(Transparent, inflation-protected, and operating under conventional banking laws) ·
B anking has become an essential
necessity of modern-day
life Government s, business es,
institution s and
private individual s all need the services of a bank. True, it is an absolute necessity in
s ome countries and not so essential in others,
but rarely a ny country can do
without it. Practically every individual in an
advanced country needs, and has, a bank account too , and the trend is in
th at direction in
every country, including the developing
countries. come to address their special
let us briefly examine the services banks provide and how they do it, so that we
can determine exactly where the problems lie. Then we can devi ce solutions to address the specific
issues that concern Muslims.
The main functions of modern conventional banks as they exist today include providing what is called current account facilities, money transfer services, accepting funds into savings accounts, granting loans and advances, facilitating import-export transactions, and buying and selling foreign currency.
Current account facilities include accepting cash deposits into your account and allowing you to withdraw from it as when you require the whole of it or a portion. You can also use a cheque to instruct the bank to pay another person or entity a stated amount of money and debit the same from your deposit in the bank. Similarly, you can receive payments made by others into your account. This ability to pay and receive without having to personally carry notes and coins is a great boon to transacting business — personal and institutional. Private individuals use the current account to receive their salaries and wages and to pay their bills. Businesses and institutions use the current account to make payments for the goods and services received and to receive payments for the goods and services provided. It saves time, and is safe and less expensive. The transactions through cheques can be made whether the payer and the receiver use the same bank or different banks, and whether the concerned banks are miles away in the same country or continents away in different countries.
Money can also be transferred from one person to another, even without having a current account with a bank, through the banks’ money transfer arrangements — money orders, pay orders, bank drafts, mail and telegraphic transfers, electronic transfers, etc. — both within and outside the country. There are also other bank guaranteed payment facilities, especially the letters of credit and bills of exchange, which greatly facilitate import-export trade. In fact such trade is practically impossible without this facility.
Banks also accept funds from the public and institutions
into savings accounts, keep them safe, and pay interest on such funds. In turn, they use these funds to grant
loans and advances to borrowers, whom the bank charges
an interest. This service provides the savers with a
known income, while their capital remains intact. On the other side, it provides the
borrowers access to funds, which they would otherwise not have. The borrowed funds may be used for
setting up a new business, to expand existing business, to provide working
capital for a running business, or for consumption purposes including buying
consumer durables, to tie over a difficult period and to meet an
They also provide many other services including agency
services, business introductions
, credit reports , etc. Another important service is in the
foreign currency field — buying and selling foreign currency, issuing travellers
cheques and credit cards.
Some of the above are paid services, others are not
; some involve paying or receiving
interest, others not. But the banks and
have become an integral part of the present-day world.
The nearly 1.2 billion Muslims in the world are scattered
all over the planet. There are 56
member-countries in the Organisation of Islamic Conference, and there are Muslim
minorities, large and small, in
practically all countries. There are over 100 million Muslims in
than all the Middle-eastern countries put together, though
they are a minority in that country of over one billion people. The countries and people are also at
various different stages of development and advancement. A major characteristic of the Muslim
population distribution is that the majority are in the developing countries,
with all the associated infrastructure deficiencies, including low levels of
literacy. But they all need modern banking
facilities, and they all
have one common concern — avoiding riba
(interest) in their dealings. A
banking system designed to address their concerns has to take into account this
main concern as well as the other factors.
In common with most developing countries, the Muslim countries also face extreme levels of inflation. Conventional banking deals with the inflation problem tacitly – by incorporating it into the interest rate. Since that is not possible in a riba-free system, we have to address the problem explicitly.
The main concern of the Muslim community is its desire to
avoid dealing in riba, because riba is strictly prohibited in their
religion — Islam.
Riba is loosely
translated as interest. Whether
this translation is accurate or not — whether the Arabic word riba and the English word interest mean
the same thing — is the subject of a long-standing debate. This question needs to be satisfactorily
resolved in order to find a proper solution to the problem. In the meantime, a comprehensive and commonly accepted
of riba is
that : when one lends some money to another, if the lender
demands more than his principal to be returned, the excess amount so demanded is
riba. Islam strictly prohibits demanding
and/or receiving riba, paying riba, and witnessing such a transaction.
In the context of modern banking, the depositors receive
interest, borrowers pay interest, and the bank both pays and receives interest,
transaction and keep s account of it. It is on this account that modern banking is
repugnant to the Muslims .
