Feature from past issue

Issue No: 12 February 1993


Interest-free banking explained Misgivings and Answers Process of Experimentation

In the latest of a New Horizon series looking at different ways in which Islamic banks might both improve the scope and quality of their operations, and strengthen their relationships with their Central Banks, Economic Consultant Ahmed H Radwan looks at alternative supervisory tools which might be used by monetary authorities in the control and monitoring of Islamic banks.


A number of misgivings, at both conceptual and operational levels, have been expressed about the viability of interest-free banking in Pakistan. The Federal Shariat Court has given its verdict in favour of a complete switch over to interest-free banking. If this happens it will be a unique experiment because no precedent is available in the ancient as well as contemporary world. It is therefore, natural to express fears that the financial system would be put to a severe test if banking industry went ahead with the experiment. The concept of interest is as old as history itself Notwithstanding the practice of lending money on interest as early as 2000 BC, all Prophets (peace be upon them), religious scholars and even philosophers condemned interest as a system of financial relationship between the lender and the borrower. Long before the advent of Islam, Moses and Christ (peace be upon them) condemned it in their preaching as embodied in the Holy Bible. One can hardly dispute the fact that interest is forbidden by all revealed religions, including Islam. On the operational side, even in the contemporary world, a number of countries have experimented with interest-free banking on a limited scale. The results so far have been fairly encouraging. Pakistan and Iran have introduced interest-free banking on a wider scale, though the process of clarifying what precisely constitutes riba (Quranic term for interest) is still continuing. Shariah experts unanimously hold the view that a financial system based on the principle of profit/loss sharing is more than akin to Islamic teachings. Pakistan has floated several variants of profit/loss sharing system, two of which, viz. mark-up and Musharika, are relatively more important. However, doubts are expressed about the Islamic character of the prevailing mark-up system and the viability of Musharika system. Let us examine these systems in detail.

Mark-up System

The prevailing mark-up system has been termed as riba by the Federal Shariat Court (Pakistan) because it involves the following practices which go against the spirit of profit/loss sharing:

(a) buy back arrangements

(b) sale of goods by banks without having possession thereof, not approved by

Shariah, and

(c) giving of rebate in respect of an account payments by the client, before the expiry date.

These defects can be removed if the system is restructured on the following lines:

(a) Arrangement of funds for overhead expenses. The client may need funds not only for purchase of goods but also to meet overhead expenses. While purchase of goods may be accommodated under mark-up arrangement, funds for overhead expenses may be provided under three alternatives. First alternative is to sanction two limits to the client. First limit would be for purchase of goods from the third party on mark-up basis. Second limit would be for interest-free loan to enable him to meet his overhead expenses. While fixing cost plus for the first limit, the amount of second limit which is interest-free would be kept in view and rate of cost-plus appropriately raised. But Shariah experts may not approve such arrangements because linking of interest-free limit with mark-up transactions would make the mark-up transactions conditional. Second alternative is to provide funds for overhead expenses under the Musharika or Istisna arrangement. Under the Istisna arrangement, client agrees to sell to the bank a given quantity and quality of manufactured goods at an agreed price. While the bank would pay the sale price forthwith, goods might be delivered by the client at a specified date in the future. Lest the bank is loaded with unsold stock of goods purchased under the arrangement, this arrangement exists for sale of goods to third party. Third alternative would be to sanction the limit or pardon thereof on hypothecating basis or against the security of assets other than stock. The client would use sale proceeds of such goods for meeting his overhead expenses.

