Concept and Ideology
Non-Banking Financial Institutions
Commercial banks and non-bank financial institutions are generally driven by profit motives even within the social welfare function of Islam. Hence, it is likely that a number of sectors of the economy like small agriculturists, cottage industry operators, artisans, and taxi and truck drivers, who are likely to be encouraged and supported by credit availability, may not be attractive to them. As one of the prime socio-economic objectives of an Islamic economic system is to reduce inequality, it is necessary that the credit will be made available to these sections of the population.
Non-Banking Financial Institutions (NBFIS)

Non-bank financial institutions (NBFIs) may be used to denote investment trusts or banks, credit unions, co-operative societies, venture capitalists, and a range of other investment-management institutions. They would mobilize savings through equity and Mudaraba deposits and make them available to prospective investors. They may also manage special funds placed with them by their clients and help individual entrepreneurs and partnerships secure equity and Mudaraba financing. These institutions would thus play the intermediary role of helping savers find profitable avenues for their savings and helping entrepreneurs find funds for expanding their businesses.        

Such institutions, as Chapra thinks, should generally be privately managed (Chapra 1985, p.174). Some of them may be of general nature while others may specialize in specific economic sectors, for example, housing construction, agriculture industry and trade. These institutions may be domestic as well as foreign. The NBFIs would thus differ from each other according to their field of activity and the nature of the maturity of funds placed with them for management. The common feature of all these institutions would be that they would acquire part of their funds from their stockholders, part from commercial banks and part from Mudaraba (but nor demand) demand deposits and special funds placed with them for short, medium or long-term management. They should be medium-sized institutions with sufficient and widespread equity-bases to guard against concentrations of wealth and power. They should be properly regulated to ensure fairness in their dealings and the safety of their depositors" funds. The board of directors of these institutions should be regulated by the central bank and or the depositors in order safeguard the interest of the depositors and the NBFIs should be aided by a stock market properly organized along Islamic, i.e., non-speculative, lines.


The NBFIs act basically as investment trusts and use the funds they have received to acquire equity in other businesses and to extend Mudaraba advances. The Mudaraba financing will normally provide only the temporary (short- and medium-term) capital needs of the business financed.  Long-term needs should finance by the businesses concerned through an increase in equity. The NBFI may itself acquire the increased equity or serve as an intermediary and bring together financiers and entrepreneurs, which it will be well qualified to do because of its intimate knowledge of the market. The bringing together of financiers and entrepreneurs is the crux of the Mudaraba scheme and it should serve to spread ownership of business and reduce concentration of wealth.

The profits earned by the NBFIs should be allocated among their equity and deposit holders in accordance with a certain agreed upon formula, after providing for reserves to be built to serve as a cushion for net losses which may be incurred in certain years. The NBFIs may also be allowed to build a "profit stabilization fund." The existence of a large number of medium-sized NBFIs should, through competition among them, induce greater efficiency in the management of Mudaraba funds and also honest reporting of profits. More Mudaraba funds may get diverted to institutions whose performance has been better, thus ensuring the transfer of real economic resources to their most efficient uses. In the interest-oriented capitalist banking system the depositor plays a passive role in the efficiency of the banking system because banks normally pay a more or less uniform rate of interest which is considerably smaller than both the interest earned by them and the profits earned by the borrowing enterprises. This results in a tendency to provide funds at lower rates of interest to larger borrowers with a "high" credit rating and to serve the "vested" interests of bank-controlling families, thus contributing substantially to an unhealthy concentration of income and wealth.


Since the NBFIs will be under the market compulsion to declare a competitive rate of return on their shares and Mudaraba deposits, there will be a natural urge on their part to demand from the users of their equity and Mudaraba financing a high rate of efficiency in the use of funds. Thus it is not realistic to assume that in an interest-free banking system the Mudaribs will cheat the NBFIs by declaring lower rates of profit. If any Mudarib resorts to such practice he will tend to deprive himself of Mudaraba financing. Since such financing may be an important source of funds for most traders and agricultural and industrial entrepreneurs, they could hardly be expected to resort to such a self-defeating policy.


