Oman’s Islamic banking on growth path

Staff Reporter from Oman Tribune

MUSCAT Islamic banking services in the Sultanate will witness robust growth in the coming days as the central bank will develop general rules and regulations to ensure good governance in these banks, said HE Hamoud Bin Sangour Al Zadjali, Executive President of the Central Bank of Oman, while speaking at the Oman Islamic Economic Forum being held at Al Bustan Palace Hotel on Saturday.

However, Islamic banks should ensure that their banking transactions are sharia compliant, he added.

These banks need to follow assorted accounting standards in certain cases that are acceptable by the parties who are trading in the stock markets and are in line with international standards, he said.

The CBO will review regulatory issues at the legislations which came into force in the first quarter of 2011 and will revise the legislations from time to time based on the developments at the local and world markets.

While elaborating on the functioning of Islamic banking, he said these banks are not isolated from traditional banks and the central bank, the regulator of the banking sector, will keep a link between Islamic banks and other banks. However, it will be a real challenge now and in future.

While talking about the future of the Islamic banking, Prof. Humayan Dar, CEO, Edbiz Consulting and chairman of the Forum, said that the size of Islamic banking industry in the world is expected to touch around $1 trillion, a rise of 7 per cent, in near future. He said while traditional banks have been affected by the global financial crisis in the past two years, the Islamic banks managed to remain immune.

Dr Abdul Aziz Mohammed Al Hinai, deputy chairman of the Islamic Bank for Development, said Islamic banks, which have witnessed robust growth since their launch, are facing challenges in developing a relationship among them, the central bank and other regulatory bodies. Creating a proper supervisory system for the Islamic financial industry, diversification of Fatwas issued by Sharia Audit authorities, lack of standard criteria for contact, lack of efficiencies and talent crunch are also posing major challenges to these banks, he added.

HE Sheikh Dr Kahlan Bin Nabhan Al Kharousi, the Sultanate’s Grand Mufti, said that the Sultanate seeks to learn from other countries’ experience in Islamic banking to avoid shortcoming and help financial and Takaful insurance companies that provide sharia-compliant products.

While talking about the establishment of legislative centres that will grant approval to Islamic banks, Al Kharousi said that banks need to fulfil three guidelines such as a legal framework, managing operations that ensure the provision of Sharia-compliant services and products and efficient and qualified human resources.

The applications require three levels of audit and sharia advice, on top of which is the Central Sharia Authority that lay the general principles and bases for the different sharia compliant activities; this is equal to bonds in capital markets in the Sultanate, he added.

Sharia committee will be in charge of developing details of daily transactions and ensure that they are compatible with the main restrictions. The Ifta house provides advice to decision-makers to ensure that the products are genuinely Sharia complaint.

In response to a question about restructuring of debts in the Islamic way, he said that this may be offered by Islamic banks to help people get rid of usurious transactions. The Islamic windows which will be opened here seek profits, hence the services offered by these windows will be based on sharia contracts.

Tun Abudllah Bin Haji Ahmed Badawi, former prime minister of Malaysia, said that there is a need for global standards in Islamic banking and finance to help it emerge as an international alternative in the sector.

Various countries have their own standards of Islamic banking and financial system. But this creates lots of difficulty in its progress, he said.

Khalid Bin Hilal Al Yahmadi, chairman of Amjad Development Company, said that researches and studies conducted found that principles of transactions at the Islamic economy provide satisfactory and fair solutions for the society.

More than 2 billion rials (over $5 billion) are semi frozen money or interest free deposits. This amount accounts for one-third of the total deposits at local banks. He pointed out that one of the studies affirmed that two-third of the Omani society prefer to deal with financial solutions that are Sharia compliant.

The two-day forum, organised by Amjad Group, was held under the auspices of HH Sayyid Shihab Bin Tariq Al Said and was attended by ministers, honoruable members of the State Council and Shura Council, undersecretaries, executive presidents of banks operating in the Sultanate and Islamic banking institutions from outside the Sultanate.