We can begin by asking whether all the operations of a
commercial bank are unacceptable to the Muslims on account of the riba prohibition. Can they make use of some and seek
alternatives for others? To do
that, we need to
first look at the working of a conventional bank in
The sources of funds available in a bank can be categorised by the type of deposit account in which it is held as well as by the purpose for which it is held. Similarly, the use of funds too can be categorised by type and purpose. A schematic representation is given in the table below.
s of funds and their uses,
Source of funds
Purpose of deposit
Use of funds
Purpose of the use
Current account deposits
Safety and ready availability; transaction convenience
Money transfers, short-term advances
To facilitate receipts, payments and transactions; to accommodate short-term financial needs
Ordinary savings account deposits
Safety, easy availability; temporary holding and possible compensation for inflation
Short- and medium-term loans
To accommodate small / medium size financial needs at small / medium terms.
Time (Fixed) savings account deposits
Safety, fixed and known return, compensation for inflation
Long- and medium-term loans
Financing large-scale / long-term investments
The first source is the current account deposit
s. They are held in the bank for the
purposes of safety and ready availability and for the transaction
convenience, which has become almost a necessity in modern life. We have already seen the working of a
The second source is the ordinary savings deposit
s. Banks pay an interest on savings
deposits in order to attract more funds, but the primary concern of the
depositor in an ordinary savings account is the safety of his/her savings and
its easy availability when needed.
It is usually a temporary holding and the paid interest cover s the value loss due to inflation. In less developed countries, many people have no need
or access to current accounts, for various reasons, and therefore they resort to
ordinary savings accounts. Whatever
the intentions of the depositors the banks use the funds to grant loans and
advances to clients and borrowers.
The third source of funds is the fixed deposits. Here the main consideration of the depositor is the fixed and assured interest (or return) he receives from the bank. Safety and compensation for inflation are also considerations but they are part of the package. The bank uses the funds from this source to grant long-term and large-size loans.
The fixed deposits are investments from the point of view
of the depositors, and the loans granted using this source of funds are finance from
the point of view of the entrepreneur-borrowers. Since the fixed return paid to the
depositor will fall under the category of riba, Muslims depositors cannot
accept the paid return. The loans
are also given on fixed-return basis.
This too is riba and therefore Muslim entrepreneurs cannot make
use of such finance. Hence a
riba-free bank cannot provide such an account. Islamic bankers came up with the idea of
converting this account into an investment account and using the funds to
finance borrowers’ projects under a profit-and-loss-sharing scheme whereby the
investment account holders too will receive a share, which will not be a
pre-fixed amount and may well be a loss.
But this scheme has proved
unviable and has in fact created more
In order to deal with these difficulties, which are peculiar to Muslims and therefore have not been taken into consideration by the conventional banking system, Muslims will have to develop their own institutions. A suitable proposal has been made elsewhere. It is suggested that the funds from the third source be handled by an entirely separate institution operating under the rules of mudaraba. Therefore this essay will deal with only the first two sources of funds and their commercial use.
Islamic banking movement has introduced another category to the use of
funds. This is called by various
names such as qard hassan, gharz-al-hasaneh and
qard-e-hasana. The important requirement here is
that if the borrower is unable to repay the loan
it should be written off and regarded as
Then we will have a bank that is free of the encumbrances of the charitable loans, but it will also be without the benefit of a large source of funds — the fixed deposits. Yet this bank will be able to provide all the services generally required of a commercial bank. We will call the resulting bank the riba-free commercial bank.
The bank under consideration is a commercial entity that provides services for a payment. It accepts deposits, guarantees their safety and full return, and provides all current account facilities — such as cash receipts, cheque collection and payment, electronic and other types of fund transfers, etc. — currently provided by conventional commercial banks. Depositors explicitly or implicitly agree to their funds being used to grant loans to borrowers, but the bank guarantees the full return of their deposits as and when required or as agreed. The depositors do not demand nor are they paid any financial returns on their deposits. As such the depositors deal in no riba.
