Concept and Ideology
Evolution of Islamic Banking
Emergence of Islamic Banking
For an expanding economy, a developed and efficient banking system is indispensable. Among others, it helps transfer of financial resources from surplus units to deficit units and, hence, helps accelerate the pace of development by securing uninterrupted supply of financial resources to people engaged in numerous economic activities. The tremendous development that the world economy has experienced in the last few decades was contrib­uted by several factors among which, growing institutional supply of loan able funds must have played the pivotal role. The role of banking is comparable to what an artery system does in the human body. Both commercial banks and other development financial institutions provide short-, medium-, and long-term credits to businesspersons and entrepreneurs who usually take the lead in ventures of economic development.

Institutional supply of credit has been made possible by a system of financial inter-mediation organized in a way where conventional banks collect small savings from the public by offering them a fixed rate of interest and advancing the loan able funds out of the deposited money to enterprising clients charging relatively higher rates of interest. The margin between these two rates is the bank's income. In addition, banks also provide many other services to the public for which it receives service charges.

Despite the outstanding contribution of the conventional banking system (interest-based), several ancient and modern economists are critical about its efficiency level. Some economists consider the role of interest in the conventional banking mechanism as a major negative factor that contributes to cyclical fluctuations in the economy (Minsky 1982). Specifically, the ineffectiveness of interest rate as a stabilization tool during the period of the Great Depression is a case to note. This eventually called for Keynesian prescription of government intervention (Keynes 1964). Similar concern was expressed in a story published in Newsweek regarding Henry Kissinger, the former Secretary of State of USA. To quote, “The instability has persisted and the uncertainty has continued. After going through the throes of painfully high levels of inflation, the world economy has experienced a deep recession and unprecedented rate of unemployment, complicated further by high level of real interest rates and unhealthy exchange rate fluctuations” (Newsweek 1983). More recent concern over the potential instability of the world monetary and financial system was expressed by Maurice Allais, a Nobel Laureate, who called for an urgent reform of the World Economic Order (Allais 1993, pp.13-16). Others vehemently oppose the argument for using rate of interest as a stabilizing tool in the economy (Saud 1980, p.88). This called for the emergence of a new system of banking capable of tackling new challenges that the present world economy, particularly the financial sector, has been facing.

In response, though not exactly to that exigency but for quite a few other reasons, the second half of the twentieth century witnessed a distinctly separate line of thinking on banking. This was institutionalized at the end of third quarter and subsequently emerged as a new system of banking called Islamic Banking {also called Profit-Loss-Sharing Banking (PLS)}. The world has now been expe­riencing operation of as many as 250 Islamic banks and financial institu­tions in more than 50 countries, Muslim and non-Muslim.

There are religious as well as economic reasons, which have contributed to the emergence of PLS-banking as an alternative to its conventional counterpart. It is the prohibition of 'Riba' in the Quran that, according to the proponents of the PLS-system, was the source of inspiration for establishing banks in line with Islamic Shariah (Muslehuddin 1987, pp.24-27). The basic intention behind establishing Islamic banks was the desire of Muslims to reorganize their financial activities in a way that do not contradict the principles of Shariah and enable them to conduct their financial transactions without indulging into Riba (Ahmad 1992). These writers consider rate of interest in the conventional banking mechanism synonymous to Riba, the term as used in the Quran [2:275; 30:39]. One of the reasons for this is that the outcome of the productive effort is uncertain, and so interest necessarily involves an element of Gharar, that is, uncertainty (Chapra 1985, p.64). On this religious ground, proponents of the PLS-system urge the Islamic community to avoid all transactions with institutions that are interest-based.

The economic reason derived from a verse of the Quran providing inspiration to devise an interest-free financial system has been substantiated in the way that interest, instead of increasing wealth, reduces it [30:34]. The primary reason of why the Quran has taken such a hard approach towards interest is that Islam stands for establishing a just economic system free from all kinds of exploitation (Chapra 1985). Further, Muslim economists consider depression and stagflation very often found in the capitalist world as an outcome of the financial system based on interest (Rahman 1976).