(b) Arrangement for the purchase and sale of goods. Since the goods required by the client are not owned by the bank but are to be purchased from the third party, the bank should first low business morality, a bank will be justified to assume that the client is able to pay unless he is declared bankrupt officially,

(c) Bank's commission on bills. In certain cases banks may offer credit facility to the drawer of the bill, i.e. seller of goods. A client may sell goods to a third party and come to the bank for financial accommodation against the documents drawn by him on the buyer of his goods. Since the bank accepts responsibility for realising the amount due to the drawer from the drawee, Shariah permits it to realise commission plus out of pocket expenses for rendering the service. The commission will be in percentage only and not at the rate of per cent per annum. This means that the commission will relate to the amount of the bill to be collected and not to the period. However, the bank may vary its commission from bill to bill. The drawer will have to enter into two separate agreements with the bank, one pertaining to the appointment of the bank as his agent for collecting amount from the drawee on due date and the other for receiving loan equal to the value of the bill. The bank commission will be payable in advance and the loan given to the client at the time of accepting the bill for collection will be free of interest. In case the bill is dishonoured, the drawer will be liable for payment of the loan amount to the bank. In case of delay in adjustment of loan, the client will be liable to penalty, along with the amount of interest-free loan.

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Profit/Loss Sharing Under Musharika

Musharika is generally believed to be the most desirable financial instrument for establishing the system of interest-free Islamic banking in its true letter and spirit. The term refers to active business partnership between investors and producers / traders on the basis of sharing of profits and losses in pre-agreed ratios. The obvious prerequisite for the success of this system is strict adherence to moral and ethical values. From the operational point of view, it is a viable system if it is built up on the following lines:

1. Deployment of Funds

So far as shareholders' investment in business is concerned, figures appearing in balance sheet in respect of paid-up capital, etc. can be accepted. However, if this basis is not considered advisable by the bank or the client the figure may be determined in accordance with their recognised accounting standards with mutual consent at the lime of signing the Musharika agreement. Similarly books of financial institutions can be relied upon for showing amount and duration of long term/ short term funds raised on profit/loss sharing basis such as profit participation certificates and Musharika.

2. Basis of Sharing Profit and Loss

a. Presently the State Bank of Pakistan lays down minimum or maximum rates of profit which banks can share. Such way of sharing in profits is not acceptable to Shariah experts. The State Bank will have to stipulate maximum weightage which various funds participating on profit and loss sharing basis would be entitled to. Subject to weightage limits for investment, banks will have complete flexibility in negotiation with their clients about profit ratios to be shared. However, losses shall be shared by financiers in proportion to the respective funds provided by them. The profit assessed in the projection chart will be called projected profit of the company/firm. However banks will share actual profit or loss, in the ratio mutually agreed upon at the time of signing the Musharika contract.

b. Company/firm will be required to give quarterly figures of its actual performance within 7 days of the close of each quarter on the preforms on which projections were given at the time of applying for Musharika.

c. At the end of each half year, amount of actual profit or loss will be distributed between he providers of funds as shown by half-yearly performance report, keeping in view the quantum of funds used in that half year and ratio of profit or weightage agreed for such funds. Bank will get/pay its share of profit/ loss by debit/credit to respective Musharika account.

To minimise the chances of manipulation by an unscrupulous client, it is suggested that the Musharika arrangement may not cover all operations of a venture. For instance, the Musharika arrangement may confine itself to acquire these goods and then sell to the client. For this purpose the bank should appoint the client as its agent for purchase of required goods. At the same time the client should execute an agreement with the bank binding himself to buy the requisite goods from the bank, when delivered to him, at cost-plus price on deferred payment basis. The agreement should state the margin of profit in percentage terms for the bank over the cost of goods to it. The cost of goods to the bank should include not only the price of goods paid to the supplier of such goods but also other incidental charges such as packaging, freight, storage, etc. Margin of profit should be in percentage only and not percentage per annum. While fixing margin of profit, limit period plus cushion period should be kept in view. This means that profit would relate to the amount and not to the period. However, while calculating the actual sale price of each consignment delivered to the client, the bank may keep in mind the period involved in each expense it incurs in connection with such consignment, i.e. the period from the date each expense is paid by the bank to the date of final adjustment of the account by the client (expiry date of limit) plus the cushion period. The client should contact the seller of goods concerned and enter into sale contact with him on behalf of the bank. The seller of goods should then arrange to transport goods to the destination mentioned in the sale contract. Sometimes the seller may ask for payment guarantee by the client's bank in the form of letter of credit.