The borrowers are granted loans on condition that the capital, which belongs to the depositors, is returned in full, whatever their financial circumstances, and they pay the bank a fee for making the funds available to them. The fee includes all the costs incurred by the bank and a remuneration (or profit) for providing the service. This service can be likened to the services provided by a courier who carries the money from the depositor (the real owner-lender of the money) to the borrower. At the end of term, the courier carries the money back to the owner. The courier is also responsible for the security of the money while in his possession. Since the owner-lender did not demand any extra amount (which would be riba), the borrower dos not pay any extra amount (to the owner-lender) beyond the principal. Since no riba was demanded or paid, the courier does not carry, witness or keep account of any riba. Therefore the bank’s “lending” operation is free of riba. The bank makes sure that the borrower has the ability to repay the capital and the fees.
At this point it is worthwhile to
point out and emphasize
the two basic assumptions in the concept
of this riba-free bank.
One, riba is what is demanded and/or received by the capital-owner
(who is the real lender) over and above the capital he lends; and two, the
payment made by the borrower to the courier for his services is not
riba. It is necessary that
these two crucial points are fully understood and accepted as correct under
Islamic law before we proceed with further discussions. This bank does not
get involved in charitable loans.
Consequently, there is no “leakage” to its funds. Compat i bility with conventional
banking is one of the desired goals in devising this riba-free bank. As mentioned above we have eliminated the possibility of a leakage and
that should find favour with the banking authorities. But the riba-free limitation has
made it a smaller bank. Let us now
examine the positive aspects of these features.
The commercial bank envisaged here is a much smaller one than a standard conventional bank. This is a consequence of accommodating the riba-prohibition rule of Islam and hence a built-in feature. Therefore we need to examine the implications of this necessarily smaller size.
It came about because we spilt the deposit base of the conventional bank into two parts: demand deposits and ordinary savings deposits on the one hand and the fixed deposits on the other. The latter is generally much larger in size, and therefore what is leftover is at most only one-half of the standard size of a conventional bank.
On account of the smaller size and its composition, this
bank cannot grant long-term and large-size loans; it is limited to advancing short-term
and small-size loans,
some medium-term and medium-size loans may be accommodated. However, on account of th is term and size limitations this bank is much less exposed to
business-failure risks. That gives
more stability to this bank and to the banking system as a whole.
The smaller deposit-base and the larger reserve requirement on these deposits also result in much reduced bank-created credit. It does not negate the bank’s credit-creating ability, and thus deny the economy of the benefits of this facility, but it limits its size. Thus it reduces the risk of bank failures and adds to the stability of the banking system. Furthermore, it restrains money supply expansion and hence helps to hold down inflation.
If the equity capital required to set up a bank is based on the size of the bank, this smaller-size bank, with much reduced failure-risk, will entail a smaller equity capital. This will enable the establishment of more commercial banks, resulting in increased competition, which, in turn, should result in better service and efficiency.
The reduced capital requirement will also help to take
banking facilities to remoter areas as well. People residing in areas away from the
main cities hold their monetary capital in the form of cash (notes and coins)
for want of a bank in the neighbourhood.
This is the case in many developing countries and hence a considerable
portion of the available monetary capital remains outside the banking
system. If this cash, both idle and
active, could be brought into the banking system and the credit creating
ability of the commercial bank is used, more
funds from domestic sources will become available for business purposes.
Our bank satisfies the basic requirements of a
deposit-taking bank. One, it
guarantees the depositor’s capital; two, its assets are
, and the return on
them are also
assessable and sufficient to maintain the bank ; and
three , the interest paid to the depositors is
non-negative. Our bank
pay s zero interest, but that is no problem for
the banking authorities so long as it is not
negative. There are also no built-in leakages due
to charitable loans. Other formal
legal requirements are easily met.
Thus our bank qualifies to be registered as a deposit-taking bank with
the central bank under conventional banking laws. This authorisation to set up and operate
as a commercial bank under conventional laws has several advantages.
this will ensure proper auditing and
monitoring, which will in turn inspire public confidence in the bank. This is vital.
Two, it will enable riba-free commercial banks to be
set up in
countries of the world, Muslim and non-Muslim. This will greatly facilitate
international export-import trade without the fear of being involved in any
Three, since this bank can be set up in non-Muslim
countries as well and will
offer all conventional commercial banking services, its clientele need not be
limited to the Muslims. Therefore
it has as
good a chance of survival as any other bank.
Four, the considerable number of Muslims living in
non-Muslim countries will have the possibility to bank with a riba-free
bank which is competitive and offers all the
facilities of a conventional bank.
