AT a symposium on ‘Islamic Banking and Investment’ in Karachi, a product manager from a leading Islamic bank claimed that his bank had launched an innovative home financing product entirely based on rent sharing idea which is 100 per cent Islamic. He calculated his bank’s profit margin (share of rent) uniformly applicable for the whole country while the rent varied from location, usage, condition etc. He admitted that the profit margins are stuck to KIBOR (Karachi Inter Bank Offer Rate) and this was approved by bank’s Shariah board.
Islamic banking in Pakistan was introduced in 1979 when government converted National Investment Trust (NIT), Investment Corporation of Pakistan (ICP), and House Building Finance Corporation (HBFC) to acceptable Islamic principles. The process continued and finally from July 1985 all commercial banks operations were declared interest-free under a presidential decree.
In June 1984 the State Bank allowed banks to provide finance on mark-up and on buy-back agreements basis. Buy-back agreement allows a customer to sell his asset to the bank and repurchase the same asset on instalments which also includes profit of the bank. The technique is nothing but disguised form of interest. Thus with the help of new terminologies, the financial institutions retained conventional methods of interest bearing finance. The Islamic modes of finances such as musharikah, mudarabah, ijara, etc. were not adopted in majority of the cases. Status quo was retained for the next 15 years till 1999 when the Supreme Court instructed the government to take prudent steps and eliminate riba.
This time the government adopted the gradual approach. It allowed Islamic banks to start their operations and also encouraged conventional banks to set up separate Islamic banking branches. Today Islamic banking sector represents around 2.5 per cent of the total banking deposits.
Even today, murabaha based transactions heavily dominate assets side of the Islamic banks’ balance sheets. Further, there is hardly any transaction in inter-banks (money at call, purchase of trade bills), intra-banks (legal reserve requirements) or the government related financial activities such as investments in government securities, borrowing from the central bank and the financial institutions and the lending to public enterprises which can be called as Islamic. KIBOR is used as a benchmark.
Murabaha is a trade based contract whereby the customer approaches a bank for the purchase of a pre-identified commodity. The bank, upon receiving the request purchases the commodity and adds its own profit and sells it to the customer on deferred payment basis. The transaction is permitted under the injunctions “Allah has permitted trading and forbidden riba” (Al-Baqarah, 2:275).
Unfortunately, Islamic banks use Murabaha contract as financing mode rather than trading mode. They prefer to loan money to entrepreneurs instead to become entrepreneurs themselves. They enjoy the convenience to charge time value of money in the name of profit margins which is mostly equivalent to interest rates charge by the conventional banks. This is the essence of all financing transactions based on trading modes.
Prof Dr Muhammad Anwar (2000) in his research paper, ‘Islamicity of Banking and Modes of Islamic Banking’ argued that conventional banks treat the amount advanced (equivalent to the purchase price) as principal loan while Islamic banks treat the amount due at the maturity (selling price) as principle loan.
However, it is common understanding that the principal has to be the amount that a bank advances in favour of the customer and not the amount the bank expects to retrieve. Quran says: “if you repent (from riba) then your capital sums are for you, deal not unjustly, and you shall not be dealt with unjustly” (Al Baqarah, 2:279). It is also true that Islamic banks use the same formulas and annuity tables for computing amount due and monthly instalments as used by the conventional banks except they are not allowed to charge compound mark up (mark up on mark up).
Islamic banks misunderstood the true philosophy of trade based contracts which are usually short-term and fixed in nature. The contracts do not allow Islamic banks to change the profit/mark up rates unilaterally once decided. This creates operational problems when trade based contracts are used for financing modes especially for medium and long-term. Let me explain with an example. Conventional banks usually link their interest rates with KIBOR. When there is an increase/decrease in the money market rates, they quickly adjust their interest rates accordingly. Thus they do not face any liquidity crisis. Islamic banks cannot avail the same opportunity due to their heavy investments in trading based instruments. The same was witnessed in Malaysia during the 1997 financial crises when Islamic banking failed to manage the increase/decrease the mark up rates, resulting in large inflows/outflows of deposits.
