University of Balochistan

Department of Commerce

Research Topic: Islamisation of
Banking in Pakistan

Supervisor: Sir. Aadeem Malik

Name: Muhammad Shafiq Aasar
Roll No: 48
Class: M.Com Previous
Section: B
Some Introduction of Islamic Banking in
There is an Islamic Iinancing boom going on these days in Pakistan. Either entirely new
Islamic banks are being opened or existing commercial banks are starting subsidiaries or
branches specializing in Islamic banking. These Iinancial institutions now oIIer Shariah-
based alternative products like Murabaha. Musharakah. Iiarah. Iiarah-Wal-Iqtina and
Modaraba to those in the conventional western banking system.
But how much oI their claim about Islamic banking is true? Are they really
working according to Islamic principles?
These are some crucial questions. which. according to economists and senior
bankers. are diIIicult to answer. Some dispute the diIIerence between the existing
interest-based banks and the so-called Islamic banks. Critics argue that the latter actually
work on the principle oI interest. or Riba. which is. oI course. prohibited under Islam
they iust dress their products in Islamic clothes.
Even the State Bank oI Pakistan (SBP). which is the regulator oI all the banking
and Iinancial institutions oI the country. has not come up with a true solution Ior Islamic
banking. and it has allowed Islamic banking and the conventional banking system. which
is based on interest. to live side by side.
'This is not Islamic banking in the real sense because the spirit oI Shariah is not
observed.¨ says Dr Shahid Hasan Siddiqui. a senior economist and the chairman oI the
Research Institute oI Islamic Banking and Finance. 'In practice. nowhere in the world is
there a model Islamic banking system. II you see the international literature on Islamic
banking. it has become a mockery.¨
At the international level. Islamic banking caught the attention oI the leading
Iinancial institutions aIter the global oil boom in 2003. Big banks the world over saw the
oil-rich Arabs as a lucrative untapped market. And given that they predominantly preIer
to earn proIits on their money through Islamic modes oI Iinancing. Ioreign banks had to
develop new Muslim-Iriendly products.
Although many Muslim countries adopted the Islamic banking system decades
ago. the system really Ilourished aIter 9/11. It is believed that many wealthy Muslims
withdrew their deposits Irom western banks and transIerred their holdings to banks in
Muslim countries. In an attempt to halt that outIlow. banks in the UK. USA and European
countries turned towards Islamic banking.
From Standard Chartered Bank to Citibank and ABN AMRO. every maior
international bank is oIIering products based on Islamic banking principles.
'The problem is that most clients under Islamic banking are non-Muslims. who
say. 'We are not concerned with Shariah. as long as we are getting handsome proIits.¨
says Dr Siddiqui.
Internationally. Islamic banking is the Iastest growing sector in banking. and it is
believed that its growth is between 15 - 20° annually. According to an oIIicial oI the
SBP. assets oI Islamic banks worldwide are estimated to be between US$350 to almost
700 billion. Recently. two licenses have been issued in the UK. one to the European
Islamic Investment Bank and the other to the Islamic Bank oI Britain. Singapore has also
opened an oIIshore centre oI Islamic Banking. Bahrain. Malaysia. Indonesia are the
oldest players in Islamic banking. and in total about 50 to 60 countries across the world
are using the Islamic mode oI banking.
In Pakistan. Islamic banking has witnessed a setback because oI the unwillingness
oI successive governments to introduce an interest-Iree system. Although the government
had committed that the banking system would gradually be converted to one based on
Islamic principles. no serious eIIort has been made. and both interest-based and Islamic
modes oI banking are in operation on a parallel basis. So despite being an Islamic
country. Pakistan has lagged behind others in adopting the Islamic banking system.
The eIIorts Ior Islamisation oI the banking system started way back in the 1960s
but. it only gained momentum during the period oI General Zia-ul-Haq who. in Iact. tried
to Islamize every sphere oI liIe. General Zia amended the legal Iramework oI Pakistan`s
Iinancial and corporate system on June 26. 1980. to permit the issuance oI a new interest-
Iree instrument oI corporate Iinancing named the Participation Term CertiIicate (PTC).
An Ordinance was promulgated to allow the establishment oI Modaraba companies and
the Iloatation oI Modaraba certiIicates Ior raising risk-based capital. Subsequently
amendments were also made in the Banking Companies Ordinance. 1962. and related
laws to include the provision oI bank Iinancing through proIit and loss sharing. mark-up
in prices. leasing and hire purchase.
As a result oI that amendment. all the nationalized commercial banks started
separate counters Irom January 1. 1981. to mobilize deposits on a proIit-and-loss sharing
basis. And Irom July 1. 1982. banks were allowed to provide Iinancing to meet the
working capital needs oI trade and industry on a selective basis under the technique oI
Musharakah. an agreement under which the Islamic bank provides Iunds. that are mixed
with the Iunds oI the business enterprise and others. and proIit is distributed among the
partners in predetermined ratios. while any loss is borne by each partner strictly in
proportion to respective capital contributions.
From July 1. 1985. no bank in Pakistan was allowed to accept any interest-bearing
deposits and all existing deposits in a bank were treated on the basis oI proIit and loss
sharing. However. deposits in current accounts continued to be accepted under which
neither interest nor a share in proIit or loss were allowed. But Ioreign currency deposits in
Pakistan and lending oI Ioreign loans continued on interest as beIore.
However. these procedures adopted by banks in July 1985. based largely on a
mark-up` technique with or without buy-back arrangement.` were eventually declared
un-Islamic by the Federal Shariat Court (FSC) in a iudgment in November 1991.
The government appealed the ruling with the Shariat Appellate Bench (SAB) oI the
Supreme Court oI Pakistan. The SAB. in its historic iudgment on December 23. 1999.
reiected the government appeals and asked it to remove all laws involving interest beIore
June 30. 2001. The court said that the present Iinancial system had to be subiected to
radical changes to bring it into conIormity with the Shariah. It also asked the government
to set up. within a speciIied time Irame. a Commission Ior TransIormation oI Financial
System (CTFS) and two task Iorces to plan and implement the process oI the
Thus. the CTFS was constituted in January 2000 by the SBP under the
Chairmanship oI Mr I.A. HanIi. a Iormer governor oI the SBP. A task Iorce was set up in
the Ministry oI Finance to suggest ways in which interest could be eliminated Irom
government Iinancial transactions. Another task Iorce was set up in the Ministry oI Law
to suggest amendments to the legal Iramework to implement the court`s iudgment.
But the government. through a public sector bank. went to court asking Ior an
extension oI the date by 2006. The court gave only a year`s extension to its earlier June
30. 2001. deadline.
The Islamic banking eIIorts received a serious blow when on June 21. 2002. on a
review petition by UBL. the Supreme Court`s SAB set aside all the previous iudgments
in this regard. including its own historic December 1999 decision. and the November
1991 decision oI the FSC. The SAB oI the Supreme Court asked the FSC to re-hear the
original case. Since then. the case has been lying in a long queue oI cases.
Meanwhile. the government decided in September 2001 that the shiIt to an interest-
Iree economy would be made in a gradual and phased manner and without causing any
disruptions. The State Bank issued detailed criteria in December 2001 Ior the
establishment oI Iull-Iledged Islamic commercial banks in the private sector. Al-Meezan
Investment Bank received the Iirst Islamic commercial banking license Irom SBP in
January 2002. and it commenced its Islamic banking operations on March 20. 2002.
According to Pervez Said. director. Islamic Banking Department at the SBP. the
central bank has adopted a system under which it has allowed three types oI Islamic
banks to operate. 'We have allowed Iull-Iledged Islamic banks. subsidiaries oI
conventional banks. or stand-alone windows. We have introduced a comprehensive
Shariah Compliance Mechanism. which is Ilexible.¨
As oI December 2006. there were Iour Iully operational Islamic banks and two
more were in pipeline. About 12 conventional banks have opened stand-alone windows
Ior Islamic banking. These banks include multinational banks like Standard Chartered.
Currently there are about three more banks who are planning to do the same; they include
another multinational bank and a pair oI local banks.
All the maior banks. like Habib Bank Ltd.. MCB. Askari Commercial Bank. Bank
AlIalah and United Bank. have their separate Islamic banking branches. Presently the
assets oI Islamic banks in Pakistan are estimated to be about Rs.109 billion. 'We have
150 branches oI Islamic banks in 25 cities across Pakistan. Market share oI total industry
assets oI Islamic banks is about 2.8°.¨ says the SBP director oI IBD. Mr Said. He Iurther
says this share oI assets is quite encouraging. when we make comparisons to other
countries. For example. over the same period. Indonesia has built up a market share oI
assets oI 1.7°. while Malaysia. which started Islamic banking about 23 years ago. has
gained 12° oI the market with Islamic banking operations. Bahrain started about 30
years ago. and Islamic banking concerns there have a market share oI about 20°.
'Currently. no new licenses Ior conventional banking have been given Ior the last
two or three years. and now licenses are being given only Ior Islamic banks. Presently.
we have not stopped issuing Islamic banking licenses. and iI a player can demonstrate
that it is oIIering a value-adding product. we consider them.¨ says Mr Said.
The SBP has established a Shariah Board comprising two Shariah scholars and
three experts in the areas oI banking. accounting and law to advise it on modes.
procedures and regulations Ior Islamic banking to ensure both Shariah compliance and
the smooth operation oI Islamic banks. Similarly a Musharakah-based Export ReIinance
Scheme has been designed by the State Bank to provide export Iinancing to eligible
exporters on the basis oI Islamic modes oI Iinancing.
Still. the Iact there is no proper ruling Irom the higher courts against interest-based
banking means that the two systems continue to run simultaneously and many
observers believe that there is no immediate hope Ior a Iully operational Islamic banking
system in the country. So. in the meantime. while it looks as iI progress is being made
behind the scenes. all the stakeholders. including the government. the SBP and the private
banks. are waiting Ior a decision Irom the FSC on the status oI interest-based banking in
Table of Contents
4.1 Historical development
4.1.1 Interest-Iree banking as an idea
4.1.2 The coming into being oI interest-Iree banks
4.1.3. The last decade
4.2 Current practices
4.2.1 Deposit accounts
4.2.2 Modes oI Iinancing
4.2.3 Services
4.2.4 Shortcomings in current practices
4.3 Problems in implementing the PLS scheme
4.3.1 Financing
4.3.2 Legislation
4.3.3 Involvement in specialized non-bank activities
4.3.4 Re-training oI staII
4.3.5 Other disincentives
4.3.6 Excess liquidity
4.3.7 Uneasy questions oI morality
4.4 Islamic banking in non-Muslim countries
4.4.1 Certainty oI capital and return
4.4.2 Supervision and control
4.4.3 Tax regulations