Five, since all religions
interest earnings, and even where it is not explicitly prohibited people look down upon those
who lend on interest, some people will appreciate the chance to bank without
interest provided the value erosion of their capital due to inflation is
compensated and all other banking facilities are offered. There are also people who eschew
interest for reasons other than religious belief. They too will appreciate the opportunity
given by this bank.
Six, this bank can hire officers who have already had
training and experience in conventional banking, and they can get to work
practically straightaway without having to undergo further training in an
entirely new system. This is a very
big advantage, and is cost-wise and time-wise efficient. It will minimise
the gestation period and reduce teething
Seven, the compatibility with conventional banking makes the conversion of a conventional bank into a riba-free one easy and quick.
Eight, from the customers’ point of view too, it is easier to understand and follow the procedures since they are not very different from the ones the customers are already used to in dealing with the conventional banks.
Finally, these banks, being compatible with the conventional system, will be able to easily communicate and deal with other banks, within and outside their own country.
Practically none of
the advantages listed above are currently available to the Islamic
banks as they operate today, even within the few Muslim
countries where they are permitted to operate on their own terms. As such it is worth giving some serious
thought to the proposed riba-free bank.
Transparency is absent in both the conventional and the Islamic forms of banking. But it is the foundation of the proposed riba-free commercial banking. In the first place, transparency tells both the bank itself and the supervising authorities what the real costs are, how they are distributed, and what the profits are. Secondly, in dealing with inflation, it enables one to know exactly what the loss of value of capital due to inflation was and how it was compensated. Both the depositors and the borrowers too know what they are being charged or paid, and for what reason.
This transparency comes about on account of the model we are using in computing the fees charged by the bank. In conventional banking this fee is a single item, called interest, and it is calculated as a percentage of the principal and depends on the duration of the deposit or loan. In Islamic banking as practised today, in most cases, it is also a single item called profit (or mark up) though it may or may not depend on the size and duration of the “loan”. In the model used here this single item is considered as consisting of six components: interest paid to the depositor (which is identified with riba), the cost of specific services provided to the borrower on account of the current loan, cost of overheads of the bank (which includes the costs of general services provided to the depositors and borrowers), bank’s profit, a premium to the loan default insurance, and compensation for the loss of value of capital due to inflation.
From the borrower’s point of view “interest” charged by the
bank is the cost of borrowing, and it has now been shown to consist of six
components, only one of which is real interest. The first component (interest) is
present in conventional banking and absent in riba-free banking; the next
three components cover the fee charged by the bank; the insurance premium goes
to a separate fund; and, if inflation is taken into consideration, the last
component (compensation for inflation) is recovered from the borrower and passed
onto the depositor. Unlike in the
the conventional interest, each one of
these components is computed in a different way
and posted to its own separate account.
This may seem much additional work, but in this computer age it is
not. The result, however, is a
positive gain. Let us take a closer
Compensation for inflation is the same for all loans in all the banks because it is computed using the same data and formula. The loan default insurance is expected to be run by a single body (or several bodies operating under the same rules) and therefore the premium should be the same for any given borrower in any bank.
Within the fees charged by the bank, the first component is
the cost of services procured in the course of processing the loan
application. This is specific to
the particular loan under consideration, and often consists of charges paid to
outside agencies (such as to a lawyer for title checking of the collateral,
stamp duties to the government, etc.) and is a one-time cost. The second is the overheads
cost. This is a generalised cost estimated
using total annual average net overhead s cost of the bank (consisting of staff
salaries, buildings, supplies, maintenance, etc. less income from paid
services using the same facilities) divided by the total annual average loans
granted by the bank during the same period. Thus it is the bank’s cost in obtaining
and sustaining loanable funds. This
per-dollar-per-day cost, equally applicable to all loans and advances. This cost, being expenses minus incomes
of the bank, will depend on the efficiency of the bank. Hence it is subject to market
forces. It is continuously
monitored, and may vary from year to year, but is kept fixed during the
year. The third component, bank’s
profit, is a percentage of the first two components. This percentage may vary from bank to
bank, but since this system is transparent, under normal circumstances market
competition will determine its size.
The fact that all th
e se information are routinely available to the borrowers gives
them the necessary information to shop around for their advantage, creating competitive market
conditions. This management
information is also very useful to the bank supervising authorities, who will
then have a good overview of general trends in the whole sector.
