QARḌ ḤASAN FINANCING IN ISLAMIC BANKS

Seyed Kazem Sadr*

Abstract

Qarḍ ḥasan—commonly defined as an interest-free loan—is a benevolent economic

behaviour, an outlet for the placement of savings, an instrument of finance and an institution
for bona fide lending. Having such versatile attributes, it is distinguishable from other
charitable financial activities such as waqf (endowments) and infāq (spending in the way of
Allah) as well as other modes of finance used in Islamic financial institutions. The purpose of
this paper is to present the alternative prospects of this Islamic instrument and to provide an
explanation for each form of its application. Applying Tobin’s (1958) Portfolio Theorem, the
paper explains why people extend loans to others without the expectation of return and
position this bona fide loan among the other recommended financial activities in Islam.
Furthermore, the paper investigates why Islamic banks continue to make use of this financial
instrument despite the fact that they gain no financial return from it. Data on Islamic banks’
application of qarḍ ḥasan financing and its share compared to other banks’ assets portfolio
are presented. It is further argued that qarḍ ḥasan is an act of worship and benevolence and
should be distinguished from the qarḍ (loan) contract, which is simply a permissible type of
exchange and a mode of saving deposits in Islamic banks. The paper concludes with
recommendations to the financial community for more extensive and effective use of this
interest-free loan.

Keywords: Qarḍ ḥasan, benevolent behaviour, Islamic finance, Islamic bank, qarḍ contract.

I. INTRODUCTION

Among the many factors that contributed to the progress of the global Islamic finance
industry in the past four decades is the development of multiple financial instruments that
could meet both consumers’ and producers’ demand for consumption and investment
expenditures. One such instrument that was introduced at the outset of Islamic banking
activities, and which continues to be used by almost all Islamic banks, is qarḍ ḥasan (QH).
Unlike other instruments that are all revenue-generating, QH entails no nominal return
according to the rules of the Sharīʿah. It is important, therefore, to discover the attributes of
this Islamic tool that have made it applicable by both firms and individuals in formal as well
as informal financial activities.

A closer analysis of QH reveals that it is not only a means of financing in Islamic banking, it
is further a practice that is much recommended in the Qurʾān (see Qurʾānic verses 2:245,
5:12, 57:11, 57:18, 64:17, 73:20) (Farooq, 2011; Zada and Saba, 2013). For instance, the
*
Seyed Kazem Sadr is Professor at the International Centre for Education in Islamic Finance (INCEIF),
Kuala Lumpur, Malaysia. He can be contacted at sadr@inceif.org. He is indebted to Ms. Alaa Al-Abed for
her contributions and also to the Journal editors for their directions and amendments.

1
Qurʾān (57:11) states: “Who is he who will give to Allah a beautiful loan (with all sincerity)
so that Allah will pay him back manifold and he will have (besides) a noble reward?”

In this latter form, QH is a financial deed that is not obligatory, as are zakāh and khums,1 but
is a voluntary form of transfer payment, a counterpart of waqf and infāq.2 In another capacity,
it has contributed to the formation of new financial institutions in Muslim and non-Muslim
countries. Many of these funds have been established in mosques, organisations and rural
communities. One source reports that the number of both registered and unregistered funds in
2005 was 6500 in Iran (Iran Stat. Center, 2006). The formation of these funds have also been
reported in countries such as Malaysia (Saad, 2011), Indonesia (Mirakhor and Iqbal, 2007),
Pakistan, Kosovo, Bosnia, Herzegovina and the United Kingdom (Khan, 2008; Najeeb and
Lahsana, 2013).3

The purpose of this paper is to discover the attributes of this Islamic financial rule of
behaviour and explain why it is commonly practiced in Muslim communities. Section II of
the paper explains why individuals extend QH loans to others and why Islamic banks
continue to make use of this financial instrument despite the fact that they gain no financial
return from it. Section III compares QH financing with the qarḍ (loan) contract and discusses
their distinguishing features. Section IV then presents data on Islamic banks’ application of
QH financing and its share compared to other bank assets. The findings of other studies that
complement the discussion are also reported. The paper concludes with recommendations to
the financial community for more extensive and effective use of this interest-free loan.