Thus, Islamic banking emerged as a response to both religious and economic exigencies. While religious exigency calls for avoiding any transaction based on interest, economic exigencies, on the other hand, provide a new outlook to the role of banking in promoting investment / productive activities, influencing distribution of income and adding stability to the economy. Islamic banking is thus perceived as an improved system in all dimensions.
The first attempt
Interestingly, the concept of Islamic Banking is several decades old. The first attempt to establish an Islamic financial institution took place in Pakistan in the late 1950s with the establishment of a local Islamic bank in a rural area (Wilson 1983). Some pious landlords who deposited funds at no interest, and then loaned to small landowners for agricul­tural development initiated the experiment. The borrower did not pay interest on the credit advanced, but a small charge was levied to cover the bank's operational expenses. The charge was far lower than the rate of interest. Although the experience was encouraging, two main factors were responsible for its failure. First, the depositors' landlords regarded the deposits as a one-time event. With the increasing number of borrow­ers the gap between available capital and credit demanded was huge. Secondly, the bank staff did not have complete autonomy over its operation; depositors showed considerable inter­est in the way their money was lent out (Ibid).
The second attempt
The second pioneering experiment of putting the principles of Islamic banking and finance into practice was conducted in Egypt from 1963 to 1967 through the establishment of the Mit Ghamr Savings Bank in a rural area of the Nile Delta. The experiment com­bined the idea of German savings banks with the principles of rural banking within the general framework of Islamic values (Ahmed 1992). The bank's operation was based on the same Islamic principle i.e. no-interest to the depositors or from the borrowers. Unlike the Pakistani bank, the borrower had to have deposits in the bank in order to request a loan. The experiment soon became success­ful; more branches were opened in different parts of the country, and the amount of deposits increased. Hence, what started as a single bank operation expanded to form a network of local savings banks. Although the project made a good start and initial results were more than encouraging, it suffered a setback owing to changes in the political atmosphere. Nevertheless, the project was re­vived in 1971 under the name of Nasser Social Bank. This was the first Islamic bank in an urban setting based in Cairo. The bank is a public authority with an autonomous status. Its purpose was mainly to promote social concerns such as granting of interest-free loans for small projects on a profit-loss-sharing basis, and assist­ance to the poor and needy students for university and higher education. Because of these social functions, Nasser Social Bank was granted an exemption from the Banking and Credit Law of 1957 in its initial stages. The bank was originated under the Ministry of Treasury but it is now functioning under the Ministry of Social Welfare and Insurance. Its capital comes from the funds allocat­ed by the President from extra budgetary resources, appropriation from the state budget, and contribution from the Ministry of Awqaf (Ahmed 1992). The principles of operation of the Naser Social Bank are very similar to those of the Mit Ghamr Savings Bank. However, the latter offers a full range of normal banking services and a wide range of investment activities through equity participation (Ashker 1987, pp.18-35).
Tabung Hajji: a successful attempt
Islamic banking, with a very different approach contemporary to that in Egypt, emerged in Malaysia. It was a financial institu­tion developed for the pilgrims of Malaysia. These institutions were established in response to what was the contention of the Malaysian Muslims that money spent on pilgrimage must be clean and untainted with 'Riba'. Since this was not possible by depositing money with the ordinary banks, a special financial institution had to be created. Consequently, Pilgrims Saving Corporation was established in 1963, which was later on incorporated into the Pilgrims Management Fund Board (Tabung Hajji) in 1969 (A. Ahmad 1993).
Other attempts
Next to follow was the Dubai Islamic Bank in 1975. The Dubai Islamic Bank is a public limited company having its office at Dubai, U.A.E. with capital of 50 million Dirhams. Since then, a number Islamic banks and financial institutions have been estab­lished in different parts of the world and have been functioning successfully.

A significant development in Islamic banking has been the granting of an Islamic bank license in Saudi Arabia to the fifty-year old "Al-Rajhi Company", a firm noted for its currency, exchange and commercial activities, whose assets exceed $5 billion. The firm started operation in 1985 under the name of "Al-Rajhi Banking Investment Corporation" and has since developed active relationships with major manufacturing and trading companies in Europe and several U.S. corporations. The emerging success of Al-Rajhi in operating profitably in different regions of the world has increased pressure on the Saudi government to go for full-fledged Islamic banking (Mangla, Uppal & Swamy 1988, p.54).

An example of multi-cooperation at the government level in the field of Islamic banking, is the Islamic Development Bank, which was founded in 1975 as a multi-national corporation by several Muslim countries. The purpose of the bank is to support social and economic development in Muslim nations within an Islamic Framework. The subscribers of the capital are the founder govern­ments and, as such, it was established by government treaty.

In addition, an Islamic bank/investment company was established in Bahamas in 1977 as a multi-national holding company under the name of Islamic Investment Company, ICC limited. Its purpose was to establish 'Mudaraba' (partnership companies) in various parts of Islamic countries. The company has established two 'Mudaraba' subsidiaries in Sharjah and Pakistan.