source : Oman tribune

Islamic banks way ahead of conventional banks

The asset-base of the Islamic banks increased by 13.3 per cent in Oct-Dec 2009 compared to 7 per cent growth in total assets, posted by conventional banking system during the same period under review.
According to the SBP latest report, Islamic banking operations remain profitable and steady in Dec-09 quarter. Growth in assets of Islamic banking continued to surpass the growth of assets in conventional banking by expanding the share of Islamic Banking Institutions (IBIs) in the industry as a whole.
Report stated despite decline in the rate of infected portfolio during Dec-09, increasing Non-Performing Finance (NPFs) remains the key challenge facing IBIs since the first quarter of CY09.
The NPFs to financing ratio decreased by 20 bps to 6.3 per cent amid healthy growth in financing. Category-wise analysis shows continuous increase in NPFs in loss category which now constitutes almost half of the NPFs.
However, increase in NPFs has resulted in marginal change in provision largely due to enhancement of FSV benefit on classified loans. Resultantly, net NPFs to financing ratio increased and provision coverage ratio declined. Increasing net NPFs also deteriorated the capital impairment ratio by 1.5 percentage points during Oct-Dec 2009. Sector wise analysis depicts that textile, others and individuals have the major share in financing. However, infection ratio is quite high for the sectors of automobile & transportation equipment and textile. As per the report revelations, the balance sheet composition of Islamic banks remains stable during the quarter.
Nevertheless, in line with the historical quarterly trend, most components saw improvement during Dec-09. On the asset side, significant increase took place in financing and investments.

source : nation

Islamic Finance Witnesses Tremendous Growth

images31Islamic Finance Witnesses Tremendous GrowthIslamic finance has witnessed tremendous growth in recent years and has the potential to emerge as a mainstream alternative to traditional investments. The industry is growing at an average rate of 15 per cent per year and total funds under its management are estimated at about $1.3 trillion.

While this is ‘a drop in the global financial ocean’, the industry’s potential is enormous. This is because many of the world’s 1.6 billion Muslims as well as non-Muslims are increasingly becoming part of its customer base. Many non-Muslims see Shari’ah-compliant products as offering an alternative ethical investment that is clean, environmentally friendly and socially responsible, as well as a way to diversify investor portfolios. The impressive realized growth as well as the tremendous potential throws up the need for trained professionals in the field to fill the ever-increasing demand-supply gap. The sector also offers interesting questions that need to be addressed urgently the global community of scholars and researchers.

Given this background, IBF Net (Islamic Business and Finance Network) and the International Institute of Islamic Business and Finance have initiated a series of International Training Programmes in India. The maiden training programme in this series was organised at the India Islamic Culture Centre, New Delhi on May 4. The programme participants comprised about 20 professionals from the RBI, several commercial banks and finance companies. It was conducted by a two-member team comprising Dr Mohammed Obaidullah, a Senior Economist with the Jeddah-based Islamic Development Bank (IDB), Founder, IBF Net and Dr Ausaf Ahmad, Former Senior Economist with IDB and President, IBF Net; supported by Shafeeq Rahman, a doctoral student in Islamic economics with Jamia Millia Islamia.

The programme comprised four intensive sessions dealing with Norms of Islamic Finance; Islamic Commercial Banking; Islamic Insurance and Islamic Investments.

According to Dr Obaidullah, IBF Net plans to organise two more programmes in Mumbai and Chennai in September 2008 focusing on Islamic capital markets and microfinance respectively.

The Islamic Business and Finance Network is a global network of over 5000 bankers, finance professionals, scholars and researchers interested in the field of IBF. It was founded in the year 1999 by Dr Mohammed Obaidullah in India and has been a pioneer in the field of IBF education, research and training on a global scale.

source radiance wk

The growing importance of Islamic finance in the global financial system

Remarks by Mr Malcolm D Knight, General Manager of the BIS, at the 2nd Islamic Financial Services Board Forum, Frankfurt, 6 December 2007.

Abstract

Although there are differences between Islamic banking and “conventional” banking, there are some fundamental principles that apply equally to both. In particular, rigorous risk management and sound corporate governance help to ensure the safety and soundness of the international banking system. In the light of the growing importance of Islamic banks and Sharia-compliant financial innovation, the increasing integration of Islamic financial services into global financial markets serves to strengthen this point.

The Basel II framework improves the risk sensitivity and accuracy of the criteria for assessing banks’ capital adequacy. This framework is fundamentally about stronger and more effective risk management grounded in sound corporate governance and enhanced financial disclosure, the importance of which has been underscored by the recent problems that have arisen in the banking industry worldwide. The guidance provided by the Islamic Financial Services Board (IFSB) is a useful contribution to the realisation of these global goals. It will support the establishment of resilient financial market infrastructures and sound and robust core Islamic financial institutions operating according to safe and sound risk management practices.

 

Full speech

Introduction

Good morning. I am pleased and honoured to address the 2nd Islamic Financial Services Board Forum today. As the General Manager of the Bank for International Settlements, I am particularly pleased to be here today to discuss Islamic finance and its growing importance in the global financial system. But let me start by commending Professor Rifaat Ahmed Abdel Karim of the Islamic Financial Services Board and Josef Tošovský of the BIS Financial Stability Institute for putting together such a comprehensive programme. It is entirely appropriate that the IFSB and the FSI should join forces to organise this conference. After all, the IFSB’s mission is to promote the soundness and stability of the Islamic financial services industry. It does so by issuing global prudential standards for the industry. Likewise, the FSI’s mission is also to promote sound supervisory standards and practices globally.