II. BENEVOLENT BEHAVIOUR

Allah’s reward for providing QH distinguishes it from other Sharīʿah-compliant financial

instruments that are used for the financing of goods and services. Usually, there is no priority
given to the application of these Sharīʿah-compliant financial instruments in both formal
banking and informal financial institutions; their application depends mostly on their
suitability to meeting the needs of customers. Why then do individuals so commonly offer
QH financing without expecting to earn any nominal return?

1
Refer to Qur’ān (8: 41). A 20-percent levy on booty gained in jihad, discovered treasure, mines, net
annual income and wealth capital gain. The coverage of khums differs among Islamic fiqh schools.
2
Waqf is the appropriation of a property in perpetuity for specific purposes. No property rights can be
exercised over the corpus. Only the usufruct is applied towards the objectives (usually charitable) of the
waqf. Infāq, on the other hand, means spending. In the literature of Islamic economics, it usually refers to
spending in the way of Allah (SWT).
3
There are many different types of these funds in different countries; but the most common type is the
informal fund that is formed by members of a family, an organisation or a locality. Members deposit an
equal amount of cash in the fund every month. The management of the fund will be undertaken by an elder
of the group or few volunteer members. The total money collected will be lent to a randomly selected
member for a year. His monthly deposits will be accepted as his loan repayment dues over the year (Arab
Mazar and Keyqobadi, 2006). Until all members receive the loan, it cannot be lent again to those who have
already benefited from the fund. Similar arrangement is followed by Ansar QH fund in the United Kingdom.
No service fee is charged for extending these QH loans. A fixed amount of fee used to be charged in
Akhuwat QH fund in Pakistan (Najeeb and Lahsana, 2013).

2
The best explanation is probably provided by the Portfolio Theorem (Tobin, 1958). The
theorem suggests that agents consider the risk of alternative assets’ returns as well as their
expected nominal return for the purpose of managing their wealth fund. Holding a diversified
portfolio that includes low-, medium- and high-return yielding assets with commensurate risk
profiles will maximize the total expected return of the portfolio. This is why people keep part
of their financial wealth in liquid form (Tobin, 1958). Money, which incurs no transaction
cost, provides utility, and this makes it a desirable asset in the composition of the wealth
portfolio. Therefore, it is not simply the nominal return of an asset that makes it a desirable
component of a portfolio; consideration is also given to utility and inherent attributes.

QH is a kind of quasi-money asset. The agents’ distribution of liquid assets into money and
QH could depend on both the perceived rate of return and risk of the latter. The rate of return
for QH is specified by the Qurʾān in several verses such as (57:11, 18), (64:17). (2:245),
assuring believers with full certainty that they will be rewarded manifold in both the present
life and in the Hereafter (Farooq, 2011). The motivation for believers to provide QH therefore
involves a consideration of the rewards promised in the Hereafter too as part of their long-
term return profile. Consequently, QH will be considered a risk-free asset having a perceived
certain return in the wealth portfolio of the believers. The study of Khan (1987) has shown
that the addition of a risk-free asset to the portfolio of wealth holders increases their
wellbeing. The choice of the borrower, however, from among family members, peer groups,
or poor people would depend on the borrower’s need for the fund and his credibility
regarding repayment of the loan. Moreover, the supply of the loan and its coverage will also
depend on the utility of fulfilling the needs of applicants and the cost of obtaining the
information for verifying the intensity of their needs.

III. QARḌ ḤASAN FINANCING AND THE QARḌ CONTRACT

One of the issues in QH financing has been the question of whether qarḍ (loan) contracts are
different from QH, and if they are, what are their distinguishing features? Farooq (2011) has
provided an extensive discussion on this issue and the distinction of both from a ribā
(interest) contract. He states that qarḍ ḥasan is a uniquely Qurʾān term; in fact, the word qarḍ
is never mentioned in the Qurʾān except with the additional description ḥasan (good).
Moreover, the Qurʾān consistently refers to it as lending to Allah (SWT) because it is
recommended that it be lent to the poor and needy and that the lender even refrain from
calling for it when the borrower is empty-handed. He further states that when qarḍ is
mentioned in the ḥadīth literature, it is as a single term without the adjective ḥasan. It may be
concluded from his discussion—and that of Mirakhor and Iqbal (2007) and other
contemporary scholars (e.g. Najeeb and Lahsana, 2013)—that the ḥadīth literature validates
qarḍ as a contractual form by distinguishing it from ribawī (interest-based) loans. Contracts
transfer property rights from one party to another. The legitimacy and equitability of
contracts will be guaranteed when the rights being exchanged are clearly specified. The fact
that no pecuniary or non-pecuniary return additional to the principal sum of the loan can be
stipulated in a qarḍ contract—while on the contrary, the borrower may voluntarily pay back a

