Lending and Borrowing: An Overview

By A.L.M. Abdul Gafoor

Appropriate Technology Foundation

Groningen, The Netherlands

Lending and borrowing between humans has taken place since time immemorial.  People borrowed and returned implements, animals, foodstuff, etc from their friends, neighbors and relations.  They returned the same after use or in the case of foodstuff consumed and returned the equivalent when they came into possession of similar stuff.  When money came into being people borrowed that too and returned.  It was all on the basis of mutual help — the borrower today may be the lender tomorrow and vice versa.  As time progressed professional moneylenders appeared on the scene, and they demanded a “fee” for the use of their money.  This fee is now called interest, but till a few centuries ago it was called usury.  In Islam, interest or usury, which in Arabic is called riba, is prohibited.  Demanding, receiving, paying, witnessing, and anything connected with these activities are all equally prohibited.  There is no controversy over this.  Similar prohibitions exist also in the religious laws of Judaism and Christianity.  Although other religions may not have written laws explicitly prohibiting usury, their followers do eschew the practice of usury. 

1.1  Lending and borrowing: then and now

In earlier times, lending and borrowing was mainly between individuals, and what was meant by usury in these transactions was commonly known and understood.  In money matters, any amount over and above the lent sum was defined as usury or riba.  The ill consequences of usurious lending — the ruination of individuals and families — were witnessed at the local level and therefore the community held the practitioners in contempt.  But the need for capital and loans existed and, in the absence of alternative solutions, the usurious lenders became an indispensable component of the society.  They also exercised invisible power over their clients’ resources.  If the clients happened to be in authority, the power extended to other areas as well; the greater the client’s authority the extensive the power of the lender. 

Kings and nobles needed money to wage war or to live extravagantly.  Moneylenders were happy to oblige, not only for the profit it brought them but also for the privileges and concessions they could extract from their royal clients.  Mining concessions, special trading licenses, tax exemptions, lucrative contracts for public projects, land grants, and personal privileges such as royal titles and appointments to influential positions are just a few examples.  These dealings were carried out discretely and the public was generally ignorant of them.  But the citizens paid the price, one way or another.

The most important concession so extracted was the passing of the Usury Law.  This law introduced an innocuous term called interest and usury was defined as high rate of interest.  Usury was still prohibited, in deference to the Church, but “reasonable” interest was made permissible.  What is reasonable and what is high was to be determined by the parliament!  Now that interest is legal, kings may lose their thrones, soldiers may lose their lives, families may lose their livelihoods, but the country must pay its debts with interest.  Moneylenders extracted their pound of flesh. 

In recent times, presidents and ministers have replaced kings and nobles, and corporate and international financial institutions the individual moneylenders.  The same game, only new names and wider settings.  It is now global, the suffering is universal, and the statistics are in the public domain.  Yet, hardly anyone dares to point the finger at the real culprit — usury, whatever the legal name it may assume.  Neither are the real needs objectively looked at.  Consequently, no meaningful alternatives are offered.

1.2  Lender, borrower and the Church: different goals

Governments, businesses and individuals need money for various purposes.  The methods of catering for these needs must match the purpose for which the money was needed.  A mismatch can lead to disastrous consequences, but this requires much thought and effort.  Borrowing is an attractively easy solution, and this is what the moneylender would recommend for all situations, for it is the most profitable one from his point of view.  When the borrower is impatient or desperate and the only game in town is the moneylender, borrowing from him is the only option and the consequences are inevitable.  To avoid disasters, then, we have to first study the different purposes for which money is needed and then devise methods most appropriate to each purpose.  We have to provide more alternatives.  The moneylender has only one purpose and concern: his profits and benefits.  But the society has more and larger concerns, for it is its responsibility to cater for and protect all its members, individually and as a whole, those living now and those still to come.  In this connection, it is well to remember that all the basic rules, methods, procedures and laws relating to banking and finance were either formulated by the moneylenders themselves or they had a hand in their design and/or execution.

When the usury law was proposed, it was argued that the merchants needed financing, they made profit using the borrowed funds and, therefore, they had the ability to pay the financiers a portion of that profit.  Very reasonable.  The trouble was, once the law was passed, it was applied to all situations — whether the borrowed funds brought about a profit or not.  The Church had become too weak but still dogmatic, and the merchants and moneylenders too strong.  The Church could not grasp the new need, brought about by the increased trade in Europe, and failed to provide an appropriate solution.  Nor could it argue successfully to limit the application of the new law to trade financing only.  Neither did it demand that the law should not be applied to non-profit-creating loans intended for basic consumption needs.  It seems that the Church granted the moneylenders a blank cheque on a platter, by default — by its all‑or‑nothing insistence on a complete prohibition and by failing in this dogmatic stance.

1.3  Islamic approach: different consequences

In Islam, the situation was different.  First, from the beginning of the history of Islam in the seventh century, the (large-scale) merchants’ need for (additional) funds was fully recognized and provided for.  There were two ways in which a merchant could finance his trade.  One: two or more merchants could pool their funds together and conduct the business together and share the profit or loss according to their (financial) contribution.  This was called musharaka, similar to the present-day partnership company.  Two: a merchant could obtain his funds from one or more financiers and share the profit with his financiers in an agreed proportion.  But he has full freedom in the conduct of his business, and any genuine financial loss must be borne entirely by the financiers.  This was called mudaraba, similar to the present-day shareholder companies.

Consequently, while the riba-prohibition of Islam related to all lending and borrowing operations, it took special note of the financing needs of traders and businessmen as well as the investment and income generation needs of those who possessed extra funds.  It does not mean that riba is acceptable in these cases; it is prohibited here too.  But a different and equitable solution was already available in Arabia when the Qur’an was revealed; so it approved of it and went onto prohibit riba in all cases.  Therefore, the merchant-need-based and return-on-investment-based arguments of Europe were not relevant or valid in the case of Islam and Muslim lands.  It is necessary to recognise this fact.  That is, the all-embracing usury-prohibition law of the Church and the riba-prohibition law of Islam are not exactly equivalent, despite the similarity of appearances. 

Second, throughout the long history of Islam, Muslim caliphs, kings and nobles have, by and large, kept away from borrowing at interest.  Even though many of them had their share of shortcomings — in common with their counterparts elsewhere — their belief in after-life and the strong words used by the Holy Book against the dealers in riba kept them away from it.  The same applied to all would-be moneylenders as well.  This saved the Muslim masses and the society from many of the ills experienced by other societies, even though this blessing goes generally unrecognised and unappreciated.  Even under colonialism they have enjoyed this benefit.  However, it would be naïve to believe that there existed absolutely no riba-based lending and borrowing, but it certainly was personal, local, small, isolated, discrete and unorganised.

Only in the second half of the twentieth century, especially after many countries became independent, established their own governments, and had to run the affairs of the country on their own, that they began to experience the claws of interest through the banking system.  They needed the banking system because it provided the various services needed by the different sectors of modern society.  But the moneylenders had developed it for their own benefit, based on the all-embracing usury law.  It did not make the differentiation the Qur’an had made.  Muslims had slumbered through the formative years of the modern world, and failed to build on the head start they had and shape a business and banking model to suit modern needs.  Yet their desire to comply with the commandments of their Creator did not die.  Their leaders and intellectuals have awoken to the demands of their constituents, experiments with Islamic banking have begun, but there is still a long road to travel.

1.4  Lending with and without interest

Before we travel further, let us state clearly what we mean by interest and riba and then note the difference between lending/borrowing with and without interest, usury or riba.  Limiting ourselves to monetary dealings only,[1] any benefit demanded or received by a lender in addition to the sum he lent is termed riba.  This would, however, include both monetary and non-monetary benefits.  Interest, on the other hand, would legally limit itself to monetary benefits only.  It is useful not to forget this difference and its significance.

When a person lends without any benefits to himself, he is bound to assess the ability of the borrower to pay back the capital as well as to ensure that the capital is to be used for a purpose that he approves of.  It is also a condition of such borrowing that the lender and the borrower are known to each other or that a reliable mutual friend/relative/acquaintance has introduced them.  In such a situation, there is an unspoken moral/ethical responsibility (and a sense of shame and reluctance, otherwise) in asking, recommending or granting such a loan. 

All these restraints are absent when the lending is done at interest.  The lender assesses only the borrower’s ability to (or the means to) repay the capital and the interest.  A collateral is usually demanded, and by the very nature of interest — its dependence on time — the lender expects that he would eventually be able to acquire the collateral at a favourable price.  Both the interest and the possibility of acquiring property at very low cost drive the moneylender to readily accede to request for loans, as well as to encourage such requests.  Thus, when riba or interest enters the picture, the attitudes of both the lender and the borrower head in a direction directly opposed to the one prevalent in its absence.   This riba-induced change of attitude is remarkable, as are the opposing characteristics of the two attitudes.  One discourages debt, and the other encourages it.  One restrains expenditure on morally or ethically unacceptable items and purposes; the other places no such restrains.  One is open to social control, the other not.  One limits both the size of borrowing and its frequency; the other encourages increase in both.  One encourages short-term loans; the other thrives on long-term arrangements. 

The last two are very interesting.  For since more and larger loans would bring more profit to the lender he would try to acquire more funds.  This eventually led the moneylender to borrow from others at low rates of interest and use the same funds to lend at higher rates, as if it were his own.  The bank’s credit-creation technique was also developed for the same end.  Furthermore, long-term loans provide a stable and steady source of income to the moneylender.  This and the availability of increased funds led the banks to widen their reach and, in recent times, to enter previously untapped areas such as housing finance and student loans.

1.5  Need for money

Let us now examine the need for money in some detail.  To begin with, there are purposes that bring profit, and others that do not.  Within these two categories there are necessary, unnecessary and harmful purposes.  In the modern world one has to also make a difference between the needs of individuals, business organisations and governments.  Let us take them in turn.

1.5.1  Extravaganza and vanity

When the borrowing is for extravaganza or vanity, the borrowed fund produces no profit.  Therefore, if the borrower is unable to repay the loan and interest from his other income sources, the interest would keep on mounting and the moneylender would eventually confiscate the collateral.  All religions and sages throughout the ages have condemned extravaganza and vanity, and have advised against it.  The Qur’an has specifically prohibited spending in vanity.  Here the reference is to one’s spending from his own resources, and the onus is on the individual.  As such, if one engages in such spending using borrowed money, he is seeking his own doom.  Yet, by making the riba-prohibition applicable to both the lender and the borrower, Islam seeks to protect people against their own selves.  If there is no borrower there will be no lender; if there is no lender there will be no borrower.  This closes all doors to doom.  Thus there is no need to find any other solutions to the apparent need of the extravagant.

1.5.2  Housing and education loans

Housing and education are real needs, and therefore their financing deserves close attention.  Building or purchasing a house is obviously a capital acquisition.  So is education, though it does not seem that obvious.  Capital acquisition has always been done using one’s own savings or wealth.  It should continue to be so.  House-owning leads to individual and collective independence.  In turn they add to national wealth and well-being.  This fact is recognised by wise governments and they actively encourage private initiatives.  Free education has produced wonderful results in the twentieth century. 

However, the modern trend, especially in the developed world, is to have them financed by long-term bank loans.  But unlike the loans for commercial purposes these loans produce no immediate profit to the borrower.  Yet, to a moneylender a loan is a loan, and from his point of view these have some attractive advantages, including a secured regular return guaranteed for a long period.  In many developed countries the fiscal laws encourage borrowing and discourage saving/investment/capital acquisition by taxing the interest/dividend received from the latter and granting tax exemption to the interest paid on loans.  These laws enable the banks to price the products very attractively and encourage mortgages, but the subsequent experience of the borrower and the effect on the nation are different. 

For example, a house-owner who bought it on mortgage remains a debtor for practically the rest of his working life and ends up paying several times the original price.  On the other hand, if he fails to pay his instalments on time, he is kicked out as if he were only a tenant.  A student forced to take a loan for his education leaves college/university with a certificate and a millstone round his neck.  He may become a government administrator, business executive, politician or any other, but he is still a bonded man.  And a bonded person cannot think or act independently.  Anyone whose parents are too poor or unwilling to pay for his education, and himself refuses to be bonded, is denied higher education.  It is a national tragedy.  These characteristics of housing and education set them apart from other needs. Therefore these require special treatment.   

1.5.3  War

Wars, in general, bring only death and destruction to people and property — never any profit.  The winner and the loser are both losers in the end.  If a war is fought by borrowing money at interest, win or lose the country will have to pay the debt with interest, and borrow again to rebuild.  Whether the war was an offensive one or a defensive one, in the end, only the moneylenders celebrate — on both sides.  Consequently, in history as well as in the present time moneylenders have played an important behind-the-scenes role in both beginning and prolonging wars.  Only a total prohibition of riba on both the lenders and borrowers and its adherence at all levels, especially at the highest levels, could eliminate this factor in the war equation.  Since everyone is a loser in a war, it is in everybody’s interest to avoid any war; eliminating its financing by funds borrowed at interest will go a long way in this effort.  Therefore we need not seek any other solution to this contingency.

1.5.4  Government expenditure

Government expenditure consists of two types: capital and current.  The funds for both are expected to come from taxation.  So a government’s ability to acquire capital goods — to buy equipment and material and to build roads, bridges, schools, hospitals, communication infrastructure, etc — are dependent on, and limited by, the tax revenue.  However, the current expenditure, such as salaries of government officers, supplies and maintenance, has priority over capital expenditure.  Often, like in the case of an individual, little is left over from the tax revenue for capital expenditure.  Consequently, since all capital expenditure cannot be postponed indefinitely, there arises a budget deficit.  A budget deficit is financed by printing money, borrowing, or both.  Printing money leads to inflation, which is a tacit form of taxing the population.  Borrowing increases national debt and interest payment.  Credit creation by banks based on the new money (printed or borrowed) increases inflation even further. 

1.5.4.1 Government bonds

Government bonds is one of the instruments used for borrowing money.  Since capital expenditure on infrastructure does not produce any profit, borrowing at interest leads to additional current expenditure in the form of interest payments.  This in turn requires curtailment of other current expenditure or further borrowing.  Government bond is big business, it provides those who have money to spare with a great source of guaranteed return.  But the public debt it creates keeps mounting.  So does the interest on it.  And the inflation generated by money-printing and credit creation add onto the interest rate and lead to further increase of the public debt. 

Thus once a government begins to spend more than its tax income, or fails to tax sufficiently to cover its essential expenditures, it gets into a vicious cycle of borrowing to spend and spending to borrow.  To tax sufficiently the country must produce enough, and taxes are always unpopular.  Borrowing is the easy way out and the country finally ends up in the grip of the moneylenders — national and international — no matter which party or person runs the government.  The debt is open and legally binding but the grip — do this or return the loan, do that or no more loans — is unseen, undeclared and least understood, and hence more hideous.  It is a great mystery, though, that developed countries with very large national debts keep on prospering, while underdeveloped countries with much smaller debt burdens crumble under it.  However, this is no place to probe into that mystery. 

1.5.4.2  Treasury bills

It is a time-honoured practice of any individual to spend on his needs from what he has earned.  If there is no more money left, he either curtails his spending or postpones it till he comes into sufficient funds.  If his income is fixed and regular, such as that of a salaried employee, and he finds himself short of money at the end of the month, he must curtail his expenditure.  Otherwise he will find himself at a worse position next month because his income is not going to increase next month, but the gap would have doubled.  If, instead, he borrows to bridge the gap he will have to borrow the next month and the following month too — an increasing amount every subsequent month.  Eventually he will have to borrow to eat, and pay the loan as soon as he receives the salary and then borrow again for the expenses of the next month.  Suppose he borrows at interest, then he will be bankrupt very soon on account of the interest payments, even though he continued to work and earn.  One could get out of this situation only by earning more or selling some property and paying off all the debts and begin to live within the income and spend only from already earned income.  Or by severely curtailing his expenditure, save and pay off the debts, and by living within one’s means from then on.   

In the case of government current expenditure too, somewhere along the line, they threw away the time-honoured practice of spending from realised earning (collected tax) and began to borrow and spend, expecting to repay when the tax revenue came in.  This committed them to an interest payment cycle.  An instrument called the Treasury Bill was developed for this purpose.  This, in effect, is a three-month loan, interest paid in advance.  The funds are used to pay the current expenditure for the next three months and the loan is paid from the taxes collected at the end of the quarter.  New treasury bills are issued every quarter, month or week.  The cycle goes on.  An elaborate set of financial tools and markets are built around this.  So elaborate that no one remembers when, how or why it started in the first place, or how it keeps perpetuating itself.  It is a given in Finance and Government, and theory and practice have canonised it.  Moneylenders (private individuals, banks, financial institutions, insurance companies, pension funds, etc) thrive on it, and a whole army of professionals service it.  But the general public pays for it, suffers the consequences, and is blissfully unaware of what is happening to it.  Enlightening the public further on this point is not within the purview of this essay.[2]

1.6  Islamic banking confusion

Islamic banking is rooted in the facts that riba is prohibited and trade is permitted, and the profit resulting from trade is permissible income.  By extension, it was argued that interest, which is equated to riba, must be replaced by profit.  To achieve this, lending transactions must be replaced by trading transactions.  This simple concept is religiously applied to all situations.  Where the difference was not clear, legal devices were adopted to dress it up as trade and profit.  One may cheat himself, but can you fool God?  He may be amused by our poor attempts, but does He approve of it?  Whatever God does or does not, others are laughing at us.  Sincerity is supposed to be the bedrock of our relationship with God.  If we are sincere in our efforts to obey His commands, He will certainly show us the right way. 

