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ISLAMIC BANKING AND FINANCE: ASSESSING THE NEED OF THE
PRESENT AND THE FUTURE
Zaman, M. Raquibuz*
The 2002 Oxford Banking Forum: “Development and Foreign Investment into the
Islamic States,” September 21, 2002, Jeddah, Saudi Arabia.
Dr. Zaman is the Charles A. Dana Professor of Finance and International Business at Ithaca College, Ithaca, New York 14850. He can be reached at: Phone: 607-274-3692)**; Fax: 607-274-1152; E-mail: Zaman@ithaca.edu
**Dr. Zaman is a away from Ithaca on sabbatical leave until the end of December 2002. All correspondence should be by e-mail until he returns to Ithaca.
ISLAMIC BANKING AND FINANCE: ASSESSING THE NEED OF THE
PRESENT AND THE FUTURE
M. Raquibuz Zaman*
This paper outlines the nature of banking and financial institutions that are needed to serve efficiently all the sectors of an Islamic economy, despite the stage of growth it is in. It argues that the existing Islamic banking and financial institutions do not serve the economic interests of all the people, even in countries where such institutions are the only ones allowed to operate, and, as such will remain in the periphery of economic activities. The paper concludes with some recommendations with respect to restructuring the institutions to meet the needs of changing economic conditions.
Islamic banking institutions, IBIs, have been in operation in some countries for over two and a half decades, yet in most Muslim countries where Islamic as well as “non Islamic” banks operate, the IBIs are relatively very small, and command even smaller market share (Timewell 1998). It is not that the majority of the Muslim citizens are ambivalent about Islam, but they do not either believe in the Islamicity of the IBIs, or that these institutions do not serve their needs. There are good reasons for skepticism on both accounts.
The basic impetus for the creation of the IBIs came from the belief of their proponents that all interest, irrespective of type and magnitude, are usurious (Riba, in
Islamic lexicon). In order to avoid the term “interest rate” the IBIs resurrected some financial practices that existed at the time of the Prophet and the early centuries of Islam. The Islamic jurists continue to approve practices that were evolved from the earlier institutions and instruments without a critical examination to determine whether or not they meet the Islamic precepts of justice and fair play and serve the needs of the public in a Muslim country.
This author has explained elsewhere (Zaman, and Movassaghi, 2001, and 2002) that “usury” (Riba) and “interest” are not synonymous in all cases, and that some
instruments, such as, Murabaha, used by the IBIs are usurious compared to conventional
installment loans offered by non-Islamic banks. Concerns can also be raised about ijarah
Muntahia Bittamleek and even the Mudaraba practices of the IBIs. Given the fact that
most of the income earned by the IBIs come from these three instruments (Islamic Development Bank Annual Report 2000), one needs to question how Islamic are the IBIs.
The objective of this paper is not to get into a discourse on Riba and interest (for
that see Afzal 1996, Al Jassas 1916, al-Saud 1985, al-Zamakhshari, Ibn al-„Arabi 1968,
Suhail 1936, Tantawi 1989, Muslim 1990, Sanhuri 1954-59, Salus 1991, Yousuf Ali 1946, Siddiqui 1978 and 1986, Chapra 1985, Naqvi 1993, Faridi 1991, Wohles-Scharf 1983, Anwar 1987, Homer 1977, and Rahman 1980), but to suggest changes in the instruments used by the IBIs to meet the short and medium-term needs of the business enterprises, the depositors, and the households. It should be borne in mind that banking institutions are only intermediaries and should act accordingly, and that the bank officials must be held accountable for their actions and should be held responsible for will full negligence.
The development of appropriate financial institutions for a modern economy is a must before it can attract and hold foreign direct investments, FDI, in the crucial economic sectors that need heavy infusion of technical know-how and expertise. The
IBIs are not geared towards facilitating the inflows of FDI and channeling them into the desired institutions and enterprises.
Streamlining the IBIs
The IBIs should be reorganized into three distinct operational units. One unit should deal strictly with commercial and consumer banking, and the second one with investment banking, and the third one with commercial financing. The sources and the uses of funds of these institutions should be clearly delineated to avoid misuse of funds and public trust.
