INTEREST is so extensively and deeply embedded in the modern economy that it has become a linch-pin of financial institutions and it seems difficult, if not impossible, to avoid it.
General Zia-ul-Haq had completed the process of introduction of interest-free banking in 1985 and 12 modes of financing were declared to be Islamic.
The present regime has introduced Islamic Banking parallel to the conventional banking so as to give a choice to their clients. It is generally believed that there have been hardly any worth mentioning advances on the basis of modes other than mark-up. Mark-up has thus been the basis, but this has been struck down by the Supreme Court as un-Islamic. However, most of the modes have been borrowed from trade and business.
The use of mark-up, cost plus, deferred payment, leasing, hire purchase, etc. is permitted by Islam for trade and business transactions with a perfect justification. Goods are produced or purchased by the capital of sellers and hence he is the owner. He engages in sale to make profit to recover his cost and to sustain himself, as a labourer, and his dependents.
Profit maximization can be through the rate of profit multiplied by the volume of turnover. The latter determines the pace of real economic activity of production and sale of goods and services and hence employment and real income generation. Any means, which help push the turnover and total profit or to avoid loss is a genuine, both short and long-term, business strategy. Banks do not meet these conditions.
First of all, they are not the owners of goods and services, as they do not employ their own capital. The fact is that the funds deployed by banks belong almost entirely to their depositors. Their own funds, representing their equity base, are no more than 10 per cent and they are consumed by management cost, leaving little for lending.
This leaves some profit and loss sharing arrangement for general lending and rent sharing for housing finance as the modes of financing. This has, however, not proved acceptable either to banks or to clients and hence its very limited use.
In the case of sharing profit and loss, for various reasons, of which taxation is most important, businessmen are not willing to reveal the true financial position of their concerns and do not want banks to even peep into it, not to mention the possibility of their interference in management for obtaining better return.
Another difficulty for banks to engage in this arrangement is the requirement that the party providing funds should be Rab-ul-Maal-owner of the funds, which banks at present cannot claim to be. This raises the basic question of the status of depositor\bank relationship.
The designing of non-interest or Islamic Banks has been mainly focused on the asset side of banks and their liability side depicting their resources, which are mostly deposits, has not been given due attention, even though they are inter-related.
There are PLS deposit accounts, but it is not clear whose profit depositors share— banks or their clients. In fact, it is neither and the whole arrangement is, at best, nebulous. The formula for distributing income between banks and their depositors is heavily weighted in favour of banks and to the loss of depositors. This is simply unjust.
The rationale for prohibition is given in the Quran in unambiguous terms: “You shall have your principal (Raus-o-Amwal-e-kum), thus you shall not wrong, nor shall you be wronged.” (2:280)
On June 5, the weighted average of return charged by banks from their borrowers was 8.41 per cent, while they paid only 1.85 per cent to depositors. This meant a spread of 6.56 per cent to benefit banks and this was more than thrice what they paid to depositors. The inflation during this period was 9.3 per cent making the return to the depositor negative by 7.4 per cent in real terms. The situation is not much different in the current year, despite the tight monetary policy,
At the end of December 5, the rate for the advances was 9.81 per cent and for deposits 2.55 per cent. This increased the spread for banks to 7.26 per cent. The inflation rate stood at 8.51 per cent year-on-year and the annualized rate for the six months was 8.43 per cent. This means a negative real rate of return of 5.88 per cent for depositors.
The weighted average conceals more than it reveals due to wide dispersion of actual rates. As of end-June 5, of the total bank advances of Rs1,415 billion to the private sector under Islamic modes of financing, Rs90 billion, or 6.3 per cent were at zero rate, with Rs103 billion, or 7.3 at 1-5 per cent.
Bank advances worth Rs451 billion, or 31.9 per cent were at up to 8 per cent or below the inflation rate. If the interest-based advances of Rs28 billion at zero rate of interest are added, total advances at that rate work out to 7.7 per cent of the overall total advances.
The privileged few do not worry about the cost or the repayment as they can conveniently default and this is reflected in the huge non-performing loans (NPL), which stood at Rs205 billion in June 05 and Rs196 billion at the end of the year as against the bad debt (NPL and defaulted loans) of Rs93 billion in 1993 when this was first disclosed officially.