When the commands were issued 1400 years ago, they were directly understood in the context of the social and economic environment then prevailing, and their application was easily achieved.  Today, the environment has changed and that makes the application seem difficult.  But the solution is not through legal devices, but through our studying and understanding the new environment and sincerely seeking to apply the commands without any adulteration.  Trade and profit have their place, but it is not appropriate for all occasions.  We have to explore other options.  If our intention is sincere, He will certainly guide us to the right solution.

1.7  Solutions

By looking at the needs of society, we can identify three different kinds of needs — investment and finance, banking and loans, and charity — and they each need be handled using a different technique.  Moneylenders offered one solution for all three needs because it was to their advantage, but the society has to cater for larger concerns and therefore must offer more appropriate solutions.  The Qur’an points out these different needs and presents us with different techniques to suit each need.  It is for us to translate them into present-day “language” and set up appropriate institutions.  Outlines of such institutions are presented in another essay (see Meeting the Financial Needs of Muslims: A comprehensive scheme).  Other essays elsewhere expand on these outlines.

Properly dealing with lending and borrowing transactions requires an understanding of the meaning of modern bank interests in relation to usury and riba.  In an essay entitled, Interest, Usury, Riba, and the Operational Costs of a Bank, the history of interest, its relation to usury and riba, the origins of dogmas and theories that prohibit or justify its practice, and the meaning of interest in the modern setting of banking are explored.  It also presents a general model of interest in which several scenarios — from person-to-person lending to modern commercial bank lending — become sub-models.  This enables one to separate riba from the operational costs of a bank and thus to devise a riba-free system of commercial banking that is both viable and compatible with the conventional one.

Inflation has become a fact of life, it erodes the value of capital — depositors’ savings, banks’ loans, cash-in-hand.  It has also been offered as an excuse for charging and accepting interest.  But the main cause of modern-day inflation is not in the short-term supply-demand  pull-push tensions, but in the long-term effects of increased money supply.  The basic cause of this increase is the de-linking of the currency-gold relationship.  It occurred gradually over time, but the final blow was dealt in 1971 when the US dollar was de-linked from gold and the promise to redeem every dollar for 1/35th of an ounce of fine gold was withdrawn, reneging on the Bretton Woods Agreement of 1945.  US dollar was allowed to float (meaning more dollars were printed without the constraint of the 35 dollars per ounce of gold ratio), and the other currencies, which were all linked to gold through the dollar, also started their free-floats, each in its own pace.  Today, at 350 dollars an ounce, gold is ten times more costly.  It is said that the price of gold has gone up; but the reality is that the currency has depreciated that much.  Re-linking all currencies directly to gold, and strictly adhering to the agreed currency-gold ratio, is the proper solution to this problem.  But a global agreement on this is not going to occur anytime soon.  In the meantime savings, loans and cash-in-hand are going to lose their purchasing power.  To neutralise the effect of inflation (due to currency depreciation) on capital, without recourse to increasing the interest rate, a new mechanism is necessary.  Such a mechanism is presented in a book entitled, Commercial Banking in the presence of Inflation.  This mechanism is applicable in person-to-person lending-borrowing transactions as well.  It is straightforward and not difficult to implement.

 

*****

 

References:

1.       Emry, Pastor Sheldon, Billions for the Bankers – Debts for the People.  Free distribution booklet, undated.  Also available at: http://www.justiceplus.org/bankers.htm, and downloadable from: Billions.exe.

2.       Gafoor, A.L.M. Abdul, Commercial Banking in the presence of Inflation.  Groningen, the Netherlands: Apptec Publications, 1999.  Published in Malaysia by A.S. Noordeen, Kuala Lumpur.

3.       ……….., Interest, Usury, Riba, and the Operational Costs of a Bank.  Article available at the author’s websites: www.IslamicBanking.nl and http://users.bart.nl/~abdul/

4.       ……….., Meeting the Financial Needs of Muslims: A comprehensive scheme.  Article available at the author’s websites: www.IslamicBanking.nl and http://users.bart.nl/~abdul/

Islamic Banking – A $300 Billion Deception

Author : Dr Muhammad Saleem

ISBN: 1599268698
ISBN-13: 9781599268699

Publisher : Xlibris Corporation

About the book
This book assesses the underlying rationale of Islamic banking, that the Quran prohibits all forms of interest. The author maintains that, first, a correct interpretation of the Quran, keeping in mind the context, would indicate that what the Quran prohibits is usury

Evolution of Islamic Banking and Insurance

Evolution of Islamic Banking and Insurance as Systems Rooted in Ethics Mohammad Nejatullah Siddiqi, Professor, Centre for Research in Islamic Economics, King Abdulaziz University, Jeddah, Saudi Arabia, read this paper at the College of Insurence, NewYork in Takaful Forum, April 26, 2000. 

Mr. President, Brothers and Sisters It is heartening indeed to see that the subject of insurance has at last started getting the attention it deserves. Your Forum and the presence of distinguished scholars as well as practitioners in the field of Islamic insurance and banking is reassuring. I have come to learn and refresh myself on the subject. But in compliance with the wishes of the organisers, especially my friend Omar Fisher, I venture to make some observations which could provide a perspective to the other presentations and deliberations. 1. Economic Progress Man has needs which he seeks to fulfil in ways available. One such need is exchange as no one can survive, much less live efficiently, on what he himself can produce. In the beginning there was barter but it was problematic and inefficient. Soon some objects came to be used as means of payment. These could be carried over time, so we had ‘money’ serving as medium of exchange as well as store of value. Providing for future needs led man to invest in order to enlarge the scope of what could be done – that was money as ‘finance’. As trade developed within and between regions and communities the role of finance increased and financial intermediation became a possibility with new promises. Modern banking spread with the social acceptance of bank credit, fractional reserve and paper currency, enabling an increasing population to cope with larger and larger volumes of trade and investment in a fast expanding world. With each new development new risks appeared. The farther into future man looked the more uncertainty he encountered. Handling risk and uncertainty became an increasingly prominent aspect of economic life even for ordinary men and women. Early ways and means of handling risks and uncertainty took simple forms of cooperation between the near and the dear. Pooling, sharing, diversification all occurred within the framework of trust, reciprocity and mutuality. That was insurance / takaful. As uncertainties increased and risk became more complex shifting risks to those willing to take them (in expectation of gain, of course) and unbundling them into manageable parts took new forms. The earlier simple stratagem of insurance and coinsurance among people brought together by kinship or vocation or trade … yielded to more sophisticated arrangements open to wider groups of people. Sometime along this bumpy road man hit upon the Law of Large Numbers and the Law of Averages. This discovery reinforced a lesson learnt in antiquity: By coming together men could face risks and uncertainties they could hardly cope with individually. That I believe is the core idea behind insurance and takaful just as financial intermediation is the core idea behind banking. Both have had revolutionary impacts on economic progress, each in its own way. 2. Ethics Running parallel to the saga of economic progress is another thread, the ethical imperative of doing things in a manner that does not harm others or violate social interests. Even though morality is a human need in the sense that man’s felicity and ultimately his survival depends on ethical conduct, in reality ethical conduct does not always obtain. Men misbehave. They act in immoral ways, one harming other. Some violate public interest. Ultimately these end up harming themselves too. This necessitated reminders and warnings and a reaffirmation of ethical conduct. It also necessitated arrangements for information, its acquisition and dissemination as well as preventing its withholding where due. Prophets and saints, philosophers and statesmen, and many ordinary men and women of strong commonsense kept reminding and warning that economic activity must be informed by public purpose and a care for the interest of others along with serving the interests of the actor himself. They also emphasised truthfulness, the key to information. Islam has legislated the minimum of morality necessary for human felicity, leaving for persuasion and voluntary compliance higher standards of morality which could make life better, more decent. Prohibition of riba (interest) and maysir (gambling) along with the strictures against telling lies, fraud and deception and breach of contract are the most relevant provisions of Shariah, insofar as economic activity is concerned. Given these, helping behaviour and regard for public interest could ensure good society so far as the economic aspect is concerned. It is in this perspective that one should see how modern banking and insurance were handled by the Muslim peoples. When they came out from under colonial rule they scrutinised these arrangements in the light of Islamic laws and ethics. This was necessary as these artefacts had evolved into an alien ethos and planted in Muslim societies by rulers with little regard to the interests of these societies or their norms and values. Let us first see what the Muslim mind did to banking. 3. Islamic Banking Beginning the middle of the twentieth century projects were launched to establish banking companies which would neither pay interest nor earn interest. Bank-depositor relation would be based on the depositor sharing the profit accruing as a result of the bank’s profitable use of the deposits pooled together. On the asset side a number of ways were tried to earn profits including partnerships and profit-sharing (mudaraba) with businessmen. Many Islamic banks entered into business directly, buying and selling commodities, land or real estate. Experimentation soon led to what is currently the predominant form of Islamic finance, i.e. murabaha. In this mode of finance the bank buys something on the specific request of a client and sells it to that client at a price higher than the purchase price, to be paid after a period of time. Leasing and prepaid orders (salam / istisna) were also used as profitable employment of the pool of deposits. In a nutshell, the core idea behind commercial and investment banking, that of financial interemediation, was retained but the ethically repugnant practice of interest on loans was discarded. Within a short period of fifty years, the first half of which was devoted mainly to theory and model building, Islamic banking established itself as an alternative, claiming ethical superiority over conventional banking. What is unethical about riba / interest to evoke such a response to interest-based banking from the Islamic civilization? The Quran (2:279) characterises it as unfair, as implied by the word zulm (oppression, exploitation, opposite of adl i.e. justice). Man’s environment does not guarantee positive return to productive use of money capital as value productivities lie in the future surrounded by uncertainty and risk. Some risk is involved in the productive use of money capital which, in fairness, the supplier of money capital must share if he wants a share in the profit of productive enterprise. A loan seeking positive return must share the risk involved in its use, otherwise it is to be returned without increase. As argued by Islamic economists this unfairness at the root of conventional banking is bound to affect its efficiency also as money capital would tend to be allocated on the basis of credit-worthiness of the borrowers rather than expected productivity of the projects being financed. They have also demonstrated how interest contributes to the instability of the capitalist system. All this refers to loans to business enterprises. When it comes to consumption loans the unfairness of interest and its negative impact on society become more obvious. Whether for business or for consumption, interest on loans violates the cooperative nature of man’s life requiring fairness and care for others. 4. Islamic Insurance The story of Islamic insurance is no different. One issue was to avoid interest in the investment of the contributions / savings / premia deposited by those taking insurance. That was easily done as the establishment of Islamic banks preceded the establishment of Islamic insurance companies. As a matter of fact the first Islamic insurance company was established towards the end of 1978 at the behest of the Faisal Islamic Bank of Sudan. Now Islamic insurance companies have a whole range of Islamic financial instruments in which to invest. The other ethical imperative was to prevent insurance from degenerating into gambling. Gambling inheres into games of chance played for a gain. The activity is created or voluntarily entered into. It is not like the chances one has to take in the ordinary business of life, i.e. the risks and uncertainties attending upon sale, purchase, investment and production, even upon travel, choosing a career or choosing your doctor. The unambiguous examples of gambling are bets in horse race, in games of cards or on spinning a roulette wheel. The financial risk involved in gambling could have been avoided if the gambler wanted to do so, by not playing the game. Not so in the case of risks in productive enterprise, investment or travelling, for to avoid financial risks in these cases one has to give up not a game but the ‘ordinary business of life’. Like interest, gambling also violates the spirit of cooperation and fairness on which civilization is based. The appropriation of existing wealth already owned by some one by mere chance is unethical. Wealth is either appropriated directly from the (yet un- owned) pool of nature, or transferred to the new owner by the old owner as a gift, against a price or by inheritance. As the gains of the gambler do not belong to the first category we have to examine its legitimacy as a transfer from the old owner. The unethical nature of this transfer reveals itself if we look at the way the old owner must have come upon it. It is largely a product of work. As explained elsewhere ownership rights on the bases of work, inheritance or gift are ethically justifiable[1]. They have a rationale, serve a social purpose and do not violate fairness or the spirit of cooperation. Allowing wealth to be transferred by pure chance would make a mockery of that rationale and the social function of ownership. It would be unfair to transfer wealth acquired on the above mentioned grounds to one who does not qualify on any one of those grounds. One need read the whole passage[2] to appreciate Wali Allah’s conclusion that “Both ways of gain (i.e. maysir and riba) are tantamount to inebriation, as they are in flagrant contradiction with the principles God has laid down for earning a livelihood”[3]. 5. The Core Idea Behind Insurance Modern insurance (Takaful) is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a very large number of similar individuals. ‘Insurance by combining the risks of many people enables each individual to enjoy the advantage provided by the Law of Large Numbers.[4]’ Of course the numbers are not usually ‘large enough[5]’ so that actual values deviate from the expected values. The theory of risk seeks to analyse these deviations. Theories seldom reach perfection, yet practice fumbles on as life in the modern metropolis is hardly possible without insurance, especially in societies with shrinking nuclear families and neighbourhoods of diverse ethnic groups. Insurance, however, is only one form of handling risk by pooling or unbundling and/or shifting it to those who are willing to take it in expectation of a gain. One other form is the market for common stock. As explained by Kenneth Arrow, ‘By this means, the owner of a business could divest himself of some of the risks, permitting others to share in the benefits and the losses. Since each individual could now own a diversified portfolio of common stocks, each with a different set of risks attached, he could derive the benefits of a reduced aggregate risk through pooling: thus, the stock market permits a reduction in the social amount of risk bearing[6].” Arrow has also pointed out that ‘insurance is a very subtle kind of contract; it is an exchange of money now for money payable contingent on the occurrence of certain events'[7]. It is this subtlety that has been causing problems for contemporary Islamic jurisprudence which failed to take a macro view of the matter. In order to avoid endorsing ‘contingent’ payments which obviously involve gharar, under pressure from the necessity of insurance, some have tried to model it on altruistic giving (tabarru`) or charity. But the notion of charity can hardly survive the explicit reciprocity involved in takaful. The gharar / uncertainty involved in the contract between one individual and the insurance company, because of the contingent nature of the payment, tends to disappear when large numbers are involved. What is still contingent for the individual becomes routine for the group as a whole as well as for the company[8]. 6. Commercial Vs. Cooperative Insurance Since the core idea on which mutual insurance or takaful is based is the same as behind all insurance, the distinction between mutual and commercial forms of insurance is a matter of organisation, not a matter of substance. When the give and take involve large number of people some coordination would be necessary. Such coordination has to be paid for. The manager may receive his salary from a mutual or a commercial, the activity remains the same. The choice between the two forms of organisation should be guided by considerations such as efficiency, transparency etc, in short, on maslaha, good of the people. The form of the organisation does not affect the legitimacy of the activity itself. It is not good reasoning to characterise mutual insurance as cooperation and commercial insurance as illegitimate profiteering. As Ibn Khaldun remarked[9], trade itself is a form of cooperation: “Man cannot survive as an individual in isolation, by his very nature he needs cooperation to get what he requires. This cooperation inevitably involves, first quid pro quo (mu`awada) then sharing (musharaka) and other forms”. In fact for – profit activities often prove to be better coordinated than those done in charity – the lesson so succinctly taught by Adam Smith[10]. That these same require regulation and overseeing by Social Authority is not to be denied. Having said that, I have no intention to wish away the problems surrounding insurance. Regulators worked hard to purge insurance from elements of gambling in its early days. But the task is hardly complete as newer more subtle opportunities of speculation present themselves. Nor has the battle against fraud and deception ended. We have only to remember the breaking story of the Lloyd’s of London to convince ourselves to the contrary[11]. Then there is the perrenial issue of moral hazard; of insurance changing the behaviour of the insured in an undesirable way. There is no doubt a ‘dark side[12]’ to insurance. Neither the regulators nor the preachers can leave things as they are. Public intervention would always be called for to ensure fairness, elminate fraud and protect the consumer. Insurance is too important for modern living to be prohibited as a preventive measure (saddan liz zariah) No doubt it is vulnerable to fraud and deception, even gambling, but so are the activities in the share market, currency market, even in commodity markets. Rather, the correct approach would be for the social authority as well as consumer groups to exercise vigilance and introduce needed regulations. 7. The Future Islamic insurance is there to stay, whatever the organisational setup and whatever the juristic rationale. The question before forums like the present one is how to take it to Muslim homes and how to do this ethically i.e. carefully protecting the interests of the people concerned. As Islamic banks and Islamic funds proliferate, it should not be difficult for Islamic insurance institutions to tag on, entering into strategic alliance with these banks and funds. Also the ulama owe it to the community to endorse Islamic insurance as vehemently as they have endorsed Islamic banking so that the community can forge ahead with a clear conscience. Having efficient banking and insurance would still leave the larger issues of social justice and equity in need of attention. It is time we start doing that. But that beginning can be made only once we have left the exhausting as well as mind boggling job of wrangling with the formal legitimacy of insurance and some other financial contracts behind us. Shall we expect this Forum to make it possible. I pray for this. Join me, and thank you. © 2000 Muhammad Nejatullah Siddiqi End Notes:____________________ 1. Mohammad Nejatullah Siddiqi, Islam ka Nazariyah Milkiyat (Islam’s Theory of Property) Chapter II and III, Delhi, Markazi Makteba Islami, 1978. Shah Wali Allah of Delhi (1703 – 1762) saw the above clearly. As Baljon noted: “The requirement of mutual aid is, in the opinion of Shah Wali Allah, the main ground for the prohibition of maysir (gambling) and riba (interest)”

Introduction to Takaful

 

Islamic finance has developed mainly in two directions namely Islamic banking and Islamic insurance (Takaful). While information about Islamic banking is being increasingly disseminated, features, models and structures of Takaful are little known particularly in Pakistan. Purpose of this brief article is to describe main features and models of Takaful system operating in various parts of the world.

