Concept and Ideology
Islamic Banking: Some Conceptual Issues
What is Islamic Banking
Islamic banking has been defined in a number of ways. The definition of Islamic bank, as approved by the General Secretariat of the OIC, is stated in the following manner. "An Islamic bank is a financial institution whose status, rules and procedures expressly state its commitment to the principle of Islamic Shariah and to the banning of the receipt and payment of interest on any of its operations"(Ali & Sarkar 1995, pp.20-25). Shawki Ismail Shehta viewing the concept from the perspective of an Islamic economy and the prospective role to be played by an Islamic bank therein opines: "It is, therefore, natural and, indeed, imperative for an Islamic bank to incorporate in its functions and practices commercial investment and social activities, as an institution designed to promote the civilized mission of an Islamic economy" (Ibid). Ziauddin Ahmed says, "Islamic banking is essentially a normative concept and could be defined as conduct of banking in consonance with the ethos of the value system of Islam" (Ibid).

It appears from the above definitions that Islamic banking is a system of financial intermediation that avoids receipt and payment of interest in its transactions and conducts its operations in a way that it helps achieve the objectives of an Islamic economy. Alternatively, this is a banking system whose operation is based on Islamic principles of transactions of which profit and loss sharing (PLS) is a major feature, ensuring justice and equity in the economy. That is why Islamic banks are often known as PLS-banks.
RIBA and its basic features
The word used by the Quran concerning 'interest' is Riba. The literal meanings of Riba are money increase, increase of anything or increment of anything from its original amount (Maududi 1979, p.84). However, all increases are not considered as Riba in Islam. Money may increase in business activities as well. This increase is not at all considered as Riba. The increase, instead of being prohibited (Haram), is approved (Halal) in Islam. Islam prohibits only those increases that are charged on the loan with a prefixed rate.

Muslim scholars equate interest with Riba. In the Shariah, Riba technically refers to the premium that must be paid by the borrower to the lender along with the principal amount as a condition for the loan or for an extension in its maturity (Chapra 1985, p.64). In other words, Riba is the predetermined return on the use of money. In the past there has been dispute about whether Riba refers to interest or usury, but there is now consensus among Muslim scholars that the term covers all forms of interest and not only "excessive" interest (Khan 1985, p.52).

In the era of Ignorance (Jahiliah) moneylenders in Arabia charged a prefixed extra amount on their money lent out. Some of them lent goods or crops and took back prefixed extra amount on and above the principal amount. In those days the extra amount charged on the principal amount of money or goods was also termed as Riba. The term Riba in the Quran has been used in the same sense.

Imam al Rajhi describes, "During the era of Jahiliah people invested their money and charged Riba on a monthly basis, though the invested amount remained unchanged. Money so invested was called back at the time of repayment. In case of the borrower being unable to pay back, the lender extended the period of repayment enhancing the amount to be paid on and above the principal amount." Abu Bakr al Jasas writes, "During the period of Ignorance the lender and borrower came to an agreement that the borrower would pay back within a specified period the principal amount along with the agreed upon excess." Ibne Hajar Askalani says, "Excess goods or money charged on and above principal amount is Riba."

Thus, any prefixed extra amount charged on a specific amount of money or goods lent out is called Riba.

The most important characteristic of Riba is that it is the positive and definite result of money when changed. In other words, when money begets money, without being exchanged for goods or services, it is called Riba. Its basic characteristics are:
  • It must be related to loan;

  • A prefixed amount of money to be paid when due;

  • A time is fixed for the repayment; and

  • All these elements for repayment are taken as conditions for loan.