BIS and BCBS support for the IFSB

As an associate member of the IFSB, the BIS has been actively supporting the IFSB’s mission and initiatives since the Board began operations in 2003. The Basel Committee on Banking Supervision, which is hosted by the BIS, is increasingly looking beyond its membership to enhance cooperation with non-member countries and organisations with related interests and similar goals. The Committee’s outreach to non-member countries is part of an initiative to promote the development of sound supervisory practices and to accommodate the growing importance and sophistication of non-member banks.

The BIS and the Basel Committee have been strong supporters of the IFSB through participation in IFSB working groups, such as the capital adequacy group, and by providing speakers for conferences and other events. I believe that the active and productive dialogue between the Basel Committee and the IFSB will continue to benefit both of our organisations. Professor Rifaat and members of the Basel Committee’s Secretariat have recently held fruitful discussions, and continue to strengthen the cooperation between the IFSB and the Committee.

In my remarks today, I will not address the specifics of Islamic finance and how it differs from conventional banking. Instead, I would like to focus on two elements of banking supervision that Islamic and conventional banking have in common. That is, appropriate levels of risk management and corporate governance, which help to ensure the safety and soundness of the international banking system.

Growth in Islamic finance

As I am sure you heard yesterday and will also hear today, there has been significant growth in Islamic financial services in recent years and there is every reason to expect that this growth will continue at a rapid pace. Clearly, there is expanding demand for these products, and a closely associated desire on the part of banks, including non-Islamic banks, to provide Islamic financial services.

Although it is still modest in size relative to conventional retail banking, Islamic retail banking is rapidly becoming more visible. This is particularly true in the Middle East and Asia Pacific regions, where a number of Islamic banks and banking units have been opened in recent years. There are also Islamic banks and asset managers in key international financial centres of the United Kingdom and the United States.

The growth in Islamic finance is also visible in the expanding range of services and products that comply with the basic precepts of Sharia law. One example is the burgeoning global market interest in Islamic bonds – Sukuks – many of which are increasingly being issued and bought outside the Islamic world. This suggests that non-Islamic investors in general are becoming comfortable with Sukuks. The broadening appeal of Islamic finance is also evident in the move by large international banks and other private sector financial institutions to provide Islamic financial services. This includes the establishment of exchange-traded funds that are screened to ensure their conformity with Islamic investment principles, as well as offering “takaful” – or Islamic insurance.

Although the elements that are usually emphasised at conferences like this are differences between Islamic banking and “conventional” banking, there are some fundamental principles that apply equally to both. For example, I can point to the necessity of strong corporate governance, rigorous risk management and sound capital adequacy requirements as essential ingredients to ensure the safety and soundness of any financial system. The increasing integration of Islamic financial services into the global financial fabric only strengthens this point.

What about risk management and corporate governance?

The issuance of the revised Basel II framework for bank capital adequacy not only improves the risk sensitivity and accuracy of the criteria for assessing capital adequacy, but it is fundamentally about stronger and more effective risk management grounded in sound corporate governance and enhanced financial disclosure. I should acknowledge that the special features of Islamic banking may not always be adequately addressed by broad international standards for conventional banking contained in the Basel II framework. Nonetheless, the IFSB considers carefully the global banking standards that have been and are being developed for conventional banking. The IFSB’s capital adequacy standard, for instance, draws to a large extent on Pillar 1 of the Basel II framework (the minimum capital adequacy requirements). It has also released an exposure draft on the supervisory review process (consistent with the principles of Basel’s Pillar 2) and another on disclosure and market discipline (Pillar 3).

As interest in Islamic finance grows, the importance of the IFSB’s role increases. The importance of the fundamental elements of banking – conventional or Islamic – cannot be emphasised enough. Topics such as corporate governance, risk management and capital adequacy are key elements that underpin sound financial practices. The guidance provided by the IFSB in these areas helps to ensure that there are resilient financial market infrastructures and robust core financial institutions operating according to safe and sound risk management practices. It is important that the same degree of supervisory oversight is applied to Islamic financial institutions, to ensure the continuing acceptance of their instruments and services in international markets and conventional banking systems . In addition, the guiding principles and standards developed by the IFSB are assisting supervisors globally to better understand and supervise institutions providing Islamic financial services.