All human beings are invariably exposed to the possibility of meeting catastrophes and disasters giving rise to misfortunes and sufferings such as death, loss of limbs, accident, destruction of business or wealth, etc.  Notwithstanding the belief of all Muslims in Qadha-o-Qadr, Islam provides that one must find ways and means to avoid such catastrophes and disasters wherever possible, and to minimize his or his family’s financial losses should such events occur. One possible way out is to buy an insurance cover as in the conventional system. 

Different views have been expressed about the status of conventional insurance from the point of view of Islam. An overwhelming majority of the Shariah scholars believe that it is unlawful due to involvement of Riba (interest), Maisir (gambling) and Gharar (uncertainty).@ Takaful, the Islamic alternative to insurance, is based on the concept of social solidarity, cooperation and mutual indemnification of losses of members. It is a pact among a group of persons who agree to jointly indemnify the loss or damage that may inflict upon any of them, out of the fund they donate collectively. The Takaful contract so agreed usually involves the concepts of Mudarabah, Tabarru´ (to donate for benefit of others) and mutual sharing of losses with the overall objective of eliminating the element of uncertainty. 

Takaful is not a new concept in Islamic commercial law.  The contemporary jurists acknowledge that the foundation of shared responsibility or Takaful was laid down in the system of ‘Aaqilah’, which was an arrangement of mutual help or indemnification customary in some tribes at the time of the Holy Prophet (pbuh).  In case of any natural calamity, every body used to contribute something until the loss was indemnified. Similarly, the idea of Aaqilah in respect of blood money or any disaster was based on the concept of Takaful wherein payments by the whole tribe distributed the financial burden among the entire tribe.  Islam accepted this principle of reciprocal compensation and joint responsibility. 

The contract of Takaful provides solidarity in respect of any tragedy in human life and loss to the business or property. The policyholders (Takaful partners) pay subscription to assist and indemnify each other and share the profits earned from business conducted by the Company with the subscribed funds.  Takaful companies normally divide the contributions into two parts, i.e., donations for meeting mortality liability or losses of the fellow policyholders and the other part for investment.  Accordingly, the clause of Tabarru´ is incorporated in the contract.  How much of the contribution is meant for mortality liability and how much for investment account is based on a sound technical basis of mortality tables and other actuarial requirements.  Both the accounts are invested and returns thereof distributed on Mudarabah principle between the participants and the Takaful operators. The profit attributable to the participants is credited into the two accounts separately.  To describe from another angle, a Takaful contract may comprise clauses for either protection or savings/investments or both the benefits of protection as well as savings and investment. The protection part of Takaful works on the donation principle according to which individual rights are given up to indemnify the losses reciprocally. In the Savings part, individual rights remain intact under Mudarabah principle and the contributions alongwith profit (net of expenses) are paid to the policyholders at the end of policy term or before, if required by him.

The distinction between the conventional insurance and Takaful business is more visible with respect to investment of funds.  While insurance companies invest their funds in interest-based avenues and without any regard for the concept of Halal-o-Haram, Takaful companies undertake only Shariah compliant business and the profits are distributed in accordance with the pre-agreed ratios in the Takaful Agreement.  Likewise they share in any surplus or loss from the pool collectively. Takaful system has a built-in mechanism to counter any over-pricing policies of the insurance companies because whatever may be the premium charged, the surplus would normally go back to the participants in proportion to their contributions.

The terms ‘Family Takaful’, ‘Takaful Ta´awani’ or just ‘Takaful’ are generally used for family solidarity in place of conventional life insurances. Other products available in various countries are General Takaful, Education/Medical Takaful, etc. Based on the nature of relationship between the company and the participants, there are various models like Wakalah (agency) Model, Mudarabah Model and the combination of agency and Mudarabah models. In the Sudanese Takaful Model that is preferable to majority of the contemporary Shariah experts, every policyholder is also the shareholder of the Takaful Company. There is a Board that runs the business on behalf of all the participants and there is no separate entity managing the business. The legal framework in other Islamic countries normally does not allow this arrangement and Takaful companies work as separate entities on the basis of Mudarabah (as in Malaysia) and on the basis of Wakalah (as in the Middle East region).  In Mudarabah model that is practised mainly in the Asia Pacific region, the policyholders get profit on their part of funds only if Takaful Company earns profit.  The sharing basis is determined in advance and is a function of the developmental stage and earnings of the Company. The Shariah committee approves the sharing ratio for each year in advance. Most of the expenses are charged to the shareholders.  

In Wakalah Model, the surplus of policyholders’ funds investments – net of the management fee or expenses – goes to the policyholders.  The shareholders charge Wakalah fee from contributions that covers most of the expenses of business.  The fee rate is fixed annually in advance in consultation with Shariah committee of the company. In order to give incentive for good governance, management fee is related to the level of performance.

The Takaful business has proved its viability in a period of only two decades.  It has been growing at the rate of 10-20% p.a. compared to the global average growth of insurance 5% p.a. A large number of Takaful Companies exist in the Middle East, Far East, Iran, Turkey, and Sudan and even in some non-Islamic countries. There are over 60 companies offering Takaful services (including Windows- 5%) in 23 countries around the world. Malaysia has developed Re-Takaful business as well. Takaful products are available to meet the needs of all sectors of the economy, both at individual as well as corporate levels to cater for short and long term financial needs of various groups of the society.

A Convention of D-8 countries was held in Kuala Lumpur in November, 2002 on “The Emergence of Takaful in the Wake of Globalization”.  It is worth noting that among D-8 countries it is only Pakistan where Takaful business has not been introduced so far. Islamic banks and financial institutions require Takaful services for their operations. Although, the insurance business in Pakistan falls in the jurisdiction of the Securities & Exchange Commission, Pakistan, institutions operating Islamic banking would have to deal with insurance. As such, the Central Bank should desire that Takaful business be introduced in the country at the earliest.  In the revised Insurance Act, the Government of Pakistan has added the provisions for Takaful companies in the country.  As reported in the press, Pak Kuwait Investment Corporation has recently been allowed by the SEC to establish a Takaful Company in Pakistan under the name of “First Takaful Insurance Company Limited” with authorized capital of Rs 100 million.

By: Muhammad Ayub

 

Why Islamic Banks formed

AN INTRODUCTION

The Prophet said: “There will come a time for men when no one will be anxious about profits, whether lawful or unlawful” Bukhârî, Ventes (34), bâb 7.

One of the aspects of the Islamic renewal is the growing importance of Islamic banking organizations in economic life. With the oil boom, Arab states found themselves with a surplus of petro-dollars which had to be invested somewhere, and at the end of the 1970’s this situation led private groups as well as, occasionally, state enterprises to set up financial institutions in accordance with the spirit of Islam. Hence arose a whole host of banks proclaiming their adherence to the sharî’a and seeking to attract the new capital. Countries like Iran and Pakistan even Islamized the whole of their banking system, both for religious motives and also to show their disapproval of Western capitalism. There was even talk of an “Islamic economic theory”. There were international colloquia on the subject and Internet sites blossomed. There is already a substantial literature on this subject. Because of its topicality, it may be useful to try and examine the subject in greater depth. One can however deal here only with the essential problem. We shall look first at the ban on usury in the Koran and in the tradition, and then at juridical developments. Then we shall consider the different juridical attitudes in different Muslim countries.

Usury in the Koran

We must of course seek in the Koran the initial reason for the condemnation of the taking of interest. The root ribâ means “increase”. The word ribâ in the sense of usury is only found in four Koranic passages. We may study them in chronological order.

 

The first is in surat 30 (al-Rûm), dating from the third Meccan period, shortly the reform before Hegira. “What you lend at interest (ribâ) for the sake of increasing (li-yarbuwa) your property will bring you no increase (lâ yarbû) in the sight of God, while what you give away as alms (zakât) in seeking the face of God will bring many times its value.” (Q. 30, 39)

 

There is not yet an explicit condemnation but only a moral directive according to social justice. This fits the context of the time and place, in which the Muslim community is still a small minority in a society in which commerce recognizes no moral rules and in which usury is a widespread practice. The three other passages are all from the same period and probably date from a few years after the installation in Medina. Following the order established by J. Schacht , we be gin with the verse 3, 130: “Do not practice (literally “eat”) usury by multiplying capital beyond due measure.”

 

Here is the first formal prohibition. It may well have been addressed in the first place to the Jewish community of Medina, well-known for its financial practices. It seems to be aimed at a particular form of usury, later called ribâ al-jâhiliyya (pre-Islamic usury), according to which if a debt was not repaid at the proper time the amount due was increased.

 

Here next is a long passage from the surat al-Baqara : “Those who feed on usury will only rise again (on the last day), like those possessed by the devil. They say in effect, usury and selling are the same thing, whereas God permits selling but forbids usury… God will reduce interest to dust while making alms fruitful…O you believers, fear God, and renounce the excess of usurious interest, if you really believe. If you do not follow this ruling, you may expect the hostility of God and of his Messenger. If you repent, you will retain your capital, neither harming anyone else nor suffering harm yourselves. To a debtor in difficulty, grant a delay until his situation improves. And if you renounce your rights that will be better still.” (Q.2, 275-280).5

 

This is a fundamental passage for our present reflection. One may list the following points

  • The clear distinction between commerce and ribâ;

  • Ribâ is condemned by God, while on the other hand he encourages almsgiving;

  • Faith implies the renunciation of usury;

  • Nevertheless, capital will be safeguarded;

  • Further, one may not put pressure on people who are in difficulties. There is a final, third passage whose context suggests that it is also addressed to the Jews. It confirms the preceding prohibitions.

 

 

Islamic Banking – A theoritical Approach

Islamic Banking

by Mohamed Ariff, University of Malaya,
taken from Asian-Pacific Economic Literature, Vol. 2, No. 2 (September 1988), pp. 46-62
Islamic banking is a new phenomenon that has taken many observers by surprise. The whole banking system has been islamized in both Iran and Pakistan. In addition, there are some thirty Islamic banks in operation in other parts of the globe, including the Jeddah-based Islamic Development Bank (IDB) but excluding numerous non-bank Islamic financial institutions (see Appendix). What is more, the speed with which Islamic banks have sprung up and the rate at which they have progressed make it worth-while to study them systematically. An attempt is made in this paper (a) to survey the growing literature on Islamic banking, in particular (b) to trace the growth and development of Islamic banking, and (c) to highlight its salient characteristics.

 


Contents

 


Evolution

The first modern experiment with Islamic banking was undertaken in Egypt under cover, without projecting an Islamic image, for fear of being seen as a manifestation of Islamic fundamentalism which was anathema to the political regime. The pioneering effort, led by Ahmad El Najjar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in l963. This experiment lasted until l967 (Ready l98l), by which time there were nine such banks in the country. These banks, which neither charged nor paid interest, invested mostly by engaging in trade and industry, directly or in partnership with others, and shared the profits with their depositors (Siddiqi l988). Thus, they functioned essentially as saving- investment institutions rather than as commercial banks. The Nasir Social Bank, established in Egypt in l97l, was declared an interest-free commercial bank, although its charter made no reference to Islam or Shariah (Islamic law).

The IDB was established in l974 by the Organization of Islamic Countries (OIC), but it was primarily an inter-governmental bank aimed at providing funds for development projects in member countries. The IDB provides fee- based financial services and profit-sharing financial assistance to member countries. The IDB operations are free of interest and are explicitly based on

 

Shariah Principles

In the seventies, changes took place in the political climate of many Muslim countries so that there was no longer any strong need to establish Islamic financial institutions under cover. A number of Islamic banks, both in letter and spirit, came into existence in the Middle East, e.g., the Dubai Islamic Bank (l975), the Faisal Islamic Bank of Sudan (l977), the Faisal Islamic Bank of Egypt (l977), and the Bahrain Islamic Bank (l979), to mention a few. The Asia-Pacific region was not oblivious to the winds of change. The Philippine Amanah Bank (PAB) was established in l973 by Presidential Decree as a specialized banking institution without reference to its Islamic character in the bank’s charter. The establishment of the PAB was a response by the Philippines Government to the Muslim rebellion in the south, designed to serve the special banking needs of the Muslim community. However, the primary task of the PAB was to assist rehabilitation and reconstruction in Mindanao, Sulu and Palawan in the south (Mastura l988). The PAB has eight branches located in the major cities of the southern Muslim provinces, including one in Makati (Metro Manila), in addition to the head office located at Zamboanga City in Mindanao. The PAB, however, is not strictly an Islamic bank, since interest-based operations continue to coexist with the Islamic modes of financing. It is indeed fascinating to observe that the PAB operates two ‘windows’ for deposit transactions, i.e., conventional and Islamic. Nevertheless, efforts are underway to convert the PAB into a full-fledged Islamic bank (Mastura l988).

Islamic banking made its debut in Malaysia in l983, but not without antecedents. The first Islamic financial institution in Malaysia was the Muslim Pilgrims Savings Corporation set up in l963 to help people save for performing hajj (pilgrimage to Mecca and Medina). In l969, this body evolved into the Pilgrims Management and Fund Board or the Tabung Haji as it is now popularly known. The Tabung Haji has been acting as a finance company that invests the savings of would-be pilgrims in accordance with Shariah, but its role is rather limited, as it is a non-bank financial institution. The success of the Tabung Haji, however, provided the main impetus for establishing Bank Islam Malaysia Berhad (BIMB) which represents a full- fledged Islamic commercial bank in Malaysia. The Tabung Haji also contributed l2.5 per cent of BIMB’s initial capital of M$80 million. BIMB has a complement of fourteen branches in several parts of the country. Plans are afoot to open six new branches a year so that by l990 the branch network of BIMB will total thirty-three (Man l988).

Reference should also be made to some Islamic financial institutions established in countries where Muslims are a minority. There was a proliferation of interest-free savings and loan societies in India during the seventies (Siddiqi l988). The Islamic Banking System (now called Islamic Finance House), established in Luxembourg in l978, represents the first attempt at Islamic banking in the Western world. There is also an Islamic Bank International of Denmark, in Copenhagen, and the Islamic Investment Company has been set up in Melbourne, Australia.

 

Rationale

The essential feature of Islamic banking is that it is interest-free. Although it is often claimed that there is more to Islamic banking, such as contributions towards a more equitable distribution of income and wealth, and increased equity participation in the economy (Chapra l982), it nevertheless derives its specific rationale from the fact that there is no place for the institution of interest in the Islamic order.

Islam prohibits Muslims from taking or giving interest (riba) regardless of the purpose for which such loans are made and regardless of the rates at which interest is charged. To be sure, there have been attempts to distinguish between usury and interest and between loans for consumption and for production. It has also been argued that riba refers to usury practiced by petty money-lenders and not to interest charged by modern banks and that no riba is involved when interest is imposed on productive loans, but these arguments have not won acceptance. Apart from a few dissenting opinions, he general consensus among Muslim scholars clearly is that there is no difference between riba and interest. In what follows, these two terms are used interchangeably.

The prohibition of riba is mentioned in four different revelations in the Qur’an.1 The first revelation emphasizes that interest deprives wealth of God’s blessings. The second revelation condemns it, placing interest in juxtaposition with wrongful appropriation of property belonging to others. The third revelation enjoins Muslims to stay clear of interest for the sake of their own welfare. The fourth revelation establishes a clear distinction between interest and trade, urging Muslims to take only the principal sum and to forgo even this sum if the borrower is unable to repay. It is further declared in the Qur’an that those who disregard the prohibition of interest are at war with God and His Prophet. The prohibition of interest is also cited in no uncertain terms in the Hadith (sayings of the Prophet). The Prophet condemned not only those who take interest but also those who give interest and those who record or witness the transaction, saying that they are all alike in guilt.2

It may be mentioned in passing that similar prohibitions are to be found in the pre-Qur’anic scriptures, although the ‘People of the Book’, as the Qur’an refers to them, had chosen to rationalize them. It is amazing that Islam has successfully warded off various subsequent rationalization attempts aimed at legitimizing the institution of interest.