3
surplus to the lender—illustrates the importance of the property rights involved. The lender
has no right to demand any amount in excess of the original principal amount, and the fact
that the borrower may voluntarily do so creates no additional earning right for the lender. In
the ribawī system, however, the lender has a right to an extra amount specified up-front in the
loan contract. To the fuqahā (jurists), qarḍ and QH are one and the same, in that no extra
amount can be obtained as a condition of the contract (Farooq, 2011). In short, qarḍ and QH
are the same as far as the contractual and exchanged rights are concerned but have different
donation and depositing behavioural attributes with respect to the intention of the client (Zada
and Saba, 2013).

QH is an act of worship and benevolence whereas the qarḍ contract is simply a permissible
type of exchange, like a sale or other exchange contract. Households who lend funds on the
basis of QH wish to behave according to the principles of QH as laid out in the Qurʾān
(2:245, 5:12, 57:18, 57:11, 64:17, 73:20). In contrast, consumers who deposit their savings in
banks want to have safe precautionary reserves. Since they are confident that banks will
repay them upon demand, they consider non-interest-bearing accounts a safe place for their
deposits. Savings accounts could be structured using the wadīʿah or qarḍ contract. If deposits
are placed with the bank according to a wadīʿah yad amānah (safe deposit based on trust)
contract, the ownership right of these deposits is not transferred to the bank. This
arrangement is in contrast to the qarḍ contract where that right is delivered but the bank is
required to pay back the deposits anytime the lenders or depositors call for them. Also, the
types of property rights that are exchanged differentiate qarḍ or QH deposits from wadīʿah.
This is why some Islamic banks offer only QH saving deposits and those who offer wadīʿah
accounts obtain specific permission of depositors to use those funds, thus structuring the
accounts based on the wadīʿah yad ḍamānah (safe deposit based on guarantee) contract.

IV. QARḌ ḤASAN FINANCING IN ISLAMIC BANKS

What benefits does qarḍ financing provide to Islamic banks? Quite often banks need to
finance projects with multiple stages and components where a single instrument, or even a
number of them, may not suffice to finance those specified stages. Qarḍ financing could be
used in such instances. It fills the gap and complements other instruments. The fact that this
instrument complements the financing process and lowers its contractual cost makes it
popular for Islamic banks. In fact, the return that banks demand from other accompanying
tools may make up what is forgone by qarḍ financing. Furthermore, banks, always wish to
accommodate their target customers at times of emergency or shortage of liquidity. Qarḍ
facilities readily serve these needs and help banks to establish a viable and reliable
relationship with customers.

The same Sharīʿah principle that prohibits the lender of QH from obtaining any extra
pecuniary or non-pecuniary return obliges the borrower to repay the loan whenever the lender
calls for it or as specified in the contractual agreement. Therefore, it is a secured loan from
the Sharīʿah point of view and has hardly any risk for the lender (if the borrower has taqwā,

4
 i.e., a fully developed conscience). It is this built-in guarantee feature of QH as well as its
liquidity and complementary nature that make it popular in the Islamic banking industry.