RIBA and Profit
There are persons who try to equate Riba with profit. In effect, they are fundamentally different from each other as can be seen from the following:

Riba Profit
1. When money is "charged", its imposed positive and define result is Riba 1. When money is used in trading (for e.g.) its uncertain result is profit.
2. By definition, Riba is the premium paid by the borrower to the lender along with principal amount as a condition for the loan. 2. By definition, profit is the difference between the value of production and the cost of production.
3. Riba is prefixed, and hence there is no uncertainty on the part of either the givers or the takers of loans. 3. Profit is post-determined, and hence its amount is not known until the activity is done.
4. Riba can not be negative, it can at best be very low or zero. 4. Profit can be positive, zero or even negative.
5. From Islamic Shariah point of view, it is Haram. 5. From Islamic Shariah point of view, it is Halal.
Types of RIBA
The term Riba is used in Shariah in two senses. The first is Riba al-nasi'ah and the second is Riba al-fadl. The term Nasi'ah comes from the root Nasa'a, which means to postpone, to defer, or wait, and refers to the time that is allowed for the borrower to repay the loan in return for the 'addition'. Therefore, Riba al-nasi'ah means interest on loans. The same meaning is reflected in the holy Quran in the verse "God has forbidden interest" [2:275]. This is also the Riba, which the Prophet (pbuh) mentioned when he said: "There is no Riba except in Nasi'ah".

The prohibition of Riba al-nasi'ah essentially implies that Shariah does not permit the fixing in advance of a positive return on a loan as a reward for waiting. It makes no difference whether the return is a fixed or a variable percent of the principal, or an absolute amount to be paid in advance or on maturity, or a gift or service to be received as a condition for the loan. The point in question is the predetermined positive return (Chapra 1985, p.57).

Chapra further pointed out that, according to Shariah, the waiting involved in the repayment of a loan does not itself justify a positive reward. There is absolutely no difference of opinion among all schools of Muslim jurisprudence that Riba al-nasi'ah is Haram or prohibited. Quoting Abd al-Rahman al-Jaziri he opines that the nature of the prohibition is strict, absolute and unambiguous. He continues to say that there is no room for arguing that Riba refers to usury and not interest, because the Prophet prohibited the taking of even a small gift, service or favor as a condition for the loan, in addition to principal (Ibid).

The second sense in which Riba has been used is Riba al-fadl. Riba al-fadl is encountered in hand-to-hand purchase and sale of commodities. It covers all spot transactions involving cash payment on the one hand and immediate delivery of the commodity on the other.

The question of Riba al-fadl arises because of a saying of the Prophet (pbuh) requiring that if gold, silver, wheat, barley, dates and salt are exchanged against themselves they should be exchanged spot and be equal and alike. It may be mentioned that the above six items did the function of money at that time. While explaining the significance of Riba al-fadl and why it has also been prohibited, Chapra provides the following arguments: On the surface it appears hard to understand why anyone would want to exchange a given quantity of gold or silver or any other commodity against its own counterpart, and that too 'spot'. What is essentially being required is justice and fair play in spot transactions; the price and the counter-value should be just in all transactions where cash payment (irrespective of what constitutes money) is made by one party and the commodity or service is delivered reciprocally by the other. Any thing that is received as "extra" by one of the two parties to the transaction is Riba al-fadl, which could be defined in the words of Ibn al-Arabi as all excess over what is justified by the counter-value. Justice can be rendered only if the two scales of the balance carry the same value of goods. The point was explained in a befitting manner by the Prophet, (pbuh) when he referred to six important commodities and emphasized that if one scale has one of these commodities, the other scale also must have the same commodity, "like for like and equal for equal". To ensure justice, the Prophet, (pbuh) even discouraged barter transactions and asked that a commodity for sale be exchanged against cash and the cash proceeds be used to buy the needed commodity. This is because it is not possible in a barter transaction, except for an expert, to accurately determine the fair equivalent of one commodity in terms of all other goods. Hence, the equivalents may be established only approximately thus leading to some injustice to one party or the other. The use of money therefore helps reduce the possibility of an unfair exchange (Ibid, pp.58-59).

It is in the above sense that all commodities exchanged in the market would be subject to Riba al-fadl. Its prohibition is thus intended to ensure justice and eliminate all forms of exploitation through 'unfair' exchanges and to close all back doors to Riba since, in the Islamic Shariah, anything that serves as a means to the unlawful is also unlawful. The Prophet (pbuh) also equated with Riba the cheating of an unsophisticated entrant into the market and the rigging of prices in an auction with the help of agents. Thus, it implies that the extra money earned through such exploitation and deception is nothing else but Riba al-fadl. People may be exploited and cheated in a number of ways and that is why the Prophet (pbuh) said: "Leave what creates doubt in your mind in favor of what does not create doubt". Inspired by this Hadith, Caliph Umar said: "Abstain not only from Riba but also from Ribah" the latter literally meaning 'doubt' which refers to income that has the semblance of Riba or which raises doubt in the mind about its rightfulness. It covers all income derived from injustice to, or exploitation of, others (Ibid, p.61).