This detailed transparency, which is not available under
the current practices, is a major characteristic of the proposed system.
On account of the fact
that all the components (of the
of borrowing) are subject to market
forces, and none to arbitrary fixation, and the results are transparent, it is a
truly free-market system.
Consequently it reaps the benefits of that system — efficiency and lower
Frankly speaking, when one talks of Islamic banking there
s to be two expectations — expressed and
unexpressed — in the minds of people.
Those who expect to borrow seem to feel that they would get loans on
which they need not pay any interest — they need to repay only the capital. account s accounts.
Yet it is good to see and record how valid these expectations and
reservations are in the
case of our bank, vis-à-vis the conventional banks .
First the current (or demand deposit) accounts. Conventional banks do not pay any interest on current account deposits. Our bank also does not. So there is no difference between the two banks in this area. This leaves us with only the ordinary savings accounts and the short- and medium-term loans.
An ordinary savings account in a conventional bank stands somewhere between a current account and a fixed-deposit (or time-fixed) savings account, both in terms of interest received and facilities provided. An ordinary savings account holder has the advantage of withdrawing his deposit (fully or partially) practically at any time (or at very short notice). In this he is nearly akin to one having a demand deposit account, but without the other facilities of the latter (mainly transactions using cheques). A depositor holds his funds in such an account because he is not sure when he may need his funds back or how much at any given time. Here he has the advantage of taking out what he needs when he needs, but what is not withdrawn earns interest, albeit at a reduced rate compared to a fixed deposit but better than the zero interest of a current account deposit. The main concern of such a depositor is the safety of his funds. In developing countries, for various reasons, some people are unable to have a current account and therefore they use a savings account instead. These latter are not concerned about the interest. Some others use this account to build up a certain amount for future use (such as to buy property, durable goods, or invest in a business) by depositing their extra earnings as and when they receive it. These and such others consider any interest received as compensation for loss of value suffered by their capital due to inflation. But the interest on these deposits are computed on the minimum balance held during a calendar period, such as a quarter or month.
When there is high inflation the lower rate paid on ordinary savings accounts hardly covers the capital loss due to inflation. Further, when the minimum balance and calendar period criteria are taken together, many depositors miss out on their interest. For example, if one deposited 5000 on 5 January and withdrew it on 27 June, given a minimum period of three months, he would have missed the first quarter by four days and the second quarter by three days and would receive no interest whatsoever, even though his money was available to the bank for a full five months and more. As another example, suppose a person deposits 5000 on 15 December, withdraws 4000 for an emergency on 20 March and deposits it back five days later on 25 March, and finally withdraws the whole amount on 15 April. He will receive interest only on the 1000 minimum balance held during the first quarter, on account of that withdrawal for five days. This happens all too often in practice, and therefore the perceived loss to ordinary savings depositors is in reality minimal. If compensation for inflation loss can be arranged, as is proposed in this system, then such fears will have no basis.
The expectation of cost-free loans from a bank is simply wishful thinking. It is both unrealistic and impractical. Unfortunately it is the result of a narrow, out of context, interpretation of a Qur’anic verse. The verse is addressed to a lender who lends his own money to a known person, in a person-to-person context. The lender is asked not to demand anything more than his capital from the borrower. The additional amount is called riba and prohibited, but the capital is his due. Even here if the borrower had to incur expenses in travelling to meet the lender, the lender is not expected to pay the travel expenses of the borrower, and the travel expense is obviously not riba. If he sent a courier instead and the courier asked for the same travel expenses, and his wages in addition, these will have to be paid by the borrower and not by the lender, and this expense is not riba. Obviously it is ridiculous to expect the courier, who provides a tangible service to the borrower spending his own time and effort, to do it free and also to incur the travel expenses, without any benefit to himself. Yet this is exactly what some seem to expect when they demand interest-free loans from a bank. That a modern bank incurs a lot of expenses — in collecting funds from depositors, keeping them safe, scrutinising the loan applications of the borrowers, disbursing the loans, recollecting them and repaying the depositors, and in keeping accounts and records of all these — is for all to see. Riba-free loans are possible, when the capital owners do not demand it, but cost-free loans are a fantasy, except when it is a person-to-person transaction in the same locality.
What the proposed riba-free bank promises is exactly
what it says — banking facilities
without involving in riba.
