Islamic Banking and Finance: Another Approach

Microsoft Word – Islamic Equity Funds.doc

Islamic Banking and Finance by salman syed

2. Zero interest and capital guarantee

Muslims are prohibited by their religion to deal in interest (riba) in any way. Giving and receiving as well as witnessing are all prohibited. Thus an Islamic banking system cannot pay any interest to its depositors; neither can it demand or receive any interest from the borrowers. Nor could the banks witness or keep accounts of these transactions. But the lender is entitled to the retum of his capital in full. This is a Qur’anic injunction.² The proposed system· complies with these fundamental Islamic requirements.

A basic tenet of commercial banking is capital guarantee. The capital entrusted to the bank by a depositor must be retumed to him in full. The proposed system fully complies with this requirement. Islamic banking as practised today does not provide capital guarantee in all its deposit accounts. In many countries, this is one of the two main objections to permitting the establishment of Islamic banks. There is no objection to paying zero interest on deposits.

Thus, by paying zero interest and guaranteeing capital, the proposed system satisfies both the riba-prohibition rule of Islam and the capital guarantee requirement of conventional Banking Acts. This enables it to obtain permission to set up and operate as a deposit bank in all countries of the world, while obeying the riba-prohibition rule and qualifying to be an “Islamic” bank. This is of paramount importance to Muslim minorities living in non-Muslim countries. Furthermore, the existence of interest-free banks in all countries will also remove the many difficulties faced today by Islamic banks in transacting intemational business.

3. Lending and investing

in conventional banking, depositing is a form of investment for the savers where the capital remains intact while a known income (in the form of interest) is promised. To the banks lending is a form of investment where the capital and a known return are assured; the return will also cover all their costs. Since Islam prohibits dealing in interest in any form this type of banking is not acceptable to the Muslims.

In Islam, there is a clear difference between lending and investing – lending can be done only on the hasis of zero interest and capital guarantee, and investing only on the hasis of mudaraba (profıt-and-loss-sharing). Conventional banking does not – and need not – make this differentiation. But an Islamic bank has to take this into consideration in devising a system to cater to the Muslims. Therefore such a system has to provide for two sub-systems – one to cater to those who would “lend” and another for those who wish to invest.

in the proposed system, the depositors are considered as lenders to the bank and, since a Muslim lender cannot receive any interest, he lends without interest but with the assurance that his capital will be returned in full. This applies to demand (current account) deposits as well as to savings deposits. The bank, in turn, lends (the depositors’ funds) to the borrower who should return the capital in full plus the costs of the bank’s services and a remuneration (or profıt) to the bank for providing these services. This suits some depositors and some borrowers. The fırst book – lnterest-free Commercial Banking – is concerned with this group of people.³ The theory and method are fully explained in the book.

The second objection to Islamic banks as they operate today is that their assets are not readily assessable (since they are tied up in equity-type investments where neither capital nor return are guaranteed), and to put a reasonable value on these assets will require enormous amounts of effort and experience. In the proposed system, the depositors’ capital and return (albeit zero) are guaranteed; and the bank’s assets are also guaranteed and their costs are fully covered; and the accounting procedures are well defıned and uncomplicated. As such the bank’s assets are assessable. Therefore the proposed method should attract no objection from any banking authority, thereby enabling interest-free (or Islamic) banks to be set up in all countries of the world.

In conventional banking those who wish to earn an income using their savings do so by putting their capital in savings deposits or time (fıxed) deposits and receive an interest payınent. A Muslim cannot earn an income by this means. He has to participate in a project by fınancing it and by sharing in its loss or profıt. The participatory fınancing described in the next section is devised to cater to this group.

4. Participatory financing

The second book, Participatory Financing through lnvestment Banks and Commercial Banks, provides the mechanics of a fınancing scheme that would cater to the needs of those Muslim capital-holders who wish to earn an income using their capital without involving themselves in riba. The Islamic option for this group is the concept called mudaraba, which is usually translated as profıt-and-loss-sharing but is in fact profıt-sharing-and-loss-absorbing, and in this book it is named as participatory fınancing. The basic idea is that two parties, one with capital and the other with  know-how, get together to carry out a project. If the project ends in profıt they share the profıt in a pre-arranged proportion; if it results in loss the entire loss is borne by the fınancier. There are many variations of this simple model but this is the basic concept.

The book provides a general mechanism for the implementation of this concept, examines various different situations that occur in real life, and shows how the same mechanism can be modifıed to suit each situation. The situations range from the simple two-person model and the slightly more complex one-project-many-investors case, to one where an intermediary comes in, to accept capital from several investors for investing in many different enterprises and then to collect and distribute the profıt/loss to the investors. The intermediaries may range from small local investment companies to large-scale multinationals, and from investment banks to commercial banks. And the investors may range from small-time individual savers to institutional savers and millionaires. The projects too may vary from small one-person enterprises to multimillion projects by very large companies. And the projects may last fora short limited period or continue for a very long time.

The investor is essentially a sleeping partner. He provides the financing and then shares the profit or absorbs the loss. It is the responsibility of the entrepreneur to present a good project proposal, convince the fınancier that it is viable and profıtable, and provide proof that he is able, qualifıed and experienced to carry out the project successfully. The intermediary is at once both an entrepreneur and a fınancier. When he accepts funds from an investor, he is an entrepreneur; and when he fınances a project submitted by an entrepreneur, he is a fınancier.