Principles of Islamic banking and finance/PIBF202/Key differences/Are problems of PLS banking insurmountable?

The differences between banking with interest and with PLS are quite profound. In the former, the principal amount deposited as well as the accrued interest must be assured. The banks are also entitled to get back their principal amounts loaned along with the interest earned. Guaranteeing of these two is not possible in an Islamic system. It should rather have mudarabah arrangements at both ends as discussed in the last section. In unit 1 we had a brief discussion on the pros and cons of such a PLS system. We look into the issues in a bit more detail under a theoretical framework.

Both the critics and the advocates of the Islamic financial system have raised several questions and issues pertaining to PLS banking which can be recapitulated as follows:


 * 1) The stock of money (as it is traditionally defined) in the economy could not be deter-mined.
 * 2) The depositors would not know their actual balance at the time they are writing cheques because the value of their deposits keep changing with fluctuations in the total value of the marketable assets of their financial liabilities.
 * 3) Without the institution of interest, people may not be able to tailor their portfolios precisely to the risk they wish to bear which may have an adverse effect on savings and capital formation (Ramchandran, 1989).
 * 4) With nontradable shares as their assets, Islamic Banks will not be able to ascertain their returns and, consequently, that of their depositors. The rate of return may then be deter-mined exogenously or arbitrarily by the government. This may effectively lead to nationalization of the banking sector (Ramchandran, 1989).
 * 5) Banks will be less willing to finance projects which require high level of monitoring. If the expected rate of profit is higher for such projects, banks may be misallocating some resources (Ramchandran, 1989).
 * 6) How the commercial banks under the ITF system will manage the consumption loans?

Measurement of money stock
The first two points are raised by Goodhart (1987) in the context of open ended mutual funds (or collective investment funds) which are increasingly competing with the commercial banks in the provision of transaction services. These funds have many characteris-tics similar to the (PLS) Islamic banking. . Goodhart (1987, pp. 83- 84) asserts that one solution to the question of the measurability of the stock of money in a world where payments' services are predominantly provided by monetary units of collective investment funds (similar to Islamic banks), is to contract its definition and make it synonymous with the dominant, "outside", base money. His other suggestion to let the stock of money become an amorphous concept devoid of any meaning does not seem to be tangible. A workable definition of money and the way it is correlated with the general level of prices in the economy is essential to keep an eye on inflation.

Uncertainty about account balance
As for the uncertainty about the amount of account balance at the time someone is writing a cheque, a solution can be found by imposing a minimum balance restriction on depositors. They should then be allowed to withdraw any amount above the minimum balance. After each transaction or at the beginning of each month, they can be notified about their overall balance and the corresponding minimum balance required. Furthermore, as proposed by Khan (1986), Islamic banks will have to offer deposits which would not carry any element of risk; we will call it "no risk deposits" (NRDs). Obviously, no profits would be paid on NRDs and a small service charge could be levied to recover the cost of handling the account and providing the security. This would particularly necessary if monetary authorities impose a 100% reserve requirement against NRDs to eliminate any risk of default or liquidity. Holders of this type of account will then have no uncertainty about their balances. The no risk deposits would also satisfy the desires of risk-averse individuals who would know with certainty how much "nominal" balance they have.

Savings under PLS banking
Ramchandran's claim that under the PLS banking system people would not be able to tailor their portfolios precisely to the risk they wish to bear (which may have an adverse effect on savings) is deluding. Siddiqui (1994) explains that, there is no conclusive theoretical or empirical ground to assume that the level of saving moves in a particular direction with a change in the rate of interest. What the changes in the rate of interest can certainly affect is the composition of the portfolio. Second, it is deceptive to purport that in the capitalist system with no firm commitment about the stock of money (which influences the rate of inflation) by the monetary authorities, the real rate of interest is ever known to the potential savers. By restricting itself to a disciplined monetary policy and offering NRDs, an Islamic financial system would actually provide the kind of service which Ramchandran spuriously thinks is rendered by the contemporary capitalist system. Furthermore, in case the NRDs are backed by 100% reserves, threat of bank runs which, in turn, endangers the payment mechanism can be exterminated.