Referring to Fakhruddin al-Razi, Chapra concludes that Riba al-nasiah and Riba al-fadl are both essential components of the verse "God has allowed trade and prohibited Riba." While Riba al-nasiah relates to loans and is prohibited in the second part of the verse, Riba al-fadl relates to trade and is implied in the first part. Because trade is allowed in principle, it does not mean that every thing is allowed in trade. Since injustice inflicted through Riba may be perpetuated through business transactions, Riba al-fadl refers to all such injustices or exploitation. It requires absence of rigging, uncertainty or speculation, and monopoly and monopsony (Ibid, p.61).

It is the considered opinion of the experts on Islamic jurisprudence that interest charged by commercial banks "is identical with the excess stipulated as an obligatory condition in the contract, which is one of the two types of usury prohibited by Islamic Shariah". Justification put forward for prohibiting this kind of usury is that it admits the possibility of fraud in transactions (Ausaf Ahmed 1995, p.16). The Shariah stands for establishing the condition that there will be no element of uncertainty (Gharar) nor of injustice (Zulm) when people enter into contracts with each other, whether these contracts pertain to real transactions of commodities or to financial transactions. Islamic Fiqh Academy established by the Organization of Islamic Conferences (OIC) in its second session held in Jeddah, Saudi Arabia, during 22-28 December 1985, declared that "any increase or profit on a loan which has matured, in return for an extension of the maturity date, in case the borrower is unable to pay, and any increase or profit on the loan at the inception of the loan agreement, are both forms of usury (Riba), which is prohibited under the Shariah" (Ibid, p.17).
Prohibition of RIBA
On religious perspective

The religious restriction on interest is quite explicit and unequivocal. All transactions based on Riba are strictly prohibited in the Quran. The prohibition of Riba appears in the Quran in four different revelations. The first of these [30:39] in Makkah, emphasized deprivation of God's blessing for a man making interest transaction and charity having the essence of manifold rise. The second revelation [4:161] concerning the subject took place in the early Madinah. It severely condemned interest-referring prohibitions taken place in the previous scriptures. The third revelation [3:130-2] enjoined Muslims to keep away from Riba. The fourth revelation [2:275-81] reveling nears the completion of the Prophet's mission. The verses giving strong verdict against Riba are as follows:

  Those who devour Riba will not stand except as stands one whom the devil hath driven to madness by [his] touch [2:275].

Condemnation of the system of interest is so strong and without any doubt can be reflected in the following verse which imposes penalties on those who hesitate in observing the verdict:

  O ye who believe! Observe your duty to Allah and give up what remains (due to you) from Riba, if you are (in truth) believers. And if you do not, then be warned of war (against you) from Allah and His Messenger. And if you repent then you have your principal (without Riba). Wrong not, and you shall not be wronged [2:278-9].

The strong disapproval of interest by Islam and the crucial role it plays in the modern commercial banking has led Muslim thinkers to explore ways and means by which commercial banking could be organized on an interest-free basis. However, for a long time, the idea of Islamic banking remained a mere wish. Some papers were written and some professional economists even worked out theoretical models of Islamic banking. However, they were quickly dismissed by highbrow economists who described them as wishful thinking and attempts to put history into reverse gear.

On socio-economic perspective

The Islamic law of prohibition of interest was originally not based on economic theory but on divine authority, which considered charging of interest as an act of injustice. Early Muslim scholars considered money as a medium of exchange, a standard of value and a unit of account but rejected its function as a store of value. Lending upon interest was prohibited because it was an act of ungratefulness and considered to be unjust since money was not created to be sought to be itself but for other objects.