Some scholars have put forward economic reasons to explain why interest is banned in Islam. It has been argued, for instance, that interest, being a pre- determined cost of production, tends to prevent full employment (Khan l968; Ahmad n.d.; Mannan l970). In the same vein, it has been contended that international monetary crises are largely due to the institution of interest (Khan, n.d), and that trade cycles are in no small measure attributable to the phenomenon of interest (Ahmad l952; Su’ud n.d.). None of these studies, however, has really succeeded in establishing a causal link between interest, on the one hand, and employment and trade cycles, on the other. Others, anxious to vindicate the Islamic position on interest, have argued that interest is not very effective as a monetary policy instrument even in capitalist economies and have questioned the efficacy of the rate of interest as a determinant of saving and investment (Ariff l982). A common thread running through all these discussions is the exploitative character of the institution of interest, although some have pointed out that profit (which is lawful in Islam) can also be exploitative. One response to this is that one must distinguish between profit and profiteering, and Islam has prohibited the latter as well.

Some writings have alluded to the ‘unearned income’ aspect of interest payments as a possible explanation for the Islamic doctrine. The objection that rent on property is considered halal (lawful) is then answered by rejecting the analogy between rent on property and interest on loans, since the benefit to the tenant is certain, while the productivity of the borrowed capital is uncertain. Besides, property rented out is subject to physical wear and tear, while money lent out is not. The question of erosion in the value of money and hence the need for indexation is an interesting one. But the Islamic jurists have ruled out compensation for erosion in the value of money, or, according to Hadith, a fungible good must be returned by its like (mithl): ‘gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt, like for like, equal for equal, and hand to hand …’.3

The bottom line is that Muslims need no ‘proofs’ before they reject the institution of interest: no human explanation for a divine injunction is necessary for them to accept a dictum, as they recognize the limits to human reasoning. No human mind can fathom a divine order; therefore it is a matter of faith (iman).

The Islamic ban on interest does not mean that capital is costless in an Islamic system. Islam recognizes capital as a factor of production but it does not allow the factor to make a prior or pre-determined claim on the productive surplus in the form of interest. This obviously poses the question as to what will then replace the interest rate mechanism in an Islamic framework. There have been suggestions that profit-sharing can be a viable alternative (Kahf l982a and l982b). In Islam, the owner of capital can legitimately share the profits made by the entrepreneur. What makes profit- sharing permissible in Islam, while interest is not, is that in the case of the former it is only the profit-sharing ratio, not the rate of return itself that is predetermined.

It has been argued that profit-sharing can help allocate resources efficiently, as the profit-sharing ratio can be influenced by market forces so that capital will flow into those sectors which offer the highest profit- sharing ratio to the investor, other things being equal. One dissenting view is that the substitution of profit-sharing for interest as a resource allocating mechanism is crude and imperfect and that the institution of interest should therefore be retained as a necessary evil (Naqvi l982). However, mainstream Islamic thinking on this subject clearly points to the need to replace interest with something else, although there is no clear consensus on what form the alternative to the interest rate mechanism should take. The issue is not resolved and the search for an alternative continues, but it has not detracted from efforts to experiment with Islamic banking without interest.

 

Anatomy

As mentioned earlier, Islam does not deny that capital, as a factor of production, deserves to be rewarded. Islam allows the owners of capital a share in a surplus which is uncertain. To put it differently, investors in the Islamic order have no right to demand a fixed rate of return. No one is entitled to any addition to the principal sum if he does not share in the risks involved. The owner of capital (rabbul-mal) may ‘invest’ by allowing an entrepreneur with ideas and expertise to use the capital for productive purposes and he may share the profits, if any, with the entrepreneur- borrower (mudarib); losses, if any, however, will be borne wholly by the rabbul-mal. This mode of financing, termed mudaraba in the Islamic literature, was in practice even in the pre-Qur’anic days and, according to jurists, it was approved by the Prophet.

Another legitimate mode of financing recognized in Islam is one based on equity participation (musharaka) in which the partners use their capital jointly to generate a surplus. Profits or losses will be shared between the partners according to some agreed formula depending on the equity ratio. Mudaraba and musharaka constitute, at least in principle if not in practice, the twin pillars of Islamic banking. The musharaka principle is invoked in the equity structure of Islamic banks and is similar to the modern concepts of partnership and joint stock ownership. In so far as the depositors are concerned, an Islamic bank acts as a mudarib which manages the funds of the depositors to generate profits subject to the rules of mudaraba as outlined above. The bank may in turn use the depositors’ funds on a mudaraba basis in addition to other lawful modes of financing. In other words, the bank operates a two-tier mudaraba system in which it acts both as the mudarib on the saving side of the equation and as the rabbul-mal on the investment portfolio side. The bank may also enter into musharaka contracts with the users of the funds, sharing profits and losses, as mentioned above. At the deposit end of the scale, Islamic banks normally operate three broad categories of account, mainly current, savings, and investment accounts. The current account, as in the case of conventional banks, gives no return to the depositors. It is essentially a safe-keeping (al-wadiah) arrangement between the depositors and the bank, which allows the depositors to withdraw their money at any time and permits the bank to use the depositors’ money. As in the case of conventional banks, cheque books are issued to the current account deposit holders and the Islamic banks provide the broad range of payment facilities – clearing mechanisms, bank drafts, bills of exchange, travellers cheques, etc. (but not yet, it seems, credit cards or bank cards). More often than not, no service charges are made by the banks in this regard.

The savings account is also operated on an al-wadiah basis, but the bank may at its absolute discretion pay the depositors a positive return periodically, depending on its own profitability. Such payment is considered lawful in Islam since it is not a condition for lending by the depositors to the bank, nor is it pre-determined. The savings account holders are issued with savings books and are allowed to withdraw their money as and when they please. The investment account is based on the mudaraba principle, and the deposits are term deposits which cannot be withdrawn before maturity. The profit- sharing ratio varies from bank to bank and from time to time depending on supply and demand conditions.4 In theory, the rate of return could be positive or negative, but in practice the returns have always been positive and quite comparable to rates conventional banks offer on their term deposits.5

At the investment portfolio end of the scale, Islamic banks employ a variety of instruments. The mudaraba and musharaka modes, referred to earlier, are supposedly the main conduits for the outflow of funds from the banks. In practice, however, Islamic banks have shown a strong preference for other modes which are less risky. The most commonly used mode of financing seems to be the ‘mark-up’ device which is termed murabaha. In a murabaha transaction, the bank finances the purchase of a good or asset by buying it on behalf of its client and adding a mark-up before re-selling it to the client on a ‘cost-plus’ basis. It may appear at first glance that the mark-up is just another term for interest as charged by conventional banks, interest thus being admitted through the back door. What makes the murabaha transaction Islamically legitimate is that the bank first acquires the asset and in the process it assumes certain risks between purchase and resale. The bank takes responsibility for the good before it is safely delivered to the client. The services rendered by the Islamic bank are therefore regarded as quite different from those of a conventional bank which simply lends money to the client to buy the good.

Islamic banks have also been resorting to purchase and resale of properties on a deferred payment basis, which is termed bai’ muajjal. It is considered lawful in fiqh (jurisprudence) to charge a higher price for a good if payments are to be made at a later date. According to fiqh, this does not amount to charging interest, since it is not a lending transaction but a trading one.

Leasing or ijara is also frequently practised by Islamic banks. Under this mode, the banks would buy the equipment or machinery and lease it out to their clients who may opt to buy the items eventually, in which case the monthly payments will consist of two components, i.e., rental for the use of the equipment and instalment towards the purchase price.

Reference must also be made to pre-paid purchase of goods, which is termed bai’salam, as a means used by Islamic banks to finance production. Here the price is paid at the time of the contract but the delivery would take place at a future date. This mode enables an entrepreneur to sell his output to the bank at a price determined in advance. Islamic banks, in keeping with modern times, have extended this facility to manufactures as well.

It is clear from the above sketch that Islamic banking goes beyond the pure financing activities of conventional banks. Islamic banks engage in equity financing and trade financing. By its very nature, Islamic banking is a risky business compared with conventional banking, for risk-sharing forms the very basis of all Islamic financial transactions. To minimize risks, however, Islamic banks have taken pains to distribute the eggs over many baskets and have established reserve funds out of past profits which they can fall back on in the event of any major loss.

 

Literature: Theory

It is not possible to cover in this survey all the publications which have appeared on Islamic banking. There are numerous publications in Arabic and Urdu which have made significant contributions to the theoretical discussion. A brief description of these in English can be found in the Appendix to Siddiqi’s book on Banking without Interest (Siddiqi l983a). The early contributions on the subject of Islamic banking were somewhat casual in the sense that only passing references were made to it in the discussion of wider issues relating to the Islamic economic system as a whole. In other words, the early writers had been simply thinking aloud rather than presenting well-thought-out ideas. Thus, for example, the book by Qureshi on Islam and the Theory of Interest (Qureshi l946) looked upon banking as a social service that should be sponsored by the government like public health and education. Qureshi took this point of view since the bank could neither pay any interest to account holders nor charge any interest on loans advanced. Qureshi also spoke of partnerships between banks and businessmen as a possible alternative, sharing losses if any. No mention was made of profit-sharing.

Ahmad, in Chapter VII of his book Economics of Islam (Ahmad l952), envisaged the establishment of Islamic banks on the basis of a joint stock company with limited liability. In his scheme, in addition to current accounts, on which no dividend or interest should be paid, there was an account in which people could deposit their capital on the basis of partnership, with shareholders receiving higher dividends than the account holders from the profits made. Like Qureshi, above, Ahmad also spoke of possible partnership arrangements with the businessmen who seek capital from the banks. However, the partnership principle was left undefined, nor was it clear who would bear the loss if any. It was suggested that banks should cash bills of trade without charging interest, using the current account funds.

The principle of mudaraba based on Shariah was invoked systematically by Uzair (l955). His principal contribution lay in suggesting mudaraba as the main premise for ‘interestless banking’. However, his argument that the bank should not make any capital investment with its own deposits rendered his analysis somewhat impractical.

Al-Arabi (l966) envisaged a banking system with mudaraba as the main pivot. He was actually advancing the idea of a two-tier mudaraba which would enable the bank to mobilize savings on a mudaraba basis, allocating the funds so mobilized also on a mudaraba basis. In other words the bank would act as a mudarib in so far as the depositors were concerned, while the ‘borrowers’ would act as mudaribs in so far as the bank was concerned. In his scheme, the bank could advance not only the capital procured through deposits but also the capital of its own shareholders. It is also of interest to note that his position with regard to the distribution of profits and the responsibility for losses was strictly in accordance with the Shariah.6 Irshad (l964) also spoke of mudaraba as the basis of Islamic banking, but his concept of mudaraba was quite different from the traditional one in that he thought of capital and labour (including entrepreneurship) as having equal shares in output, thus sharing the losses and profits equally. This actually means that the owner of capital and the entrepreneur have a fifty-fifty share in the profit or loss as the case may be, which runs counter to the Shariah position. Irshad envisaged two kinds of deposit accounts. The first sounded like current deposits in the sense that it would be payable on demand, but the money kept in this deposit would be used for social welfare projects, as the depositors would get zero return. The second one amounted to term deposits which would entitle the depositors to a share in the profits at the end of the year proportionately to the size and duration of the deposits. He recommended the setting up of a Reserve Fund which would absorb all losses so that no depositor would have to bear any loss. According to Irshad, all losses would be either recovered from the Reserve Fund or borne by the shareholders of the bank.

A pioneering attempt at providing a fairly detailed outline of Islamic banking was made in Urdu by Siddiqi in l968. (The English version was not published until l983.) His Islamic banking model was based on mudaraba and shirka (partnership or musharaka as it is now usually called). His model was essentially one based on a two-tier mudaraba financier-entrepreneur relationship, but he took pains to describe the mechanics of such transactions in considerable detail with numerous hypothetical and arithmetic examples. He classified the operations of an Islamic bank into three categories: services based on fees, commissions or other fixed charges; financing on the basis of mudaraba and partnership; and services provided free of charge. His thesis was that such interest-free banks could be a viable alternative to interest-based conventional banks.

The issue of loans for consumption clearly presents a problem, as there is no profit to be shared. Siddiqi addressed this problem, but he managed only to scratch the surface. While recognizing the need for such interest-free loans (qard hasan), especially for meeting basic needs, he seemed to think it was the duty of the community and the State (through its baitul mal or treasury) to cater to those needs; the Islamic bank’s primary objective, like that of any other business unit, is to earn profit. He therefore tended to downplay the role of Islamic banks in providing consumption loans, but he suggested limited overdraft facilities without interest. He even considered a portion of the fund being set aside for consumption loans, repayment being guaranteed by the State. He also suggested that consumers buying durables on credit would issue ‘certificates of sale’ which could be encashed by the seller at the bank for a fee. It was then the seller not the buyer who would be liable as far as the bank was concerned. However, the principles of murabaha and bai’ muajjal were not invoked.

Strangely, Siddiqi favoured keeping the number of shareholders to the minimum, without advancing any strong reasons. This is contrary to the general consensus which now seems to have emerged with reference to Islamic banks operating on a joint stock company basis, a consensus which incidentally is also in line with the Islamic value attached to a broad equity base as against heavy concentration of equity and wealth. Ironically, Siddiqi thought that interest-free banking could operate successfully ‘only in a country where interest is legally prohibited and any transaction based upon interest is declared a punishable offense’ (l983b:l3). He also thought it important to have Islamic laws enforced before interest-free banking could operate well. This view has not gained acceptance, as demonstrated by the many Islamic banks which operate profitably in ‘hostile’ environments, as noted earlier.

Chapra’s model of Islamic banking (Chapra l982), like Siddiqi’s, was based on the mudaraba principle. His main concern, however, centered on the role of artificial purchasing power through credit creation. He even suggested that ‘seigniorage’ resulting from it should be transferred to the public exchequer, for the sake of equity and justice. Al-Jarhi (l983) went so far as to favor the imposition of a l00 per cent reserve requirement on commercial banks. Chapra was also much concerned about the concentration of economic power private banks might enjoy in a system based on equity financing. He therefore preferred medium-sized banks which are neither so large as to wield excessive power nor so small as to be uneconomical. Chapra’s scheme also contained proposals for loss-compensating reserves and loss-absorbing insurance facilities. He also spoke of non-bank financial institutions, which specialize in bringing financiers and entrepreneurs together and act as investment trusts.

Mohsin (l982) has presented a detailed and elaborate framework of Islamic banking in a modern setting. His model incorporates the characteristics of commercial, merchant, and development banks, blending them in novel fashion. It adds various non-banking services such as trust business, factoring, real estate, and consultancy, as though interest-free banks could not survive by banking business alone. Many of the activities listed certainly go beyond the realm of commercial banking and are of so sophisticated and specialized a nature that they may be thought irrelevant to most Muslim countries at their present stage of development. Mohsin’s model clearly was designed to fit into a capitalist environment; indeed he explicitly stated that riba-free banks could coexist with interest-based banks. The point that there is more to Islamic banking than mere abolition of interest was driven home strongly by Chapra (l985). He envisaged Islamic banks whose nature, outlook and operations could be distinctly different from those of conventional banks. Besides the outlawing of riba, he considered it essential that Islamic banks should, since they handle public funds, serve the public interest rather than individual or group interests. In other words, they should play a social-welfare-oriented rather than a profit-maximizing role. He conceived of Islamic banks as a cross-breed of commercial and merchant banks, investment trusts and investment-management institutions that would offer a wide spectrum of services to their customers. Unlike conventional banks which depend heavily on the ‘crutches of collateral and of non-participation in risk’ (p. l55), Islamic banks would have to rely heavily on project evaluation, especially for equity-oriented financing. Thanks to the profit-and-loss sharing nature of the operations, bank-customer relations would be much closer and more cordial than is possible under conventional banking. Finally, the problems of liquidity shortage or surplus would have to be handled differently in Islamic banking, since the ban on interest rules out resort to the money market and the central bank. Chapra suggested alternatives such as reciprocal accommodation among banks without interest payments and creation of a common fund at the central bank into which surpluses would flow and from which shortages could be met without any interest charges.