4.5 Discussion and suggestions
4.5.1 Savings accounts and capital guarantee
4.5.2 Loans with a service charge
4.5.3 Investment under PLS scheme
4.6 Conclusions
Brief Introduction of Islamic Banking:

Modern banking system was introduced into the Muslim countries at a time when
they were politically and economically at a low ebb. in the late 19th century. The main
banks in the home countries oI the imperial powers established local branches in the
capitals oI the subiect countries and they catered mainly to the import export
requirements oI the Ioreign businesses. The banks were generally conIined to the capital
cities and the local population remained largely untouched by the banking system. The
local trading community avoided the 'Ioreign¨ banks both Ior nationalistic as well as
religious reasons. However. as time went on it became diIIicult to engage in trade and
other activities without making use oI commercial banks. Even then many conIined their
involvement to transaction activities such as current accounts and money transIers.
Borrowing Irom the banks and depositing their savings with the bank were strictly
avoided in order to keep away Irom dealing in interest which is prohibited by religion.
With the passage oI time. however. and other socio-economic Iorces demanding
more involvement in national economic and Iinancial activities. avoiding the interaction
with the banks became impossible. Local banks were established on the same lines as the
interest-based Ioreign banks Ior want oI another system and they began to expand within
the country bringing the banking system to more local people. As countries became
independent the need to engage in banking activities became unavoidable and urgent.
Governments. businesses and individuals began to transact business with the banks. with
or without liking it. This state oI aIIairs drew the attention and concern oI Muslim
intellectuals. The story oI interest-Iree or Islamic banking begins here. In the Iollowing
paragraphs we will trace this story to date and examine how Iar and how successIully
their concerns have been addressed.
4.1 Historical development
It seems that the history oI interest-Iree banking could be divided into two parts.
First. when it still remained an idea; second. when it became a reality -- by private
initiative in some countries and by law in others. We will discuss the two periods
separately. The last decade has seen a marked decline in the establishment oI new Islamic
banks and the established banks seem to have Iailed to live up to the expectations. The
literature oI the period begins with evaluations and ends with attempts at Iinding ways
and means oI correcting and overcoming the problems encountered by the existing banks.
4.1.1 Interest-free banking as an idea
Interest-Iree banking seems to be oI very recent origin. The earliest reIerences to
the reorganization oI banking on the basis oI proIit sharing rather than interest are Iound
in Anwar Qureshi (1946). Naiem Siddiqi (1948) and Mehmood Ahmad (1952) in the late
Iorties. Iollowed by a more elaborate exposition by Mawdudi in 1950 (1961).

Muhammad Hamidullah`s 1944. 1955. 1957 and 1962 writings too should be included in
this category. They have all recognized the need Ior commercial banks and the evil oI
interest in that enterprise. and have proposed a banking system based on the concept oI
Mudarabha - proIit and loss sharing.
In the next two decades interest-Iree banking attracted more attention. partly
because oI the political interest it created in Pakistan and partly because oI the emergence
oI young Muslim economists. Works speciIically devoted to this subiect began to appear
in this period. The Iirst such work is that oI Muhammad Uzair (1955). Another set oI
works emerged in the late sixties and early seventies. Abdullah al-Araby (1967).
Neiatullah Siddiqi (1961. 1969). al-Naiiar (1971) and Baqir al-Sadr (1961. 1974) were
the main contributors.

