Interest-Free Banking System

Objections, Reservations and their Evaluation

The rationale of prohibition of interest has already

been discussed. Many people, however, argue that even
if interest is prohibited in Islam. Interest-free banking is
not practicable in the modern world as an economic
system minus interest cannot be visualized. It is now
proposed to discuss and analyze these objections and
reservations.
 Interest-Free Banking System

The interest-free banking system will not be able to bring

an optimum allocation of resources. It is argued that
since funds will be available at zero rate of interest, the
demand for money will tremendously increase’ and in the
absence of interest rates mechanism, there will he no
tool for equating demand and supply of money.
 Interest-Free Banking System

This argument is based on a gross misconception. It is

important to perceive clearly that interest-free banking
does not mean that funds will be available free of cost to
the entrepreneur for their business requirements. Islamic
system of interest-free banking, among other things,
means that finances will he available on profit and loss
sharing basis as against predetermined rates of interest.
The rates of profit depending upon the operational
results, will, therefore, replace interest rates in allocation
of resources and will also provide a mechanism for
equating the demand and supply of money.
 Interest-Free Banking System
The diversion of funds towards a project, will largely
depend, within the Islamic framework, on the projected rate
of profit i.e. greater the projected rate of profit, the greater
may be the supply of funds to that project. If the actual
profit is constantly lower than the projected profit, the
entrepreneur is likely to face difficulty in securing funds for
his project in future. The mechanism of profit sharing is,
therefore, likely to be more instrumental in creating financial
discipline, higher efficiency and would lead to a more
careful and realistic feasibility and evaluation of projects as
also of post-finance monitoring. This would result in not
only higher rates of profit but would also provide a better
and more efficient mechanism for allocation of resources as
compared to interest-based system. In any case, there is
not much evidence to support that rate of interest is an
efficient mechanism for allocation of resources.
 Interest-Free Banking System
Islam discourages keeping funds idle. The Islamic system
of Zakat (Poors’ due) @ 2.5% per annum, on specified
assets, discourages the Muslims to keep the money in
bank lockers or at home, as the savings are automatically
consumed each year through the payment of Zakat.
Further, an Islamic state can also impose tax or duty on idle
assets. This will be a fiscal devise in lieu of interest. It will,
therefore, be observed that while interest may he seen as a
compensation for parting with money in the interest-based
system, the expected profit sharing, duty if imposed, and
Zakat in the Islamic system will discourage keeping the
funds idle? This, coupled with the instinct of human beings
to save for uncertain future, will ensure equilibrium in both,
the commodity market and the money market.
 Islamic Banking
Philosophy, Development

Islamic banking, an alternate to interest-based

banking is not banking in the traditional sense of the word.
It derives its inspirations and guidance from the religious
edicts of Islam and has to conduct its operations strictly in
accordance with the directives of Shariah.
 Islamic Banking
It is, therefore. not merely refraining from interest—based
transactions (Ahmed, 1985:18) but the objective is to make
a positive contribution to the fulfillment of socio-economic
objectives of the society in all spheres, including trade,
industry, agriculture, science, technology, employment,
benevolent sector and the environment, with special focus
on the ‘human factor’.
 Islamic Banking
An Islamic bank is a Financial and social institution which
identifies itself with the principles of Shariah, as laid down
by the Holy Qur’an and Sunnah, as regards its objectives,
principles, practices and operations. An Islamic bank does
not normally lend money except the interest-free loan which
is termed as Qard Hasan. Islamic bank is a partner in
trade, industry and agriculture for production and
development financing. This, therefore, implies that an
Islamic bank should also share in the risk with the
entrepreneur which is in sharp contrast with interest-based
bank. Islamic banking implies zero rate of interest but not
zero rate of return as Islamic banks do not deal in money
but deal with money.
 Areas of Operations
The areas of operations of Islamic banks can be
broadly classified as:

a) Non-fund based transactions

For all practical purposes, the Islamic banks transact all

non-fund based business and provide almost the entire
range of services like conventional banks. It is,
however, obvious that these services are provided
against appropriate fee and charges and that Islamic
banks do not involve themselves in activities like
gambling, trading of prohibited items like wine and
hoarding, etc.
 Areas of Operations
b) Investment activities