This is why I am particularly pleased to see the issuance by the IFSB, over the last couple of years, of its capital adequacy standards and guiding principles on corporate governance and risk management. The issuance of these prudential standards and guiding principles helps to enhance the soundness and stability of the Islamic financial services industry and helps fill an important niche, as will the recent exposure draft on market discipline.

The importance of robust risk management systems and corporate governance cannot be overstated. Many of the recent problems that have arisen in the banking industry worldwide, such as losses due to accounting improprieties, low underwriting standards and inappropriate valuation methodologies – particularly when applied to complex financial instruments, are primarily due to poor corporate governance and inadequate risk management. Given these shortcomings, what then are the implications for banks and supervisors?

Risk management

First and foremost, with respect to risk management banks must have policies and procedures in place that enable them to identify, measure, control and report all material risks. Bank management is primarily responsible for understanding the nature and degree of the risks being undertaken by the institution. This was not necessarily the case with respect to subprime residential mortgages, mainly packaged by conventional banks in the United States, which were then securitised and resold as mortgage-backed securities and collateralised debt obligations. Investors at large, and the managements of even some of the largest internationally active banks, did not fully appreciate the risk inherent in the subprime mortgages embedded in the structured securities they had purchased. Instead, many relied too heavily on the credit ratings that the specialised credit rating agencies established for the various branches of the resulting structured products. While Basel II provides a better framework for supervisors to focus discussions with banks on the robustness of their risk measurement and management of complex financial instruments, banks’ risk management systems need to be constantly adapted to better address the effects of innovation in the financial markets and increased complexity and opacity of financial activities in which banks are engaged. While weaknesses in these areas have focused on conventional banking instruments and institutions, Islamic instruments are not immune to them.

Strong risk management is a critical component of a bank’s ability to withstand adverse conditions. And this is certainly as important for Islamic banks as for other types of financial institutions. One element that is essential is comprehensive stress testing that can capture the effects of a downturn on market and credit risks, as well as on liquidity. This helps ensure that banks have a sufficient capital buffer to carry them through difficult periods. In the events of last summer and this autumn, it became clear that many banks’ stress tests did not anticipate the degree and breadth of illiquidity that resonated throughout the credit markets. Stress tests must consider the effects of prolonged market tensions and illiquidity, and must reflect the nature of institutions’ portfolios and realistic assumptions about the amount of time it may take to hedge out risks or manage them in severe market conditions.

Corporate governance

The necessity of a robust corporate governance framework has long been recognised by bank supervisors around the world. Indeed, supervision would not be possible without sound corporate governance in place. Over the years, experience has highlighted the need for banks to have the appropriate levels of accountability, as well as sufficient checks and balances. In general, sound corporate governance effectively addresses the manner in which the decision-making process in the organisation is structured, the respective responsibilities and accountability of senior management and the board of directors, and the control functions that ensure the accuracy of the monitoring processes.

Of course, when supervisors review an institution’s risk management system and corporate governance framework, they must consider the system’s appropriateness in relation to the bank’s size, its risk exposures and the nature and complexity of the financial instruments it deploys.

Market disclosure

I have already noted the IFSB’s exposure draft on disclosure and market discipline that was released for comment late last year. This interest in promoting increased transparency and market discipline is especially important, particularly given the recent difficulties experienced by banks and investors alike with respect to complex structured products. Much of the current turmoil in the credit markets has related to questions about the soundness of certain types of collateralised debt obligations (CDOs) and asset-backed commercial paper. These problems might well have been avoided or at least mitigated if there had been greater transparency both about the products themselves and the commitments made by the banks that originated them. Again, this problem has thus far been concentrated in conventional banks in the key financial countries. A crucial area where more transparency has proved necessary has been in the exposures of some large financial institutions to CDOs of securities backed by subprime mortgages in the United States.

Basel II and the IFSB’s exposure draft on transparency both seek to raise the bar on the quality of financial disclosures by providing clearer industry benchmarks. Enhanced financial disclosure that improves the transparency of banks and complex structured products, valuation, and the measurement of risk exposure can certainly help to improve overall risk management. In addition, requiring enhanced qualitative disclosures will permit all banks to put their quantitative disclosures into better context and assist them in explaining their approach to risk management.

Conclusion

Let me conclude by emphasising that rigorous risk management and sound corporate governance are key elements of any bank’s ability to understand and manage its risks. With the growing importance of Islamic banks and Sharia-compliant financial innovation, it will be increasingly important to ensure sound Islamic financial institutions going forward. Supervisors must work together to encourage all banks to improve their risk management systems, controls and transparency. Such improvements will help ensure the stability and soundness of the international banking system. Thank you very much.

soure : bis.org

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/