Early seventies saw the institutional involvement. ConIerence oI the Finance
Ministers oI the Islamic Countries held in Karachi in 1970. the Egyptian study in 1972.
First International ConIerence on Islamic Economics in Mecca in 1976. International
Economic ConIerence in London in 1977 were the result oI such involvement. The
involvement oI institutions and governments led to the application oI theory to practice
and resulted in the establishment oI the Iirst interest-Iree banks. The Islamic
Development Bank. an inter-governmental bank established in 1975. was born oI this
4.1.2 The coming into being of interest-free banks
The Iirst private interest-Iree bank. the Dubai Islamic Bank. was also set up in
1975 by a group oI Muslim businessmen Irom several countries. Two more private banks
were Iounded in 1977 under the name oI Faisal Islamic Bank in Egypt and the Sudan. In
the same year the Kuwaiti government set up the Kuwait Finance House.
However. small scale limited scope interest-Iree banks have been tried beIore.
One in Malaysia in the mid-Iorties
and another in Pakistan in the late-IiIties.
survived. In 1962 the Malaysian government set up the 'Pilgrim`s Management Fund¨ to
help prospective pilgrims to save and proIit.
The savings bank established in 1963 at
Mit-Ghamr in Egypt was very popular and prospered initially and then closed down Ior
various reasons.
However this experiment led to the creation oI the Nasser Social Bank
in 1972. Though the bank is still active. its obiectives are more social than commercial.
8. 9

In the ten years since the establishment oI the Iirst private commercial bank in
Dubai. more than 50 interest-Iree banks have come into being. Though nearly all oI them
are in Muslim countries. there are some in Western Europe as well: in Denmark.
Luxembourg. Switzerland and the UK. Many banks were established in 1983 (11) and
1984 (13). The numbers have declined considerably in the Iollowing years.

In most countries the establishment oI interest-Iree banking had been by private
initiative and were conIined to that bank. In Iran and Pakistan. however. it was by
government initiative and covered all banks in the country. The governments in both
these countries took steps in 1981 to introduce interest-Iree banking. In Pakistan.
eIIective 1 January 1981 all domestic commercial banks were permitted to accept
deposits on the basis oI proIit-and-loss sharing (PLS). New steps were introduced on
1 January 1985 to Iormally transIorm the banking system over the next six months to one
based on no interest. From 1 July 1985 no banks could accept any interest bearing
deposits. and all existing deposits became subiect to PLS rules. Yet some operations were
still allowed to continue on the old basis. In Iran. certain administrative steps were taken
in February 1981 to eliminate interest Irom banking operations. Interest on all assets was
replaced by a 4 percent maximum service charge and by a 4 to 8 percent proIit` rate
depending on the type oI economic activity. Interest on deposits was also converted into a
guaranteed minimum proIit.` In August 1983 the Usury-Iree Banking Law was
introduced and a Iourteen-month change over period began in January 1984. The whole
system was converted to an interest-Iree one in March 1985.

4.1.3 The last decade
The subiect matter oI writings and conIerences in the eighties have changed Irom
the concepts and possibilities oI interest-Iree banking to the evaluation oI their
perIormance and their impact on the rest oI the economy and the world. Their very titles
bear testimony to this and the places indicate the world-wide interest in the subiect.
ConIerence on Islamic Banking: Its impact on world Iinancial and commercial practices
held in London in September 1984. Workshop on Industrial Financing Activities oI
Islamic Banks held in Vienna in June 1986. International ConIerence on Islamic Banking
held in Tehran in June 1986. International ConIerence on Islamic Banking and Finance:
Current issues and Iuture prospects held in Washington. D.C. in September 1986. Islamic
Banking ConIerence held in Geneva in October 1986. and ConIerence Into the 1990`s
with Islamic Banking` held in London in 1988 belong to this category. The most recent
one is the Workshop on the Elimination oI Riba Irom the Economy held in Islamabad in
April 1992.
Several articles. books and PhD theses have been written on Islamic Banking
during this period. Special mention must be made oI the work by M. Akram Khan in
preparing annotated bibliographies oI all published (and some unpublished) works on
Islamic Economics (including Islamic Banking) Irom 1940 and beIore. It is very useIul to
students oI Islamic Economics and Banking. especially since both English and Urdu
works are included (1983. 1991. 1992). M.N. Siddiqi`s bibliographies include early
works in Arabic. English and Urdu (1980. 1988). Turkish literature is Iound in
Sabahuddin Zaim (1980).
4.2 Current practices
Generally speaking. all interest-Iree banks agree on the basic principles. However.
individual banks diIIer in their application. These diIIerences are due to several reasons
including the laws oI the country. obiectives oI the diIIerent banks. individual bank`s
circumstances and experiences. the need to interact with other interest-based banks. etc.
In the Iollowing paragraphs. we will describe the salient Ieatures common to all banks.
4.2.1 Deposit accounts
All the Islamic banks have three kinds oI deposit accounts: current. savings and
investment. Current accounts
Current or demand deposit accounts are virtually the same as in all conventional
banks. Deposit is guaranteed. Savings accounts
Savings deposit accounts operate in diIIerent ways. In some banks. the depositors
allow the banks to use their money but they obtain a guarantee oI getting the Iull amount
back Irom the bank. Banks adopt several methods oI inducing their clients to deposit with
them. but no proIit is promised. In others. savings accounts are treated as investment
accounts but with less stringent conditions as to withdrawals and minimum balance.
Capital is not guaranteed but the banks take care to invest money Irom such accounts in
relatively risk-Iree short-term proiects. As such lower proIit rates are expected and that
too only on a portion oI the average minimum balance on the ground that a high level oI
reserves needs to be kept at all times to meet withdrawal demands. Investment account
Investment deposits are accepted Ior a Iixed or unlimited period oI time and the
investors agree in advance to share the proIit (or loss) in a given proportion with the
bank. Capital is not guaranteed.
4.2.2 Modes of financing
Banks adopt several modes oI acquiring assets or Iinancing proiects. But they can
be broadly categorized into three areas: investment. trade and lending. Investment financing
This is done in three main ways: a) Musharaka where a bank may ioin another
entity to set up a ioint venture. both parties participating in the various aspects oI the
proiect in varying degrees. ProIit and loss are shared in a pre-arranged Iashion. This is
not very diIIerent Irom the ioint venture concept. The venture is an independent legal
entity and the bank may withdraw gradually aIter an initial period. b) Mudarabha where
the bank contributes the Iinance and the client provides the expertise. management and
labor. ProIits are shared by both the partners in a pre-arranged proportion. but when a
loss occurs the total loss is borne by the bank. c) Financing on the basis oI an estimated
rate of return. Under this scheme. the bank estimates the expected rate oI return on the
speciIic proiect it is asked to Iinance and provides Iinancing on the understanding that at
least that rate is payable to the bank. (Perhaps this rate is negotiable.) II the proiect ends
up in a proIit more than the estimated rate the excess goes to the client. II the proIit is less
than the estimate the bank will accept the lower rate. In case a loss is suIIered the bank
will take a share in it. Trade financing
This is also done in several ways. The main ones are: a) Mark-up where the bank
buys an item Ior a client and the client agrees to repay the bank the price and an agreed
proIit later on. b) Leasing where the bank buys an item Ior a client and leases it to him Ior
an agreed period and at the end oI that period the lessee pays the balance on the price
agreed at the beginning an becomes the owner oI the item. c) Hire-purchase where the
bank buys an item Ior the client and hires it to him Ior an agreed rent and period. and at
the end oI that period the client automatically becomes the owner oI the item. d) Sell-and-
buv-back where a client sells one oI his properties to the bank Ior an agreed price payable
now on condition that he will buy the property back aIter certain time Ior an agreed price.
e) Letters of credit where the bank guarantees the import oI an item using its own Iunds
Ior a client. on the basis oI sharing the proIit Irom the sale oI this item or on a mark-up
basis. Lending
Main Iorms oI Lending are: a) Loans with a service charge where the bank lends
money without interest but they cover their expenses by levying a service charge. This
charge may be subiect to a maximum set by the authorities. b) No-cost loans where each
bank is expected to set aside a part oI their Iunds to grant no-cost loans to needy persons
such as small Iarmers. entrepreneurs. producers. etc. and to needy consumers.
c) Overdrafts also are to be provided. subiect to a certain maximum. Iree oI charge.
4.2.3 Services
Other banking services such as money transIers. bill collections. trade in Ioreign
currencies at spot rate etc. where the bank`s own money is not involved are provided on a
commission or charges basis.
4.2.4 Shortcomings in current practices
In the previous section we listed the current practices under three categories:
deposits. modes oI Iinancing (or acquiring assets) and services. There seems to be no
problems as Iar as banking services are concerned. Islamic banks are able to provide
nearly all the services that are available in the conventional banks. The only exception
seems to be in the case oI letters oI credit where there is a possibility Ior interest
involvement. However some solutions have been Iound Ior this problem -- mainly by
having excess liquidity with the Ioreign bank. On the deposit side. iudging by the volume
oI deposits both in the countries where both systems are available and in countries where
law prohibits any dealing in interest. the non-payment oI interest on deposit accounts
seems to be no serious problem. Customers still seem to deposit their money with
interest-Iree banks.
The main problem. both Ior the banks and Ior the customers. seem to be in the
area oI Iinancing. Bank lending is still practised but that is limited to either no-cost loans
(mainly consumer loans) including overdraIts. or loans with service charges only. Both
these types oI loans bring no income to the banks and thereIore naturally they are not that
keen to engage in this activity much. That leaves us with investment Iinancing and trade
Iinancing. Islamic banks are expected to engage in these activities only on a proIit and
loss sharing (PLS) basis. This is where the banks` main income is to come Irom and this
is also Irom where the investment account holders are expected to derive their proIits
Irom. And the latter is supposed to be the incentive Ior people to deposit their money
with the Islamic banks. And it is precisely in this PLS scheme that the main problems oI
the Islamic banks lie. ThereIore we will look at this system more careIully in the
Iollowing section.
4.3 Problems in implementing the PLS scheme
Several writers have attempted to show. with varying degrees oI success. that
Islamic Banking based on the concept oI proIit and loss sharing (PLS) is theoretically
superior to conventional banking Irom diIIerent angles. See. Ior example. Khan and
Mirakhor (1987). However Irom the practical point oI view things do not seem that rosy.
Our concern here is this latter aspect. In the over halI-a-decade oI Iull-scale experience in
implementing the PLS scheme the problems have begun to show up. II one goes by the
experience oI Pakistan as portrayed in the papers presented at the conIerence held in
Islamabad in 1992.
the situation is very serious and no satisIactory remedy seems to
In the Iollowing paragraphs we will try to set down some oI the maior
4.3.1 Financing
There are Iour main areas where the Islamic banks Iind it diIIicult to Iinance
under the PLS scheme: a) participating in long-term low-yield proiects. b) Iinancing the
small businessman. c) granting non-participating loans to running businesses. and d)
Iinancing government borrowing. Let us examine them in turn. Long-term projects
Table 1 shows the term structure oI investment by 20 Islamic Banks in 1988. It is
clear that less than 10 percent oI the total assets goes into medium- and long-term
investment. Admittedly. the banks are unable or unwilling to participate in long-term
proiects. This is a very unsatisIactory situation.