The small reduction in the charges the borrower pays this bank (as
th at to a
conventional bank), because it does not include the riba component, is
incidental. So is the minimal loss an ordinary
savings account depositor may suffer.
The yardstick of success is whether the bank operates riba-free or
not — not whether the loss or gain is more or less compared to a conventional bank.
However, the transparency we discussed earlier will bring
about reductions to the cost of borrowing, compared to a conventional bank
so long as it
The compatibility of this bank with
that of a conventional
makes the operation of this bank
easy. For all the
tried-and- proved methods of the conventional banks can be
readily used by this bank . Only
the cost of borrowing as explained above will replace bank interest
in all calculations, and the deposit interest rate will be set equal to
zero. Where relevant, compensation
for inflation will be computed as explained in Gafoor (1999) and will be
collected from the borrowers and paid to the depositors, as appropriate. Now let us very briefly sketch the main
operations of the bank.
This bank will have two kinds of deposit accounts: demand and savings. Demand deposits will earn neither riba nor any compensation for inflation. Savings deposits too will not earn any riba but they will be paid compensation for inflation on minimum balances held, say, for a minimum of three calendar months.
It will provide short-term advances, and short-term and
medium-term loans, which can be for durations of less than a month, less than a
year and less than three years, respectively. Borrowers will pay the cost of borrowing
on all loans and advances. However,
one or more components of the cost of borrowing may become zero, depending on
the type of loan. For example,
compensation for inflation will be collected from all loans of three months or
more duration but this component will be zero in shorter-term loans; short-term
advances will not have the service cost component; and inter-bank loans will
entail only overhead
s charge, all others being zero. Islamic banks as they operate today find
it difficult to provide needed services in many important areas. These include short-term advances to
over liquidity problems, medium-term loans to set up small businesses,
short-term loans (or working capital) to running businesses, and consumer
credit, on a viable commercial basis.
But these are among the most important banking services required in any
economy. Inter-bank credit is also
another important necessity in a banking system, but
Islamic banks are unable to provide it.
Other important areas include treasury bills, bills of exchange, and letters of credit. These too present no problems, since they can be treated as short-term loans (of generally less than three months) and charged accordingly.
Another important area is government bonds. The suggested solution to this is to
denominate these bonds in units of gold. Then they will be sold at the current
price of gold and will be bought back at the price current at the time of
maturity. Thus the government will
not pay any riba and the bond-holders will not demand or receive any
riba, but the real loss of value of their capital due to inflation will
be automatically and very transparently compensated.
All other normal commercial banking operations will take place as in a conventional bank.
Depositors, both current and savings account holders,
receive several types of services from the bank. These include
, safekeeping of their
money , accepting
deposits whenever they bring them in, returning them fully or in part when requested, keeping account of all
these, accepting cheques drawn in favour of an account-holder and presenting it
to the drawer’s bank and collecting the proceeds and crediting it to the payee,
paying cheques drawn by an account-holder, honouring standing orders for regular
payments, electronic transfer of funds, cash dispensing from automatic teller
machines , etc., etc. Most of these are offered free of charge
though the bank incurs a lot of expense in providing them. They are offered to the depositors free
only because their money, while held in the bank, is used by it to lend to
borrowers and thereby earn an income.
These services are needed by the depositors, and they should pay for them
in cash if obtained from any other source.
But the bank provides them free in order to induce them to keep their
money with the bank. This service
in kind is offered and received only because the depositor has given (or lent)
some money to the bank; otherwise it would require payment in cash. Seen in this light, is it
The Islamic banking literature seems to be largely silent
on this question. But it is necessary to raise the
question, even though we do not propose to answer it. It is for the Shari’a experts to
enlighten us on this. All that we
can say here is that the bank as proposed above can accommodate both yes and no
answers. If the answer is no, then
nothing in the present state of affairs need to change. If yes, then the depositors will have to
pay a fee for the services they receive and it will become an income to the
; consequently it will reduc e the overheads cost and hence the cost of
borrowing will become cheaper.
In the foregoing paragraphs we have taken a conventional bank and divided it into two sectors, one that provides a banking service and the other that caters to investment and finance. Our essay here was concerned with the former and the latter has been dealt with in a companion article. The sector that is under consideration here plays an important and essential role in conducting the businesses of individuals, organisations, businesses and the government, and touches the lives of practically everyone. Most of the daily activities in a bank, including almost all the transactions, take place in this sector. Comparatively speaking, the number of people involved and the number of transactions taking place in the other sector are much smaller, even though each transaction may involve huge sums of money.
