Critical Analysis of the Current Islamic Banking System

Islamic Banking was introduced in Zia’s regime in the 80s. Since then, it has developed very rapidly. Meezan Bank, Dubai Islamic Bank, First Dawood Islamic Bank, Bank Al-Baqarah, Emirates Global Islamic Bank and Bank Islami are full fledged Islamic banks operating in Pakistan. A number of local and foreign scheduled banks have started Islamic banking windows and exclusive Islamic banking branches. It is expected that Islamic banking will capture 12% of the deposit market by 2012.

Apart from the growth, Islamic banking products have received criticism from many sections of the society. The technique used in coming up with Islamic products is to transform the consumables (like money) into tangible assets and sell these assets at a profit (in consideration for deferred payment). In this research paper, these products have been analyzed in detail. The areas in which current Islamic banking products fail to provide compatible solutions with Islamic principles are also discussed.

This research paper outlines the economic teachings of Islam with regard to income, earning and spending. It compares interest with rent and with profit and shows that interest is equivalent to neither rent nor profit. It also analyzes the logical arguments put forward in favor of interest by different economists and refutes any economic and logical justification of interest.

This research paper recommends a few major changes in the whole structure of economy with special focus on fiscal reforms and Islamic banking reforms. The fiscal reforms will ensure that government is able to eliminate fiscal deficit which will allow it to abstain from interest based financing.

The research paper recommends radical but important changes in the Islamic banking products, such as introduction of options contract in mortgage financing, which will allow the bank to separate the tenancy and sale contract. This will still ensure that it locks the sale with the borrower or the third party without making both contracts dependent on each other. It will benefit the bank as well as the borrower, who will have an option but not an obligation to buy the asset at maturity.

The modified role of bank entering in a modarba contract as a “Rab-ul-maal” (investor) will ensure that the bank takes on operational risk. It will enable the resources to go into productive avenues rather than in financial instruments, as the bank previously had no other choice to invest the proceeds in financial instruments in the conventional system of Modarba. This will generate employment and productive activities in the economy.

The division of Modarba corporate and Modarba consumer will target two very distinct markets and will result in channeling of funds from saving surplus units to saving-deficient units.

The Current Islamic Banking System

Assets

Home Financing

1. The installment is calculated based on 1 year KIBOR. KIBOR is used as there is no other benchmark rate available. The logical argument is that in a society if there is only one merchant who sells prohibited products, and then he starts to sell one legitimate product, he will use the profit rates on prohibited products for pricing and calculating profit margin on the legitimate product.
2. In the master Musharikah agreement, the floor rate and the ceiling rate is stated based on which the installment amount can vary.
3. In a master Musharikah agreement, it is stated that if payment is made on time, the transfer of ownership will take place accordingly.
4. Reputable estate agencies are consulted for the valuation of assets.
5. The risk of damage to the property is borne by the bank and the customer, according to the stake in the property at the time of disaster.
6. Just like in conventional mortgage, a penalty is charged if a customer withdraws from the contract which is paid to charity. The logical argument presented for such a penalty is that the contract involves a sale of property as well and if a customer withdraws from the sale contract, he can be asked to pay a penalty.
7. Master Musharikah agreement contains details of the tenancy agreement as well as the sale agreement. A contract is made when the customer signs the contract, which means that he has agreed to the terms of the contract.
8. The seller of the property is paid by the bank and only the bank and the customer remain in the scenario.

Murabiha

1. Murabiha is just like a sale transaction. If a trader has the right to sell a good at a profit, the bank should also have the right to sell an asset if he obtains constructive possession of the asset and bears the risk of damage to the property until the sale is made to the customer.
2. Murabiha is used in working capital financing and trade financing.
3. The customer is asked to buy the asset acting as an agent to the bank because he has more knowledge about the product and better relationships with the supplier to obtain the goods at a competitive price and in a timely and appropriate manner.

In the case of import/export, if the exporter does not know the buyer of the asset (importer or bank), it does not matter. The logical argument presented here is that if person A takes a loan from the bank and buys an asset from B, who has no concern from where the money is coming from (the buyer’s own pocket or the bank). B’s only concern is getting the price he is selling for.

Liabilities

Current Account

1. The money deposited in the current account is considered ‘Qard’ (Non-interest bearing loan).
2. The money is invested in the fund by the bank.
3. The money is payable on demand.