The Islamic banks mobilize savings, investments and

other financial resources and also participate in
providing equity to entities like joint stock companies
working under the Islamic system and also provide
finance for trade, industry and agriculture. The modes
of financing being presently used broadly include:
 Areas of Operations
I) Murabaha - Financing on cost plus basis.
2) Bai-Salam - Deterred payment sales.
3) Musharikah - A partnership.
4) Leasing.
5) Mudaraba - Venture Capital or Project finance.
 Areas of Operations
c) Social Activities

1) Providing Qard Hasan basically to deserving persons

for non-commercial activities like marriage, education,
etc. or for small business requirements. In such cases
only the principal amount is payable, provided the
borrower is in a position to repay.

2) Collection and deduction of Zakat from shareholders,

investors and depositors as also the administration of
Zakat fund and distribution from this fund to the poor
and needy as per the guidelines provided by the Holy
Qur’an.
 Areas of Operations
It is important to appreciate that most of the modes
of financing being practiced as a replacement of
interest do not contribute fully in achieving the socio-
economic objectives as envisaged by Islam. Further,
these modes of financing, in some cases, seem to
guarantee a fixed predetermined return and no risk is
practically shared by the financier with the
entrepreneur. It is, therefore, obvious that these types
of financing modes are not in conformity with the
requirements of Shariah.

To replace interest, there are essentially only two

modes of financing under the Islamic banking system,
namely, Qard Hasan and financing on Profit and loss
sharing basis.
 Qard-Hasan
The Holy Qur’an says:

“If you loan to Allah, a beautiful loan, He will double it to

your (Credit)” (64:17).

“And give regular charity: And loan to Allah, a beautiful

loan” (73:20).
 Qard-Hasan
Qard Hasanat is for the benefit of the individual and the
society at large. Islamic banks give loans to deserving
persons for their genuine consumption requirements such
as marriage, education, health care etc. Loans are also
given for setting up small business enterprises. In these
cases, only the principal amount is payable to the bank by
the end of the agreed period, provided the borrower is in a
position to repay the loan. Islam encourages Muslims to
give Qard Hasan and has termed these loans as ‘loan to
Allah’, which will be rewarded by Him.

These types of loans, however, as a matter of policy, do

not constitute a significant source of financing by Islamic
banks. However, ii in any country, an Islamic System of
Zakat is established and the Islamic State treasury starts
functioning, the requirements of Qard Hasan would
primarily he met by the treasury.
 Financing under Profit and
Loss Sharing System
The bulk of financing under the Islamic System is
equity oriented. In this mode of financing, the risks and
losses are shared by the financer along with the
entrepreneur in the ratio of their respective capitals. The
profits are, however, shared in an agreed ratio.

Equity financing may he carried out in various forms

including participation in equity of joint stock companies
or share in partnership or in the form of temporary equity
on profit and loss sharing basis for the working capital
requirements for a specified period. As the financing
under this mode is based on profit and loss sharing.
 Financing under Profit and
Loss Sharing System
Islamic banks pay more attention to the profitability of
the project and not merely on collaterals. As is obvious,
this mode of financing has some inherent risks and can
successfully operate in an honest and just society. If
unethical practices are followed, duplicate hooks of
accounts are maintained, and true profits are not
declared, this mode of financing is likely to suffer serious
setbacks. It is for this reason that Islamic banks have
been shy in adopting this mode of financing on a large
scale.
 Potential of Islamic Banks

Islamic world has tremendous potentials. It has about

20% of the world population and as much of its land
mass. It produces half of the world’s oil and accounts for
40% of world’s export of raw material. Muslims are now
rediscovering their identity and the process of
establishment of Islamization of banking is gaining
momentum. The establishment of Islamic banks is a
recent phenomenon and in a short span of time, over 200
Islamic banks and financial institutions have been
established in Asia, Africa and Europe.
 Potential of Islamic Banks

According to projections, the Muslim population of the

world by the middle of next century will be over 2600
million. Many Muslim countries are presently involved in
interest-free banking and it is visualized that by the year
2050, a significant number of Islamic countries would
switch over or would be in the process of switching over
to interest-free banking.