Principles of Islamic banking and finance/PIBF202/Islamic banking industry/How to remove misconception about Islamic banking

While Islamic banking industry is growing fast, they continue to face a number of criticism from both Muslims and non Muslims. The main criticisms are that products of Islamic banks mimic those of conventional banks. They are supposed to do financial intermediation without interest, which they claim they are doing. However, according to the critiques, apart from the documentation that is required to do Islamic banking transactions, the end result is not very different from those of commercial banks.

In theory, as we have learnt in previous sessions, Islamic banking should be operating on a two tier mudarabah system. On one hand Islamic banks' assets should be comprised of investments that are based on profit and loss sharing instruments. On the liability side too, banks should be sharing the profits and loss on the basis of predetermined ratios for different types of accounts. To really avoid interest, the only other instruments Islamic banks can use, are operating lease or ijarah, salam and istisna. The failure of Islamic banks to establish profit and loss sharing Islamic banking (PALSIB) or even a credible movement towards the same, is a major cause of skepticism among Muslim population. Siddiqui (2010) provides a roadmap to establish PALSIB which will be discussed below.

Another criticism of Islamic banks is that they do not appear to be very transparent about their operations. This issue becomes very important if we refer to the basic concept of Islamic banking which is supposed to uphold Islamic ethics and also, treat their depositors as partners in their business somewhat similar to their share holders.

How to establish PALSIB
There are four parties involved in commercial banking each with its own interest; funds providers (or savers), funds users, commercial banks and the government. The role of government is to make relevant rules and regulations and establish institutions for smooth running of the commercial banks, and to safeguard the interests of the bank owners (who provide initial funds or owners capital), funds providers, and the funds users. Furthermore, by allowing commercial banks to create money and empowering central banks to stand for them as the bank of last resort, the government has the right to be actively involved with banking industry. As the general public also benefit from the stable and growing level of economic activities partially made possible through financial intermediation, the government has responsibility and a stake in smooth running of the banking sector.

A basic requirement for the eventual success of PALSIB is that all these four parties have necessary commitment, compulsion and incentives to carry out what is required of them. There is no denial that some of them (especially the funds users), at least occasionally, following their instincts of self or group interest would tend to drift from the ideal. A necessary environment has to be created through rules, regulations and their effective implementation that could minimize such behaviors.

As mentioned earlier, conventional commercial banks have grown over centuries creating many institutions to support its smooth running. Even now, in a free market era, they are the most heavily and extensively regulated industry constantly under watch by the central banks. The backbone of conventional banking is (a) the right of the depositors to their principal amount (up to a certain limit) in nominal terms and any interest accrued no matter what happens to a bank and its fund users, which necessitates (b) provision of loans to the funds users only against collateral. Both the depositors and banks thus are supposed to be risk averse by design. The banks are actually discouraged to offer higher rates of returns as it may require them to charge higher rates to their funds users raising the chances of higher incidences of business failures. The system has thus resulted in very low levels of assured returns to the depositors that, in many countries even do not reach to their rates of inflation. This is a new kind of injustice that is often not given due consideration in Islamic banking literature.

While assuring the depositors of their principal and interest accrued on them is the backbone of conventional banking, such assurance is a negation of PALSIB unless the amount is deposited as an amanah (safe custody) in which case the principal would be protected and a service charge for safe custody and other facilities imposed. There is a whole lot of difference in these two types of arrangements and requires a completely different and new approach of thinking, attitude, operative methods and supporting institutions to do PALSIB. By doing banking with murabaha and its variants, not much was done to move in this direction.

Changes in Attitude and Approach
Perhaps the most important thing for PALSIB is the attitude of their bankers. They must be trained to do a different type of banking. Conventional banks are trained to ascertain the provision and value of collateral before giving a loan. PALSIB requires that they train their staff for evaluating the fund users (more importantly their integrity and capability), their business plans and monitor their operations and activities after deciding to invest funds with them. It would certainly increase the cost of banking operations; more so during the initial period of PALSIB until such devices are created that can minimize the costs of screening, observing and inspections. However, this has also potential to increase the total returns of PALSIB banks. Furthermore, as banks will be involved in financing diverse businesses in different sectors of the economy as co-sponsors of projects or businesses, they will be in a better position to give valuable guidance to the funds users. This would reduce the chances of over investment in a particular sector or region of the economy.