Non-tradable assets
According to Siddiqui, Ramchandran's second point is valid that although the Islamic banks are similar in character, unlike the mutual funds or collective investment funds, they would also be performing as commercial banks. A significant part of their assets would be, therefore, non-tradable. In comparison to the collective investment funds, it would be more difficult for the Islamic banks to ascertain their return and consequently those of their depositors. It should be conceded that during the transition period, this task would be even more complex and multifarious. Instead of monthly or quarterly returns, it may be warranted to announce the rate of return to the share holders (depositors) on an annual basis, and after consulting the government and the central bank. But, as the Islamic banks would move from their infancy, the process of learning by doing will diminish the need for government support in this regard and assessment of average return based on realized returns from short and long term projects would become a routine. Nevertheless, continuous government's surveillance and vigilance of Islamic banks would be as necessary as it is for the commercial banks in the contemporary capitalist system which are among one of the most heavily regulated industries. But there is no reason to assume that banks under the PLS system would eventually have to be nationalized.

Monitoring cost and inefficient allocation of banks' funds
Ramchandran's next point is that banks will be unwilling (or less inclined) to finance projects which are difficult to monitor. Siddiqui accepts this argument but mentions the mention the following point. The projects which are difficult to monitor are usually small in scale. Big firms and projects maintain (or may be asked to maintain) all the records and accounts where irregularities can be detected. As far as small businesses are concerned, loans can be provided on zero interest or through some techniques of Islamic finance other than Mudarabah or Musharakah. If given on zero interest, the government can provide the necessary funds to the banks from her development budget. Although, it has a transfer payment aspect, this solution is economically efficient.

Financing of consumers' durables
The question of consumption loans for durable goods and loans for house financing has been a labyrinthine issue in Islamic finance. Again Siddiqui (1994) claims that, this issue too is not formidable. Indeed, the Islamic banks can neither grant consumption loans on the basis of interest, nor they can give unlimited amount of consumption loans to unlimited number of people on zero rate of interest. A solution could, however, be found by asking the producers of the durable goods to have a provision to sell their products on an instalment basis. Many companies in the contemporary capitalist system already have this provision but they charge a higher nominal price which is a form of exploitation as the people who buy durable goods on installments usually belong to relatively low income groups. The monetary discipline and the resulting price stability in an Islamic economy would make it less resistible to sell a large fraction of their product on an instalment basis. Any remaining cost may be spread over all the units produced by charging a uniform price for both cash payment and installment sale.

The consideration of capital gains and loss has made the loan for housing a very complicated issue in the capitalist system. Islamic governments should grant housing loans to low income families on zero interest out of its development budget. A rent and capital gains & loss sharing arrangement can be devised for middle and upper class families of the society. Again, the price stability and monetary discipline would be very conducive in this context.

Lender of last resort under PLS banking
Siddiqui also considers an issue which, according to him, has been neglected in the literature on monetary system of Islam. It can be acknowledged that with the provision of NRDs, people would not be coerced to put their savings into the risk bearing deposits of the banks. But what would happen if, at a given point in time, most people choose to put their savings into NRDs? Although, due to a minimum balance requirement not all the amount can be shifted from risk bearing deposits (RBDs) to NRDs, the financial system would plunge into a disarray if, following a panic, most people attempt to shift even the maximum permissible amount. The catastrophe would be similar to a bank run in the traditional capitalist system and hence a solution should also be found on similar pattern. In an Islamic financial system the central bank must maintain a risk bearing deposit at each commercial bank and under such circumstances it should have full legal authority to pump the necessary liquidity through its own RBD account. Indeed, this should be done un reluctantly and decisively only if the panic, which caused the massive and rapid withdrawal of money from the RBDs, was unfounded or unjustified. But, under the normal conditions too, the central bank will have to keep a close and continuous eye on each Islamic commercial bank and to avoid any cataclysm, appropriate corrective actions should be taken promptly and expediently.

Deposit insurance
According to Siddiqui, even when bank managers are working with normal perspicuity in the interest of the holders of the RBDs, sheer chance can bring some failures, and spawn some consternation. A particular action by the central bank may be required in each individual event. For instance, if the situation cannot be controlled through temporary supply of liquidity, a bailout by the government may be unavoidable. In case of delinquency and sheer negligence on the part of the bank mangers and / or the relevant officials in the central banks responsible for watching the commercial banks, appropriate punitive and disciplinary actions would be required to prevent any future catastrophe. But any suggestion to insure all the risk bearing deposits would be inefficient and against the spirit of Islamic finance. Fear, not the elimination of all risk, is the key to keep the bank managers perspicacious and discerning.