The crux of Islamic banking problem is the concept of time value of money. It creeps into Islamic banking transactions whenever trading and investment based contracts are used as financing modes. Islamic finance literature neither recognises the loss in the value of money due to macroeconomic factors such as inflation, depreciation of currency nor suggests any definite solution.
Islamic jurists at one side declare amount over and above the principal sum as riba but on the other side allow using KIBOR as a benchmark to facilitate Islamic banks. The transactions are justified under the injunction “trading with mutual consent” (Nissa 4:279). Shariah scholars also maintain that KIBOR is only used as benchmark to compensate Islamic banking against any loss in profit.
Irfan Qazi (2006) in his article ‘Unfair to Islamic Banking and Finance’ raised the issues of moral fibre when interest is not used for profit making but for compensation. He argued that using interest as compensation means justifying the use of interest not for making profit. Making profit is not prohibited in Islam but it is rather prohibited with the use of interest. Thus why the compensation with the use of interest shall be considered justified. Will it be logical to say what is prohibited is riba not the kind of interest that is used for the compensation?
Thus Islamic banks cannot convince the masses how they are different from conventional banking until they do not adopt a clear stance on the concept of time value of money. The writer at first will try to explain the difference between profit rate and interest rates and then provide a possible solution for separate benchmark for Islamic banks.
Islam encourages trade and investment. It does not deny the right to earn fair profit. Islam also allows the contracting parties to demand written contract, collateral against the financial transaction and can even appoint caretaker. The statement can be best explained with the help of mudarabah transaction executed between Hazrat Muhammad (PBUH) and his wife Hazrat Khatija. The later also appointed her servant as companion to Prophet Muhammad (PBUH) during the journey. The issue needs attention was the role of that servant during the journey. Although the Prophet was independent in trade but still Hazrat Khatija appointed her servant as representative and silent observer. The appointment clearly indicated her motive to minimise and manage the risks associated to business transaction.
Now take the example of everyday business. Suppose, A has an option to import machinery of same quality and price either from China or from America. It is also assumed that if machinery is imported from China it will take lesser time and risks as compared to America. Logically, A shall be ready to charge lesser profit on Chinese machinery rather than if it is imported from America. If we carefully examine this transaction we can find two motives behind A’s profit calculations 1) compensation against the time value of money 2) compensation against the risks involve in terms of loss of his efforts and personal money.
Again, A enters in the same transaction with same terms and conditions as mentioned above. This time, however, he borrows money from the bank at fixed interest rate. The bank also has two motives behind interest based lending 1) compensation against the time value of money; 2) compensation against the risk involves in terms of loss of money. Summing up the example, the main difference between profit and interest is that Islam does not recognise money as separate mode of production. Money is only recognised once it is mixed with some Halal human efforts/commodities. In mathematical terms it can be narrated as,:
Money x [Time value of money x Halal human efforts/commodities] = Profit (Loss)
Money x [Time value of money x Money] = Interest
Now I develop a concept for separate benchmark for Islamic banks. Islamic banks are mostly involved in murabaha and ijara (lease) based trading contracts. Here they enter into the sale/purchase and leasing of selected commodities at the instructions of their clients. It is the free market forces which decide the commodities prices. Market forces automatically adjust compensations against the time value of money and incorporate various risks involve in terms of profit margins. Such a beautiful mechanism of adjustment is not available in case of interest rate. If the central bank only identifies the types and kinds of commodities Islamic banks presently invest and then collects profit margin data on daily or weekly basis, it will become a natural benchmark for Islamic banks. The new Islamic benchmark will be based purely on the profit margins prevailing in the free markets. Moving one step forward, there are various business associations and government departments which have already accessed to such type of data. The need is to identify the relevancy and consolidate the data as per Islamic banks requirements.
The author is an Associate Professor at Lahore School of Economics.
AT a symposium on ‘Islamic Banking and Investment’ in Karachi, a product manager from a leading Islamic bank claimed that his bank had launched an innovative home financing product entirely based on rent sharing idea which is 100 per cent Islamic. He calculated his bank’s profit margin (share of rent) uniformly applicable for the whole country while the rent varied from location, usage, condition etc. He admitted that the profit margins are stuck to KIBOR (Karachi Inter Bank Offer Rate) and this was approved by bank’s Shariah board.