A second example of Islamic banking in the West comes from Luxembourg, where the Islamic Banking System International Holding was established in 1978 as a joint-stock company. Its purpose was to establish international Islamic banks in different parts of the western countries where there are communities of Muslims, and to participate in investment projects in Islamic and non-Islamic countries. The company's investment operations are spread over different parts of the world. As a holding company, it established a new affiliated company in London in June 1983 under the name of Islamic Finance House, and another in Denmark in 1982 under the name of the Islamic Bank International of Denmark.

Dar-al-mal-al-Islami (DMI), based in Geneva, was established in 1981. DMI aims to foster an Islamic financial system based on equity and social justice by incorporating three types of insti­tutions - banking, investment and insurance. Thus, DMI may be considered as a major multi-national company, the activities of which consist of Islamic investments, Islamic solidarity (insur­ance) and Islamic banking operations (Ashker 1987, pp.18-35). DMI group has adopted a high profile and ambitious campaign to open an Islamic bank and investment in over thirty countries.

The second major group is the Kuwait Finance House (KFH). It was established in 1978. The Kuwait government and the remainder by private Kuwait investors own Forty-nine percent of the KFH. Total value assets of KFH at the end of 1987 was $3.92 billion with a deposit of $3.62 billion. The source of KFH's liquidity is cheap deposits from faithful Muslims. The group has concentrated on large scale project financing, particu­larly in real estate. The KFH does have a minimum account size and, therefore, it could be argued that the institution only caters to the richer members of the society.

Another dynamic Islamic banking conglomerate is the 'Al-Baraka' group, which operates banks, investment companies, finan­cial advisory and management companies in more than a dozen coun­tries. It launched its activities only in 1982, but the group now has a total asset of over $2.7 billion. It is considered to be one of the fastest growing Islamic enterprises. The group has operations in Tunisia, Sudan, Bahrain, Turkey, and Malaysia. It is the first group to obtain a license to launch Islamic banking in London.
Complete Islamization Efforts
A development of complete Islamization of banking at national levels had been gaining momentum since the second half of the 1970s. The movement took basically two forms. First, an attempt was made to establish Islamic financial institutions side-by-side with traditional banking. In such attempts, two types of institutions were evolved: Islamic banks were established mostly in Muslim countries; and Islamic investment and holding companies started operating in some Muslim but mostly in non-Muslim countries. These institutions claimed to be operating without interest in their transactions and competed with conventional banks to attract deposits. The majority of these institutions were established through private initiatives. Second, an attempt was made to restructure the whole financial system of the economy in accordance with the teachings of Islam. This second approach was accomplished in two distinct ways, as exemplified by the changes in Iran and Pakistan. Complete Islamization efforts of some leading countries are now discussed.
Iran
The process of Islamization of Islamic banking in Iran has proceeded in three distinct phases. Nationalization, restructuring, and reorganization of the entire banking system characterized phase one taking place between 1979 and 1982. External and internal developments did not allow the policy makers to develop a coherent plan for Islamization of the banking system, although various piecemeal attempts were made towards this objective (Khan & Mirakhor 1989).

The second phase began in 1982 and lasted until 1986. It was a phase primarily characterized by adoption of legislative and administrative steps in order to implement a clearly articulated model of Islamic banking (Iqbal & Mirakhor 1987, p.106). The law for Riba-free banking was passed in August 1983, giving a very short deadline of one year to the banks to convert their deposits in line with Islamic law and their total operations within three years from the date of the passage of the law.

The third phase, which continues till now, began in 1986. This phase defines the role of the Islamic banking system differently from the earlier phases. The system is now expected to be an integral part of the Islamic government, and thus, a direct instrument of its policies. This development is a direct result of the political debate within Iran surrounding the proper role of the government in an Islamic economy. This debate culminated in a ruling by Imam Khomini, which confirmed a highly activist role for the central government in shaping the structure of the Iranian economy and legitimized a trend in the interventionist posture of the government vis-à-vis the economy. The ruling also indirectly affirmed the use of the banking system as an instrument for promoting social and economic development.