Still far more serious is the huge write-offs of advances to the affluent without going through any legal bankruptcy procedure. According to the revelation by the SBP Governor on July 26, 2003, loans of Rs0.5 million or more each had been written off between 1999 and 2003 to the tune of Rs23.5 billion. The process continues and the governor expected that during the next three years defaulted loans to the tune of Rs25-30 billion would be written off.
Even though individual banks publish this information in their annual reports, the consolidated position of the entire banking system is still to be given by the SBP and does not appear to be considered important enough to be mentioned in its annual report.
The list of beneficiaries makes a Who is Who of business community. One instance may be quoted of a government-controlled bank, that is, National Bank of Pakistan.
During CY 04, the bank wrote off loans of Rs4.64 billion. This was no less than 62.5 per cent of the amount outstanding at the beginning of the year. It is very significant that the outstanding amount, which stood at Rs7.42 billion includes arrear of interest\mark up of Rs3.52 billion as compared with the amount of principal of Rs3.26 billion. This indicates the period over which the loans have remained un-serviced by the affluent, even though they had access to cheap credit.
In one case, the principal was only Rs3 million but the interest\mark up accumulated was as much as Rs127 million or 42 times the principal. Only one client, namely Saadi Cement, accounted for no less than 27.3 per cent of the total write-offs.
The Senate was informed in Nov 05 that the bank had written off loans worth Rs2.28 billion and the main individual write-offs were Quality Steel, Rs980 million; Kohinoor Looms, Rs945 million; Kanzan Textile Mills, Rs118 million; Bashir Textile Mills, Rs86 million; Al-Qadir Textile Mills, Rs54 million; and Bela Ghee, Rs39 million.
Banks’ treatment of depositors, particularly the small one is quite shabby, to say the least. The paltry weighted average return on deposits, has been negative in real terms. Banks have adopted a graduated scale for the return, the larger the balance, the higher the rate of return. They have individually set a limit below which they give no return at all.
To add insult to the injury, there is a 10 per cent withholding tax on return on deposits, regardless of the amount of the return or the fact whether the person is rich enough to be liable for income tax. Moreover, even rate in the first income tax bracket is much lower.
The central bank, as the custodian and supervisor of financial institutions, is expected to be even handed and take effective measures to prevent glaring injustice in the system.
Instead, the SBP has played a very important active role in exploitation of depositors and has deliberately depressed the interest rate structure to the ultimate disadvantage of the saver whether he is a bank depositor or a holder of government financial instruments.
Also, instead of serving the traditional limited role of lender of the last resort to ease the temporarily difficult liquidity situation of banks, the central bank has become the permanent principal source of capital, accounting for no less than a quarter of the total money supply. This has artificially augmented the supply of loan-able funds in the economy and hence depressing the rate of return for the saver as a lender, directly or via banks.
In managing public debt, the central bank has been denying opportunity to banks to invest in the desired government securities by setting difficult conditions, both in terms of maturity structure and the rate of return. In this process, the central bank has large public debt holdings. As of end-December 05, central government securities held by the central bank stood at Rs535.5 billion as compared with Rs347.9 billion in June 05 and Rs134.1 billion a year earlier.
In comparison, the investment in these securities by scheduled banks was of Rs551.0 billion as against of Rs600.7 billion in June 05 and Rs670.5 billion a year earlier. Their investment is mostly of short-term nature and banks are under compulsion to hold them, as captive investors meeting the legal requirement of minimum liquidity ratio.
The focus on Islamic modes of financing has ignored the Islamic purposes of financing, which is no less important. Interest-based banking is the product of capitalism and this is supposed to be value-neutral, rather amoral, in which banks are worried only about the security of their lending and do not bother about the purpose of loan.
However, there is, of late, increasing concern about the sources and uses of funds by banks as part of the campaign against money laundering, corruption, terrorism, drug trafficking, etc.
Islamic Banks follow the recent trend under international and domestic official pressure but not the Islamic teachings, which are far more demanding. They cannot finance activities which are explicitly prohibited or discouraged by Islam. This is quite a list extending to hoarding and cornering of goods and speculative activity, bordering on sophisticated gambling, of any kind including the stock exchange. There is a whole Islamic code of business conduct to be complied with.
Banks command tremendous resources and their use or misuse has deep impact on the economy as well as society. The assets\liabilities of scheduled banks in June 05 stood at Rs5.2 trillion representing 78 per cent of GDP (MP) for FY 05.
Islamic Banks are bound to do some thing to ameliorate the condition of the poor not only as a social responsibility but also as a religious obligation.