Recent Muslim scholars, however, place the major emphasis of their explanation of the Law on the lack of a theory of interest. They have countered the arguments that interest is a reward for saving, a productivity of capital and an inevitable consequence of the difference between the value of capital goods today and their value a year hence. The basic arguments are summarizes below:
  1. Interest and savings: To the argument that interest is a reward for saving, Muslim scholars (see, for example, Mirakhore 1995, pp.31-34) respond that such payments could only be rationalized if savings were used for investment to create additional capital and wealth. According to them, the mere act of abstention from consumption should not entitle anybody to a return.

  2. Interest and the productivity of capital: To the argument that interest is justified as productivity of capital, they respond that although the marginal productivity of capital may enter as one factor into the determination of the rate of interest, interest, per se, has no necessary relation with the capital productivity. Interest, they argue, is paid on money, not on capital, and has to be paid irrespective of capital productivity. In distinguishing between interest as a charge for the use of money and a yield from the investment of capital, Muslim scholars argue that it is an error of modern theory to treat interest as the price of, or return for, capital. Money, they argue, is not capital, it is only  'potential capital' which requires the service of the entrepreneur to transform the potentiality into actuality; the lender has nothing to do with the conversion of money into capital and with using it productively.

  3. Interest as a time value of capital: To the argument that interest arises as an inevitable consequence of the difference between the value of capital goods today and their value a year hence, they respond that this only explains its inevitability and not its rightness. Even if the basis for time preference is the difference between the value of commodities this year and the next, Muslim scholars argue, it seems more reasonable to allow next year's economic conditions to determine the extent of the reward.

Muslim scholars maintain that when a person lends out, the funds are used to create either a debt or an asset (i.e., through investment). In the first case, there is no justifiable reason why the lender should receive a return. Further, there is no justification from the point of view of the smooth running of the economy, or from the point of view of any tenable scheme of social justice. The state should attempt to enforce an unconditional promise regardless of the use of borrowed money.

 

If the money is used to create additional capital wealth, the question is raised as to why the lender should be entitled to only a small fraction (represented by interest rate) of the exchange value of the utilities created by the use made of loaned-out money. Justice demands that he should be remunerated to the extent of the involvement of his financial capital in creating the incremental wealth.

The elimination of interest from the economic system is intended to promote economically just, socially fair and ethically correct dealings according to Islamic principles.  This harmonious trade creates powerful economic incentives, and brings about co-operation and co-participation in all walks of life. Moreover, prohibition of the practice of hoarding in the Quran applies to money also. Islam wants to make it sure that one's money is used productively for oneself and the community.

  1. Economic rationale for eliminating Riba

The economic rationale for eliminating Riba (interest) is based on values of justice, efficiency, stability and growth.

 

The arguments for distributive justice are:

  1. The industrial and/or commercial risk is shared more equitably between the entrepreneur and the capital owner.

  2. Replacing a fixed return by a proportionate share in actual profits would ensure equitable returns to capital regardless of whether profits are high or low, and whether prices are inflationary, stable or deflationary.

  3. Wealth would generate more wealth of its owners only when its employment in economic activities results in the creation of value added.

The arguments for efficient allocation of capital are:

  1. Loan finance in contrast to the provision of risk capital, tends to serve the most credit worthy borrowers and not necessarily the most productive and profitable projects.

  2. Profit-sharing arrangements harmonize the interests of the suppliers and users of capital, resulting in a joint focus on productivity.

  3. This approach also provides for social cohesion between different classes, the motivations of which are often conflicting and opposed in the conventional system.

On the subject of stability, the argument is put forward that an interest-based economy has a built-in tendency toward inflation, because the creation of money is not related to productive investments, either at the level of the central banks or at the level of commercial banks.

Objectives of Islamic Banking

The primary objective of establishing Islamic banks all over the world is to promote, foster and develop the application of Islamic principles in the business sector. More specifically, the objectives of Islamic banking when viewed in the context of its role in the economy are listed as following:

  • To offer contemporary financial services in conformity with Islamic Shariah;

  • To contribute towards economic development and prosperity within the principles of Islamic justice;

  • Optimum allocation of scarce financial resources; and

  • To help ensure equitable distribution of income.

These objectives are discussed below.

 

Offer Financial Services: Interest-based banking, which is considered a   practice of Riba in financial transactions, is unanimously identified as anti-Islamic. That means all transactions made under conventional banking are unlawful according to Islamic Shariah. Thus, the emergence of Islamic banking is clearly intended to provide for Shariah approved financial transactions.