A review of financial activities of 26 Islamic banks from 2005 up to 2011 shows that all were
offering QH facilities (see Table 1). Half of these banks increased the amount of this loan
over the review period. In some countries like Bangladesh and Indonesia, all the listed banks
increased their provision of QH both in absolute value and in proportion to other assets. The
share of QH financing in total assets increased over the stated period to 13.4 and 6 per cent
respectively for Syariah and Muamalat banks in Indonesia—the highest among the listed
banks (see Table 2). The same applies to Iranian banks, except for one. In fact, the share of
QH facilities in total outstanding assets increased steadily after the Islamic Revolution in Iran
until the end of the war with Saddam Hossein of Iraq, after which it started to decrease
because QH saving deposits were gradually transferred to investment accounts (Arab Mazar
and Kayqobadi, 2006). The share of QH loans in total assets was 5 per cent, on average, for
all banking and credit institutions and 7 per cent for the commercial banks alone during the
period 2010-2011 (Central Bank of Iran, 2012). In countries like Bahrain, Jordan and Yemen,
all of the banks listed in Table 1 decreased the amount of this loan. In Malaysia, the
performance of the six Islamic banks was mixed; half of them increased, while the other half
decreased, the amount of this financial service. The same mixed result was also observed in a
study of QH financing that focused only on Malaysian Islamic banks (Ariffin and Adnan,
2011). Furthermore, the share of QH in the total assets of most of the listed banks increased
too. The same increase in QH share applied to two Indonesian banks. The latter measure
increased for all Iranian banks from 2005 to 2010. Interestingly, the share of QH in the total
assets increased for the three Malaysian banks whose absolute QH financing was also
increasing. That proportional increase is also observed for one Jordanian bank, although the
absolute amount of its QH financing declined.

Table 1: Qarḍ Ḥasan Financing for Selected Islamic Banks from 2005 to 2011

COUNTRY BANK NAME 2005 2006 2008 2009 2010 2011

BAHRAIN INVESTMENT BANK 106.53 140.42 86.66 134.29 31.14 3.21

(U.S.DOLLARS '000)
BAHRAIN ISLAMIC 125 125 125 125 2
BANK (DINAR '000)

BANGLADESH ISLAMI (TAKA '000) 1996132 1974204 2450987 2999399 4101051

XM BANK 250602.1 757979.6 383563.59 209492.1
AL-ARAFAH 609143.4 624061 987261.84 1278660.3

INDONESIA SYARIAH (RUP 71821.55 250295.8 618854.4 1066812 2258330.4 6529509.9

'000,000)
MUAMALAT 16753.97 34435.67 186493.3 306412.7 1195645.4 1955293

IRAN SARMAYEH (RIAL 137245145 23573385

'000,000)

5
 PASARGAD 299441 1218320 2244864 2503934
PARSIAN 8 24 70 946800 166
TEJARAT 9676437 12465543
SEDARAT 11179000 16094000 17753000

JORDAN ISLAMIC INT. 40.75 151.35 267.97 584.8 479.41 518.53

(DINAR '000)
ISLAMIC BANK F & I 6093.05 5736.5 15806.29 8644.29 7704.18 7578.72

MALAYSIA KFH (RINGGIT '000) 43 115 2450 32239 947

RAKYAT 126833 105423 102654 31807 5507
MUAMALAT 7089 6555 7608 4844 16344
ALLIANCE 369 443 376 251
ASIAN FINANCE 103.64 250.46 627.56 702.6
AL-RAJHI 236 3436 3708 3616 3758

QATAR QATAR 8681 5361 2186 426 118 48

INTERNATIONAL
ISLAMIC BANK
(RIAL QAR '000)

SUDAN SAVING & SOCIAL 142849 225439 223539 50134 36672

DEVELOPMENT
BANK (DINAR SDD
'000)

SYRIA SYRIA 222428 525358 250000

INTERNATIONAL
ISLAMIC BANK
(POUND '000))

UNITED ARAB SHARJAH (DIRHAM 13959 3436 33037 83474 149255 250133
EMIRATE '000)

YEMEN TADHAMON (RIAL 3126 6081 1738 16173 233

'000)
SABA 82.87 96.7 73.7 70.26
Source: ibisonline.net

Table 2: Percentage Share of Qarḍ Ḥasan in Total Assets for Selected Islamic Banks
from 2005 to 2011

