Islamic Banking Needs Restructuring

Islamic economic system is rooted in the values and principles to solve the economic problems of mankind from a moral and socially responsible perspective.

It integrates economics with ethics so that efficiency and equity become elements of a composite reality. It has the ability to prevent the mess now gripping the world and created by conventional banking.

The abolition of interest is one of the pillars of the Islamic economic system. According to Quran, “ Allah has permitted trading, and prohibited riba.”

Islamic financing instruments based on the concept of profit and loss sharing are Musharikah and Mudarabah. Where these financing systems are not workable or feasible, the other financing systems in Islamic financial framework are Murabahah, Ijarah, Salam or Istisna.

The Islamic financial system requires that the transaction must be backed by real asset and not shady repackaged sub-prime mortgage that have impacted the global financial system. The risk is shared between the bank and the depositor. There is an incentive for both the banks and the depositors/borrowers to ensure that the deal is sound. The asset-backed financing differs from conventional banking which deals with money and monetary papers and not so much trading in goods and making inventories.

In Islamic financing, money is considered to have no intrinsic utility; it is only a medium of exchange. It makes a vital difference between Islamic financing and conventional financing in terms of earning of profit and interest. The profit earned through dealing in money or the papers representing them is interest which is prohibited in Islam. Thus financing in Islam is always based on illiquid assets which creates real estates and inventories.

The State Bank is promoting Islamic banking and interest-based banking side by side. The Shariah Supervisory Committee (SCC) of the SBP has not approved this policy of parallel system of banking announced in 2003. But the SCC has neither disclosed this fact nor has announced its correct stand on the issue.

Islamic banking is an alternate of interest based banking system. Hence it requires an independent and specific Islamic bank. The fundamentals of both the banking systems are different. The ideal mode of financing under Islamic banking system is financing on profit and loss (PLS) basis. In case profit is earned by the IBIs it must be shared between the bank and the depositors and, in case of loss, vice versa. Contrary to this, the depositor/investor/entrepreneur has to bear fixed interest irrespective of the fact that the bank is making huge profit which is unjust to all the stakeholders. The Islamic banking system ensures justice by distributing the profit/loss earned by the bank among all stakeholders.

Unfortunately most of the Islamic banks are operating parallel to conventional banking. They have adopted the mode of financing on fixed rate of return basis and not on PLS basis. The true modes of financing under Islamic banking system are Musharakah and Mudarabah based on PLS. But during the year 2008, the Islamic banks allowed only 2.3 per cent of their total funding under these modes of financing and 92 per cent under Murabah, Ijarah and Diminishing Musharakah based on the mutually agreed fixed return corresponding to the prevailing fixed interest rates system under the conventional banking

The Islamic banking is not Sharia-compliant in true sense. But the Shariah Advisor of the bank certifies in the annual accounts report that the affairs of Islamic Banking Division have been carried out in accordance with rules and principles of Shariah etc.

Problem of the low rate of return on deposits offered by banks, whether conventional or Islamic, has not been tackled effectively. It is stated that there are inherent difficulties in determining the rates of return on PLS deposits until the annual accounts of the banks are finalised. This does not justify low return to their depositors. They should offer fair rate of return subject to the adjustment on final declaration of the annual accounts.

While banks generally offer low returns on deposits and charge high interest rates on loans to boost their incomes, the issue is aggravated in case of Islamic banks. They offer the lowest or even negative real rate of returns to their depositors/investors under the cover that risk sharing is Islamic mechanism under the PLS system.

They exploit the depositors by making this product profitable venture under the cover of Islamic banking. This is the main reason that Islamic banking has achieved robust growth, despite slow economic activities and global financial crisis. The total assets of Islamic banking have reached Rs313 billion.

Islamic banking world over grew at the rate 15-20 per cent per annum. Its growth is not confined to Pakistan but it also includes the western secular countries. Islamic banks are willing to enter into this new business product with a view to maximise their profitability, offering low return to the depositors and to investors under the cover of PLS system

The Islamic banking system to encourage savings and capital formation, ensure equitable distribution of income and wealth and justice between the parties can only be achieved if financing by it is allowed on the PLS and fixed rate techniques based on mutually agreed ratios is discarded in totality. Therefore, there is a need to restructure the mode of financing.

The end-product of all economic activities in the Islamic state is the betterment and well-being of the people. The financial policies must ensure that the system of production of national wealth and its distribution is geared towards the maximum happiness of the maximum numbers of the people. Concentration of wealth within fewer hands and riba/interest/mark-up/usury which are repugnant to the Islamic spirit of equality and universal well-being, should be eliminated from financial system/banking.

The article was originally published in The Daily Dawn.