Since the seller of goods has been selected by the client himself and the former will generally be unknown to the bank, the client should agree to buy the goods on "as is where is" basis as is the case with the financing of foreign trade by the Islamic Development Bank, Jeddah. When the goods are taken possession of by the client as agent of the bank, he sends a letter to the bank intimating the receipt thereof on behalf of the bank and offers to purchase the same at cost-plus price. The bank accepts his offer and sells the goods to him at the cost-plus price, which price is payable by him on a definite date. The amount of cost-plus at the rate already agreed between the bank and the client should be calculated for the period from the date of payment of cost price of the goods to the date of payment of the goods to the date of final adjustment plus the cushion period.

(c) Security against deposits in mark-up accounts. Banks would like to hold some security against deposits outstanding in the mark-up account as they do under the interest-based system. Security may be in the shape of goods purchased by the client from the bank, goods manufactured by him or some other goods. When the client requires goods given to the bank as security, he makes payment to the bank. Under the interest-based system also the client deposits into his loan account his surplus cash to lessen that interest burden. The facility of deposit when surplus and withdrawal are in need is also available under the non-interest system. The client gets rebate on his payment into the account as the mark-up is calculated on debit balance of each day. Since mark-up account cannot be operated like a running account, the client can open a special deposit account with the bank wherein he can deposit money whenever he wants to take delivery of the goods pledged with the bank or otherwise but such deposits shall not be deemed to be part-payment of marked-up price due from the client. To compensate him, a special weightage agreed at the time of sanctioning of the limit can be given on such deposits.

(d) Penalties upon defaulting clients. Shariah experts agree that unscrupulous clients can be pressurised to honour the commitment. A client who is in a position to pay but defaults should be penalised. Provision for penalty along with rate of penalty in percentage terms per annum can be made part of the mark-up agreement which will be recoverable from the client if the bank dues are not realised even after the expiry of the cushion period. Shariah experts further agree that banks can recover the penalty amount as provided for in the agreement along with the amount due. They, however, say that the amount of penalty cannot be taken as income. It should be used by the bank for welfare purpose such as granting of Qarz-e-Hasna. However, penalty cannot be recovered from those who are unable to pay. Shariah experts acknowledge that, in view of the purchase and sale of manufactured/ marketable goods. The client owning a factory may undertake to sell his products to a joint venture between him and his bank at a price per unit mutually agreed upon at the time of joining Musharika or its renewal thereof. The Musharika will then arrange to sell the goods, and profit/ loss arising therefrom will be shared and the bank need not scrutinise various expenses accounted for upto manufacturing stage. It may confine itself to the selling aspect only.

3. Concealment of Profit

If a venture has sustained loss due to (a) dishonesty, (b) gross negligence, or (c) breach of covenants of agreement on the part of client as determined by arbitration, the amount of loss caused by such act or acts will have to be sustained by client singly and bank will not share any such loss. Rather, the bank will be entitled to a share at the agreed ratio in the profit if it is determined by the arbitrator that the Musharika has actually earned profit which has been concealed by the client.

4. Right of Recall of Funds

Funds provided by the bank for working capital may be for the period of one year, renewable at the bank's option. In case a bank has apprehensions about the intention of a client, it may recall its investment even earlier, notwithstanding its commitment to participate in the project/ venture according to the profit projection report. In such a case, however, the bank will have to share in loss or profit, as determined by arbitration, at the rate stipulated in the Musharika agreement.

5. Acquisition of Equity

To ensure that accounts of clients are not manipulated to the detriment of a bank, provision may be made in the Musharika agreement that the bank shall have the right to convert its investment, outstanding at any time during the currency of agreement, into ordinary shares of the client. Such conversion may be on the basis of formula agreed upon at the time of Musharika agreement. The bank should not exercise this right if the client earns profits at the rate not less than two-third of what was shown in the projection.

6. Arrangement for Sale of Shares

Existing shareholders should have the first right to purchase shares acquired or to be acquired by a bank at a price to be mutually agreed upon at the time of sales. 