The literature also discusses the question of central banking in an Islamic framework. The general opinion seems to be that the basic functions of a modern central bank are relevant also for an Islamic monetary system, although the mechanisms may have to be different. Thus, for example, the bank rate instrument cannot be used as it entails interest. Uzair (l982) has suggested adjustments in profit-sharing ratios as a substitute for bank rate manipulations by the central bank. Thus, credit can be tightened by reducing the share accruing to the businessmen and eased by increasing it. Siddiqi (l982) has suggested that variations in the so-called ‘refinance ratio’ (which refers to the central bank refinancing of a part of the interest-free loans provided by the commercial banks) would influence the quantum of short-term credit extended. Siddiqi has also proposed a prescribed ‘lending ratio’ (i.e., the proportion of demand deposits that commercial banks are obliged to lend out as interest-free loans) that can be adjusted by the central bank according to changing circumstances. In this context, reference may also be made to a proposal by Uzair (l982) that the central bank should acquire an equity stake in commercial banking by holding, say, 25 per cent of the capital stock of the commercial banks. The rationale behind this proposal was that it would give the central bank access to a permanent source of income so that it could effectively act as lender of last resort. The discussion of central banking in an Islamic context is somewhat scanty, presumably because Islamic central banking is viewed as too far-fetched an idea, except in Iran and Pakistan.

It emerges from all this that Islamic banking has three distinguishing features: (a) it is interest-free, (b) it is multi-purpose and not purely commercial, and (c) it is strongly equity-oriented. The literature contains hardly any serious criticism of the interest-free character of the operation, since this is taken for granted, although concerns have been expressed about the lack of adequate interest-free instruments. There is a near-consensus that Islamic banks can function well without interest. A recent International Monetary Fund study by Iqbal and Mirakhor (l987) has found Islamic banking to be a viable proposition that can result in efficient resource allocation. The study suggests that banks in an Islamic system face fewer solvency and liquidity risks than their conventional counterparts. The multi-purpose and extra-commercial nature of the Islamic banking operation does not seem to pose intractable problems. The abolition of interest makes it imperative for Islamic banks to look for other instruments, which renders operations outside the periphery of commercial banking unavoidable. Such operations may yield economies of scope. But it is undeniable that the multipurpose character of Islamic banking poses serious practical problems, especially in relation to the skills needed to handle such diverse and complex transactions (Iqbal and Mirakhor l987).

The stress on equity-oriented transactions in Islamic banking, especially the mudaraba mode, has been criticized. It has been argued that the replacement of pre-determined interest by uncertain profits is not enough to render a transaction Islamic, since profit can be just as exploitative as interest is, if it is ‘excessive’ (Naqvi l98l). Naqvi has also pointed out that there is nothing sacrosanct about the institution of mudaraba in Islam. Naqvi maintains that mudaraba is not based on the Qur’an or the Hadith but was a custom of the pre-Islamic Arabs. Historically, mudaraba, he contends, enabled the aged, women, and children with capital to engage in trade through merchants for a share in the profit, all losses being borne by the owners of capital, and therefore it cannot claim any sanctity. The fact remains that the Prophet raised no objection to mudaraba, so that it was at least not considered un-Islamic.

The distribution of profit in mudaraba transactions presents practical difficulties, especially where there are multiple providers of capital, but these difficulties are not regarded as insurmountable. The Report of Pakistan’s Council of Islamic Ideology (CII l983) has suggested that the respective capital contributions of parties can be converted to a common denominator by multiplying the amounts provided with the number of days during which each component, such as the firm’s own equity capital, its current cash surplus and suppliers’ credit was actually deployed in the business, i.e., on a daily product basis. As for deposits, profits (net of administrative expenses, taxes, and appropriation for reserves) would be divided between the shareholders of the bank and the holders of deposits, again on a daily product basis.

Literature: Practice

Recent years have brought an increasing flow of empirical studies of Islamic banking. The earliest systematic empirical work was undertaken by Khan (l983). His observations covered Islamic banks operating in Sudan, United Arab Emirates, Kuwait, Bahrain, Jordan, and Egypt. Khan’s study showed that these banks had little difficulty in devising practices in conformity with Shariah. He identified two types of investment accounts: one where the depositor authorized the banks to invest the money in any project and the other where the depositor had a say in the choice of project to be financed. On the asset side, the banks under investigation had been resorting to mudaraba, musharaka and murabaha modes. Khan’s study reported profit rates ranging from 9 to 20 per cent which were competitive with conventional banks in the corresponding areas. The rates of return to depositors varied between 8 and l5 per cent, which were quite comparable with the rates of return offered by conventional banks.

Khan’s study revealed that Islamic banks had a preference for trade finance and real estate investments. The study also revealed a strong preference for quick returns, which is understandable in view of the fact that these newly established institutions were anxious to report positive results even in the early years of operation. Nienhaus (1988) suggests that the relative profitability of Islamic banks, especially in the Middle East in recent years, was to a large extent due to the property (real estate) boom. He has cited cases of heavy losses which came with the crash of the property sector.

The IMF study referred to earlier by Iqbal and Mirakhor (l987) also contains extremely interesting empirical observations, although these are confined to the experience of Iran and Pakistan, both of which have attempted to islamize the entire banking system on a comprehensive basis. Iran switched to Islamic banking in August l983 with a three-year transition period. The Iranian system allows banks to accept current and savings deposits without having to pay any return, but it permits the banks to offer incentives such as variable prizes or bonuses in cash or kind on these deposits. Term deposits (both short-term and long-term) earn a rate of return based on the bank’s profits and on the deposit maturity. No empirical evidence is as yet available on the interesting question as to whether interest or a profit-share provides the more effective incentive to depositors for the mobilization of private saving. Where Islamic and conventional banks exist side by side, central bank control of bank interest rates is liable to be circumvented by shifts of funds to the Islamic banks.

Iqbal and Mirakhor have noted that the conversion to Islamic modes has been much slower on the asset than on the deposit side. It appears that the Islamic banking system in Iran was able to use less than half of its resources for credit to the private sector, mostly in the form of short-term facilities, i.e., commercial and trade transactions. The slower pace of conversion on the asset side was attributed by the authors to the inadequate supply of personnel trained in long-term financing. The authors, however, found no evidence to show that the effectiveness of monetary policy in Iran, broadly speaking, was altered by the conversion.

The Pakistani experience differs from the Iranian one in that Pakistan had opted for a gradual islamization process which began in l979. In the first phase, which ended on l January l985, domestic banks operated both interest- free and interest-based ‘windows’. In the second phase of the transformation process, the banking system was geared to operate all transactions on the basis of no interest, the only exceptions being foreign currency deposits, foreign loans and government debts. The Pakistani model took care to ensure that the new modes of financing did not upset the basic functioning and structure of the banking system. This and the gradual pace of transition, according to the authors, made it easier for the Pakistani banks to adapt to the new system. The rate of return on profit-and-loss sharing (PLS) deposits appears not only to have been in general higher than the interest rate before islamization but also to have varied between banks, the differential indicating the degree of competition in the banking industry. The authors noted that the PLS system and the new modes of financing had accorded considerable flexibility to banks and their clients. Once again the study concluded that the effectiveness of monetary policy in Pakistan was not impaired by the changeover.

The IMF study, however, expressed considerable uneasiness about the concentration of bank assets on short-term trade credits rather than on long-term financing. This the authors found undesirable, not only because it is inconsistent with the intentions of the new system, but also because the heavy concentration on a few assets might increase risks and destabilize the asset portfolios. The study also drew attention to the difficulty experienced in both Iran and Pakistan in financing budget deficits under a non-interest system and underscored the urgent need to devise suitable interest-free instruments. Iran has, however, decreed that government borrowing on the basis of a fixed rate of return from the nationalized banking system would not amount to interest and would hence be permissible. The official rationalization is that, since all banks are nationalized, interest rates and payments among banks will cancel out in the consolidated accounts. (This, of course, abstracts from the banks’ business with non-bank customers.) There are also some small case studies of Islamic banks operating in Bangladesh (Huq l986), Egypt (Mohammad l986), Malaysia (Halim l988b), Pakistan (Khan l986), and Sudan (Salama l988b). These studies reveal interesting similarities and differences. The current accounts in all cases are operated on the principles of al-wadiah. Savings deposits, too, are accepted on the basis of al-wadiah, but ‘gifts’ to depositors are given entirely at the discretion of the Islamic banks on the minimum balance, so that the depositors also share in profits. Investment deposits are invariably based on the mudaraba principle, but there are considerable variations. Thus, for example, the Islamic Bank of Bangladesh has been offering PLS Deposit Accounts, PLS Special Notice Deposit Accounts, and PLS Term Deposit Accounts, while Bank Islam Malaysia has been operating two kinds of investment deposits, one for the general public and the other for institutional clients.

The studies also show that the profit-sharing ratios and the modes of payment vary from place to place and from time to time. Thus, for example, profits are provisionally declared on a monthly basis in Malaysia, on a quarterly basis in Egypt, on a half-yearly basis in Bangladesh and Pakistan, and on an annual basis in Sudan.

A striking common feature of all these banks is that even their investment deposits are mostly short-term, reflecting the depositors’ preference for assets in as liquid a form as possible. Even in Malaysia, where investment deposits have accounted for a much larger proportion of the total, the bulk of them were made for a period of less than two years. By contrast, in Sudan most of the deposits have consisted of current and savings deposits, apparently because of the ceiling imposed by the Sudanese monetary authorities on investment deposits which in turn was influenced by limited investment opportunities in the domestic economy. There are also interesting variations in the pattern of resource utilization by the Islamic banks. For example, musharaka has been far more important than murabaha as an investment mode in Sudan, while the reverse has been the case in Malaysia. On the average, however, murabaha, bai’muajjal and ijara, rather than musharaka represent the most commonly used modes of financing. The case studies also show that the structure of the clientele has been skewed in favor of the more affluent segment of society, no doubt because the banks are located mainly in metropolitan centres with small branch networks.

The two main problems identified by the case studies are the absence of suitable non-interest-based financial instruments for money and capital market transactions and the high rate of borrower delinquency. The former problem has been partially redressed by Islamic banks resorting to mutual inter-bank arrangements and central bank cooperation, as mentioned earlier. The Bank Islam Malaysia, for instance, has been placing its excess liquidity with the central bank which usually exercises its discretionary powers to give some returns. The delinquency problem appears to be real and serious. Murabaha payments have often been held up because late payments cannot be penalized, in contrast to the interest system in which delayed payments would automatically mean increased interest payments. To overcome this problem, the Pakistani banks have resorted to what is called ‘mark-down’ which is the opposite of ‘mark-up’ (i.e., the profit margin in the cost-plus approach of murabaha transactions). ‘Mark-down’ amounts to giving rebates as an incentive for early payments. But the legitimacy of this ‘mark-down’ practice is questionable on Shariah grounds, since it is time- based and therefore smacks of interest.

In the Southeast Asian context, two recent studies on the Bank Islam Malaysia by Man (l988) and the Philippine Amanah Bank by Mastura (l988) deserve special mention. The Malaysian experience in Islamic banking has been encouraging. Man’s study shows that the average return to depositors has been quite competitive with that offered by conventional banks. By the end of l986, after three years of operation, the bank had a network of fourteen branches. However, 90 per cent of its deposits had maturities of two years or less, and non-Muslim depositors accounted for only 2 per cent of the total. Man is particularly critical of the fact that the mudaraba and musharaka modes of operation, which are considered most meaningful by Islamic scholars, accounted for a very small proportion of the total investment portfolio, while bai’muajjal and ijara formed the bulk of the total. It is evident from Mastura’s analysis that the Philippine Amanah Bank is, strictly speaking, not an Islamic bank, as interest-based operations continue to coexist with Islamic modes of financing. Thus, the PAB has been operating both interest and Islamic ‘windows’ for deposits. Mastura’s study has produced evidence to show that the PAB has been concentrating on murabaha transactions, paying hardly any attention to the mudaraba and musharaka means of financing. The PAB has also been adopting unorthodox approaches in dealing with excess liquidity by making use of interest- bearing treasury bills. Nonetheless, the PAB has also been invoking some Islamic modes in several major investment activities. Mastura has made special references to the qirad principle adopted by the PAB in the Kilu-sang Kabuhayan at Kaunlaran (KKK) movement launched under Marcos and to the ijara financing for the acquisition of farm implements and supplies in the Quedon food production program undertaken by the present regime. So far no reference has been made to Indonesia, the largest Muslim country in the world, with Muslims accounting for 90 per cent of a population of some 165 million. The explanation is that a substantial proportion, especially in Java, are arguably nominal Muslims. Indonesians by and large subscribe to the Pancasila ideology which is essentially secular in character. The present regime seems to associate Islamic banking with Islamic fundamentalism to which the regime is not at all sympathetic. Besides, the intellectual tradition in Indonesia in modern times has not been conducive to the idea of interest-free banking. There were several well respected Indonesian intellectuals including Hatta (the former Vice President) who had argued that riba prohibited in Islam was not the same as interest charged or offered by modern commercial banks, although Islamic jurists in Indonesia hold the opposite view. The Muslim public seems somewhat indifferent to all this. This, however, does not mean that there are no interest-free financial institutions operating in Indonesia. One form of traditional interest-free borrowing is the still widely prevalent form of informal rural credit known as ijon (green) because the loan is secured on the standing crop as described by Partadireja (1974). Another is the arisan system practiced among consumers and small craftsmen and traders. In this system, each member contributes regularly a certain sum and obtains interest-free loans from the pool by drawing lots. The chances of an Islamic bank being established in Indonesia seem at present remote (cf. Rahardjo 1988).

Finally, in the most recent contribution to the growing Islamic banking literature, Nien-haus (l988) concludes that Islamic banking is viable at the microeconomic level but dismisses the proponents’ ideological claims for superiority of Islamic banking as ‘unfounded’. Nienhaus points out that there are some failure stories. Examples cited include the Kuwait Finance House which had its fingers burned by investing heavily in the Kuwaiti real estate and construction sector in l984, and the Islamic Bank International of Denmark which suffered heavy losses in l985 and l986 to the tune of more than 30 per cent of its paid-up capital. But then, as Nienhaus himself has noted, the quoted troubles of individual banks had specific causes and it would be inappropriate to draw general conclusions from particular cases. Nienhaus notes that the high growth rates of the initial years have been falling off, but he rejects the thesis that the Islamic banks have reached their ‘limits of growth’ after filling a market gap. The falling growth rates might well be due to the bigger base values, and the growth performance of Islamic banks has been relatively better in most cases than that of conventional banks in recent years.

According to Nienhaus, the market shares of many Islamic banks have increased over time, notwithstanding the deceleration in the growth of deposits. The only exception was the Faisal Islamic Bank of Sudan (FIBS) whose market share had shrunk from l5 per cent in l982 to 7 per cent in l986, but Nien-haus claims that the market shares lost by FIBS were won not by conventional banks but by newer Islamic banks in Sudan. Short-term trade financing has clearly been dominant in most Islamic banks regardless of size. This is contrary to the expectation that the Islamic banks would be active mainly in the field of corporate financing on a participation basis. Nien-haus attributes this not only to insufficient supply by the banks but also to weak demand by entrepreneurs who may prefer fixed interest cost to sharing their profits with the banks.

 

Conclusion

The preceding discussion makes it clear that Islamic banking is not a negligible or merely temporary phenomenon. Islamic banks are here to stay and there are signs that they will continue to grow and expand. Even if one does not subscribe to the Islamic injunction against the institution of interest, one may find in Islamic banking some innovative ideas which could add more variety to the existing financial network.

One of the main selling points of Islamic banking, at least in theory, is that, unlike conventional banking, it is concerned about the viability of the project and the profitability of the operation but not the size of the collateral. Good projects which might be turned down by conventional banks for lack of collateral would be financed by Islamic banks on a profit-sharing basis. It is especially in this sense that Islamic banks can play a catalytic role in stimulating economic development. In many developing countries, of course, development banks are supposed to perform this function. Islamic banks are expected to be more enterprising than their conventional counterparts. In practice, however, Islamic banks have been concentrating on short-term trade finance which is the least risky.

Part of the explanation is that long-term financing requires expertise which is not always available. Another reason is that there are no back-up institutional structures such as secondary capital markets for Islamic financial instruments. It is possible also that the tendency to concentrate on short-term financing reflects the early years of operation: it is easier to administer, less risky, and the returns are quicker. The banks may learn to pay more attention to equity financing as they grow older.

It is sometimes suggested that Islamic banks are rather complacent. They tend to behave as though they had a captive market in the Muslim masses who will come to them on religious grounds. This complacency seems more pronounced in countries with only one Islamic bank. Many Muslims find it more convenient to deal with conventional banks and have no qualms about shifting their deposits between Islamic banks and conventional ones depending on which bank offers a better return. This might suggest a case for more Islamic banks in those countries as it would force the banks to be more innovative and competitive. Another solution would be to allow the conventional banks to undertake equity financing and/or to operate Islamic ‘counters’ or ‘windows’, subject to strict compliance with the Shariah rules. It is perhaps not too wild a proposition to suggest that there is a need for specialized Islamic financial institutions such as mudaraba banks, murabaha banks and musharaka banks which would compete with one another to provide the best possible services.