Table 1
Term Structure of Investment by 20 Islamic Banks. 1988
Type of Investment Amount` º of Total
Short-term 4.909.8 68.4
Social lending 64.2 0.9
Real-estate investment 1.498.2 20.9
Medium- and long-term investment 707.7 9.8

Source: Aggregate balance sheets prepared by the
International Association oI Islamic Banks. Bahrain. 1988.
Quoted in: AusaI Ahmed (1994). * Unit oI currency not given.
The main reason oI course is the need to participate in the enterprise on a PLS
basis which involves time consuming complicated assessment procedures and
negotiations. requiring expertise and experience. The banks do not seem to have
developed the latter and they seem to be averse to the Iormer. There are no commonly
accepted criteria Ior proiect evaluation based on PLS partnerships. Each single case has
to be treated separately with utmost care and each has to be assessed and negotiated on its
own merits. Other obvious reasons are: a) such investments tie up capital Ior very long
periods. unlike in conventional banking where the capital is recovered in regular
installments almost right Irom the beginning. and the uncertainty and risk are that much
higher. b) the longer the maturity oI the proiect the longer it takes to realize the returns
and the banks thereIore cannot pay a return to their depositors as quick as the
conventional banks can. Thus it is no wonder that the banks are averse to such
investments. Small businesses
Small scale businesses Iorm a maior part oI a country`s productive sector.
Besides. they Iorm a greater number oI the bank`s clientele. Yet it seems diIIicult to
provide them with the necessary Iinancing under the PLS scheme. even though there is
excess liquidity in the banks. The observations oI Iqbal and Mirakhor is revealing:
Given the comprehensive criteria to be Iollowed in granting loans and monitoring
their use by banks. small-scale enterprises have. in general encountered greater
diIIiculties in obtaining Iinancing than their large-scale counterparts in the Islamic
Republic oI Iran. This has been particularly relevant Ior the construction and service
sectors. which have large share in the gross domestic product (GDP). The service sector
is made up oI many small producers Ior whom the banking sector has not been able to
provide suIIicient Iinancing. Many oI these small producers. who traditionally were able
to obtain interest-based credit Iacilities on the basis oI collateral. are now Iinding it
diIIicult to raise Iunds Ior their operations. Running businesses
Running businesses Irequently need short-term capital as well as working capital
and ready cash Ior miscellaneous on-the-spot purchases and sundry expenses. This is the
daily reality in the business world. Very little thought seems to have been given to this
important aspect oI the business world`s requirement. The PLS scheme is not geared to
cater to this need. Even iI there is complete trust and exchange oI inIormation between
the bank and the business it is nearly impossible or prohibitively costly to estimate the
contribution oI such short-term Iinancing on the return oI a given business. Neither is the
much used mark-up system suitable in this case. It looks unlikely to be able to arrive at
general rules to cover all the diIIerent situations.
Added to this is the delays involved in authorizing emergency loans. One staII member oI
the Bank oI Industry and Mines oI Iran has commented:
OIten the clients need to have quick access to Iresh Iunds Ior the immediate needs to
prevent possible delays in the proiect`s implementation schedule. According to the set
regulations. it is not possible to bridge-Iinance such requirements and any grant oI
Iinancial assistance must be made on the basis oI the proiect`s appraisal to determine type
and terms and conditions oI the scheme oI Iinancing.
The enormity oI the damage or hindrance caused by the inability to provide Iinancing to
this sector will become clear iI we realize that running businesses and enterprises are the
mainstay oI the country`s very economic survival. Government borrowing
In all countries the Government accounts Ior a maior component oI the demand
Ior credit -- both short-term and long-term. Unlike business loans these borrowings are
not always Ior investment purposes. nor Ior investment in productive enterprises. Even
when invested in productive enterprises they are generally oI a longer-term type and oI
low yield. This latter only multiplies the diIIiculties in estimating a rate oI return on these
loans iI they are granted under the PLS scheme. In Iran

it has been decreed that Iinancial
transactions between and among the elements oI the public sector. including Bank
Markazi |the central bank| and commercial banks that are wholly nationalized. can take
place on the basis oI a Iixed rate oI return; such a Iixed rate is not viewed as interest.
ThereIore the Government can borrow Irom the nationalized banking system without
violating the Law.
While the last claim may be subiect to question. there is another serious
consequenceContinued borrowing on a Iixed rate basis by the Government would
inevitably index bank charges to this rate than to the actual proIits oI borrowing entities.