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Textbook Misgivings

Will interest-free banking prove more risky than interest-based banking? What will be its impact on the income of banks and financial institutions? Will it affect trade and industry? Will it reduce savings? These apprehensions are based on general unfamiliarity with the way business operations are financed in Pakistan.

It is feared that under the mark-up system a bank can run the risk of refusal by its client to buy goods from it after he has purchased them as an agent to the bank from a third party. All a bank needs to do is to assess the worth and creditability of a client before financing him. Even under the interest-based system banks suffer if they are not careful. Further, genuine clients who want to stay in business will think many times before refusing to honour their commitment. In case they do so, they can be sued in a court of law for breach of contract. In Musharika the major risk is concealment of profit by clients. In our latter discussion a number of safeguards have been suggested to cope with this problem.

Another fear is about adverse impact on the profitability of banks. There may be lesser profits or even losses under Musharika and absence of any return whatsoever if payments are delayed under mark-up mode of financing.

Actually these apprehensions are equally applicable to the interest-based system. The lending banks are bound to suffer if business conditions deteriorate. No one would like to put one's money in a business where chances of earning a reasonable return are not well assured, not to speak of the possibility of sharing a loss. One may argue that in such a situation the bank will refuse to lend further. This can happen under the interest-based system too. But sometimes a bank is forced to bail out the business in the hope of salvaging its earlier loan. Further, securities held against loans when sold do not necessarily fetch a proper price as frustrated sales always depress sale prices. If a suit is filed, courts stop application of interest and in a majority of cases do not allow payment of interest on decretal amounts and where they do so it is at a very nominal rate.

Regarding the concealment of profit or manipulation of accounts by client under profit/loss sharing system, certain safeguards are necessary. First, the bank should thoroughly vet the honesty and efficiency of management, profitability of project, and realisabilty of security offered by clients. Second, after the disbursement of funds, bank should insist on regularly receiving performance reports and in case of adverse developments should immediately discuss the matter with the client and take corrective measures. Last, if it is found that results are subjected to manipulation, the bank should either exercise its right to acquire the equity so as to replace the management, or immediately recall its funds, and get the enterprise black-listed with the entire banking and financial sector. In addition, the matter should be reported to other government agencies such as Income-tax Department and also to one of banking tribunals set up by the Federal Government of Pakistan) for recovering amounts due plus penalties.

Some express fear that interest-free banking may lead to a fall in the rates of return on deposits as compared with interest rates, thereby adversely affecting mobilisation of deposits and savings so urgently needed to meet the growing needs of industry and trade. Since rates of return on deposits are not predetermined and fixed under the interest-free system, depositors may feel shy to entrust banks with their savings. In actual fact there is no strong relation between rates of return, whether in the shape of profits or interest, and behaviour of bank deposits. There have been instances, particularly in some Western European economies, where the inflation rate was more than the prevalent interest rate, yet deposits increased. Deposits also registered a fall when real rate of interest was higher. Pakistan's experience shows that while there have been variations in profit rates on profit/loss deposits from bank to bank and from period to period, and also these profit rates have generally fallen below the previously quoted interest rates, deposit mobilisation has progressively increased even in the case of banks which declare lower profit rates. It can, therefore, be reasonably assumed that deposit mobilisation would not be affected adversely under the interest-free banking system. On the contrary, it is expected that even those persons who were not depositing their money with the banks on religious grounds would now place their deposits with the banks. So industry and trade should not suffer because of lack of funds. However, other factors like credit restrictions imposed by the government or the State Bank (of Pakistan) may affect the interest-free system as much as they affect the interest-based system.

Three more apprehensions are noteworthy. First, the cost of funds to trade and industry is feared to rise. In actual practice, costs of funds are determined by general marketing conditions and have nothing to do with interest-based or interest-free financial framework. Second, fears are expressed about the likelihood of collusion between the bank staff and the parties seeking finances. This is an issue concerned with the overall moral framework of society. Malpractices exist even under the interest-based system. Anyhow, procedural regulations and safeguards can be framed, with the help of the State Bank (of Pakistan), to check bungling of accounts. Third, the business community fears that a system based on profit and loss sharing will result in undue interference by banks. This fear seems to be fallacious as banks will not have adequate trained staff to sit on the management of thousands of enterprises to whom they provide funds. The bank will generally exercise monitoring and supervision by calling for certain returns periodically, which they do even under the interest-bearing system.