 

Islamic Banking for Development: Islamic banking is claimed to be more development- oriented than its conventional counterpart. The concept of profit sharing is a built-in development promoter since it establishes a direct relationship between the bank's return on investment and the successful operation of the business by the entrepreneurs.

 

Optimum Allocation of Resources: Another important objective of Islamic banking is the optimum allocation of scarce resources. The foundation of the Islamic banking system is that it promotes the investment of financial resources into those projects that are considered to be the most profitable and beneficial to the economy.

 

Islamic Banking for Equitable Distribution of Resources: Perhaps the must important objective of Islamic banking is to ensure equitable distribution of income and resources among the participating parties: the bank, the depositors and the entrepreneurs.

Distinguishing features of Islamic Banking

An Islamic bank has several distinctive features as compared to its conventional counterpart. Chapra (1985, PP.154-57) has outlined six essential differences as below:

Abolition of interest (Riba): Since Riba is prohibited in the Quran and interest in all its forms is akin to Riba, as confirmed by Fuqaha and Muslim economists with rare exceptions, the first distinguishing feature of an Islamic bank must be that it is interest-free.        

 

Adherence to public interest: Activity of commercial banks being primarily based on the use of public funds, public interest rather than individual or group interest will be served by Islamic commercial banks.  The Islamic banks should use all deposits, which come from the public for serving public interest and realizing the relevant socio-economic goals of Islam. They should play a goal-oriented rather than merely a profit-maximizing role and should adjust themselves to the different needs of the Islamic economy.

 

Multi-purpose bank: Another substantial distinguishing feature is that Islamic banks will be universal or multi-purpose banks and not purely commercial banks. These banks are conceived to be a crossbreed of commercial and investment banks, investment trusts and investment -management institutions, and would offer a variety of services to their customers. A substantial part of their financing would be for specific projects or ventures. Their equity-oriented investments would not permit them to borrow short-term funds and lend to long-term investments. This should make them less crisis-prone compared to their capitalist counterparts, since they would have to make a greater effort to match the maturity of their liabilities with the maturity of their assets.

 

More careful evaluation of investment demand:  Another very important feature of an Islamic bank is its very careful attitude towards evaluation of applications for equity oriented financing. It is customary that conventional banks evaluate applications, consider collateral and avoid risk as much as possible. Their main concern does not go beyond ensuring the security of their principal and interest receipts. Since the Islamic bank has a built in mechanism of risk sharing, it would need to be more careful in how it evaluates financing requests. It adds a healthy dimension in the whole lending business and eliminates a whole range of undesirable lending practices.

 

Work as catalyst of development: Profit-loss sharing being a distinctive characteristic of an Islamic bank fosters closer relations between banks and entrepreneurs. It helps develop financial expertise in non-financial firms and also enables the bank to assume the role of technical consultant and financial adviser, which acts as catalyst in the process of industrialization and development.

Conventional and Islamic banking

Conventional banking is essentially based on the debtor-creditor relationship between the depositors and the bank on the one hand, and between the borrowers and the bank on the other. Interest is considered to be the price of credit, reflecting the opportunity cost of money.

 

Islam, on the other hand, considers a loan to be given or taken, free of charge, to meet any contingency.  Thus in Islamic Banking, the creditor should not take advantage of the borrower. When money is lent out on the basis of interest, more often it happens that it leads to some kind of injustice. The first Islamic principle underlying such kinds of transactions is that "deal not unjustly, and ye shall not be dealt with unjustly" [2:279]. Hence, commercial banking in an Islamic framework is not based on the debtor-creditor relationship.

 

The second principle regarding financial transactions in Islam is that there should not be any reward without taking a risk. This principle is applicable to both labor and capital. As no payment is allowed for labor, unless it is applied to work, there is no reward for capital unless it is exposed to business risk (Ausaf Ahmed 1995, P.17).