COUNTRY BANK 2005 2006 2008 2009 2010 2011

6
BAHRAIN INVESTMENT BANK 0.07702 0.09486 0.09119 0.18084 0.06736 0.00754
B.S.C

BAHRAIN ISLAMIC 0.03897 0.02863 0.0143 0.0137 0.00023

BANK

BANGLADESH ISLAMI BANK 1.60004 1.31392 1.06158 1.07774 1.24054

XM BANK 0.36613 0.90962 0.33922 0.16276

AL-ARAFAH 1.6385 1.2863 1.33405 1.1976

INDONESIA SYARIAH 0.86815 2.61954 3.6263 4.8411 6.9529 13.41534

MUAMALAT 0.2256 0.41139 1.47883 1.91183 5.58692 6.02008

IRAN SARMAYEH 0.43764 0.0573

PASARDAG 0.52565 1.2821 1.81465 1.34575

PARSIAN 0.20904 0.2291 0.38212 0.49253 0.6467

TEJARAT 2.5233 2.67896

SEDARAT 2.72785 3.34587 3.13961

JORDAN ISLAMIC INT. 0.01006 0.02635 0.02952 0.05618 0.04231 0.04599

ISLAMIC BANK F & I 0.45391 0.39221 0.85515 0.39597 0.29589 0.2615

7
MALAYSIA KFH 0.00143 0.0012 0.0212 0.29533 0.00934

RAKYAT 0.5286 0.3833 0.24578 0.06273 0.00887

MUAMALAT 0.06902 0.04873 0.05283 0.02898 0.08928

ALLIANCE 0.01245 0.01397 0.0077 0.00403

ASIAN FINANCE 0.00568 0.0121 0.02798 0.02882

AL-RAJHI 0.0801 0.0716 0.06501 0.0611 0.0611

QATAR QATAR 0.13702 0.06383 0.01702 0.00257 0.00065 0.00021

INTERNATIONAL
ISLAMIC BANK

SUDAN SAVING & SOCIAL 0.52265 0.62288 0.48361 0.09588 0.06309

DEVELOPMENT
BANK

SYRIA SYRIA 0.61973 0.15434 0.39481

INTERNATIONAL
ISLAMIC BANK
(POUND '000)

UNITED ARAB SHARJAH 0.2635 0.0441 0.21265 0.5373 0.8955 1.41054

EMIRATES

8
YEMEN TADHAMON 0.00234 0.0033 0.0006 0.0043 0.00006

SABA 0.11780 0.06370 0.04232 0.05003

Source: ibisonline.net

These results reveal the indispensable place of QH in Islamic finance. Overall, the listed
Islamic banks have continued using QH financing, though at different scales. Although the
list of the banks in Table 1 is not exhaustive and no conclusion for a specific country can be
drawn, the findings still verify to some extent the proposition stated at the outset regarding
the use of QH in Islamic banks. This finding also indirectly documents the formation and
expansion of QH funds in some Muslim countries.

On the demand side for QH funds, the attitudes and norms of bank customers in Malaysia
have a significant effect on their acceptance of QH financing. Furthermore, the processing
price of this tool has determining effects on customers’ demand for it. The study by Handin
Amin and Rostinah (2010) recommends enhancing the service quality of this mode of
financing and better handling of the customers by Malaysian Islamic banks. For the deposit
side, a study, which was carried out in Iran has found that advertisement has positive and
significant effects on the collection of QH deposits by Iranian banks (Hosseini and Shahbazi,
2008).

Other studies have focused on the supply side of QH loans. Ariffin and Adnan (2011)
recommended that Malaysian banks simplify QH operational procedures and improve the
service quality. The findings of another research (Abbasi and Sadr, 2005), which measured
the operational cost of QH facility for the Agricultural Bank of Iran, support the former
recommendations. In the latter study, the operational cost of all financial instruments of the
bank from 1984 to 1997 was measured. The cost of operations for any single contract, i.e. the
labour and capital cost not the opportunity cost of the fund, varied from one year to another
because of the change in labour and capital expenses. In 1997, the cost of QH was lower than
that of other instruments.

Table 3: The Respective Cost of Alternative Islamic Instruments in the Agricultural

Bank of Iran

Instrument Price in Iranian riyals

Qarḍ ḥasan 79,305
Murābaḥah (mark-up sale with instalment payments) 538,225
Salam (forward sale) 243,722
Mushārakah (profit and loss sharing) 284,535
Muḍārabah (profit sharing between a silent partner and 307,251
entrepreneur)

9
As mentioned above, one of the determining factors in the measurement of operational cost is
labour. Therefore, banks can bring down their operational cost and secure clients’ satisfaction
by better managing and training their human resources.