In the history of banking, the origins of the first sector goes
back to the goldsmiths and their receipts confirming the deposit of gold by a
client and its availability to the bearer, and the second sector goes back to
the moneylender who lent his own money on interest. Later on these two were combined to form
the progenitors of the modern bank.
The activities in the first sector provides the modern bank with the
ability to create bank credit, and the second the bulk of the monetary basis for
this creation (using depositors’ money).
Thus this combination enables the modern bank to lend huge sums of
money. In turn, this enables the
debt-based financing of enterprises, large and small. This contributes to greatly accelerated
By separating the two sectors, this chain of events can be eliminated at source without losing the benefits of either. The commercial bank can still create credit and help cash flow and provide financing, but on a smaller scale and on shorter terms, using the funds in current and savings accounts. This would practically eliminate risks of bank failures. And, the funds that would otherwise go into time-deposits will be used by investment companies and investment banks to equity-finance enterprises, giving stability to the economy. But both will have to go together to create a comprehensive banking and finance system.
Unfortunately Islamic banking has come to be associated with
the investment and finance sector, and has practically ignored the other sector,
except in a few countries such as
Pakistan, Iran and the Sudan
where it has been compelled to accommodate the other too. It is also h ere that
it has dismally failed. Besides the fundamental flaws
in the model used, the re is also a
historical reason for
this. T he
Islamic banks came into being consequent to the oil
price hike of 1973 and the resultant flow of huge amounts of money into the oil
producing countries of the Middle East. The only
income-earning investment options available were those offered by the
conventional banks, based on interest.
What was required here was an agent to find
opportunities for the direct employment of new money. The ancient concept of mudaraba suited this situation best, and the
investment accounts of these banks and the mark-up trade financing model served
the purpose well.
chunks of the new inflow of money
deposited in the investment accounts of these banks, and the y used it to finance the huge
imports required for public and private development projects and
consumption needs. The size of both
the deposits and the transactions were large, and the profits were good. There was enough new money to support several such new
banks, and more was
left over in private hands providing sufficient liquidity in the
economy. The conventional banks
continued to operate in these countries side by side with the new
banks. They satisfied the commercial banking needs of the
country and, b ecause the current
account operations were considered riba-free, the need for a fully
riba-free system was not acutely felt.
When it was sought to establish Islamic banks in Western
countries, based on this model, their conventional central bank regulatory
authorities refused permission.
net worth individuals and large ticket trade
items. They concentrated on
short-term trade financing and
generally avoided long-term commitments.
Reputed Western banks joined in the bonanza, and Islamic banking came to
be identified with this model.
But the needs and circumstances of
countries mentioned above
are East, there is no (or very
little) inflow of new (oil-bonanza) money here. Most of the money comes from normal
economic activities, except for any outside loans and aid. There are few high net worth individuals. The deposits come mainly from a large
number of small depositors. There
are also few large ticket items of import.
The economies of these countries are dominated by a large number of small
and medium size businesses which need temporary advances to tide over
short-term liquidity problems, and loans to set up new enterprises and to expand
existing ones. Inflation and
liquidity are also acute problems.
The situation is similar in most of the other Muslim countries too. The existing Islamic banking model do es not suit this
situation. Therefore their search
for a riba-free alternative
The profit-and loss-sharing (PLS) concept of the Islamic
banks seems to work when it comes to financing one-time trade contracts (even
give r aise to questions of morality), but it is very difficult to
when financing enterprises on medium or long-term basis. We have dealt with this aspect and
provided a viable solution in the companion article mentioned earlier.
The PLS scheme is also unsuit
able to cater to the short-term liquidity needs of
businesses, individuals and the government ; nor to provide short- and medium-term loans to
set up new small enterprises and working capital to running businesses. Neither is
it suitable for
providing consumer loans on a commercially viable basis. Inter-bank credit is another difficult
In this article we have tried to rectify this lacuna by establishing a riba-free commercial bank that uses conventional banking methods and operates under conventional banking laws. This bank provides all current account services, and makes use of the riba-free demand and savings deposits to provide riba-free — but not cost-free — loans and advances. It can also create bank credit to meet the credit needs of its clients, and provide inter-bank loans.