PALSIB should be initiated in countries where the governments and central banks are fully supportive of the idea and ready to do whatever is necessary to establish it. The top managers for PALSIB banks should be chosen from a pool of bankers who know the importance and complexity of the job and eager to offer best of their abilities. The next step would be to pick middle and lower level staff who are appropriately educated, intelligent and capable. They should be then trained extensively to work in the evaluation and monitoring departments of the banks. The success of Grameen bank and its founder must be a reminder to all those who thought that banking without collateral was not possible. This bank has shown that if the staff is trained for a purpose and they are involved with the fund users, commercial banking is possible without collateral even when the borrowers are the poorest of the poor. If Islamic banks had done necessary home work and put required efforts, they could have shown the world that commercial banking is possible without involving interest.

Dividend Markets
The continued low levels of returns to depositors has, at least partially, also contributed to the growth of mutual funds that are increasingly providing comparative services with higher returns by investing in liquid assets such as readily tradable stocks and bonds. They never face a bank run situation as the depositors are never assured of their returns and they can always liquidate their assets to meet any demand of withdrawal. PALSIB is close to the concept of (non-money market) mutual funds. Indeed, commercial banks are different from mutual funds and they do provide funds to many small producers to start new businesses or to expand their existing businesses. As they have to guarantee the principal and interest to their depositors, they cannot be allowed to invest beyond a limited amount in stocks and other risky assets. As PALSIB is based on the concept of non-guaranteeing a fixed and positive return to their funds providers, they would be well placed to invest a large fraction of their funds in stocks. While this may be seen as PLALSIB banks being involved in PLS mode of finance, too much exposure to stocks may keep the value of their assets and returns to their funds providers discouragingly unstable. This leads to another related issue in Islamic finance, the elimination of mysir (or gambling like transactions) in general and from the stock markets in particular. It is often claimed that the current modus operandi of stocks markets creates an efficient and extremely liquid system. Any new information quickly adjusts the prices of stocks through continuous buying and selling of stocks. The system also allows liquidating one’s position with ease and speed. The focus of participants, however, remains on making quick capital gains rather than earning through dividends. There is no denial that many of the best minds in the world try to gather and process information to make intelligent buying and selling of stocks. But I hope one should also admit that the system still creates such an immense level of speculative environment and drive to outsmart others that it hardly conform to Islamic teachings of patience and cooperation. One should also consider that stock markets are part of capital markets that are mainly responsible for financial intermediation. Stock markets, as secondary markets for shares, make the underlying asset attractive and thus facilitate initial sale of stocks that provides the resources needed for business expansion by growing companies. One can argue that a market of stock that makes the stock less liquid but reduces the amount of speculation and induce people to focus on dividend payments would be better suited for Muslim communities. I call it dividend markets.

The basic goal of dividend markets would remain the same as the conventional markets i.e., efficiently allocating the investible funds to the productive units of the economy. One of the requirements for listing in dividend markets could be that companies must not be violating any Islamic injunction and arrange all their financial needs through non-debt instruments. Establishment of PALSIB and dividend markets will thus help both of them in achieving their goals. Banks under PALSIB will be able to invest their funds in dividend markets earning regular income through dividend. The requirement that both PALSIB banks and companies listed at dividend markets only deal in profit and loss sharing transaction could also lead to devise a mechanism for even short term financing through profit and loss sharing methods.

The idea is to bring reforms in the current working of stock markets by making dividend payments the most important variable instead of capital gains. For example, one can argue what will be lost if people are allowed to trade shares only once a week or for that matter once in a month. Similarly, companies could be restricted in their decision about retained earnings, necessarily distributing most of the profits to the share holders in every financial period. Any new investment by a successful company could be attracted through new shares many of which could be sold to existing share holders or PALSIB banks.

Funds Providers, Central Banks and Shari’ah Boards
PALSIB banks should be asked to accept investment and non investment accounts. The non investment accounts would not pay any return and will require 100% reserve requirement. PALSIB banks could be allowed to charge a nominal fee for providing different kinds of banking facilities. The investment accounts on the other hand should not be subject to any reserve requirement but would not be allowed to invest more than what is provided by its original owners and investment accounts holders. The central bank should be the most important account holder of every PALSIB bank and must keep an active account providing necessary liquidity if needed for investment or meet demand for withdrawal. As a special account holder of the PALSIB banks, the central bank would closely watch the investment activities of these banks. The central bank would thus be able to control the supply of money without involving open market operations that involves interest. Each central bank should constitute a National Shari’ah Board consisting of Shari’ah experts, Islamic economists, prominent ex-bankers, and contemporary financial experts from business and academia. This would enhance the quality of the judgments and avoid the perceived conflict of interests of the members. It will also lead to standardizing PALSIB products within a country.