The banking sector has been used as an instrument to restructure the Iranian economy. The restructuring was essentially directed towards the shifting of financial resources from services and consumption to the production sector in four ways. First, credit to the service sector, which constituted some 55 percent of the GDP (1984-85), has been drastically reduced to halt its expansion in the short-run and curtail its size in the mid-term. Second, using all available modes of Islamic finance to help farmers to improve and expand production has used bank credit to encourage the growth of the agricultural sector. Coupled with substantial government subsidies for seed, fertilizer, machinery, and crop insurance, the credit policy of the banking system is aimed at reviving the agricultural sector. Third, Islamic banking has been used to create incentives for the development of a co-operative sector spanning agriculture, industry, and trade. Fourth, the banking system, in partnership with the government, undertakes to finance large industrial projects and investment in social overhead capital (Mirakhor & Zaidi 1988, p.3).
Pakistan
Pakistan adopted a policy of gradual transformation of its banking system from February 1979 after several years of study and preparation by the government-appointed Council of Islamic Ideology (CII). The process started when the President of Pakistan announced that interest was to be removed from the economy within a period of three years. Three of the specialized credit institutions--the House Building Corporation, National Investment Trust, and Mutual Trust Funds of Investment Corporation of Pakistan--were to remove interest from their financing operations immediately.

Following the directive issued by the government in January 1981, separate counters were opened in the commercial banks for accepting deposits on a PLS basis. Commercial banks were instructed to create separate accounts for deposits in their interest-based operation and those received on the PLS basis. A series of directives were issued in 1981 by the State Bank of Pakistan permitting commercial banks to issue non-interest based credit to finance exports and imports of commodities, and to provide financing for trading operations and housing. In June 1984, the government announced discontinuation of dual window operations of the banking system within one year. As a result, all financial operations of the banking and financial system, except the foreign currency deposits which continue to earn fixed interest, were brought under the non-interest based modes of financing.

However, along with the change of regime the progress of Islamic banking has been constrained by lack of operating Islamic ethical norms in the business environment. The posture of the policy makers toward Islamic banking in Pakistan has been marked by a great deal of caution. The banking community has shown a reluctance to engage in medium- or long-term industrial financing on a profit-sharing basis. Islamic banking in Pakistan appears to be at a crossroads, and if there is to be further progress the regulatory and legal conditions must be such that the system will have a fair chance to perform as expected.
Bangladesh
In November 1982, a delegation of IDB visited Bangladesh and showed keen interest to participate in establishing a joint venture Islamic bank in the private sector. They found a lot of work had already been done and Islamic banking was in a ready form for immediate introduction. Two professional bodies -Islamic Economics Research Bureau (IERB) and Bangladesh Islamic Bankers' Association (BIBA) made significant contributions towards introduction of Islamic banking in the country. They came forward to provide training on Islamic banking to top bankers and economists to fill-up the vacuum of leadership for the future Islamic banks in Bangladesh. They also held seminars, symposia and workshops on Islamic economics and banking throughout the country to mobilise public opinion in favour of Islamic banking.

Their professional activities were reinforced by a number of Muslim entrepreneurs working under the aegis of the then Muslim Businessmen Society (now reorganised as Industrialist & Businessmen Association). The body concentrated mainly in mobilising equity capital for the emerging Islamic bank. At last, the long drawn struggle to establish an Islamic bank in Bangladesh became a reality and Islami Bank Bangladesh Limited was established in March 1983 in which 19 Bangladeshi national, 4 Bangladeshi institutions and 11 banks, financial institutions and government bodies of the Middle East and Europe Including IDB and two eminent personalities of the Kingdom of Saudi Arabia joined hands to make the dream a reality. Later, other three Islamic Banks were established in the country.

Islami Bank Bangladesh Limited (IBBL) is considered to be the first interest free bank in Southeast Asia. It was incorporated on 13-03-1983 as a Public Company with limited liability under the companies Act 1913. The bank began operations on March 30, 1983.

IBBL is a joint venture multinational Bank with 63.92% of equity being contributed by the Islamic Development Bank and financial institutions like-Al-Rajhi Company for Currency Exchange and Commerce, Saudi Arabia, Kuwait Finance House, Kuwait, Jordan Islamic Bank, Jordan, Islamic Investment and Exchange Corporation, Qatar, Bahrain Islamic Bank, Bahrain, Islamic Banking System International Holding S. A., Luxembourg, Dubai Islamic Bank, Dubai, Public Institution for Social Security, Kuwait Ministry of Awqaf and Islamic Affairs, Kuwait and Ministry of Justice, Department of Minors Affairs, Kuwait. In addition, two eminent personalities of Saudi Arabia namely, Fouad Abdul Hameed Al-Khateeb and Ahmed Salah Jamjoom are also the sponsors of IBBL. The total number of branches as of December 2001 stood at 121. The authorized capital of the bank is Tk. 500 million and subscribed capital is Tk. 160 million.