Savings Account & Term Deposit

1. The money is invested in the fund.
2. The bank acts as ‘Mudarib’ i.e. 'Fund Manager' and the customer acts as ‘Rab-ul-maal’ i.e. 'investor'
3. The money is only invested in Shariah compliant assets.
4. The Weightage is assigned to each category of investment that is stated to the customer at the outset.
5. The assigned Weightage reflects the time value of money.
6. The profit is distributed as follows:

Category	Deposit (Rs.)	Weightage	Weightage Average	Profit	Rate*
Savings	3,000	0.1	300	57	1.89%
1 Month	1,000	0.3	300	57	5.66%
3 Months	3,000	0.5	1,500	283	9.43%
6 Months	6,000	0.6	3,600	679	11.32%
1 year	7,000	0.7	4,900	924	13.21%
Total	20,0000		10,600	2,000

Application of Time Value of Money

Time value of money is the basis of interest. Interest is said to be the charge on the use of money for a particular time period. Islam prohibits interest which entails that no fixed amount can be charged for the use of money for a particular time period.

The investment will have to go through the entire process of a business activity which involves risk taking at each stage and any compensation on investment will be strictly dependent upon the outcome of the business activity. Time value of money is the problem for the investor to avoid keeping his money idle and to avoid forgoing the use of money that may bring positive value to his investment. However, it does not mean that the investor can demand an arbitrary increase (or is given as the case may be) as the cost of using money without taking the risk.

Assigning weightage to investment based on tenor of investment is another way of paying interest based on time value of money. The profit rates are calculated through weightages which when plotted on a graph will create the same yield curve as in the case of term deposits. The situation where losses are incurred would have been very interesting, but the money is invested in instruments in which the chance of loss is remote. Also, the arrangement is such that the bank makes sure that it gets comparable returns taking KIBOR as the benchmark rate.

A businessman facing the problem of time value of money will invest his money in a business activity, bear all the risks especially the market risk and price risk and will eventually make a profit or loss. The profit for the businessman strictly depends upon the actual profit realized after taking market risk including price risk. It does not depend upon the time.

The use of weightages as a compensation for time value of money will be appropriate if the business earns same level of profits and no loss in each period. This happens in the case of Islamic savings account and term deposits because the pool of money collected in the fund is invested in instruments in which chance of loss is remote. Now a discussion on those instruments (assets of the bank) will clearly demonstrate that these instruments inherently involve interest which enables the bank to provide compensation based on tenor.

Critical Analysis of Diminishing Musharikah in Home Financing

In ‘Diminishing Musharikah’, two contracts i.e. tenancy and sale are mixed. Both are made contingent upon each other. The rent is calculated and charged on the basis of 1 year KIBOR. The rent increases when the KIBOR increases. It is referred to as ‘Diminishing Musharikah’ because of the arrangement, the ownership stake of the tenant increases and that of the bank decreases or diminishes with the passage of time. The rent decreases as the ownership stake of tenant increases. Following table compares the conventional mortgage and ‘Diminishing Musharikah'.

Features	Conventional Mortgage	Diminishing Musharikah
Benchmark Rate	KIBOR	KIBOR
Basis of Installment	KIBOR	KIBOR
Nature of Installment	Interest +Principal	Rent + Principal
Prepayment Penalty	Yes	Yes
Tenancy + Sale contract	Dependent	Dependent
In subsequent years	Interest payment decreases	Rent payment decreases
In subsequent years	Principal payment increases	Principal payment increases
Changes in Installment	Based on KIBOR	Based on KIBOR
Price and Market Risk	No	No
Price of Asset	Locked at initiation	Locked at Initiation
Cost to the borrower	Same in both cases	Same in both cases
Profit to the bank	Same in both cases	Same in both cases

As can be seen from the table above that there is no difference between the two modes of financing. The minor differences are procedural and do not change anything. The only noteworthy argument that people put forward regarding ‘Diminishing Musharikah’ is that the bank bears risk which is also a myth and is discussed separately.

Critical Analysis of Risk Taking By Bank

There are several types of risks. The most relevant risk is the market risk including price risk i.e. the risk that the goods will not be sold or will be sold at lower prices which may or may not cover costs. This risk is only borne by the seller when the goods are ‘held for trade’. In ‘Murabiha’ and ‘Diminishing Musharikah’, operational risk is not taken by the bank. The only risk taken is against ‘destruction of property’, the occurrence of which is highly unlikely and this is also transferred to the insurance company. Had the tenancy and sale contract not been made dependent, the bank would have had to bear the market risk which the bank cleverly avoids by making both contracts dependent and locking the price at the outset.