 

References

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Al-Jarhi, Ma’bid Ali, l983. ‘A monetary and financial tructure for an interest- free economy, institutions, mechanism and policy’, in Ziauddin, Ahmad et al. (eds.), Money and Banking in Islam, International Centre for Research in Islamic Economics, Jeddah, and Institute of Policy Studies, Islamabad.

Ali, M. (ed.) l982. Islamic Banks and Strategies of Economic Cooperation, New Century Publishers, London.

____ (ed.) 1984. Papers on Islamic Banking, New Century Publishers, London.

Ariff, M. l982. ‘Monetary policy in an interest-free Islamic economy – nature and scope’ in M. Ariff, (ed.), Monetary and Fiscal Economics of Islam, International Centre for Research in Islamic Economics, Jeddah.

____ 1988. Islamic Banking in South-east Asia, Institute of Southeast Asian Studies, Singapore.

Bruce, N.C., 1986. ‘Islamic banking moves east’, Euromoney, July: 142-5.

Chapra, M. Umer, l982. ‘Money and banking in an Islamic economy’ in M Ariff (ed.), above.

____ l985. Toward a Just Monetary System, The Islamic Foundation, Leicester.

Choudhury, Masul Alam, l986. Contributions to Islamic Economic Theory: A Study in Social Economics, St Martin Press, New York.

Council of Islamic Ideology (CII), Pakistan, l983. ‘Elimination of interest from the economy’, in Ziauddin, Ahmed et al. (eds.).

El-Asker, A.A.F., 1987. The Islamic Business Enterprise, Croom Helm, London.

El-Din, A.K., 1986. ‘Ten years of Islamic banking’, Journal of Islamic Banking and Finance, July-September, 3(3):49-66.

Halim, Abdul, l986. ‘Sources and uses of funds: a study of Bank Islam Malaysia Berhad,’ paper presented to the Seminar on Developing a System of Islamic Financial Instruments, organized by the Ministry of Finance Malaysia and the Islamic Development Bank, Kuala Lumpur.

Hjarpe, Jan, l986. ‘Mudaraba banking and taka-ful insurance: the question of “Islamic Banks”, their significance and possible impact’, in Jan Selmer, and Loong Hoe Tan, Economic Relations between Scandinavia and ASEAN: Issues on Trade, Investment, Technology Transfer and Business Culture, University of Stockholm and Institute of South-east Asian Studies, Singapore.

Homoud, S.H., 1985. Islamic Banking, Arabian Information, London. Huq, Azizul, l986. ‘Utilization of financial investments: a case study of Bangladesh’, paper submitted to the Seminar on Developing a System of Islamic Financial Instruments, organized by the Ministry of Finance Malaysia and the Islamic Development Bank, Kuala Lumpur.

Iqbal, Zubair and Mirakhor, Abbas, l987. Islamic Banking, International Monetary Fund Occasional Paper 49, Washington D.C.

Irshad, S.A., l964. Interest-Free Banking, Orient Press of Pakistan, Karachi.

Kahf, Monzer, l982a. ‘Saving and investment functions in a two-sector Islamic economy’, in M. Ariff (ed.) , above.

____ l982b. ‘Fiscal and monetary policies in an Islamic economy’, in M. Ariff (ed.),above.

Karsten, I., 1982. ‘Islam and financial intermediation’, IMF Staff Papers, March, 29(1):108-42.

Khan, Abdul Jabbar, l986. ‘Non-interest banking in Pakistan: a case study’, paper presented to the Seminar on Developing a System of Islamic Financial Instruments, organized by the Ministry of Finance Malaysia and the Islamic Development Bank, Kuala Lumpur.

Khan, M. Fahim, l983. ‘Islamic banking as practised now in the world’ in Ziauddin, Ahmad et al. (eds.).

Khan, M. S.,1986.’Islamic interest-free banking’, I M F Staff Papers, March, 33(1):1-27.

____, 1987 ‘Principles of monetary policy in an Islamic framework’, paper presented to the International Institute of Islamic Economics, Islamabad, Pakistan, July.

____, and Mirakhor, A., 1986. ‘The frame-work and practice of Islamic banking’, Finance and Development, September.

____ and ____, 1987. Theoretical Studies in Islamic Banking and Finance (Book Distribution Centre, Houston.

____ and ____ forth-coming (1988). ‘The financial system and monetary policy in an Islamic economy’, Journal of Research in Islamic Economics.

Khan, Muhammad Akram, l968. ‘Theory of employment in Islam’, Islamic Literature, Karachi, XIV (4): 5-l6.

____ n.d. ‘International monetary crisis, causes and cure’, The Criterion, Karachi, 6 (2): 5-l9.

Khan, W.M., l985. Towards an Interest-Free Islamic Economic System, The Islamic Foundation, Leicester.

Man, Zakariya, l988. ‘Islamic banking: the Malaysian experience’, in M. Ariff (ed.), above.

Mannan, M.A., l970. Islamic Economics, Lahore.

Mastura, Michael O., l988. ‘Islamic banking: the Philippine experience’, in M. Ariff (ed.), above.

Mirakhor, Abbas, 1986. ‘Some theoretical aspects of an Islamic financial system’, paper presented at a Conference on Islamic Banking sponsored by the Central Bank of the Islamic Republic of Iran, Tehran, 11-14 June.

Mohsin, M., l982. ‘Profile of riba-free banking’, in M. Ariff (ed.), above. Naqvi, S.N.H., l98l. Ethics and Economics: An Islamic Synthesis, The Islamic Foundation, Leicester.

____, l982. ‘Interest rate and intertemporal allocative efficiency in an Islamic economy’, in M. Ariff (ed.), above.

Naughton, S.A.J. and Tahir, M.A., 1988. ‘Islamic banking and financial development’, Journal of Islamic Banking and Finance, 5 (2).

Nienhaus, V., l983. ‘Profitability of Islamic PLS banks competing with interest banks: problems and prospects’, Journal of Research in Islamic Economics, l(l):37-47.

____, l986. ‘Islamic economics, finance and banking – theory and practice’, Journal of Islamic Banking and Finance, 3(2):36-54.

____, l988. ‘The performance of Islamic banks – trends and cases’, paper presented to the Conference on Islamic Law and Finance, convened in the University of London, 8 April.

Partadireja, Ace, 1974. ‘Rural credit: the Ijon system’, Bulletin of Indonesian Economic Studies, 10 (3): 54-71.

Qureshi, Anwar Iqbal, l946. Islam and the Theory of Interest, Lahore.

Rahardjo, Dawam, 1988. ‘Islamic banking in Indonesia?’ in M. Ariff (ed.), above.

Rahman, Fazalur, n.d. ‘Riba and interest’, Islamic Studies, Karachi, 3(l):l-43.

Ready, R.K., l98l. ‘The march toward self-determination’, paper presented at the First Advanced Course on Islamic Banks, International Institute of Islamic Banking and Economics, Cairo, 28 August – l7 September.

Rosa, D.A., 1986. ‘Islamic financial policies and domestic resource mobilisation’, Savings and Development, 2:143-53.

Salama, Abidin Ahmad, l986. ‘Utilisation of financial instruments: a case study of Faisal Islamic Bank (Sudan)’, paper submitted to the Seminar on Developing a System of Islamic Financial Instruments, organized by the Ministry of Finance Malaysia and the Islamic Development Bank, Kuala Lumpur.

Scharf, T.W., 1983. Arab and Islamic Banks, OECD, Paris.

Siddiqi, M.N., l982. ‘Islamic Approaches to Money, Banking and Monetary Policy: A Review’, in M. Ariff (ed.), above.

____, l983a. Banking Without Interest, The Islamic Foundation, Leicester.

____, 1983b. Issues in Islamic Banking, Islamic Foundation, Leicester.

____, 1985. Partnership and Profit-Sharing in Islamic Law, Islamic Foundation, Leicester.

____, l988. ‘Islamic banking: theory and practice’, in M. Ariff (ed.), above.

Su’ud, M. Abu, n.d. ‘The economic order within the general conception of the Islamic way of life’, Islamic Review, London, 55 (2): 24-26 and (3): ll-l4. Udovitch, Abraham L., l970. Partnership and Profit in Medieval Islam, Princeton University Press, Princeton, N.J.

Uzair, Mohammad, l955. An Outline of `Interestless Banking’, Raihan Publications, Karachi.

____, l982. ‘Central banking operations in an interest-free banking system’, in M. Ariff (ed.), above.

Zaidi, N.A., l987. ‘Profit rates policy for PLS depositors’, Journal of Islamic Banking and Finance, 4 (4): 35-46.

1 Surah al-Rum (Chapter 30), verse 39; Surah al-Nisa (Chapter 39), verse l6l; Surah al-Imran (Chapter 3), verses l30-2; Surah al-Baqarah (Chapter 2), verses 275-8l. See Yusuf Ali’s Translation of the Qur’an.

2 Hadith compiled by Muslims (Kitab al-Musaqat).

3 This refers to a Hadith compiled by Muslims (Kitab al-Musaqat).

4 Bank Islam Malaysia Berhad has been offering a 70:30 profit-sharing ratio in favour of depositors (Man l988).

5 In l984 the Islamic Bank of Bangladesh offered rates of return ranging from 4.95 per cent to l4.l3 per cent. The Faisal Islamic Bank of Egypt, Cairo, gave a 9 per cent rate of return on deposits in the same year (Afkar Inquiry, December l985).

6 According to Sharia, profits arising from a mudaraba arrangement can be divided in any proportion between the two contracting parties as agreed upon at the time of the contract, but losses, if any, will fall on the financier only.

7 Some Muslim countries have recently introduced what are called ‘Muqarada Bonds’, the proceeds of which are to be used for income-yielding public utility projects such as the construction of bridges and roads. The bond holders will have a share in the collection of tolls and other receipts.

8 Qirad, sometimes also called muqarada, refers to a financial arrangement whereby the financier gets a share in the output, as in the case of Muqarada Bonds (see footnote 7). In the literature, the terms qirad and mudaraba are often used interchangeably.

9 The market shares of the Islamic banks are close to 20 per cent in Egypt, Kuwait and Sudan and roughly l0 per cent in Jordan and Qatar. By contrast, in Turkey, Islamic banks account for less than 1 per cent of the market (see Nienhaus 1988).

Islamic Banking – Literature

The early contributions on the subject of Islamic banking were somewhat casual in the sense that only passing references were made to it in the discussion of wider issues relating to the Islamic economic system as a whole. In other words, the early writers had been simply thinking aloud rather than presenting well-thought-out ideas. Thus, for example, the book by Qureshi on Islam and the Theory of Interest (Qureshi 1946) looked upon banking as a social service that should be sponsored by the government like public health and education. Qureshi took this point of view since the bank could neither pay any interest to account holders nor charge any interest on loans advanced. Qureshi also spoke of partnerships between banks and businessmen as a possible alternative, sharing losses if any. No mention was made of profit-sharing.

Ahmad, in Chapter VII of his book Economics of Islam (Ahmad 1952), envisaged the establishment of Islamic banks on the basis of a joint stock company with limited liability. In his scheme, in addition to current accounts, on which no dividend or interest should be paid, there was an account in which people could deposit their capital on the basis of partnership, with shareholders receiving higher dividends than the account holders from the profits made. Like Qureshi, above, Ahmad also spoke of possible partnership arrangements with the businessmen who seek capital from the banks. However, the partnership principle was left undefined, nor was it clear who would bear the loss if any. It was suggested that banks should cash bills of trade without charging interest, using the current account funds.

The principle of mudaraba based on Shariah was invoked systematically by Uzair (1955). His principal contribution lay in suggesting mudaraba as the main premise for ‘interestless banking’. However, his argument that the bank should not make any capital investment with its own deposits rendered his analysis somewhat impractical.

Al-Arabi (1966) envisaged a banking system with mudaraba as the main pivot. He was actually advancing the idea of a two-tier mudaraba which would enable the bank to mobilize savings on a mudaraba basis, allocating the funds so mobilized also on a mudaraba basis. In other words the bank would act as a mudarib in so far as the depositors were concerned, while the ‘borrowers’ would act as mudaribs in so far as the bank was concerned. In his scheme, the bank could advance not only the capital procured through deposits but also the capital of its own shareholders. It is also of interest to note that his position with regard to the distribution of profits and the responsibility for losses was strictly in accordance with the Shariah (6).

Irshad (1964) also spoke of mudaraba as the basis of Islamic banking, but his concept of mudaraba was quite different from the traditional one in that he thought of capital and labour (including entrepreneurship) as having equal shares in output, thus sharing the losses and profits equally. This actually means that the owner of capital and the entrepreneur have a fifty-fifty share in the profit or loss as the case may be, which runs counter to the Shariah position. Irshad envisaged two kinds of deposit accounts. The first sounded like current deposits in the sense that it would be payable on demand, but the money kept in this deposit would be used for social welfare projects, as the depositors would get zero return. The second one amounted to term deposits which would entitle the depositors to a share in the profits at the end of the year proportionately to the size and duration of the deposits. He recommended the setting up of a Reserve Fund which would absorb all losses so that no depositor would have to bear any loss. According to Irshad, all losses would be either recovered from the Reserve Fund or borne by the shareholders of the bank.

A pioneering attempt at providing a fairly detailed outline of Islamic banking was made in Urdu by Siddiqi in 1968. (The English version was not published until 1983.) His Islamic banking model was based on mudaraba and shirka (partnership or musharaka as it is now usually called). His model was essentially one based on a two-tier mudaraba financier-entrepreneur relationship, but he took pains to describe the mechanics of such transactions in considerable detail with numerous hypothetical and arithmetic examples. He classified the operations of an Islamic bank into three categories: services based on fees, commissions or other fixed charges; financing on the basis of mudaraba and partnership; and services provided free of charge. His thesis was that such interest-free banks could be a viable alternative to interest-based conventional banks.

The issue of loans for consumption clearly presents a problem, as there is no profit to be shared. Siddiqi addressed this problem, but he managed only to scratch the surface. While recognizing the need for such interest-free loans (qard hasan), especially for meeting basic needs, he seemed to think it was the duty of the community and the State (through its baitul mal or treasury) to cater to those needs; the Islamic bank’s primary objective, like that of any other business unit, is to earn profit. He therefore tended to downplay the role of Islamic banks in providing consumption loans, but he suggested limited overdraft facilities without interest. He even considered a portion of the fund being set aside for consumption loans, repayment being guaranteed by the State. He also suggested that consumers buying durables on credit would issue ‘certificates of sale’ which could be encashed by the seller at the bank for a fee. It was then the seller not the buyer who would be liable as far as the bank was concerned. However, the principles of murabaha and bai’ muajjal were not invoked.

Strangely, Siddiqi favoured keeping the number of shareholders to the minimum, without advancing any strong reasons. This is contrary to the general consensus which now seems to have emerged with reference to Islamic banks operating on a joint stock company basis, a consensus which incidentally is also in line with the Islamic value attached to a broad equity base as against heavy concentration of equity and wealth. Ironically, Siddiqi thought that interest-free banking could operate successfully ‘only in a country where interest is legally prohibited and any transaction based upon interest is declared a punishable offence’ (1983b:l3). He also thought it important to have Islamic laws enforced before interest-free banking could operate well. This view has not gained acceptance, as demonstrated by the many Islamic banks which operate profitably in ‘hostile’ environments, as noted earlier.

Chapra’s model of Islamic banking (Chapra 1982), like Siddiqi’s, was based on the mudaraba principle. His main concern, however, centred on the role of artificial purchasing power through credit creation. He even suggested that ‘seigniorage’ resulting from it should be transferred to the public exchequer, for the sake of equity and justice. Al-Jarhi (1983) went so far as to favour the imposition of a l00 per cent reserve requirement on commercial banks. Chapra was also much concerned about the concentration of economic power private banks might enjoy in a system based on equity financing. He therefore preferred mediumsized banks which are neither so large as to wield excessive power nor so small as to be uneconomical. Chapra’s scheme also contained proposals for loss-compensating reserves and loss-absorbing insurance facilities. He also spoke of non-bank financial institutions, which specialize in bringing financiers and entrepreneurs together and act as investment trusts.

Mohsin (1982) has presented a detailed and elaborate framework of Islamic banking in a modern setting. His model incorporates the characteristics of commercial, merchant, and development banks, blending them in novel fashion. It adds various non-banking services such as trust business, factoring, real estate, and consultancy, as though interest-free banks could not survive by banking business alone. Many of the activities listed certainly go beyond the realm of commercial banking and are of so sophisticated and specialized a nature that they may be thought irrelevant to most Muslim countries at their present stage of development. Mohsin’s model clearly was designed to fit into a capitalist environment; indeed he explicitly stated that riba-free banks could coexist with interest-based banks.

