The Theory Of Islamic Banking (1/5)

The theory of Islamic banking is based essentially on the premise that interest, which is strictly forbidden in Islam, is neither a necessary nor a desirable basis for the conduct of banking operations, and that Islamic teachings provide a better foundation for organizing the working of banks. Muslim economists have pointed out that it is a historical accident that interest has become the kingpin of modern banking. The practice of interest has been condemned by foremost thinkers in human history and by all Biblical religions. Aristotle dwelt on the "barren" nature of money and vehemently condemned the institution of interest which he described as "birth of money from money". Under Judaism, Israelites were forbidden to demand any increase on the principal amount of the sum lent in transactions among themselves, though interest could be charged in dealings between Israelites and gentiles. The reason for this distinction, according to many scholars of Judaism, was that there was no law at that time among the gentiles which prohibited the practice of interest, and it was not regarded as unfair that Jews be allowed to recover interest from people who charged interest from them. In Christianity, the reported saying by Christ to "lend freely, hoping nothing thereby" (Luke 6:35) is taken by many commentators as condemnation of interest. However, the Church gradually changed its doctrine on the subject of interest. In any case, the divorce between religion and mundane affairs accepted by Christian societies after the reformation opened the door for widespread practice of interest. Among the followers of Islam, the institution of interest has always been regarded as highly ignoble because the Holy Qur'an strictly prohibits interest based transactions in all forms.

In the early history of Islam the injunction relating to prohibition of interest was strictly observed, but with the decline of the hold of religion and spread of Western influence, financial practices based on interest began to permeate Muslim societies as well. In the period of colonial domination of Muslim countries by Western powers, the interest based system became solidly entrenched. It is this string of historical circumstances, Muslim scholars argue, which has led to the present-day dominance of interest in financial transactions all over the globe. Had the societies developed in a different fashion and paid greater heed to the injunctions of religion, the development of the financial system would have surely taken a different course, and we could have had in actual operation an alternative system free of interest but fully meeting the needs of modern society.

Muslim scholars recognize the important role banks play in the economy of a country in modern times. Banking institutions act as financial intermediaries between savers and investors. They can be of significant help in assisting the process of capital formation and development. There was no prototype of modern banks in the early history of Islam. Even in Western countries, banking in the form in which it exists today is of comparatively recent origin. Before the advent of modern banking, direct finance, where the owner of capital deals directly with the user of capital, was the customary mode of transference of funds from savers to investors. With the progress of trade and industry and increased financing requirements of productive enterprises, direct finance proved an inadequate mechanism for such transference and banks emerged on the scene to undertake financial intermediation between savers and investors. The attitude of Islam to all known innovations is that nothing should stand in the way of their adoption if they are useful for human society and do not conflict with the fundamental teachings of the Qur'an and the Sunnah. Since banks perform a useful service of financial intermediation, they are wholly acceptable in a Muslim society. What is not acceptable, however, from the shari'ah point of view, is the use of interest rate mechanism in the process of financial intermediation.

For long Muslims the world over were beset with a dilemma. Islam prohibits the giving and taking of interest while it looked almost impossible to steer clear of interest in the modern world where interest played a key role in most of the financial transactions. The contemporary Islamic resurgence has begun to provide an answer to this dilemma. Theoretical work by Muslim scholars has sought to demonstrate that it is possible to run an economy without interest even in modern times. Replacement of interest based banking by interest-free banking has received the greatest attention in this endeavor.

The basic postulate that has guided all theoretical work on Islamic banking is that while interest is forbidden in Islam, trade and profit is permissible. Conventional banking uses the interest rate mechanism to perform its task of financial intermediation. Muslim scholars have developed a radically different model of banking which does not make use of interest. It relies instead on profit/loss sharing for purposes of financial intermediation. The earliest references to the reorganization of banking on the basis of profit/loss sharing are found in the writings of certain Muslim scholars in the late forties and early and mid-fifties of this century. The sixties and seventies saw more elaborate formulations of the concept of Islamic interest free banking. The subsequent period has witnessed further refinements in the theory of Islamic banking.

Theoretical work on Islamic banking encompasses several aspects related both to the operating procedures of Islamic banks and the possible socioeconomic consequences of the adoption of the new system. In this section of the paper we shall review the main contributions to the theory of Islamic banking under the following broad heads:

(1) The concept and models of Islamic banking;

(2) Viability of Islamic banking, and

(3) Socioeconomic consequences of Islamic banking.

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