Critical Analysis of Murabiha

It is referred to as “cost + profit” transaction which is not true. It is a “cost + financing” transaction. It involves a loan and a deferred sale. Considering it equivalent to the spot sale is not true. Even the eminent scholar Mufti Taqi Usmani when analyzing it in his book “Islam Aur Jadid Maishat-o-Tijarat” accepts the fact that it is a loan transaction and further states that ‘compensation on deferred payment to the seller is allowed’. With all due respect, this compensation is nothing but interest.

For example if a person needs a machine worth Rs.1,000. The bank appoints the person as an agent to buy it and pays the amount (Rs. 1,000) and simultaneously sells it to the person at a profit. The bank makes sure that it gets the required profit by locking the price at the outset and avoids taking any market related risk. This is not equivalent to a spot sale because if the person had Rs.1,000, he would never have come to the bank. The transaction is the same as taking a loan of Rs.1,000 from the bank, using it for some purpose for a particular time period and then repaying the bank an amount greater than Rs.1,000.

Critical Analysis of Modarba

Modarba is said to be an Islamic mode of financing which is historically not true. At the age of 25, Prophet Muhammad (Peace Be Upon Him) entered into a Modarba contract with Hazrat Khadija (May God be Pleased With Her). This is a period before revelation. So Modarba as a mode of financing was prevalent. Since Modarba financing did not contradict with the values of Islam, people even after the beginning of revelation were allowed to enter into Modarba financing.

Secondly, in the example of Prophet Muhammad (Peace Be Upon Him), He entered into the contract as Mudarib (Businessman, Fund Manager or Asset Manager). So the flow of money is from a rich financial entity to a business entity in need of finance. In the case of currently practiced Islamic banking, the flow of funds is from the small pool of investors to a large financial entity. That large financial entity can not invest the funds in instruments other than the financial instruments. Therefore, it has no productive effect on the economy and no employment and self-employment generation takes place. Mudarib is a person in need of finance, bank as a reservoir of money acting as Mudarib is a senseless arrangement.

Thirdly, Muslim jurists have formulated certain rules regarding Modarba financing that are now considered as ‘Islamic rules of Modarba financing.’ This is not the right place to highlight the problems this practice has created over the centuries. However, it must be emphasized that anything which does not contradict with any of the Islamic laws is permissible. The work of Muslim jurists can only serve as guidelines and should be open for debate and can never ever become a law which can not be modified.

Fourthly, it is argued that profit and loss sharing is the only alternative of interest. The work of Javed Ahmed Ghamidi on ‘Islamic Economic Framework’ has argued that profit and loss sharing is not the only alternative of interest. He argues that an investor can opt to become a partner only in profits. This is a common practice in limited liability partnership of professionals like lawyers and doctors where the other partners do not make good of any loss if the loss was solely caused by the actions of a particular partner.

This arrangement of partnering only in profits is very different from interest. An investor investing to earn interest gets the fixed amount irrespective of profit or loss of the borrowing entity. When a partner in a Modarba contract opts for partnering only in profits, he will only get a profit if the borrower gets a profit. Therefore, this does not result in any exploitation of the borrower and does not contradict with any of the Islamic laws.

Moreover, in the conventional Modarba arrangement, Mudarib (Fund manager) bears no loss while he is the only reason of loss. The Rab-ul-maal (investor) is not allowed to interfere in the affairs of the business. When a loss occurs, the Mudarib acts like an employee of the business and when the profit occurs, he shares in the profit as if he was the only reason behind the profits.

Concluding Remarks

The current Islamic modes of financing are no different than conventional system. Nothing can be charged on consumables including money but rent can be charged on tangibles like property or any asset. The technique is to convert the money into asset and then sell the asset on a profit or give the asset on rental basis to earn profit. This article has highlighted the defects of these instruments.

Editor's note: The above article is the initial part of a two-part reserach paper on Islamic Banking System. In the next part, the author will outline the guidelines for Islamic Economic and Banking Systems. Please note that the opinions expressed in this article are solely of the author and Accountancy may or may not agree with them.

About the Author: The author Salman Ahmed Sheikh is a business graduate from Bahria University Karachi. He has worked with ABN AMRO Bank and Citibank in the pastand is currently authoring books at the BCOM level for Ghazanfar Academy publishers and teaching at Acumen institute in Karachi, Pakistan.

Article courtesy of Salman Ahmed Sheikh