The point that there is more to Islamic banking than mere abolition of interest was driven home strongly by Chapra (1985). He envisaged Islamic banks whose nature, outlook and operations could be distinctly different from those of conventional banks. Besides the outlawing of riba, he considered it essential that Islamic banks should, since they handle public funds, serve the public interest rather than individual or group interests. In other words, they should play a social-welfare-oriented rather than a profit-maximizing role. He conceived of Islamic banks as a crossbreed of commercial and merchant banks, investment trusts and investment-management institutions that would offer a wide spectrum of services to their customers. Unlike conventional banks which depend heavily on the ‘crutches of collateral and of non-participation in risk’ (p. l55), Islamic banks would have to rely heavily on project evaluation, especially for equity-oriented financing. Thanks to the profit-and-loss sharing nature of the operations, bank-customer relations would be much closer and more cordial than is possible under conventional banking. Finally, the problems of liquidity shortage or surplus would have to be handled differently in Islamic banking, since the ban on interest rules out resort to the money market and the central bank. Chapra suggested alternatives such as reciprocal accommodation among banks without interest payments and creation of a common fund at the central bank into which surpluses would flow and from which shortages could be met without any interest charges.

The literature also discusses the question of central banking in an Islamic framework. The general opinion seems to be that the basic functions of a modern central bank are relevant also for an Islamic monetary system, although the mechanisms may have to be different. Thus, for example, the bank rate instrument cannot be used as it entails interest. Uzair (1982) has suggested adjustments in profit-sharing ratios as a substitute for bank rate manipulations by the central bank. Thus, credit can be tightened by reducing the share accruing to the businessmen and eased by increasing it. Siddiqi (1982) has suggested that variations in the so-called ‘refinance ratio’ (which refers to the central bank refinancing of a part of the interest-free loans provided by the commercial banks) would influence the quantum of short-term credit extended. Siddiqi has also proposed a prescribed ‘lending ratio’ (i.e., the proportion of demand deposits that commercial banks are obliged to lend out as interest-free loans) that can be adjusted by the central bank according to changing circumstances. In this context, reference may also be made to a proposal by Uzair (1982) that the central bank should acquire an equity stake in commercial banking by holding, say, 25 per cent of the capital stock of the commercial banks. The rationale behind this proposal was that it would give the central bank access to a permanent source of income so that it could effectively act as lender of last resort.

The discussion of central banking in an Islamic context is somewhat scanty, presumably because Islamic central banking is viewed as too farfetched an idea, except in Iran and Pakistan.

It emerges from all this that Islamic banking has three distinguishing features: (a) it is interest-free, (b) it is multi-purpose and not purely commercial, and (c) it is strongly equity-oriented. The literature contains hardly any serious criticism of the interest-free character of the operation, since this is taken for granted, although concerns have been expressed about the lack of adequate interest-free instruments. There is a near-consensus that Islamic banks can function well without interest. A recent International Monetary Fund study by Iqbal and Mirakhor (1987) has found Islamic banking to be a viable proposition that can result in efficient resource allocation. The study suggests that banks in an Islamic system face fewer solvency and liquidity risks than their conventional counterparts.

The multi-purpose and extra-commercial nature of the Islamic banking operation does not seem to pose intractable problems. The abolition of interest makes it imperative for Islamic banks to look for other instruments, which renders operations outside the periphery of commercial banking unavoidable. Such operations may yield economies of scope. But it is undeniable that the multipurpose character of Islamic banking poses serious practical problems, especially in relation to the skills needed to handle such diverse and complex transactions (Iqbal and Mirakhor 1987).

The stress on equity-oriented transactions in Islamic banking, especially the mudaraba mode, has been criticized. It has been argued that the replacement of predetermined interest by uncertain profits is not enough to render a transaction Islamic, since profit can be just as exploitative as interest is, if it is ‘excessive’ (Naqvi 198l). Naqvi has also pointed out that there is nothing sacrosanct about the institution of mudaraba in Islam. Naqvi maintains that mudaraba is not based on the Qur’an or the Hadith but was a custom of the preIslamic Arabs. Historically, mudaraba, he contends, enabled the aged, women, and children with capital to engage in trade through merchants for a share in the profit, all losses being borne by the owners of capital, and therefore it cannot claim any sanctity. The fact remains that the Prophet raised no objection to mudaraba, so that it was at least not considered un-Islamic.

The distribution of profit in mudaraba transactions presents practical difficulties, especially where there are multiple providers of capital, but these difficulties are not regarded as insurmountable. The Report of Pakistan’s Council of Islamic Ideology (CII 1983) has suggested that the respective capital contributions of parties can be converted to a common denominator by multiplying the amounts provided with the number of days during which each component, such as the firm’s own equity capital, its current cash surplus and suppliers’ credit was actually deployed in the business, i.e., on a daily product basis. As for deposits, profits (net of administrative expenses, taxes, and appropriation for reserves) would be divided between the shareholders of the bank and the holders of deposits, again on a daily product basis.

– Mohamed Ariff, University of Malaya

TAKAFUL: Objectives and Methodology

images10By : Atiquzzafar Khan

 

Introduction:

 

Insurance is the most important sector in present day modern economies after banking. In fact, banking and insurance go Hand-in-Hank and greatly complement and support each other’s operations. Almost all large scale business activities are bound to arrange insurance cover in one way or the other. Insurance business is an important contemporary issue which has attracted so many debates and discussions. Muslim scholars have been writing on this issue since the introduction of this business in the Muslim societies. In sixties and seventies the issue of insurance business came on the agenda of many conferences and seminars and consensus was emerged after long discussions that although the concept of insurance is not contradictory to Islamic principles but its present practice involves some elements such as interest, Gharar, Unlawful appropriation of others’ property etc. which are forbidden in Islam. Cooperative insurance has been suggested as an alternate to the present commercial insurance. Some scholars presented the concept of Takaful as an alternative scheme for running the insurance business in private sector. Involvement of Mudarabah and Tabarru’ (gift) in this scheme removes the objectionable elements from the business. On these lines many Islamic insurance (Takaful) companies were established in eighties and nineties in various Muslim countries and performing their business successfully.

 

The objective of this paper is to give an introduction of Islamic insurance (Takaful) business by mentioning its objectives, principles and operational mechanism. The arrangement of the paper is follows: The second section of the paper provides a brief introduction of contemporary insurance. Section three analysis the major points for and against commercial insurance to determine its Shariah position. Section four lists the basic Shari’ah principles of business in general and insurance business in particular and gives a brief introduction of Takaful scheme. The final section describes the operational mechanism of Takaful business in the light of Takaful experience of Malaysia.

 

 

Section 2.

Contemporary Insurance: Nature, History and Management

 

2.1. Introduction of Conventional Insurance and its Mechanism:

 

All human activities are subject to risk, which may lad to financial or physical losses to him. Insurance is a device to covers the loss arise due to occurrence of some undesired event. There are many possible ways of handing the risk. We can briefly mention some important ones as follows:

1. Risk Avoidance 4. Risk Transfer

2. Risk Retention 5. Risk Sharing

3. Risk Reduction

The last two methods provide the possibility of insurance business and naturally the third method is also used by insurance companies through instructing the policy holders to adopt suitable safety measures for reducing the risk.

Insurance is a complicated and intricate mechanism, and it is consequently difficult to define. However, in its simplest, it has two fundamental characteristics.

Transferring or shifting risk from one individual to a group.

Sharing losses by all members of the group on some equitable basis.

 

The term insurance, in its real sense, is community pooling to alleviate the burden of the individual, lest is should be ruinous to him. More precisely it can be defined as, “The simplest and most general conception of insurance is a provision made by a group of persona, each singly in danger of some loss, the incidence of which cannot be foreseen, that when such loss shall occur to any of them it shall be distributed over the whole group.”1

Insurance has a very long history. There is evidence of many practices resembling insurance in the ancient world. As early as 3000 B,C. Chinese merchants utilized the technique of sharing risk..2 The practices similar to insurance were in vogue in pre-Islamic Arab Society. 3 Some of the known practices were A’qila, Qasama Mawalat, and Willa’. The institutions were allowed to work in Islam due to there usefulness and some other institutions of the similar nature were established under Islamic state. Although these were insurance of sort, the modern insurance business did not begin until the commercial revolution in Europe. Marine insurance appears to have been started in Italy sometime during the thirteenth century. 4 Fire insurance in the modern era can be traced to Germany, where a fire association known as the Feuer Casse was organized in 1591. In 16666 the great fire of London broke out and an English Physician named Nicholas Barbon formed a stock company in 1680 with several associates called “The first life insurance policy was issued on June 18, 1536 by a group of underwriters in London.

Objectives of Insurance Business

The major objectives of insurance business, as gi en in the printed material of insurance, are the following:

Provision for the necessities of life of heirs as a result of sudden death of head of the family.

Security from economic loss in case of some accident such as fire, burglary etc.

Provision beforehand for the payment of any unforeseen financial liability or penalty.

Provision for inevitable needs of the future like after retirement, Provision beforehand for children’s education or marriages.

Increase in capital.

Provision against unforeseen business loss due to sudden fluctuations in money market, international market, or stock market etc.

 

Insurance business is broadly classified into two groups: Life insurance and General insurance. The latter has three main branches Marine, Fire, and Accident. The last mentioned type includes insurance of Motor Vehicles and Aero plane etc. Life insurance is also broadly classified as Whole Life policies and Endowment policies. Annuities come in the later group. Annuity in periodic payment to commence at a stated or contingent date and to be continued to be paid, to a designated persons(s), for a fixed period or for the life or lives of the person or persons entitled to receive payment

 

Classification of Insurance Business

Insurance Pricing:

The pricing of insurance policies is same as pricing policies for other commodities. In either case the seller must charge enough to cover all his costs and give some reasonable profit. But beyond this basic similarity there are some major differences. Two of them are particularly important: First, when an insurer sells a policy it has no way of knowing what its costs for that particular policy will be. It cannot just add up the cost of labor, rent, and so forth. Instead, the insurer must estimate the cost, basing its estimate upon what it has cost to provide similar policies in the past. The second difference is that the cost to the seller depends partly on who the buyer is. The insurer’s cost depends largely upon whether or not the policy buyer has losses and, it so, how many and how large they are. Of course, this is the reason that different people are charged different prices for policies providing the same kind and amounts of insurance. It is among the statutory requirements that the insurance rates must “discriminate fairly”, which means that proper distinctions should be made among various insured’s. Those who are alike should be charged the same rate; those who are different should be charged different rates.

There are three basic elements that premium must cover. The first component, the amount needed to pay policyholders’ losses, is the pure premium. The second part of the premium pays for the operating expenses of insurance company. These include the sales commission and other marketing costs, administrative costs, taxes, and the cost of handling claims. The third part of the premium is classed the margin, which includes an allowance for (a) contingencies, and (b) underwriting gain or profit.

 

Premiums, Rates, and Exposure Units:

As we know, insurance price is called premium; premiums are based on rates; and rates are prices per unit of exposure. As total price for any commodity is determined by multiplying the price per unit times the number of units of that commodity, the premium in case of insurance policy is the rates times the number of exposure units.

Pure Premium = rates * exposure units

Where exposure units

are the quantitative units used in insurance pricing. As gallons are the quantitative units in gasoline pricing, the quantitative units in automobile insurance are cars; the rates apply on a per car basis. In life insurance, for instance, the rates apply per $1,000 of insurance, and in workers’ compensation the rates apply per $100 of payroll.5

The final premium that the insured pays is called the gross premium or gross rate. For converting the pure premium into a gross rate requires addition of the loading, which is intended to cover the expenses of operation. The final gross rate is derived by dividing the pure premium by a permissible loss ratio, defined as t he percentage of the premium that will be available to pay losses after provision of expenses. It is equal to (1 – Expense ratio). Thus gross rate is defined as,

Gross Rate = Pure Premium /(1 – Expense ratio) 6

 

 

 

Section 3:

Arguments For and Against Insurance

Muslim scholars are writing on the issue of insurance and their opinion is sharply divided on the issue. Generally these views of the Muslim scholars could be classified into three groups:

Both the concept and the practice of insurance is contradictory to Islamic principles. According to them insurance involves Riba gambling and uncertainty, and is opposed to the concept of predestination (Taqdeer).This view is held by Dr. Hussain Hamid Hussan7 , Mufti Wali Hasan8 , Sheikh Abu Zahra9 and many other Shari’ah scholars.

Other group while appreciating the philosophy and rationale of insurance disapprove most of the forms of insurance contracts undertaken by commercial insurance companies. They see in them elements of risk, uncertainty, ignorance, usury which are inalienably associated with contemporary insurance. Among the prominent scholars of this group are Muft Muhammad Shafi10, Maulana Maudui11, Sheikh Ahmad Ibrahim12, Mustafa Zaid713, Sheikh Mohammad Bakheet14,, Issa Abduho15, Ahmad Fahmi16, Dr. Muslehuddin17, Dr. Mustafa Sayyad18 and many other distinguished scholars.

Third group of Muslim scholars maintains that insurance is permissible since it is based upon the principles of mutual assistance an reciprocal responsibility which Islam wants to promote among the Muslims. Further, the uncertainty involved in insurance is not of a sufficiently high degree to warrant its prohibition. This viewpoint is held by Mustafa Zarqa19, Sheikh Ali al Khafif20, Dr. Yousuf Musa21, Muhammad Ali Bahi22, Dr. Nijatullah Siddiqui23, Ahmad Taha Al-Sannusi24. Gharib Jamal25, and some other scholars.

In this section we ill briefly present the major arguments of both the proponents and the opponents of existing insurance in some detail and evaluate them in the light of Shari’ah

 

3.1. Arguments of opponents

 

Shari’ah scholars have raised many objections in contemporary insurance business. Some major objections are as follows:

 

3.1.1. Elements of Gharar (Uncertainty)

 

According to various Ahadith of the Prophet (SAW) any sale involving Gharar is prohibited whereas the insurance contract involves an element of Gharar of a high degree. The attribute of Gharar exists in insurance in four kinds.

 

 

 

 

 

Gharar in existence:

The existence of the amount of compensation is doubtful since it is paid only at the occurrence of the event which is uncertain.

Gharar of quantum:

The insured does not know at the time of the contract how much compensation he will get in case of any damage to his property.

Gharar with regard to time of payment:

It suggests that the time of payment of compensation in case of insurance is unknown and uncertain.

 

3.1.2. Element of Gambling

: In the contracts of insurance the insured loses his premium if the event does not happen, and in the other situation the company pays his several time more than what he has paid as premium. This clearly amounts to gambling as one party loses by more chance and the other gains undeservedly.

 

3.1.3. Element of Interest:

The opponents argue that the element interest is found in insurance in two ways. The first is that insurance companies invest the collected amounts in interest-oriented government securities and businesses for earning purposes. The second is the difference between what company receives from the policy holders and what it pays back as compensation as contractual objection comes under the definition of Riba.

 

3.1.4 Unlawful Appropriation of Other’s Properties

:

Islam enjoins upon believers not to devour other people’s properties wrongfully. 25 In most contracts of insurance the insured does not get anything from the company because the event never occurs during the period of contract. The premium money is thus wasted without any material benefit. All the money on account of premium goes to the company without any effect on its part..

 

3.2. Arguments of the Proponent

:

We also find scholars who consider contemporary insurance desirable from Islamic point of view and they don’t see any major problem into this business. There arguments are briefly stated below.

3.2.1 Principle of Mutual Assistance

:

Insurance encourages and promotes mutual assistance and reciprocal responsibility which are an indispensable part of the teachings and value system of Islam. 26

3.2.2. Non Resemblance with Gambling

:

The advocates of insurance deny the presence of gambling in insurance. They distinguish between the risk taken by the gambler and the risk in insurance which is a necessary part of living. The gambler takes up a risk voluntarily. The hope for gain is the only motivation of the taking of risk in his case. This risk contained in insurance, on the other hand, is indispensable and a useful social process conducive to productivity. 27 The objective of the insured person behind insurance is not to gain the amount of compensation. He does not intend the event to happen. His interest lies in the incident not taking place. He contracts only for peace of mind derived from the knowledge that whenever a catastrophe takes place, he will be indemnified. Gambling upsets the normal system based on work and reward and is inimical to equitable distribution of income and wealth, whereas insurance protects the disruption of the system by accidents and events beyond human control.28

 

3.2.3. Low degree of Gharar:

 

Insurance does not contain a high degree of Gharar. An insurance company can predict the chance of actual occurrence. The law of large number helps the company to calculate the number of likely happenings with some accuracy. This law points to the fact that some quantities which are uncertain and changing in individual cases, being different for each one, are certain and remain constant for a large group of similar persons. There, the element of Gharar is negligible in the contracts of insurance.

 

3.2.4. Analogy between Insuracne and the Institution of A’qila:

 

It is argued by the supporters of insurance that insurance resembles the institution of A’qila of early Islam. A’qila is an adult and sane male clan of an offender or convict from whom he receives help to pay blood money in culpable homicide.29

 

3.2.5. Insurance and Suretyship of Unknown Thing or Event:

 

It is allowed for a person in Shari’ah to be surety for an unknown and unspecified thing30. In insurance each policy holder becomes a surety for the other for an uncertain happening. The company also assumes the role of surety and compensates the loss incurred by a policy holder by way of being a surety.

