loss sharing techniques of mudarabah and musharakah.

The literature on Islamic banking also encompasses central banking and monetary policy. It has been emphasized that, in the initial stages of the Islamization of a country's financial system, the main task of central banking would be the promotion of an institutional framework necessary for the smooth operation of financial markets in compliance with the rules of the shari'ah [2]. The central bank would have to play a leading role in the development of new financial instruments for the money and capital markets of an Islamic economy. The new financial instruments that have been suggested in this context include Participation Term Certificates (which would entitle their holders to share in the profits of the concerns issuing them), Specific Investment Certificates (which would carry the name of the enterprise in which the proceeds of the certificates would be invested and in whose profit their holders would share) and Leasing Certificates (which would entitle their holders to a proportionate share in the yield of the assets leased by a company net of administrative expenses[3]. (It has also been suggested that the central bank may itself issue a distinctive type of investment certificate and invest its proceeds through the banking system.[4] All these certificates may be issued in different denominations and with different maturities to suit the preferences of various groups of savers. It is envisaged that a secondary market will then develop in which the aforesaid types of primary securities will be sold and resold before maturity, imparting liquidity to such securities and widening the choice of investment media available to savers.

While discussing other responsibilities of the central bank in an Islamic economy, Muslim writers have stressed the need for pursuing monetary policies designed to help achieve Islamic socioeconomic objectives. They have emphasized that monetary policy in an Islamic economy cannot afford to be value neutral. The central bank is expected to make a skillful use of monetary policy instruments available to it to influence the operations of the banking system in such a way that the egalitarian objectives of an Islamic society are achieved with greater ease. A conscientious effort has to be made to ensure that the financing provided by the banks makes a positive contribution to eradication of poverty, generation of maximum employment opportunities and achievement of an equitable pattern of income distribution. Another major responsibility of the central bank is to safeguard monetary stability as both inflation and deflation impose a welfare cost on the society and cause severe hardship to the poorest sections of the population.

Considerable attention has been given in the literature to the modifications that would be needed in the actual conduct of monetary policy when a transition is made from an interest based economy to an interest free economy. In an interest free economy, the central bank will have no use for the traditional monetary policy instrument of changes in the Bank Rate. Open market operations in the traditional sense of the term will also lose their relevance in an interest free framework. Most other monetary policy instruments available to the conventional central banks will, however, remain usable by a central bank operating on non-interest basis. Thus, it will be possible for it to set cash reserve requirements for commercial banks and to vary them as an instrument of monetary policy. It could also impose a liquidity ratio and vary it from time to time in accordance with the needs of the situation. The central bank would also be able to regulate the monetary situation by placing quantitative ceilings on the financing operations of banks. For influencing the flow of bank funds in the desired manner and for encouraging or discouraging the use of bank finance for specified purposes, the central bank will be able to use measures of selective control like restricting the use of bank resources for certain purposes and setting mandatory targets for financial assistance to be provided by banks for stated purposes.

To compensate for the loss of the bank rate weapon, some study groups and scholars have suggested that central banks operating on a non-interest basis may be empowered to vary the profit sharing ratios applicable to various types of financial assistance to be made available by the central bank to commercial banks. In addition, the central bank may be empowered to prescribe maximum and minimum profit sharing ratios for banks in respect of finance provided by them, which may be varied from time to time as the situation warrants [5]. Others have not favored these proposals as they feel that any change in profit sharing ratio after it has been written into a contract is not permissible under Islamic legal code [6]. However, they would probably not object to changes in profit sharing ratios which apply to future contracts and prescription of a range of differential profit sharing ratios to influence both the overall monetary situation and the pattern of resource allocation.

Regarding open market operations, different opinions have been expressed. Some scholars have ruled out the use of this instrument of monetary policy on account of the absence of a government securities market in an interest free economy. They do not favor open market operations in shares of private concerns for several reasons [7]. It is not desirable, they point out, for the central banks to buy and sell the stocks of private sector companies. Besides, variations in the prices of equity-based instruments brought about by central bank open market operations would benefit or penalize the shareholders of companies whose shares are used for this purpose. This will not be equitable and can introduce distortions in the share market. Others, however, do not rule out the possibility of open market operations and propose issuance of variable dividend securities by the central bank related to their profit in which such operations could be conducted.

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