4.3.2 Legislation
Existing banking laws do not permit banks to engage directly in business enterprises
using depositors` Iunds. But this is the basic asset acquiring method oI Islamic banks.
ThereIore new legislation and/or government authorization are necessary to establish
such banks. In Iran a comprehensive legislation was passed to establish Islamic banks. In
Pakistan the Central Bank was authorized to take the necessary steps. In other countries
either the banks Iound ways oI using existing regulations or were given special
accommodation. In all cases government intervention or active support was necessary to
establish Islamic banks working under the PLS scheme.
In spite oI this. there is still need Ior Iurther auxiliary legislation in order to Iully realize
the goals oI Islamic banking. For example. in Pakistan the new law has been introduced
without Iundamental changes in the existing laws governing contracts. mortgages. and
pledges. Similarly no law has been introduced to deIine modes oI participatory Iinancing.
that is Musharakah
and PTCs. It is presumed that whenever there is a conIlict between
the Islamic banking Iramework and the existing law. the latter will prevail. In essence.
thereIore. the relationship between the bank and the client. that oI creditor and debtor is
leIt unchanged as speciIied by the existing law. .... The existing banking law was
developed to protect mainly the credit transactions; its application to other modes oI
Iinancing results in the treatment oI those modes as credit transactions also. Banks doubt
whether some contracts. though consistent with the Islamic banking Iramework. would be
acceptable in the courts. Hence. incentives exist Ior deIault and abuse.
In Iran. although the law establishing interest-Iree banking is comprehensive. the lack oI
proper deIinitions oI property rights may have constrained bank lending. Thus Iar there
has been no precise legislative and legal expression oI what is viewed as 'lawIul and
conditional¨ private property rights. This may also have militated against investment
lending in agricultural and industrial sectors and thus encouraged increased concentration
oI assets in short-term trade Iinancing instruments.
Iran and Pakistan are countries committed to ridding their economies oI riba and have
made immense strides in towards achieving it. Yet there are many legal diIIiculties still to
be solved as we have seen above. In other Muslim countries the authorities actively or
passively participate in the establishment oI Islamic banks on account oI their religious
persuasion. Such is not the case in non-Muslim countries. Here establishing Islamic
banks involves conIormation to the existing laws oI the concerned country which
generally are not conducive to PLS type oI Iinancing in the banking sector. We will see
some oI these problems below in section 4.4.
4.3.3 Involvement in specialized non-bank activities
Dr Hasanuz-Zaman. lists the traditional tasks oI the bank and then questions its ability to
take on the additional Iunctions it is called upon to perIorm under the PLS scheme It is
due to historical reasons that banks have evolved purely as a Iinancial institution. They
are suited to attract money. keep it in saIe custody. lend it under saIety. invest it
proIitably and enioy the capacity to create the means oI payment. A bank has to maintain
a balance between income. liquidity and Ilexibility. While allocating its Iunds it has to be
meticulously sensitive about the Iactors like capital position and rate oI proIitability oI
various types oI loans. stability oI deposit. economic conditions. inIluence oI monetary
and Iiscal policy. ability and experience oI bank`s personnel and credit needs oI the area.
So Iar these banks thrive on a Iixed rate oI return a portion oI which is passed on by them
to the depositor. Thus the entire eIIort oI a bank is directed towards money management
and it is not geared to act as an entrepreneur. trader. industrialist. contractor or caterer.
The question arises: with all these limitations can a bank claim any competence in trading
or entrepreneurship which is necessary Ior musharakah or mudarba
contract. or can it
act as an owner oI a large variety oI heavy machinery. transport vehicles or real estate to
take the position oI a lessor or. can it act as a stockiest to buy and resell the entire stock
oI imports and exports that are needed by genuine traders?
Then he raises the even more serious question:
In case the bank is historically and practically not competent to do all these iobs its claim
to share a portion oI proIits as a working partner. trader or lessor becomes questionable.
Traditional banks do perIorm a certain amount oI proiect evaluation when granting large
medium- and long-term loans. But doing such detailed evaluation as would be required to
embark on a PLS scheme. such as determining the rates oI return and their time schedule.
is beyond the scope oI conventional banks. So is the detailed accounting and monitoring
necessary to determine the actual perIormance.
Under Islamic banking these exercises are not limited to relatively Iew large loans but
need to be carried out on nearly all the advances made by the bank. Yet. widely
acceptable and reliable techniques are yet to be devised. This is conIounded by the Iact
that no consensus has yet been reached on the principles. Both the unprecedented nature
oI the task as well as the huge amount oI work that need be done and the trained and
experienced personnel needed to carry them out seems a daunting prospect.
4.3.4 Re-training of staff
As was seen in the previous section. the bank staII will have to acquire many new skills
and learn new procedures to operate the Islamic banking system. This is a time
consuming process which is aggravated by two other Iactors. One. the sheer number oI
persons that need to be re-trained and. two. the additional staII that need to be recruited
and trained to carry out the increased work.
Principles are still to be laid down and techniques and procedures evolved to carry them
out. It is only aIter the satisIactory achievement oI these that proper training can begin.
This delay and the resulting conIusion appears to be among the main reasons Ior the
banks to stick to modes oI Iinancing that are close to the Iamiliar interest-based modes.
4.3.5 Other disincentives
Among the other disincentives Irom the borrower`s point oI view are the need to disclose
his accounts to the bank iI he were to borrow on the PLS basis. and the Iear that
eventually the tax authorities will become wise to the extent oI his business and the
proIits. Several writers have lashed out at the lack oI business ethics among the business
community. but that is a Iact oI liIe at least Ior the Ioreseeable Iuture. There is a paucity
oI survey or case studies oI clients to see their reaction to current modes oI Iinancing. As
such we are not aware oI Iurther disincentives that might be there. Accounts
When a business is Iinanced under the PLS scheme it is necessary that the actual
proIit/loss made using that money be calculated. Though no satisIactory methods have
yet been devised. the Iirst requirement Ior any such activity is to have the necessary
accounts. On the borrowers` side there are two diIIiculties: one. many small-time
businessmen do not keep any accounts. leave alone proper accounts. The time and money
costs will cut into his proIits. Larger businesses do not like to disclose their real accounts
to anybody. On the banks` side the eIIort and expense involved in checking the accounts
oI many small accounts is prohibitive and will again cut into their own share oI the
proIits. Thus both sides would preIer to avoid having to calculate the actually realized
proIit/loss. To quote Iqbal and Mirakhor the commercial banks do Iace an element oI
moral hazard owing to the non-existence oI systematic book-keeping in this sector.
Additionally the reluctance oI small producers to submit their operations to bank audits
and the perceived enormous cost oI auditing and monitoring relative to the small size oI
the potential credits makes banks unwilling to extend credit on the basis oI new modes oI
Iinancing to these small producers. These reduced lending to small producers may also
explain the existence oI excess liquidity in the banking system. Tax
The bank is a big business and it has to declare its proIit and loss and is legally required
to present an audited account oI its operations. Once the bank`s accounts are known it
doesn`t take much Ior the tax collectors to Iigure out the share oI the businesses Iinanced
by the bank under the PLS scheme. Thus it`s no surprise that businesses are not too very
happy about the situation. The Iact that suggestions have been made to use the banks to
collect taxes due has not helped the matter either.
4.3.6 Excess liquidity
Presence oI excess liquidity is reported in nearly all Islamic banks. This is not due to
reduced demand Ior credit but the due to the inability oI the banks to Iind clients willing
to be Iunded under the new modes oI Iinancing. Some oI these diIIiculties are mentioned
under section 4.3.1 Financing. Here we have a situation where there is money available
on the one hand and there is need Ior it on the other but the new rules stand in the way oI
bringing them together! This is a very strange situation -- specially in the developing
Muslim countries where money is at a premium even Ior ordinary economic activities.
leave alone development eIIorts. Removal oI riba was expected to ease such diIIiculties.
not to aggravate the already existing ones!
4.3.7 Uneasy questions of morality
The practices in use by the Islamic banks have evoked questions oI morality. Do the
practices adopted to avoid interest really do their iob or is it simply a change oI name? It
suIIices to quote a Iew authors.