There is need for riba-free banks in all countries where Muslims live. But most countries operate under
conventional banking laws, and it is futile to expect the situation to
ed not either. Given also the generally tight monetary
situation in countries other than the oil producing ones, we have to look for a
solution within the conventional model.
The model presented above is designed to work within the conventional
laws. Under this model converting
an existing bank into a riba-free one as well as setting up new ones are relatively easy.
Now it is up to the Muslim bankers and others to take steps to establish such riba-free commercial banks in all countries of the world, and pave the way for riba-free economies in Muslim countries.
1. Ahmad, Shaik Mahmud, Towards Interest-free Banking. New Delhi: International Islamic Publishers, 1992.
2. Ainley, Michael, A Central Bank’s View of Islamic Banking. In: European Perceptions of Islamic Banking. London: Institute of Islamic Banking and Insurance, 1996.
3. Diwany, Tarek El, The Problem with Interest. London: Ta-Ha Publishers, 1997.
4. Gafoor, A.L.M. Abdul, Interest-free Commercial Banking. Groningen, the Netherlands: Apptec Publications, 1995.
5. ¾¾ , Participatory Financing through Investment Banks and Commercial Banks. Groningen, the Netherlands: Apptec Publications, 1996.
6. ¾¾ , Commercial Banking in the presence of Inflation. Groningen, the Netherlands: Apptec Publications, 1999.
7. ¾¾ , Islamic Banking and Finance: Another Approach. Groningen, the Netherlands: Apptec Publications, 2000.
8. George, Eddie, Islamic Banking. In: European Perceptions of Islamic Banking. London: Institute of Islamic Banking and Insurance, 1996.
9. Institute of Policy Studies, Elimination of Riba from the Economy. Islamabad: Institute of Policy Studies, 1994.
10. Rad, Tourani A., Theoretical and Practical Aspects of the Interest-free Banking System. Amsterdam: Nederlands Institut voor het Bank- en Effectenbedrijf, 1991.
11. Usmani, Muhammad Taqi, An Introduction to Islamic Finance. Karachi: Idaratul Ma’arif, 1999.
Yassseri, Ali, “Islamic
Banking Contracts as Enforced in Iran: Implications for the Iranian Banking
Practice”. Paper presented at the
4 th International Conference on
Islamic Economics and Banking, August 13-15, 2000, Loughborough University,
· Based on a talk given to
The City Circle, at The Toynbee Hall, London, 26 May 2000.
 Neither the Qur’an, the Holy Book of Islam, nor the traditions of the Prophet of Islam explain the reason for this prohibition. But rational and experience-based explanations have been offered by many. For some recent expositions, see Ahmad (1992) and El Diwany (1997). In the present study we take the prohibition as given.
 See Gafoor (1995) Chapter 4 for details.
 If compensation for inflation is also granted, as proposed in this model, more money will be brought into the savings accounts.
 See quotations from Pemberton and Schotta in Rad (1991). Also Eddie George (1996).
 A special collective insurance scheme proposed in this system. See Gafoor (1995, 2000) for details.
 Details are given in Gafoor (1995 and 1999).
 The rationale and
method of computing realised capital loss due to
inflation is given in Gafoor (1999).
 There is a
new tendency in advanced countries to
pay some interest on these too. But
that need not distract us here.
 Of course the effect will be less severe
if the minimum period is one calendar month, but the argument still holds. The trend now is to reduce the minimum
period and this is being helped by the widespread
 Empirical studies testing the truth of this claim will be very useful.
Regrettably, the day-to-day banking facility needs of ordinary individuals,
businesses, organisations and the government are not given sufficient attention
in the Islamic banking literature.
The number and size of the transactions effected daily are very large,
and they affect many aspects of life
of a large number of people.
 Contrary to popular perception, the pure interest component in the cost of borrowing (CoB) is much smaller than (only a fraction of) the interest paid to the depositor. This comes about on account of the bank’s credit creation. See Gafoor (1996) Appendix B for a concise explanation of the process of credit creation. For a mathematical explanation of its role in reducing CoB, see Gafoor (1999) Appendix A.
 See Gafoor (1995) for details.
 See Ainley (1996), Usmani (1999).
 See Gafoor (1999) for details.
 Please correct me if I am wrong.
 Please see footnote
 See Gafoor (1995), Chapter 4.