To reinforce further the above-mentioned deterrent against dishonesty in declaring profits to the NBFIs, the accounts of firms financed by NBFIs could be made subject to a random audit by the Investment Audit Corporation (IAC). The IAC may also audit the accounts of customers specially referred by the NBFIs, particularly those who report suspect profits. The IAC could also audit the accounts of firms referred to it by any of the firm's silent financing partners. Exposure to such audit should serve to keep the users of equity and Mudaraba funds on the alert.

However, there is one factor, which will almost certainly act against honesty in the reporting of profits to or by the NBFIs. This is the unrealistic tax system with unduly high tax rates forcing businesses to maintain two sets of accounts. Hence it would be necessary to rationalize the tax system so that it does not have a built-in incentive to cheat the government, the banks and the NBFIs.


The scheme of NBFIs as suggested by Chapra above could be questioned as leading to a concentration of wealth similar to that brought about by conventional banks in capitalist societies. The danger of concentration through the inverted pyramid of loan-equity financing and availability of large resources to privileged borrowers will have to be removed. However, the danger of concentration of power attained by NBFIs would remain, but this could be substantially reduced by a number of measures as below:


  1. The number of NBFIs should be large and none should be allowed to expand beyond a certain limit determined by the Central bank.

  2. They should be required to provide financing to a large number of entrepreneurs and not to provide more than a small proportion of their resources to any one business or family.

  3. They should not be allowed to acquire a controlling stock in any business.

  4. None of the NBFIs directors should be allowed to become a Director in any other business.

  5. Their effort should be to bring financiers and entrepreneurs together so that they do not themselves hold the equity for a long period.

  6. Their own equity should be broadly distributed so that any specific individual, family or group does not have a controlling ownership in these institutions.

  7. Other specific measure may be adopted by means of well-conceived and properly enforced laws to ensure that the NBFIs do not lead to concentration of wealth and power.

Deposit Insurance Company (DIC)


Demand depositors, specifically in regards to sharing profits of Mudaraba banks and the risk of erosion of their deposits through losses suffered by the Mudaraba banks, may prefer to hoard their savings. This behavior would not be desirable from the viewpoint of the long-term interest of an Islamic society. This calls for an initiative, which would help protect demand deposits against such risks. Several Muslim scholars think that a deposit insurance scheme should be an integral part of the Islamic banking system (Ibid, pp.50-51).  A deposit insurance corporation will insure demand deposits at the commercial banks. The corporation should not, however, insure Mudaraba deposits at either the commercial banks or NBFIs (Ibid, p.178).


Chapra argues that this will not discourage Mudaraba deposits against demand deposits. For instance, he mentions that the prospect of losses on corporate securities has not reduced investments in corporate securities in spite of the unhealthy and destabilizing speculation in stock markets. Since the opportunity to hold interest-earning assets will not be available in the Islamic economy, the only alternative to Mudaraba deposits and equity will be demand deposits yielding no return. Moreover, the establishment of a loss-offsetting fund would make Mudaraba deposits preferable to demand deposits by substantially reducing risks on such deposits.


Functioning Procedures

Chapra visualizes the deposit insurance corporation as an autonomous, non-profit government organization operating under the supervision of the central bank. It should be self-sustaining with no budgetary appropriations from the government except in the initial phase when it may receive an interest-free loan from the government, to be repaid out of reserves built by the DIC over a period of years. This will be a service rendered by the government to the banking system, partially in return for the interest-free loan it will be receiving and partly due to its obligation toward the establishment and success of the Islamic banking system.