The Economist writes

Muslim theoreticians and bankers have between them devised
ingenious ways oI coping with the interest problem. One is murabaha. The Koran says
you cannot borrow $100m Irom the bank Ior a year. at 5° interest. to buy the new
machinery your Iactory needs? Fine. You get the bank to buy the machinery Ior you --
cost. $100m -- and then you buy the stuII Irom the bank. paying it $105m a year Irom
now. The diIIerence is that the extra $5m is not interest on loan. which the Koran
(perhaps) Iorbids. but your thanks to the bank Ior the risk it takes oI losing money while
it is the owner oI the machinery: this is honest trading. okay with the Koran. Since with
modern communications the bank`s ownership may last about halI a second. its risk is not
great. but the transaction is pure. It is not surprising that some Muslims uneasilv sniff
logic-chopping here.
Dr Ghulam Qadir says oI practices in Pakistan
Two oI the modes oI Iinancing prescribed by the State Bank. namely Iinancing through
the purchase oI client`s property with a buy-back agreement and sale oI goods to clients
on a mark-up. involved the least risk and were closest to the old interest-based operations.
Hence the banks conIined their operations mostly to these modes. particularly the Iormer.
aIter changing the simple buy-back agreement (prescribed by the State Bank) to buy-back
agreement with a mark-up. as otherwise there was no incentive Ior them to extend any
Iinances. The banks also reduced their mark-up-based Iinancing. whether through the
purchase oI client`s property or through the sale oI goods to clients. to mere paper work.
instead oI actual buying oI goods (property). taking their possession and then selling
(back) to the client. As a result. there was no diIIerence between the mark-up as practised
by the banks and the conventional interest rate. and hence it was iudged repugnant to
Islam in the recent decision oI the Federal Shari`ah court.
As banks are essentially Iinancial institutions and not trading houses. requiring them to
undertake trading in the Iorm oI buy-back arrangements and sale on mark-up amounts to
imposing on them a Iunction Ior which they are not well equipped. ThereIore. banks in
Pakistan made such modifications in the prescribed modes which defeated the verv
purpose of interest-free financing. Furthermore. as these two minimum-risk modes oI
Iinancing were kept open to banks. they never tried to devise innovative and imaginative
modes oI Iinancing within the Iramework oI musharakah and mudarba.

ProI. Khurshid Ahmad says
Murabaha (cost-plus Iinancing) and bai muaiial (sale with deIerred payment) are
permitted in the Shari`ah under certain conditions. Technically. it is not a Iorm oI
Iinancial mediation but a kind oI business participation. The Shari`ah assumes that the
Iinancier actually buys the goods and then sells them to the client. UnIortunately. the
current practice oI 'buy-back on mark-up¨ is not in keeping with the conditions on which
murabaha or bai muaiial are permitted. What is being done is a fictitious deal which
ensures a predetermined profit to the bank without actuallv dealing in goods or sharing
anv real risk. This is against the letter and spirit of Shariah iniunctions.
While I would not venture a fatwa. as I do not qualiIy Ior that Iunction. yet as a student oI
economics and Shari`ah I regard this practice oI 'buy-back on mark-up¨ very similar to
riba and would suggest its discontinuation. I understand that the Council oI Islamic
Ideology has also expressed a similar opinion.
Dr Hasanuz Zaman is more scathing in his condemnation:
It emerges that practically it is impossible Ior large banks or the banking system to
practice the modes like mark-up. bai salam. buy-back. murabaha. etc. in a way that
IulIils the Shari`ah conditions. But in order to make themselves eligible to a return on
their operations. the banks are compelled to plav tricks with the letters of the law. They
actually do not buy. do not posses. do not actually sell and deliver the goods; but the
transition is assumed to have taken place. By signing a number oI documents oI purchase.
sale and transIer they might IulIill a legal requirement but it is bv violating the spirit of
It seems that in large number oI cases the ghost of interest is haunting them to calculate a
Iixed rate percent per annum even in musharakah. mudarba. leasing. hire-purchase. rent
sharing. murabaha. (bai muaiial. mark-up). PTC. TFC.
etc. The spirit behind all these
contracts seems to make a sure earning comparable with the prevalent rate oI interest and.
as Iar as possible. avoid losses which otherwise could occur.
To sum up. in Dr Hasanuz Zaman`s words
many techniques that the interest-Iree banks are practicing are not either in Iull
conIormity with the spirit oI Shari`ah or practicable in the case oI large banks or the
entire banking system. Moreover. thev have failed to do awav with undesirable aspects of
interest. Thus. thev have retained what an Islamic bank should eliminate.
4.4 Islamic banking in non-Muslim countries
The modern commercial banking system in nearly all countries oI the world is mainly
evolved Irom and modeled on the practices in Europe. especially that in the United
Kingdom. The philosophical roots oI this system revolves around the basic principles oI
capital certainty Ior depositors and certainty as to the rate oI return on deposits. In order
to enIorce these principles Ior the sake oI the depositors and to ensure the smooth
Iunctioning oI the banking system Central Banks have been vested with powers oI
supervision and control. All banks have to submit to the Central Bank rules. Islamic
banks which wish to operate in non-Muslim countries have some diIIiculties in
complying with these rules. We will examine below the salient Ieatures.