Before concluding the discussion on this financing activity, it should be mentioned that qarḍ
contractual agreements provide an ideal form for saving deposits in Islamic banks. In this
contract, the ownership of the deposits is transferred from the lender to the borrower
according to Islamic law.4 Consequently, banks can use the deposited savings freely. In the
wadīʿah (trust) contract, banks do not obtain the ownership right and have to keep the
deposits as they are. In muḍārabah contracts, banks have to transfer part of the gained
revenues to depositors, based on their initial agreements. However, all the revenues can be
possessed by the bank when the deposits are in the form of QH.

What incentivises consumers to deposit their savings in QH accounts? Formal and informal
institutions provide different motives for this behaviour. Consumers do not invest all of their
savings in any time period; they keep part of it in liquid form for precautionary and
unforeseen expenses. The most secure place for depositing this type of savings is formal
financial institutions. Although wadīʿah accounts serve this purpose well, they are not
provided by all banks (Arab Mazar and Kayqobadi, 2006).

The incentives for households to provide QH to individuals or deposit in informal funds is

clearly benevolent and spiritual. It is mainly on the basis of abiding by the Qurʾānic call, as
specified in (2:45), (11:57), for lending to Allah. It is this feature of QH transactions that has
contributed to establishing benevolent financial institutions in many Muslim countries.
However, it is appropriate to point out the consequences of mixing the two sets of incentives
and misperceiving households’ decision to deposit in the banks as being out of benevolent
motives. The perception that both types of behaviour are identical led the authorities in Iran
to their decision to establish “Qard ul Hasan banks” and require all other public banks to
transfer their QH savings deposits to these new banks (Central Bank of Iran 2012). The two
QH banks thus founded are required to extend the collected funds to deserving applicants.

V. CONCLUSION

The purpose of this paper is to identify QH as a benevolent behavior representing a loan to

Allah (SWT), as recommended in the Qurʾān, as opposed to the qarḍ contract as an
instrument of finance. Consideration of QH as a loan to Allah (SWT) and assignment of
reward for it is the main cause of its provision to needy individuals and as deposits in QH
funds. This benevolent spiritual motive should not be mixed with households’ precautionary
savings although the same qarḍ contractual arrangement is applied by both QH funds and
Islamic banks for the collection of deposits. The fact that consumers willingly contribute to
QH funds is to have access to a portfolio of assets with varying degrees of returns and risks.
4
In a qarḍ contract the ownership of the property loaned is transferred from the lender to the borrower.
The lender obtains claim over the debt of the borrower. In a wadīʿah contract the ownership of the property is
maintained and guarantor cannot make use of the property that is guaranteed.

10
The QH asset entails utility of loaning to Allah (SWT), on the one hand, and bearing no risk
for the return, on the other hand. The Qurʾānic verses assure the contributor of the return
from his interest-free loans. The Sharīʿah rules of contract ensure repayment of the principal,
whenever the lender calls for it. The choice of this type of wealth portfolio by the believers
has rendered formation of QH funds with a sustainable pace of growth in Islamic
communities (Sadr, 2008). Therefore promotion of QH benevolent behavior in the rest of the
Muslim communities would contribute to the formation of funds offering bona fide loans to
needy and vulnerable households.

The facility that the qarḍ contract provides for financing multiple-purpose and multi-stage
projects—and for complementing other instruments in the process of financing by banks—
makes it a versatile tool of finance for Islamic financial institutions. Its security feature, as
provided by the Sharīʿah, makes it a desirable quasi-money asset in Islamic banks’ portfolios.
Data presented for Islamic banks show that they continuously use QH, in different
proportions, along with other permissible Islamic financial contracts. In addition to its unique
features as a mode of finance, the QH contract provides a favorable savings opportunity for
the banks. Unlike wadīʿah arrangements, qarḍ contracts empower banks to acquire the
property rights of the deposits and invest them in profitable avenues. Therefore efforts by
Islamic banks to decrease the operational cost of this tool and to promote it among their
clients complement the set of financial products that they offer and enhance the profitability
of their banking business.

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