Analyzing the conventional tools - innovating, enhancing or renaming?

Mar 12 - 18, 2007


Traditionally, Islamic banks have only been able to pay interest that was tied to the bank's profits. A fixed interest rate, conservative scholars hold, is equivalent to usury or "Riba" - the earning of money without doing any work for it. But Agence France-Presse (AFP) reports that the Islamic theological research committee of Egypt's Al-Azhar institute - seen by many as the philosophical centre of the dominant Sunni strand of the faith - has voted 21-1 to approve fixed interest rates.


In practice, Egyptian banks may not notice any immediate difference. Despite the problems traditionalists have with interest, nine out of 10 banking institutions in Egypt pay a fixed rate of interest. And from the Al-Azhar institute's point of view the decision was necessary. "Religious jurisprudence means change, and it is illogical to remain frozen while the world changes around us," Sheikh Saber Talaab, head of the research committee secretariat, told AFP. "So long as we do not go against what is written (in the Qura'an) or the Sunna (Islamic tradition), we have a clear conscience."


But despite Al-Azhar's importance and influence, the decision risks stirring up controversy. The prohibition of Riba is at the heart of Islamic financial practices, and the arguments are all the more vocal for being rooted in differences in the interpretation of the Prophet Muhammad's writings and deeds. For the reformers, there is a parallel between Muhammad's acceptances of money from members of his tribe in order to finance trading caravans. The sharing of the profits between the contributors, they say, is broadly similar to a bank paying interest using the profits it makes on commercial deals using the money deposited with it. But the conservatives say that can apply only if the interest is proportional to the profit - in other words, if depositors are taking a risk with their money.


Since I am not fully aware of the global practices in the Islamic banking sector, therefore, I am strictly restricting my views on the Islamic banking in Pakistan only. The biggest loophole in the Islamic banking sector of Pakistan is the false perception of risk sharing. Let's compare the concept of risk sharing in traditional and Islamic banking scenarios.


This is what happens in the local banking scenario when a traditional bank (non-Islamic) is reached by a customer for availing finance facility for any purpose. The banker would require certain documentation and credentials that would assist in determining the credibility of the person and the risk that could potentially be involved in lending the person a certain amount. Bankers have a pre-determined range, for instance each loan can only be charged from 25% to 65% depending on the time variant, risk factors and other associated variables. After all analysis, the loan is granted. Each of the installment payment includes a certain portion of the principle (that increases over the period of time) and a certain portion of interest (that decreases over time as it is charged on the outstanding principle only). The following diagram is a clearer depiction of how the repayment procedure proceeds.

The interest rate that is applied is taken from a table that is generally referred to as the present value table in finance terminology.


Currently, as far as I have witnessed, the practice of giving loans stands fairly the same as mentioned above and of course the process cannot differ to any extent. The bankers are generally aware of the fact that the customer coming to them for Islamic banking services is coming just because of the premier service of serving a Halal product. Therefore, cashing on this opportunity, a premium price can be charged. Therefore, all the present value tables and tools and techniques are the same for calculation of each of the installments. The only difference that comes up is the incremental interest rate being charged. Another difference is that the financing has been renamed by different Arabic terms and alongside, the principle is quoted as the share from the actual price while interest is quoted as the rent applied on the product since it is the property of the bank. I believe that any person having some finance background would find the meanings synonymous.


In my personal view, the above-mentioned argument proves that the majority of Islamic banking used is just renaming the different terms and tools of Finance. Renaming is not just what makes a Haram into a Halal; it is the underlying concept that would change the meaning. But this is not all that is happening. In true Islamic banking system, I believe, as implemented by a few of the Islamic banks in Pakistan, the installment would be divided into two distinct portions i.e. fixed and variable. Fixed can be charged as the principle, there is no objection in Islam for that. However, the variable portion should depend on the profits that have been made by using that financing scheme. For instance, if a loan worth Rs.600,000/- is laid off, probably, the fixed portion would be Rs.10,000/- per month for 5 years (pays off the principle amount) while the variable can be, for example, 10% of the operating profits earned from the utilization of this loan. That, to me, would be a true application of an Islamic finance, because the risk of failure would actually be shared by both the financer and the creditor.


During the initial days of Islamic banking when the above-mentioned phenomenon was exercised by one of the leading Islamic banks in Pakistan, cases bounced back whereby, the customer went totally bankrupt, which caused the bank to suffer millions of rupees worth losses. But there are always alternate ways out. If the strategy suggested in the previous section is applied, then a way to prevent such problems could be the induction of another rule that, for example, constant operating losses for 3 months would mean that the lender has to pay Rs.30,000 as a fine (this is a continuation of the previous section example.


There are still a lot of in-depth studies that need to be conducted and various tools and techniques need to be developed over periods of time that can assist in having a true and fair Islamic banking system. The current Islamic financing schemes have reached the boom or are in the process of reaching the same. However, it shouldn't be forgotten that the concept of Riba free banking appeared from the context of Riba. The PLS accounts introduced a couple of decades back, offered constant returns which are the basic places where Riba rose from. It is noticeable that PLS i.e. Profit and Loss Sharing accounts were risk-sharing accounts of a sort and were meant to be an Islamic instrument for routine banking. Against the name of it, banks have a pre-determined rate of return on PLS accounts though these should be determined on the basis of profits or losses made by the bank during a fiscal year. If done so on the later concept, then there is always a chance for having losses being deducted from (as profits are added to) the customer accounts. In such a case, it would be interesting to see how many people still stick to this "so-called" basic Islamic banking product. By the way, has any bank ever declared a loss on its PLS accounts?