 

3.3. Evaluation of the Argumetns:

 

If we examine the arguments of both the groups, we reach the conclusion that the insurance business as it is practiced today b the insurance companies, contains elements of uncertainty, deceit, usury and many other objectionable features. It contains Gharar of the highest degree. The elements of gambling and interest are also present in the contracts of insurance. The claim of the proponents that the element of uncertainty is negligible since the company has the ability to predict for event with some accuracy does not carry much weight. The event may be certain for the company but it remains quite uncertain for the policy holder. It is also a fact that a large amount of collected money by the company is invested in interest bearing assets. It does not resemble “Aqila of the early ages of Islam, since the purpose of the institution is to help and assist a person and share his burden by way of assistance, sympathy, benevolence, whereas the objective of insurance company is to earn profit. It is also not analogous to kafala contract because kafala is a contract of Tabarru’ and mutual assistance and not a contract to gain money.

As regards the concept and philosophy of insurance there seems to bean agreement of opinion among Muslim jurists, which emerged after many conferences and discussions at various forums, that the concept and objectives of insurance business in no way opposed to the injunctions and value system of Islam since it promotes mutual help, assistance, and cooperation. We can trace from the practice of the Prophet (SAW) and the companions (RAA) that all the needs mentioned in previous section under objectives of insurance, were recognized by Shari’ah.31 There is no doubt about the utility of the institution for society. The only thing required to be done is that the business of insurance should be brought in conformity with the tenets of Shari’ah. The elements of uncertainty, ignorance, gambling, and usury inherent in the business of insurance, need to be removed. The best method to run this business, as suggested by a large number of scholars, is to run this business on the basis of mutual suretyship and reciprocal responsibility. Islamic models of investment such as Musharaka and Mudharaba should be observed while investing the money collected by the company. Mutual insurance has been commonly suggested as a substitute for commercial insurance.32

 

Section 4: Islamic Guiding Principles4.1. General Principles governing Financial Contracts

 

Before discussing the Islamic model of insurance it will be quite appropriate to first mention the fundamental Islamic principles governing contracts in general. These principles are as follows:

1. The subject matter of the contract should not be unlawful in Islam.
2. The intended objectives of the contract should not be contradictory to the will of
the law- giver.

3. The contract should be free from the following elements,

i) Qimar (Gambling),

ii). Gharar (Aleatory),

Hi). Ghaban-al-Fahish (Grave Deception), and

iv). Ikrah (Coercion)

4.2. Principles Governing the Islamic Insurance Businessi). It should be based on Mutual Guarantee and Co-operation.

The objectives for which the institution of insurance initially started were very noble. The philosophy underlying insurance was that the consequences of an unhappy event will be shared by a large number of people and will not be left for a single individual to bear. It goes without saying that mutual guarantee and solidarity are integral parts of the value system of Islam.

The present state of this institution is that it does not contain any attribute of mutual co-operation, and guarantee. It is now a business through which a small group of capitalists attempts to attract the wealth of the society to use it for its own benefit and to shift the losses to others. Mufti Muhammad Shaft highlights this situation in the following words:

The prevalent insurance system cannot be described as a cooperative one. It is a misleading device to let the nation face the ill effects of interest-based insurance and speculation. If we analyze this system it will be established that insurance and speculation are in fact the supplements of the same interest- based business by means of which we try to feather our own nest without caring for the profit and loss of the entire nation. It is also used as a means of diverting one’s impending liabilities towards others through the cleaver use of the pharases of “national solidarity” and “cooperatives.^ Therefore, it is suggested that the Islamic insurance should be established on mutual or cooperative bases and preferably run by the government for keeping the spirit of solidarity and cooperation alive. Even if it is in the private sector, help should be provided from a common pool (a Trust fund), meant for this purpose and not for earning profits. The company can earn profits by investing the amount given in investment account

ii) Islamic Modes of Investment should be adopted.

At present many types of investments are being employed in the insurance business without any distinction between the lawful modes and forbidden ones. Most of them contain the element of Riba which is strictly prohibited in Islam. Some of these are founded on gambling and Gharar. Quite apparently all these three elements are unlawful according to Shari’ah. As such, any business or forms of investment which contains any one of these, will be unlawful in Islamic Shari’ah.

An Islamic insurance company is supposes to invest the funds in Islamically approved investments, such as stocks of companies, real estate, and participatory financing (Musharakah, Maudarabah).

Section 5: Islamic Alternative to insurance business:

 

Muslim Jurists have devoted much time and energy in their efforts to find an Islamic alternative to the existing insurance business. They have discussed the issue in a number of conferences. After extensive deliberations they have reached the conclusion that cooperative insurance provides the Islamic substitute for the prevalent unlawful insurance practices because profits are shared by the policy holders themselves. But this suggestion waslittle restrictive as it did not allowed the private sector to perform any role. Some Muslim scholars offered the scheme of Takaful, based on the elements of Tabarru1 and Mudharabah as the basis for a lawful insurance business35. The word Takaful1 means joint guarantee. The objective of Takaful is cooperation and mutual help among the members of a defined group. In a practical sense Takaful can be visualized as a method of joint guarantee among a group of members or participants against loss or damage that may inflict upon any of them. The members of the group agree to guarantee jointly that should any of them suffer a catastrophe or disaster, he would receive certain sum of money to meet the loss or damage. All members of the group pool together their efforts to support the needy 35.

Under Takaful scheme the participants deposit annually an agreed sum of money with the company. This contribution is divided into two parts. A larger portion goes into investment fund and remains the property of the contributor. The other part which is nearly 2 to 5 percent of the contribution goes into a Waqf fund and considered as Tabarru1 (Donation). The company invests the available funds in mudarabah ventures or some other approved modes. The profits, if any, are added into the investment and Waqf funds according to the previous ratios. The purpose of Takaful may be life insurance and it may also be risk insurance of property. If the insured person dies before the end of the covered time in case of life insurance or if an insured risk on the property materializes, then the company will pay back the amount deposited in investment account by the policy-holder along with profits earned during that period. The other component of compensation will come from the Waqf fund to satisfy the need or to make the compensation up to a certain level.

As company uses Islamically approved modes of investment and distribute profit among the policy holders, element of Riba is eliminated. The other objectionable element, Gharar is still there but as the company manages a separate Waqf fund from donationes of the policy holders, for providing support to the needy member(s) of the group, this Gharar will not invalidate the insurance contract. According to Malki Fuqaha Gharar in Uqood al Tabarru1 (Donation contracts) is acceptable and does not invalidate the contract. The other objectionable elements such as violation of Islamic law of inheritance, confiscating the previously deposited money after a non payment of contribution etc. can easily be corrected as they are not the integrated part of the contract. This is a brief introduction of Takaful scheme suggested as a substitute for commercial insurance. There are many Takaful companies operating in various Muslim countries. To have a better understanding of this scheme it would be appropriate to see the actual functioning of a Takaful company. For this purpose, the structure and functioning of Sharikat Takaful Malaysia is presented as follows.

5.1. Sharikat Takaful Malaysia Sendirian Berhad

In Malaysia the operation of Takaful is licensed and regulated by the Takaful Act 1984. Sharikat Takaful Malaysia Sendirian Berhad was incorporated on 29 November 1984, with an authorized capital of RM 100 million and a paid-up capital of RM 10 million. It officially commenced business operation on 1 August 1985. Sharikat Takaful Malaysia is a subsidiary of the Malaysian Islamic Bank, Bank Islam Malaysia Berhad with, 87.15% of its equity held by the Bank. Other shareholders are States Islamic Councils and Bait-ul-mals of various states in Malaysia. Types of Takaful Business

The commercial activity of Takaful is reflected in two basic types of business that it undertakes,

Family Takaful Business (Islamic life insurance)

General Takaful Business (Islamic general insurance)

The fundamental objective and basic working operation differ between these two types of business. Under the Family Takaful Business, Sharikat Takaful Malaysia provides various types of Family Takaful Plan, which generally, are long-term al-Mudharabah contracts. Basically, a Family Plan provides cover of mutual aid among its members or participants expressed in the form of financial benefits paid from a defined fund should any of its members be inflicted by a tragedy.

For the General Takaful Business, Sharikat Takaful Malaysia manages various types of General Takaful Scheme, such as Fire Takaful Scheme, Motor Takaful Scheme, Marine Takaful Scheme, and Engineering Takaful Scheme etc, usually on a short-term basis. These schemes provide protection in the form of mutual financial help to compensate its members or participants for any material loss, damage or destruction suffered out of any catastrophe, disaster or misfortune that falls on a member’s property or belongings.

 

 

Working of the Takaful BusinessTakaful Business is based on the concepts of Al-Mudarabah and Tabarru1. Involvement of these two Islamic forms of business eliminates the elements of Riba and Gharar from the insurance contract.The operational details of different Takaful Businesses are as follows:

Family TakafulAny individual between the ages of 18 to 55 years can participate in the Family Takaful business. Participants are required to pay Sharikat Takaful Malaysia regularly. The Takaful installments are then credited into a defined fund known as the Family Takaful Fund. Each Takaful instalment is divided and credited into two separate Accounts namely, the Participants’s Account (PA) and the Participants Special Account (PSA). A substantial proportion of the installments is credited into the PA solely for the purpose of savings and investment. The balance of the installments is credited into the PSA as tabarru1 for Sharikat Takaful Malaysia to pay the Takaful benefits to the heir(s) of any participant who may die before the maturity of the Family Takaful Plan. The amount accumulated in the PA is invested in various businesses according to Islamic financing techniques, and the resultant profits are divided betweer the Sharikat and the participants according to an agreed ratio, e.g., 30-70. The participants’ shares are calculated according to their individual shares in the PA, and credited into their respective accounts, the PA and the PSA.

In case of occurrence of some unfortunate event like death or disability, the
Sharikat makes payment to the policy holder or his heirs. The amount deposited in the
PA along with the profits plus some amount from the PSA according to a formula is paid
by the company. For example if the person die or suffer permanent and the total
disability (PTD) in the fifth year of participation, Takaful benefits will be paid in the
following manner:
i. From Participant’s Account RM 4,890.00

= RM 978 x 5 (i.e. installments paid by the Participant

in his Participants Account from the date of entry

up to the date of death or suffering of PTD) together

with profit, if any, which have been earned from

investment for during the same period, say RM 400.00

ii. From Participants Special Accounts RM 5,000.00

= RM 1000 x 5 yearly payment (i.e. outstanding

amount of Takaful installments that would have been

paid should the Participant survive).

Total Takaful Benefit Payable ( i + ii ) RM 10,290.00

For the Permanent Total Disability (PTD) cover Takaful benefit shall be paid in ten equal installments annually.
If the Participant is still alive at maturity of his FTP, payment of Takaful benefit will be
made to him as follows:-

i. From his Participant’s Account RM 9,780.00

= RM 978 x 10 (i.e. total amount installments credited into his Participant’s Account from date of entry to the maturity) together with the profit from investment if any, accumulated during the same period. RM 1,800.00

ii. From Participants Special Accounts, RM XXXX

Total Takaful Benefit = RM 11,580.00 + surplus as determined by Sharikat Takaful.

General Takaful Business

 

In consideration for participating in the various schemes of General Takaful Business, participants agree or undertake to pay Takaful contributions as tabarru1 for the purpose of creating a defined asset as illustrated in the ‘General Takaful Fund’. The amount of Takaful contributions will vary according to the value of property or asset to be covered under the Scheme. It is from this Fund that mutual compensation would be paid to any participant who suffers a defined loss or damage arising from a catastrophe or disaster affecting his property or belonging.

As the Mudharib, Sharikat Takaful Malaysia will invest the Fund. All returns on the investment will be pooled back to the Fund. In line with the virtues of mutual help, shared responsibility, and joint guarantee as embodied in the concept of Takaful, compensation or indemnity will be paid to any participant who suffers a defined loss or damage consequent upon the occurrence of a catastrophe or a disaster. Other operational costs to manager the General Takaful Business such as the cost for arranging retakaful programme and setting-up of reserve shall also be deducted from the Fund.

After satisfying all the claims and deducting the operational costs, if the Fund registers a surplus shall be shared between the participants and Sharikat Takaful Malaysia. The sharing of such surplus will be at an agreed ratio as expressed in the principle of al-Mudharabah such as 6:4, 5:5, etc. Profits attributable to the participants are paid on expiry of their respective General Takaful Schemes provided they have not received or incurred claims during the period of participation.

The General Takaful Business is different from Family Takaful, as all the payments are credited to only Tabarru account, and not divided into two separate accounts. One problem which we can feel here is the distribution of surplus among the policy holders. If the payments were given as Tabarru, then they should not bring any profit and if these were given as loan even then providing any share from the profit will not be appropriate and bring the element of Riba in the contract. Therefore, the company should divide the available funds into two separate accounts as the case of Family Takaful Business. If due to short period of policy it is not feasible to make investment and earn some profit then the payments from the policy holders should be considered as Tabarru and no return should be given to them. If the Fund registers surplus, the management can decide to reduce the amount of premium for the renewal of policy which will indirectly help and encourage the policy holders.

References:

 

Encyclopedia Britannica (11 th Ed.), Cambridge, 1911.

Frank H. Knight, “Risk, Uncertainty, and profit”, Houghton Mifflin, Boston, 1921,
pp. 233.

Dr. M. Muslehuddin, “Insurance and Islamic Law”, Islamic Publications Ltd.
Lahore, 1978, pp. 19.

Emmett J. Vaugnan, “Fundamentals of Risk and Insurance”, John Wiley & Sons,
New York, U.S.A. 1986, pp. 64.

Crane G. Frederick, “Insurance Principles & Practices”, John Wiley & Sons, New
York, 1980, pp. 383.

E. F. Brigham, “Financial Management: Theory and Practice”, 4th ed., Dryden
Press, Chicago, 1985, pp. 53.

Hussain Hamid Hassan, “Al-Ta’min wa Mauqif al-Shariah Minhu,

Mufti Mohammad Shafi, “Bima-e- Zindagi(Life Insurance)”, Dar-ul-lsha’at
Karachi, pp. 40-44.

Mustafa Zaid, “al-Tamin”, Majallah al-Buhuth al-lslamiyyah, ldarat al-Buhoth al-
lluiyyah, Riyadh, Vol. 19-20, July 1995.

Mufti Mohammad Shafi, op.ct. pp. 17-23.

Abul A’la Maududi, Ma’ashiat-e-lslam, Islamic Publications Limited, Lahore,
1988, pp.408.

Siddiqi, M. Nijatullah, “Muslim Economic Thinking”, International Centre for
Research in Islamic Economics, Jeddah, 1981, pp. 26.

Mustafa Zaid, op.ct.

Ibid

Ibid

Ahmad Fahmi, “Al-Tamin” I’nd al-Nawazil wa-al-hawa’ij”, paper presented at the
First International Conference on Islamic Economics, Makkah, 1976.

Dr. M. Muslihuddin,” Insurance and Islamic Law”lslamic Publications Limited,
Lahore, 1979.

Jalal Mustafa, “Al-Ta’min wa ba’dh al-Shubhat”, paper presented at First
International Conference on Islamic Economics, Makkah, 1976.

Mustafa Ahmad Zarqa, “Nizam al ta’min wa Mawqif al Shari’ah minhu” paper
presented at First International Conference on Islamic Economics, Makkah,
1976.

Shaikh Ali al-Khafif, “al-Tamin wa hukmuho ala Mabadi’ al-Shari’yyah wa
Usuliyyha al-a’mmah, paper presented at First International Conference on
Islamic Economics, Makkah, 1976.

Majallah al-Buhuth al-lsmiyyah, op.cit. Vol.19, 20.

Siddiqi, M. Nijatullah, “Muslim Economic Thinking”, op.ct. pp. 26.

Siddiqi, M. Nijatullah , “Insurance in an Islamic Economy”, Islamic Foundation,
U.K. 1985.

Siddiqi, M. Nijatullah, “Muslim Economic Thinking”,op.ct. pp. 26.

Ibid.

The Qur’an 5 : 2.

Mufti Muhammad Shafi, op.ct. pp.22.

Siddiqi, M. Nijatullah, “Insurance in Islamic Economy”, op.cit. pp.40-41.

Ibid.

Majallah al Buhuth al-lslamiyyah, op.cit. vol.20, pp.46.

Council of Islamic Ideology, “Report on Islamic Insurance System”, 1992, pp.47.

ibid, pp.31.

Mufti Mohammad Shafi, op.ct. pp.21.

ibid. pp. 24-26.

M. Fadzli Yousof, ‘Takaful: An Islamic Alternative to Insurance”, Islamic Banking
and Insurance, Islamic Bank Bangladesh Limited, Dhaka, 1990, p.61-75

Billah M. Masum, “Islamic Insurance: Its original sketch and Development
Scenario”, Journal of Islamic Banking and Finance, Volume 14, Aprail-June
1997, pp. 24.