Principles of Banking: Reading 4

Development Banking & Islamic Banking

Concepts, Evolution and features of Development Bank and Developmental Banking

A development bank is a ‘bank’ established for the purpose of ‘financing development’. In

most instances they provide medium and long-term finance to the industrial and agricultural
sector. They provide finance to both private and public sector. Development banks are
multipurpose financial institutions. They do term lending, investment in securities and other
activities. They even promote saving and investment habit in the public.

As per banking subject, "Development banks are financial institutions established to lend
(loan) finance (money) on subsidized interest rate. Such lending is sanctioned to promote and
develop important sectors like agriculture, industry, import-export, housing and allied
activities."

In regard to the feature of a development bank, a development bank generally 1) does not
accept deposits from the public like commercial banks and other financial institutions who
entirely depend upon saving mobilization; 2) it is a specialized financial institution which
provides medium term and long-term lending facilities. 3) It is a multipurpose financial
institution; 4) besides providing financial help it undertakes promotional activities also; 5) It
provides financial assistance to both private as well as public sector institutions; 6)
Development banks react to the socio-economic needs of development.

The concept of development banking rose only after Second World War, Successive of the
Great Depression in 1930s. The demand for reconstruction funds for the affected nations
compelled in setting up a worldwide institution for reconstructions. As a result the IBRD was
set up in 1945 as a worldwide institution for development and reconstruction.

By and large, it is a post-second World War phenomenon. The French Credit Mobilizer of 1852,
the Japanese Industrial Bank of 1902 and the so-called ‘industrial banks’ of Germany had at one
time made a profound appeal to countries which were seeking to set up suitable financial
machinery for accelerating the pace of industrial development. But these institutions have to be
sharply distinguished from the ‘development banks’ which came to be established in the post-
war years in the developing countries of the world. In sharp contrast with the prewar institutional
devices the new development banks are intended to provide not simply capital, whether equity or
loan, but also technical, managerial and entrepreneurial talent wherever necessary and to assist in
building up a financial infrastructure conducive to the rapid economic growth of the respective
countries.
Developmental banking is much broader a concept. It could be performed by commercial or any
other financial institutions targeting socio-economic development. For the commercial banks and
financial institutions, the may be tagged with CSR.

An examination of the structure and design of these development banks shows that they may be
owned either by the Government or by central bank or by private investors. Sometimes they are
found to have a ‘mixed ownership’ in the sense that their capital has been contributed jointly by
the Government and/or the central bank as well as by private investors, institutional or
individual. In Bangladesh, the development banks (BDBL, BKB, RAKUB, and BASIC) are
owned by the Government.

Twin Roles of Development Banks: Financing and Promotional:

Development banks have a twofold role. By far the more important role is that of a financial
institution, providing finance to industrial enterprises in various ways. Equity participations,
provisions of medium-and long-term loans, subscription to the bonds and debentures of the
companies, underwriting of their shares, ordinary and preference, and of bonds or debentures
issued by them, and guaranteeing of loans raised from foreign or domestic sources are the usual
forms in which finance is furnished by the development institutions. Apart from the role of a
provider of industrial finance, these institutions have a promotional role to play.

Indeed in some cases the promotional role is more significant than the role of the industrial
financier. The promotion of industrial enterprises, the provision of various kinds of technical and
managerial assistance, the undertaking of economic and technical research, the conducting of
survey work and feasibility studies and the fostering of the capital market, etc., constitute the
main features of the promotional role of development banks.

A Debate on Development Banking:

Should Development Banks undertake commercial Banking activities (such as providing short
term working capital, mobilizing deposit, opening L/C etc.)? Or Should Commercial Banks
undertake Development Banking activities (such as long- term finance, underwriting etc.)?

Development banking may include activities of the development banks and all the CSR
activities by commercial banks:

 Agri and Rural Loans targeting vulnerable

 Small targeted deposits
 Small and micro enterprise credit (SME) facilities
 Mobile and agent banking
 Green financing
 Transparency and disclosure
 Community Investment
 Philanthropic activities

Activities of MFIs may also be branded as development banking activities.