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Foreign Investments and Loans

Some persons apprehend that if the interest-free system is introduced, the economy will suffer as foreign investments and loans will not be forthcoming. Such persons have not gone into the issue very closely. Foreign investments are always project related and generally in the shape of equity participation. Foreign loans may or may not relate to project financing but banks advance loan for projects. Such loans are used for procurement of equipment and services of technicians. Goods can be acquired on mark-up basis instead of loan. Islamic Development Bank is already following this procedure. The marked-up price can be in terms of foreign currency, payable in instalments. The cost of services of technicians or preparation of feasibility reports where required can be included in the marked up price of the machinery supplied. The writer was once invited by Pakistan - Japan Business Association to allay the fears of visiting Japanese investors and industrialists who after detailed discussion were completely satisfied about the viability of interest-free system. What is required is a proper understanding of the system by Pakistani financial experts and critics and its knowledgeable explanation to foreign investors and lenders. In the meantime the interest-based system may be allowed to continue till such time as foreign transactions are brought under the interest-free system through negotiations with the parties concerned.

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Wider Socio-Economic Implications

(a) In the case of fixed return on capital, as is the case with lending on interest, capital gets preference over man's labour. Uncertainty is inherent in a business enterprise, irrespective of time and space dimensions. Occurrence of profit or loss and its magnitude cannot be fully determined in advance. It is, therefore, sheer injustice if the party providing money capital is guaranteed a fixed and pre-determined return while the party providing enterprise is exposed to uncertainty all alone. Further, fixed interest can be unjust to the lender of money in case the entrepreneur using his money earns a profit quite out of proportion to what he pays by way of interest. Profit/ loss system will remove this imbalance between reward for capital and that for human endeavours and initiative.

(b) It is generally stated that interest is a price like all prices and performs the function of allocating scarce loanable funds among infinite users of such funds in an objective manner on the basis of ability to pay the price. If demand for or supply of loanable funds changes, a new equilibrium is reached at a different rate of interest. The equilibrium rate of interest is only a text-book phenomenon. In realty such a market clearing rate does not exist. There are a host of rates and the function of allocating resources optimally is not performed efficiently. The rate of interest tends to be a perverted price and reflects price discrimination in favour of some.

Introduction of profit/loss sharing system should be able to redistribute profits of big businesses among depositors and small enterprises, bringing about greater efficiency in the allocation of resources and reducing concentration of wealth and power.

(c) Profit/loss sharing system will not only enable a bank, an independent institution, to have a critical look at the project feasibility before its acceptance but also to do proper monitoring after its implementation. This extra care, both before and after implementation, would keep the project on sound footings. Although banks, even under the interest-based system, look into feasibility of the borrowing venture, then main concern is about the adequacy of security for their loans. Under the profit/loss sharing system banks will per force have to develop expertise within their own institution to study the feasibility of projects and to ensure proper monitoring of such projects after their implementation.

(d) By spreading risks more evenly, profit/ loss sharing system will encourage more economic activity and thus improve the welfare of society. A happy and progressive society is that where all its members join hands in the process of production of goods and services for society and bear the risk equitably.

(e) The malpractice of maintaining different sets of books is resorted to by enterprises mainly for evading taxes. Under the profit/ loss sharing system enterprises obtaining funds will show profit, if they have earned, at least to the extent of rate acceptable to the banks. This will, therefore, bring more enterprises under the income tax net and thus increase public revenue. With the increase in its revenue, the government may be prepared to consider rationalisation of existing income tax rate structure.

(f) Under the profit/loss system, the entrepreneur will per-force be required to maintain a high standard of efficiency because of regular monitoring by the bank. Otherwise, in the event of unfavourable results, he is apt to be exposed to criticism.

Reprinted from 'The Pakistan Banker" by kind permission of the Bank of Punjab, Lahore.


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