Commercial banking: The sources of the fund are depositors‟ money and the
equity financed by the bank shareholders, the share of the latter as directed by national and international standards for commercial banks. The depositors earn flexible rates of return based on the overall costs of and returns for the bank during a quarter, or such time by which the bank can estimate its net returns. All deposits -- ordinary savings accounts, or time deposits -- should earn flexible rates, subject only to some adjustments for risks. Similarly Certificates of Deposits, CDs, should also earn flexible returns, unlike in modern commercial banks.
In the past some modern banks have run into heavy disintermediation during rapid changes in the interest rates, and in some cases, went bankrupt when long term fixed loans at low rates could no longer be financed through costly deposits. The Islamic principles of justice and fair play require that no party should take advantage of the other. Only flexible rates of interest/return can assure that.
Insurance is an integral part of an Islamic economic system. Depositors‟ money,
up to a certain limit, must be insured by some national system of insurance in a manner similar to the Federal Deposit Insurance Company of the U.S.A., or elsewhere. The depositors need to have some assurance that their funds would not be completely lost in case the bank faces serious economic problems.
The uses of funds should be limited to commercial and consumer loans, e.g., accounts receivable financing, inventory financing, line of credit, installment loans for short and medium terms, and mortgage financing. All loans should also be on flexible cost basis, i.e., the rates charged for these loans must be adjusted periodically as suggested above. The FDI inflows from foreign commercial banks would increase with such a system since they will no longer be tied with fixed rate commitments. The business community and the consumers in the Muslim countries will prefer the new system to what exist in their communities now.
Investment Banking: The principal source of funds for this institution should
come from the shareholders‟ equity. This can be supplemented by borrowing through the money market. Such a bank should not be allowed to use depositors‟ money. Its earnings will be fee based for intermediation services, and flexible returns from its investments. The activities of the investment bank should also be clearly monitored to avoid questionable practices and transactions. The role the investment bankers played in the Enron disaster in the U.S.A. needs to be averted.
Commercial Financing: At present the IBIs are essentially finance companies.
Their practices are contrary to what they are supposedly trying to avoid. The Murabaha
transactions are fixed interest- bearing instrument in reality. No matter how quickly one pays back the loan, one has to pay the full extent of the so-called „mark up‟, making them
usurious. This and the instrument of ijarah Muntatahia Bittamleek should all be
modified and standardized, removing the need for Shariah councils, and be based on
flexible rates only.
While the recent trend in the world of banking and finance is mergers and consolidation of institutions and functions, the idea of proposing a break up of IBIs into three separate functional areas may appear to be far fetched. Yet, this possibly is a very sound way to learn the ropes of running a flexible rate based banking and financial system. From the practice of determining, more or less arbitrarily, the „profit‟ or „mark
up‟ rate, the new institutions will have to institute a system of accounting to monitor very closely costs of and returns from operations so that they can set competitive rates for their customers. This will be a very difficult task, but must be undertaken in order to ensure that all parties are treated equitably.
It appears that the IBIs have hitherto faced very little supervision and scrutiny from the banking authorities of the countries where they operate. This needs to be remedied. Not only these should be brought under the supervision of the monetary authorities, especially the central banks, but also be subjected to regular examinations by the regulatory authorities, results of which should be made available to the public. The IBIs disclose very little information to the public, and this keeps the depositors, the borrowers, and the investors in the dark about their financial health. The restructured IBIs must fulfill their fiduciary responsibilities wholeheartedly.
At present the IBIs lack uniform standards and policies within and across national boundaries. This needs to be instituted, subject to the overall banking and finance policies of individual states. There will not be any meaningful role for the ever- present Shariah councils in the reorganized IBIs, and these should be disbanded. Banking and financial operations should be left on the shoulders of those who are well trained and well versed in the management of financial services and instruments.
It is important to realize that banking and financial institutions are engaged in a trade (tijara) that deals with the management of money and financial securities and services, and they do not operate like “money lenders” or “loan sharks.” The depositors place their deposits either for a short or a longer period, seeking some returns to offset the loss of purchasing power if kept „under the mattress, or to augment their future income, while the borrowers borrow to meet the needs for funds for business and/or consumption that are vital to them and are willing to pay a reasonable fee for the service.
The existing IBIs seem to ignore this basic characteristic of the modern financial system. The proposal here is not to replicate such modern institutions, but to create a system of financial services that are based on flexible rates, determined on the basis of actual costs and returns. Only such a system can truly ensure that the basic Islamic economic precept of fairness and justice prevails.
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