Principles of Islamic Financial System:

The basic framework for an Islamic financial system is a set of rules and laws, collectively
referred to as shariah, governing economic, social, political, and cultural aspects of Islamic
societies. Shariah originates from the rules dictated by the Quran and its practices, and
explanations rendered (more commonly know as Sunnah) by the Prophet Muhammad. Further
elaboration of the rules is provided by scholars in Islamic jurisprudence within the framework of
the Quran and Sunnah. The basic principles of an Islamic financial system can be summarized as
follows:

Prohibition of Interest.
Prohibition of riba, a term literally meaning “an excess” and interpreted as “any unjustifiable
increase of capital whether in loans or sales” is the central tenet of the system. More precisely,
any positive, fixed, predetermined rate tied to the maturity and the amount of principal (i.e.,
guaranteed regardless of the performance of the investment) is considered riba and is prohibited.
The general consensus among Islamic scholars is that riba covers not only usury but also the
charging of “interest” as widely practiced. This prohibition is based on arguments of social
justice, equality, and property rights.

Risk sharing.
Because interest is prohibited, suppliers of funds become investors instead of creditors. The
provider of financial capital and the entrepreneur share business risks in return for shares of the
profits.

Prohibition of speculative behavior.

An Islamic financial system discourages hoarding and prohibits transactions featuring extreme
uncertainties, gambling, and risks.

Sanctity of contracts.
Islam upholds contractual obligations and the disclosure of information as a sacred duty. This
feature is intended to reduce the risk of asymmetric information and moral hazard.

Shariah-approved activities.
Only those business activities that do not violate the rules of shariah qualify for investment. For
example, any investment in businesses dealing with alcohol, gambling, and casinos would be
prohibited.

Islamic Financial Instruments:

Some of the more popular instruments in Islamic financial markets are Trade with markup or
cost-plus sale (murabaha). One of the most widely used instruments for short-term financing is
based on the traditional notion of purchase finance. The investor undertakes to supply specific
goods or commodities, incorporating a mutually agreed contract for resale to the client and a
mutually negotiated margin. Around 75 percent of Islamic financial transactions are cost-plus
sales.
Leasing (ijara).
Another popular instrument, accounting for about 10 percent of Islamic financial transactions, is
leasing. Leasing is designed for financing vehicles, machinery, equipment, and aircraft. Different
forms of leasing are permissible, including leases where a portion of the installment payment
goes toward the final purchase (with the transfer of ownership to the lessee).
Profit-sharing agreement (mudaraba).
This is identical to an investment fund in which managers handle a pool of funds. The agent-
manager has relatively limited liability while having sufficient incentives to perform. The capital
is invested in broadly defined activities, and the terms of profit and risk sharing are customized
for each investment. The maturity structure ranges from short to medium term and is more
suitable for trade activities.
Equity participation (musharaka).
This is analogous to a classical joint venture. Both entrepreneur and investor contribute to the
capital (assets, technical and managerial expertise, working capital, etc.) of the operation in
varying degrees and agree to share the returns (as well as the risks) in proportions agreed to in
advance. Traditionally, this form of transaction has been used for financing fixed assets and
working capital of medium and long term duration.
Sales contracts.
Deferred-payment sale (bay’ mu’ ajjal) and defferred-delivery sale (bay’salam) contracts, in
addition to spot sales, are used for conducting credit sales. In a deferred-payment sale, delivery
of the product is taken on the spot but delivery of the payment is delayed for an agreed period.
Payment can be made in a lump sum or in installments, provided there is no extra charge of the
delay. A deferred-delivery sale is similar to a forward contract where delivery of the product is in
the future in exchange for payment on the spot market.

Deposits are mobilised through the application of the following two Shariah principles:
i) Al – Wadia and
ii) Mudaraba

Al – Wadia principle implies that the Bank receives funds with undertaking to refund the deposit
on demand and also with authorization from the depositors to use the funds for benefit of and at
the risk of the bank. Bank’s Current Account Deposits are managed on this principle.

Mudaraba principle implies that the bank receives deposits from the depositor with the authority
that the bank will have exclusive right to manage the fund and the profit resulting from such
deposits will be shared between the bank and the depositor at a pre-agreed ratio and the loss, not
resulting form the negligence of the Bank or any of its representative, will be borne by the
depositors.

[Islamic Banking Market, Activities and Operations in Bangladesh [Review of

Islamic Banking in Bangladesh- Banking Review Series 2019]