 

Thus, financial intermediation in an Islamic framework has been developed on the basis of the above two principles. Consequently financial relationships in Islam have been participatory in nature. Several theorists suggest that commercial banking in an interest-free system should be organized on the principle of profit and loss sharing. The institution of interest is thus replaced by a principle of participation in profit and loss. That means a fixed rate of interest is replaced by a variable rate of return based on real economic activities (Mangla & Uppal 1990. pp.179-215, 185). The distinct characteristics which provide Islamic banking with its main points of departure from the traditional interest-based commercial banking system are: (a) the Islamic banking system is essentially a profit and loss sharing system and not merely an interest (Riba) banking system; and (b) investment (loans and advances in the Conventional sense) under this system of banking must serve simultaneously both the benefit to the investor and the benefit of the local community as well.  The financial relationship as pointed out above is referred to in Islamic jurisprudence as Mudaraba.

 

For the interest of the readers, the distinguishing features of the conventional banking and Islamic banking are shown in terms of a box diagram as shown below:



Banks Islamic Banks
1. The functions and operating modes of conventional banks are based on manmade principles. 1. The functions and operating modes of Islamic banks are based on the principles of Islamic Shariah.
2. The investor is assured of a predetermined rate of interest. 2. In contrast, it promotes risk sharing between provider of capital (investor) and the user of funds (entrepreneur).
3. It aims at maximizing profit without any restriction. 3. It also aims at maximizing profit but subject to Shariah restrictions.
4. It does not deal with Zakat. 4. In the modern Islamic banking system, it has become one of the service-oriented functions of the Islamic banks to collect and distribute Zakat.
5. Leading money and getting it back with interest is the fundamental function of the conventional banks. 5. Participation in partnership business is the fundamental function of the Islamic banks.
6. Its scope of activities is narrower when compared with an Islamic bank. 6. Its scope of activities is wider when compared with a conventional bank. It is, in effect, a multi-purpose institution.
7. It can charge additional money (compound rate of interest) in case of defaulters. 7. The Islamic banks have no provision to charge any extra money from the defaulters.
8. In it very often, bank's own interest becomes prominent. It makes no effort to ensure growth with equity. 8. It gives due importance to the public interest. Its ultimate aim is to ensure growth with equity.
9. For interest-based commercial banks, borrowing from the money market is relatively easier. 9. For the Islamic banks, it is comparatively difficult to borrow money from the money market.
10. Since income from the advances is fixed, it gives little importance to developing expertise in project appraisal and evaluations. 10. Since it shares profit and loss, the Islamic banks pay greater attention to developing project appraisal and evaluations.
11. The conventional banks give greater emphasis on credit-worthiness of the clients. 11. The Islamic banks, on the other hand, give greater emphasis on the viability of the projects.
12. The status of a conventional bank, in relation to its clients, is that of creditor and debtors. 12. The status of Islamic bank in relation to its clients is that of partners, investors and trader.
13. A conventional bank has to guarantee all its deposits. 13. Strictly speaking, and Islamic bank cannot do that.
References
  • Ahmed, Ausaf (1995). "The Evolution of Islamic Banking". In Encyclopedia of Islamic Banking, London: Institute of Islamic Banking and Insurance.

  • Ali, M and Sarkar, A. A. (1995). "Islamic Banking: Principles and Operational Methodology". Thoughts on Economics, Vol. 5 No. 3 & 4. July-December 1995. Dhaka: Islamic Economics Research Bureau.

  • Chapra, M. U. (1985). Towards a Just Monetary System. Leicester: The Islamic Foundation.

  • Hamid, M.A. and S.M.H. Rahman (2001). "The Role of Islamic Banks in the Development of Small Entrepreneurs: An Empirical Investigation".  IBTRA/IBBL, Dhaka.

  •  Khan, W. M. (1985). Towards an Interest-Free Islamic Economic System. Leicester, Islamabad: The Islamic Foundation, The International Association of Islamic Economics.

  • Mangla, I. Y., and Uppal, J. Y. (1990). "Islamic Banking: a Survey and Some Operational Issues". Research in Financial Service, Vol. 2.

  • Maududi, Syed Abul Ala (1979). Sud and Adhunic Banking. Adhunik Prokashani, Dhaka.

  • Mirakhor, A. (1995). "The Theory Of Islamic Financial System". In Encyclopedia of Islamic Banking, London: Institute of Islamic Banking and Insurance.

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