The central bank should make sure that the activities and financial standing of PALSIB banks are transparent to a level that the conventional or other Islamic banks have never reached to. While the concerns of International Accounting Standard for banks and the compliance to BASEL II must be addressed, the central banks should come up with their own standard for accounting practices, accounts certification system and capital adequacy requirements based on the nature of their PALSIB products. To create the right environment for PALSIB, central banks should be constitutionally asked to make price stability as their main responsibility and given necessary autonomy to achieve this goal.

Gradualism
It is important to realize that PALSIB cannot be established overnight. A lot of patience is required. However, things should not be left open ended. The PALSIB units at the central banks, top managers of PALSIB banks, Shari’ah Board members and other relevant government agencies should sit together to determine the speed of work in different aspects of PALSIB and come up with bench marks. The Shari’ah Boards should also be looking into the need to make changes such as operating rules of traditional mudarabah and other modes of financing. It has been often argued by Islamic bankers that they are handicapped by not having any control over the activities of mudaribs. Rules of mudarabah could be changed to allow the Rab-ul-Mal (owner of fund) to take part in the management, supervision and monitoring of a business. Similarly, with the help of the government, central banks must establish banking tribunals to make speedy resolutions of conflicts between PALSIB banks and their funds users.

Financing of Consumer Durables and Micro or Medium Size Loans
Commercial banks have been in the forefront for financing consumer loans specially that of automobiles and housing. Many of these loans are provided against expected stable stream of future income or collaterals and paid back in installments with accrued interest. First of all, there is no denial that such financing facilities do provide an important service to millions of people. However, if one accepts the notion that any amount of interest paid (that is over and above a compensation for inflation, in my opinion) is Islamically unacceptable, how would then the banks under PALSIB system continue to provide loans for consumer durables? It is proposed that that availability of reasonable funds for consumer durables should be available through government resources. We should keep in mind that under an Islamic system the commercial banks will not be allowed to create money and hence an added room for (non inflationary) money creation will be available to the government. A part of this resource plus an appropriate amount from government tax revenue could be channeled for financing consumer durables and housing. The management of these funds could be given to specially created government institutions for these purposes. Alternatively, these entities could be allowed to be established in the private sector who would receive the required funds from the government along with a reasonable percentage as fees for their services. An added advantage of this arrangement will be that, through proper guidelines given to these institutions, the government should be able to curb the rampant consumerism currently seen in many Muslim countries. Micro financing is a relatively new phenomenon. Its founder, Dr. Younus has clearly shown the world that through an appropriate approach loans could be given to the poorest of the poor without involving collateral. The key to his success was the way bank employees engaged themselves with their funds users. Some people have criticized his organization for charging a high rate of interest. However, one has to see the motive of his organization which was to help as many poor as possible through a sustainable non profit organization (interest was not charged to make money but to cover the cost of operation and expand the helping the poor activity (not making money through interest). Indeed if the government could provide funds, there would be no need to charge any interest at all. Also an appropriate structure of profit and loss sharing arrangement could also be developed to finance such loans with proper training and organizational set up. Works on similar line have to be done to cater the needs of small and medium size enterprises. With the level of advancement in information technology and improvement and innovation in forensic accounting, the supervision and monitoring of even small business are not as difficult as it used to be.

Cultivating a Reservoir of Islamic Entrepreneurs
Notwithstanding a possible objection to the term Islamic entrepreneurs, in my opinion, there is a need and opportunity to produce entrepreneurs that are properly trained and motivated to do business at different scales in an Islamically desirable way. Siddiqui (2005) emphasizes the importance of entrepreneurs in general and for an Islamic economic and financial system in particular. Academic and professional training for different levels of managers should include all aspects of Islamic business ethics. Finally, the certification to do business could be awarded after taking a public oath to uphold the moral commitment required of them. After all, is it not the case that society expects a particular standard of morality from our doctors, teachers, preachers, etc., more than ordinary citizens? Entrepreneurship is vital for any economy; morally upright entrepreneurs could be produced through proper training and creating a high social status for them in the society.