4.4.1 Certainty of capital and return
While the conventional banks guarantee the capital and rate oI return. the Islamic banking
system. working on the principle oI proIit and loss sharing. cannot. by deIinition.
guarantee any Iixed rate oI return on deposits. Many Islamic banks do not guarantee the
capital either. because iI there is a loss it has to be deducted Irom the capital. Thus the
basic diIIerence lies in the very roots oI the two systems. Consequently countries working
under conventional laws are unable to grant permission to institutions which wish to
operate under the PLS scheme to Iunctions as commercial banks. Two oIIicial comments.
one Irom the UK an the other Irom the USA suIIice to illustrate this.
Sir Leigh Pemberton. the Governor oI the Bank oI England. told the Arab Bankers`
Association in London that
It is important not to risk misleading and conIusing the general public by
allowing two essentially diIIerent banking systems to operate in parallel;
A central Ieature oI the banking system oI the United Kingdom as
enshrined in the legal Iramework is capital certainty Ior depositors. It is
the most important Ieature which distinguished the banking sector Irom
the other segments oI the Iinancial system;
Islamic banking is a perIectly acceptable mode oI Iinancing but it does not
Iall within the deIinition oI what constitutes banking in the UK;
The Bank oI England is not legally able to authorize under the Banking
Act. an institution which does not take deposits as deIined under that Act;
The Islamic Iacilities might be provided within other areas oI the Iinancial
system without using a banking name.
In the United States. Mr Charles Schotte. the US Treasury Department specialist in
regulatory issues has remarked
There has never been an application Ior an Islamic establishment to set up either as a
bank or as anything else. So there is no precedent to guide us. Any institution that wishes
to use the word bank` in its title has to guarantee at least a zero rate oI interest -- and
even that might contravene Islamic laws.

4.4.2 Supervision and control
Besides these. there are other concerns as well. One is the Central Bank supervision and
control. This mainly relates to liquidity requirements and adequacy oI capital. These in
turn depend on an assessment oI the value oI assets oI the Islamic banks. A Iinancial
advisor has this to say

The bank oI England. under the 1979 Act. would have great diIIiculty in putting a value
on the assets oI an Islamic institution which wanted to operate as a bank in the UK. The
traditional banking system has much oI its assets in Iixed interest instruments and it is
comparatively easy to value that. For example. iI they are British Government
instruments they will have a quoted market value; and there are recognized methods Ior
valuing traditional banking assets when they become non-productive. But it is very
diIIicult indeed to value an Islamic asset such as a share in a ioint venture; and the Bank
oI England would have to send a team oI experienced accountants into every Islamic
bank operating in the UK as a bank under the 1979 Act. to try to put a proper and
cautious value on its assets.
Another Iinancial analyst states

Even iI a method could be Iound Ior assessing the risks to calculate the capital necessary.
little comIort could be taken Irom the proIitability which is usually relied upon to cover
day-to-day losses arising Irom the bank`s business. because a substantial part oI an
Islamic bank`s portIolio is venture capital without any guaranteed return.
It is evident then that even iI there is a desire to accommodate the Islamic system. the
new procedures that need be developed and the modiIications that need be made to
existing procedures are so large that the chances oI such accommodation in a cautious
sector such as banking is very remote indeed. Any relaxation oI strict supervision is
precluded because should an Islamic bank Iail it would undermine the conIidence in the
whole Iinancial system. with which it is inevitably identiIied. As Suratgar puts it
There could be potential dangers Ior the international system. where the Iailure oI such an
institution could bring with it the Iailure oI other associated institutions. or oI all the
Western banking institutions which come closely tied to with such an operation.
The question has engaged the attention oI Central Banks in Muslim countries as well. But
reliable satisIactory methods are still to developed.
4.4.3 Tax regulations
Another important consideration is the tax procedures in non-Muslim countries. While
interest is a passive` income. proIit is an earned income which is treated diIIerently. In
addition. in trade Iinancing there are title transIers twice -- once Irom seller to bank and
then Irom bank to buyer -- and thereIore twice taxed on this account decreasing the
proIitability oI the venture. The Director oI the International Islamic Bank oI Denmark
Tax laws are against the Islamic philosophy and pose the greatest diIIiculty. In most
OECD countries Mudarabha is constrained by Iiscal acts which deIine proIits as an aIter
tax item Ior the proIit creator and a Iully taxable item Ior the proIit receiver.
4.5 Discussion and suggestions
People have needs -- Iood. clothes. houses. machinery. services; the list is endless.
Entrepreneurs perceive these needs and develop ways and means oI catering to them.
They advertise their products and services. peoples expectations are raised and people
become customers oI the entrepreneur. II the customers` needs are IulIilled according to
their expectations they continue to patronise the entrepreneur and his enterprise
Ilourishes. Otherwise his enterprise Iails and people take to other entrepreneurs.
Banks too are enterprises; they cater to peoples` needs connected with money -- saIe-
keeping. acquiring capital. transIerring Iunds etc. The Iact that they existed Ior centuries
and continue to exist and prosper is prooI that their methods are good and they IulIill the
customers` needs and expectations. Conventional commercial banking system as it
operates today is accepted in all countries except the Islamic world where it is received
with some reservation. The reservation is on account oI the Iact that the banking
operations involve dealing in interest which is prohibited in Islam. Conventional banks
have ignored this concern on the part oI their Muslim clientele. Muslims patronised the
conventional banks out oI necessity and. when another entrepreneur -- the Islamic banker
-- oIIered to address their concern many Muslims turned to him. The question is: has the
new entrepreneur successIully met their concerns. needs and expectations? II not he may
have to put up his shutters!
Broadly speaking. banks have three types oI diIIerent customers: depositors. borrowers
and seekers oI bank`s other services such as money transIer. Since services do not
generally involve dealing in interest Muslims have no problem transacting such
businesses with conventional banks; neither do Islamic banks experience any problems in
providing these services. Among the depositors there are current account holders who
too. similarly. have no problems. It is the savings account holders and the borrowers who
have reservations in dealing with the conventional banks. In the Iollowing paragraphs we
will see how well the Islamic banks have succeeded in addressing their customers`
special concern.
4.5.1 Savings accounts and capital guarantee
As pointed out earlier. our concern here is the savings account holders. As the name itselI
indicates the primary aim oI the saving account depositor is the saIe-keeping oI his
savings. It is correctly perceived by the conventional banker and he guarantees the return
oI the deposit in toto. The banker also assumes that the depositor will preIer to keep his
money with him in preIerence to another who might also provide the same guarantee iI
the depositor is provided an incentive. This incentive is called interest. and this interest is
made proportional to the amount and length oI time it is leIt with the bank in order to
encourage more money brought into the bank and leIt there Ior longer periods oI time. In
addition. the interest rate is Iixed in advance so that the depositor and the banker are Iully
aware oI their respective rights and obligations Irom the beginning. And laws have been
enacted to guarantee their enIorcement. In Economic theory the interest is oIten taken to
be the 'compensation¨ the depositors demand and receive Ior parting with their savings.
The Iact that the depositors accept the paid interest and that. given other things being
equal. they preIer the bank or the scheme which oIIers the highest interest proves the
banker`s assumption correct.
The scheme is simple. transparent and seems to have satisIied the requirements oI all
types oI savers -- Irom teenagers to old-age pensioners. Irom individuals to large
institutions. pension Iunds and endowments. Irom small amounts to millions. and Irom a
Iew weeks or months to years -- that it has survived over centuries and operates across
national. cultural and religious borders.
The situation is very diIIerent in the Islamic banks. Here too the depositor`s Iirst aim is to
keep his savings in saIe custody. Islamic bankers divide the conventional savings account
into two categories (alternatively. create a new kind oI account): savings account and
investment account. The investment accounts operate Iully under the PLS scheme --
capital is not guaranteed. neither is there any pre-Iixed return. Under the savings account
the nominal value oI the deposit is guaranteed. but they receive no Iurther guaranteed
Banks may consider Iunds under the savings accounts too as part oI their
resources and use it to create assets. This is theory. In practice. however. the banks preIer.
encourage and emphasize the investment accounts. This is because since their assets
operate under the PLS scheme they might incur losses on these assets which losses they
cannot pass onto the savings accounts depositors on account oI the capital guarantee on
these accounts. In the process the Iirst aim oI the depositor is pushed aside and the basic
rule oI commercial banking --capital guarantee-- is broken.