Al-Baraka Bank Limited, often called the second Islamic bank in Bangladesh, commenced banking business as a scheduled bank on May 20, 1987. It is a joint venture enterprise of Al-Baraka Investment and Development Company a renowned financial and business house of Saudi Arabia, Islamic Development Bank, a group of eminent Bangladesh industrialists and the Government of Bangladesh. The authorized capital of the bank is Tk 600 million and the paid up capital is Tk. 204.07 million. The Bank currently operates 34 branches throughout the country. Apart from extending conventional commercial banking facilities to its customers, the bank has also given substantial financial support to the development of industrial and real estate projects.

Al-Arafa Islami Bank Bangladesh Limited commenced its business as a scheduled bank on September 27, 1995. The authorized capital of the bank is Tk. 1,000 million while its paid up capital is Tk. 101.20 million. The Bank follows the Shariah principles in investment and invests its funds under Mudaraba, Musharaka, Bai-Muajjal, Bai-Salam, etc. Up to 2001, the Bank has been operating its business through 40 branches all over the country.

Social Investment Bank Limited is another bank guided by the Islamic principles. It started its journey in November 1995. Its authorized capital is Tk. 1,000 million and paid-up capital is Tk. 118.36 million. Up to September 2001, the Bank has been operating its business through 15 branches.
References
  • Ahmed, A. (1992). “Contemporary Experiences of Islamic Banks”. Journal of Objective Studies.
  • Ahmed, A. (1993). Contemporary Practices of Islamic Financing Techniques. Jeddah: Islamic Research and Training Institute, Islamic Development Bank.
  • Allais, M. (1993). The Monetary Conditions of an Economy of Markets, Jeddah: Islamic Research and Training Institute.
  • Ashker, A. A. F. (1987). The Islamic Business Enterprise. London: Croom Helm.
  • Chapra, M. U. (1985). Towards a Just Monetary System, Leicester: The Islamic Foundation.
  • Iqbal, Z. and Mirakhor, A. (1987). “Islamic Banking”. Al-Tawhid, Vol. 4, No. 3. : A Journal of Islamic Thought and Culture.
  • Keynes, J. M. (1964). The General Theory of Employment, Interest and Money, London: Macmillan.
  • Khan, M. S., and Mirakhor, A. (1989). Islamic Banking: Experiences in the Islamic Republic of Iran and Pakistan. (IMF Working Paper No. wp/89/12). Washington DC: International Monetary Fund. (JEL Classification Nos. 3116; 3120; 314). p. 1.See also Mangla, I. Y.,& Uppal, J. Y. (1990). Islamic Banking: A Survey and Some Operational Issues. Research in Financial Service, Vol. 2.
  • Mangla, I. U., Uppal J. Y. and Swamy, C. R. K. (1988). “Interest-free Banking- A Financial Innovation : Some Conceptual Issues”, Journal of Midwest Finance Association.
  • Minsky, H. P. (1982).” Can it Happen Again”, in M. E. Sharpe (ed.), Essays on Instability and Finance.
  • Mirakhor, A., and Zaidi, I. (1988). Stabilization and Growth in an Open Islamic Economy. (IMF Working Paper no. wp/88/22). Washington DC: International Monetary Fund. (JEL classification nos. 3110; 4312).
  • Muslehuddin, M. (1987). “Meaning of Riba”, in A. Haque (ed.), Readings in Islamic Banking. Dhaka: The Islamic Foundation Bangladesh. Also see Ahsan, A. S. M. F. (1990). Islamic Banking in Perspective, in Hussain, M. S., Huq, M. A., & Islam, M. N. (Ed.), Islamic Banking and Insurance. Dhaka: Islami Bank Bangladesh Limited, pp. 163-179.
  • Newsweek, January 24, 1983.
  • Rahman, A. (1976). Economic Doctrines of Islam (Vol. I). Lahore: Islamic Publications Ltd. Saud, M. A. (1980). Money, Interest and Qirad, in K. Ahmed (ed.), Studies in Islamic Economics. Jeddah, Leicester: International Center for Research in Islamic Economics, Islamic Foundation. See also Siddiqui, M. N. (1980). Muslim Economic Thinking: A Survey of Contemporary Literature, in K. Ahmed (ed.), Studies in Islamic Economics. Jeddah, Leicester: Interna­tional Center for Research in Islamic Economics, Islamic Foundation. pp. 219-227. For further study see also Kahf, M. (1982). Saving and Investment Functions in a Two Sector Islamic Economy, in M. Arif (ed.), Monetary and Fiscal Economics of Islam (pp. 107-123). Jeddah: Center for Research in Islamic Economics.
  • Saud, M. A. (1986). Contemporary Economic Issues - Usury and Interest, Ohio: Zakah and Research Foundation.
  • Wilson, R. (1983). Banking and Finance in Arab Middleast. London: Macmillan Publisher Ltd.
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