There might be two sources of DIC income. First, assessments on all commercial banks at the rate of a small percentage of the total of demand deposits after allowing for certain exclusions and deductions, and second, income from the investment of its reserves. The government, Chapra says, should pay the premium on the proportion of demand deposits it obtains as an interest-free loan and the central bank should pay the premium on statutory reserves. Premium rates should allow rebates for good performance to encourage healthy banking practices. The deposit insurance fund accumulated through such premiums would be available to meet future deposit insurance claims and related losses. Its adequacy to meet these future requirements would depend upon the soundness of the insured bank and adverse factors such as unfavorable general economic conditions.

At the beginning, the limited resources at the disposal of the DIC may not be sufficient to cover wide spectrum of deposits and would compel it to set a limit on the small depositors. The limit may be raised later when the reserves of the DIC have risen sufficiently, provided this is considered to be in the interest of serving the socio-economic objectives of Islam. It is, however, instructive to note that most countries have opted for less than full coverage of deposits because of considerations of equity even though this approach has been subjected to increasing criticism.


DIC being a non-profit organization financed by the commercial banks would be a truly mutual or co-operative insurance company. The scheme hence would be fully acceptable even to those Fuqaha who find certain types of commercial insurance unacceptable by the Shariah.

Investment Audit Corporation

Chapra contends that this should also be a government-sponsored organization constituted in the same manner as the DIC. Auditing of the accounts of Mudaribs who have obtained funds from others directly or through commercial banks and NBFIs, whether in their form of equity or Mudaraba advances, would be the main objective of the Investment Audit Corporation (IAC). In other words, the objective of the IAC would be to safeguard the interest of financial institutions, depositors, and equity holders. IAC operation will keep the users of equity and Mudaraba funds on their guard and create a deterrent to under-reporting of profits, provided the tax rates structure is rationalized.


The establishment of an institution like the IAC is a cost-effective means for the individual financial institutions since it relieves them from the need of hiring a large staff of auditors. It will thus provide an opportunity for the investors to have the accounts audited by a qualified public incorporated institution.

Functioning Procedure

IAC can be organized in a way such that all of its expenses will be shared by the financial institutions in accordance with some formula which may be based on a general charge on their total Mudaraba advances and equity investments and a specific charge on the special cases audited for them. (Chapra 1985, p.179). Individual investors while receiving the service of audit for any specific business may pay a service fee according to the nature and extent of audit required.


Floating of the IAC is itself an answer to one of the major criticisms against the Islamic banking system, that it would require each bank to hire a large staff of auditors, which would make bank management very expensive.  In the absence of such staffs, it is argued, the banks would not be able to determine the accuracy of accounts. Chapra argues that market forces will automatically take care of the problem. Creation of an IAC would, according to him, work as an additional safeguard to the interests of investors (Ibid).


The whole concept of "audit" needs to undergo a thorough transformation in Muslim economies. It is widely accepted that conventional auditing is "not expressly designed to uncover management frauds" (Khan, p.39). Going with "generally accepted accounting principles", while performing an audit and evaluating the financial statements may fulfill the professional obligations of the auditors, but this does not provide the auditor with the responsibility to detect management malpractice or to determine the "real" profit. As per conventional auditing principles, an auditor does not have the responsibility to check and to question management practices and the reason is very simple. Accounting firms generally tend to accommodate their clients, particularly the big clients, who hire them.


In an Islamic audit system, the auditor is required to go beyond "generally accepted accounting principles."  He would be given responsibility of detecting and disclosing dishonest and questionable acts by management. The objective would be to determine the real amount of profits so as to ensure a "fair" return to the shareholders and Mudaraba depositors.  A state-sponsored IAC can play an important role in this regard. It will set new principles for auditing in the light of Islamic teachings and guide and help private auditing firms perform their task more effectively.

  • Chapra, M.U. (1985, Towards A Just Monetary System, London, Islamic Foundation, UK.

  • Khan, A.Jabbar, Commercial Banking Operations in the Interest-Free Framework, Mimeo, Islamabad.

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