It is suggested that all Islamic banks guarantee the capital under their savings accounts.
This will satisIy the primary need and expectation oI an important section oI the
depositors and. in Muslim countries where both Islamic and conventional banks co-exist.
will induce more depositors to bank with the Islamic banks. At the same time. it will
remove the maior obiection to establishing Islamic banks in non-Muslim countries.
But the question is how does the bank make an income Irom these deposits? We will
examine this in the next section.
4.5.2 Loans with a service charge
We have already seen that all the problems oI the Islamic banks arise Irom their need to
acquire their assets under the PLS scheme. A simple solution does. in Iact. already exist
in the current theories oI Islamic banking. It need only be pointed out and acted upon. We
will examine the provisions in the Iranian. Pakistani and the Siddiqi models.

All three models provide Ior loans with a service charge. Though the speciIic rules are
not identical. the principle is the same. We suggest that the Iunds in the deposit accounts
(current and savings) be used to grant loans (short- and long-term) with a service charge.
By doing this the Islamic banks will be able to provide all the loan Iacilities that
conventional banks provide while giving capital guarantee Ior depositors and earning an
income Ior themselves. Furthermore. and it is important. they can avoid all the problems
discussed in section 4.3. This would also remove the rest oI the obstacles in opening and
operating Islamic banks in non-Muslim countries.
The bonus Ior the borrowers is that the service charge levied by the Islamic banks will
necessarily be less than the interest charged by conventional banks.
Let us now look at the existing relevant rules in the three models. The Iranian model
provides Ior Gharz-al hasaneh whose deIinition. purpose and operation are given in
Articles 15. 16 and 17 oI Regulations relating to the granting oI banking Iacilities
Article 15
Gharz-al-hasaneh is a contract in which one (the lender) oI the two parties relinquishes a
speciIic portion oI his possessions to the other party (the borrower) which the borrower is
obliged to return to the lender in kind or. where not possible. its cash value.
Article 16
the banks ... shall set aside a part oI their resources and provide Gharz-al-hasaneh Ior the
Iollowing purposes:
(a) to provide equipment. tools and other necessary resources so as to enable the
creation oI employment. in the Iorm oI co-operative bodies. Ior those who lack
the necessary means;
(b) to enable expansion in production. with particular emphasis on agricultural.
livestock and industrial products;
(c) to meet essential needs.
Article 17
The expenses incurred in the provision oI Gharz-al-hasaneh shall be. in each case.
calculated on the basis oI the directives issued by Bank Markazi Jomhouri Islamic Iran

and collected Irom the borrower.

In Pakistan. permissible modes oI Iinancing include
Financing by lending:
(i) Loans not carrying any interest on which the banks may recover a service
charge not exceeding the proportionate cost oI the operation. excluding the cost oI
Iunds and provisions Ior bad and doubtIul debts. The maximum service charge
permissible to each bank will be determined by the State Bank Irom time to time.
(ii) Qard-e-hasana loans given on compassionate grounds Iree oI any interest or
service charge and repayable iI and when the borrower is able to pay.
Siddiqi has suggested that 50 percent oI the Iunds in the loan` (i.e. current and savings)
accounts be used to grant short-term loans.
A Iee is to be charged Ior providing these
An appropriate way oI levying such a Iee would be to require prospective borrowers to
pay a Iixed amount on each application. regardless oI the amount required. the term oI
the loan or whether the application is granted or reiected. Then the applicants to whom a
loan is granted may be required to pay an additional prescribed Iee Ior all the entries
made in the banks registers. The criterion Ior Iixing the Iees must be the actual
expenditure which the banks have incurred in scrutinizing the applications and making
decisions. and in maintaining accounts until loans are repaid. These Iees should not be
made a source oI income Ior the banks. but regarded solely as a means oI maintaining
and managing the interest-Iree loans.
It is clear Irom the above that all three models agree on the need Ior having cash loans as
one mode oI Iinancing. and that this service should be paid Ior by the borrower. Though
the details may vary. all seem to suggest that the charge should be the absolute cost only.
We suggest that a percentage oI this absolute cost be added to the charge as a payment to
the bank Ior providing this service. This should enable an Islamic bank to exist and
Iunction independently oI its perIormance in its PLS operations.
4.5.3 Investment under PLS scheme
The idea oI participatory Iinancing introduced by the Islamic banking movement is a
unique and positive contribution to modern banking. However. as we saw earlier. by
making the PLS mode oI Iinancing the main (oIten almost the only) mode oI Iinancing
the Islamic banks have run into several diIIiculties. II. as suggested in the previous
section. the Islamic banks would provide all the conventional Iinancing through lending
Irom their deposit accounts (current and savings). it will leave their hands Iree to engage
in this responsible Iorm oI Iinancing innovatively. using the Iunds in their investment
accounts. They could then engage in genuine Mudaraba Iinancing. Being partners in an
enterprise they will have access to its accounts. and the problems associated with the non-
availability oI accounts will not arise.
Commenting on Mudaraba Iinancing. The Economist says
some people in the West have begun to Iind the idea attractive. It gives the provider oI
money a strong incentive to be sure he is doing something sensible with it. What a pity
the West`s banks did not have that incentive in so many oI their lending decisions in the
1970s and 1980s. It also emphasizes the sharing oI responsibility. by all the users oI
money. That helps to make the Iree-market system more open; you might say more
4.6 Conclusions
Islamic banking is a very young concept. Yet it has already been implemented as the only
system in two Muslim countries; there are Islamic banks in many Muslim countries and a
Iew in non-Muslim countries as well. Despite the successIul acceptance there are
problems. These problems are mainly in the area oI Iinancing.
With only minor changes in their practices. Islamic banks can get rid oI all their
cumbersome. burdensome and sometimes doubtIul Iorms oI Iinancing and oIIer a clean
and eIIicient interest-Iree banking. All the necessary ingredients are already there. The
modiIied system will make use oI only two Iorms oI Iinancing -- loans with a service
charge and Mudaraba participatory Iinancing -- both oI which are Iully accepted by all
Muslim writers on the subiect.
Such a system will oIIer an eIIective banking system where Islamic banking is obligatory
and a powerIul alternative to conventional banking where both co-exist. Additionally.
such a system will have no problem in obtaining authorization to operate in non-Muslim
Participatory Iinancing is a unique Ieature oI Islamic banking. and can oIIer responsible
Iinancing to socially and economically relevant development proiects. This is an
additional service Islamic banks oIIer over and above the traditional services provided by
conventional commercial banks.

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