Islamic Banking

Abbas Mirakhor, and Zubair Iqbal

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1987
• ISBN:
  9780939934829

NONE

II Islamic Banking in the Islamic Republic of Iran and in Pakistan

All Muslim countries have practiced Islamic credit arrangements to varying degrees. Interest-free banks have also been operating in several non-Muslim countries. The experiences of the Islamic Republic of Iran and of Pakistan—two countries that have recently attempted to implement Islamic banking on a comprehensive scale—are drawn upon here to assess implications of such a banking system. It is important to note that these two countries have approached the process of transformation from two different directions. The authorities in the Islamic Republic of Iran chose to convert their banking system to an interest-free system at one time by passing the comprehensive Law for Usury-Free Banking in 1983. Pakistan, on the other hand, chose to introduce an interest-free system gradually.

Owing to this difference, the experiences of the two countries have, in several respects, been quite distinct. While both have opted for outwardly similar non-interest modes for deposit and asset generation to effect changes in the banking system, the characteristics and specific application of chosen instruments are sufficiently different to merit separate analysis for each country.

It is too soon to assess the full impact of new regulations on the operations of the banking system, monetary policy, and the economy at large. Nevertheless, it is clear that problems have been encountered in moving away from traditional short-term trade financing operations and toward profit-sharing medium- and long-term equity-financing operations. Similarly, issues regarding bank financing of the government sector remain to be addressed. Banks have, in general, adapted well to the new procedures, but speedy progress may have been hampered by the time-consuming process of retraining staff. The effectiveness of monetary policy in both countries has remained largely unaffected. The authorities recognize, however, that a further transformation of the banking system, that is, toward equity-based profit-and-loss-sharing operations, would not only entail considerable structural changes in the financial sector but also require a new legal framework and a change in the attitudes of banks, their clients, and the policymakers toward implementing the new system.

Islamic Republic of Iran

Following the revolution in 1979, the Iranian authorities took steps to bring the banking system’s operations into correspondence with the requirements of Islamic law. In February 1981, certain administrative steps were taken by Bank Markazi (the central bank) to eliminate interest from banking operations; as a result, interest on all asset-side transactions was replaced by a 4 percent maximum service charge and by a 4 percent to 8 percent minimum “profit” rate, depending on the type of economic activity. Interest on the deposits was also converted into a “guaranteed minimum profit.”³⁸ In the meantime, preparations got under way for submission of comprehensive legislation to bring the operations of the entire banking system into compliance with the Shari’a. The legislation, prepared by a high-level commission (composed of bankers, academics, businessmen, and religious specialists), was passed by the Parliament in August 1983 as the Law for Usury-Free Banking, henceforth referred to as “the Law” (see Appendix). The Law required the banks to convert their deposits in line with the Shari’a within one year, and their total operations within three years, from the date of the passage of the Law, and specified the types of transactions that must constitute the basis for asset and liability acquisition by banks.

The implementation of the new system was constrained by diverse economic developments, associated with the weakening of the quality of banks’ asset portfolios since the mid-1970s, political upheavals, the freezing of Iranian assets held abroad, economic recession, and war.³⁹ The banking system at the time of the revolution was characterized by a large number of newly established banks, which were saddled with high levels of nonperforming assets and of debt obligations to both Bank Markazi and foreign creditors. The position of these banks reflected, in large part, a lack of banking and management experience, as well as inadequate regulatory controls. The resulting inherent weakness of banks’ asset portfolios, leading to lower overall profits, has continued to hamper the effective transformation of the banking system.⁴⁰

Characteristics of Bank Liabilities and Assets

Bank Liabilities Under the New Law

According to the new Law, liabilities acquired by the banks must be based upon two kinds of transaction.

Qard al-Hasanah deposits. In the context of the Law, Qard al-Hasanah constitutes current and savings deposits (as in the conventional banking system), except that they earn no returns. The banks can, however, offer incentives to attract such savings deposits and can include one or all of the following: nonfixed prizes and bonuses in cash or in kind; an exemption from, or a discount in, the payment of commission and fees; and priority in use of banking facilities.

The purpose of these accounts, from the point of view of the customers, would be to serve as a means of transaction, payment, and liquidity. Moreover, the banks are to consider these deposits (both current and savings) as “their own resources” in their utilization, but no profits are to be passed on to the depositors. The full nominal value of the deposits, however, is required to be guaranteed by the banks.

Term investment deposits. Banks are authorized to accept two types of investment deposits, short-term and long-term. The deposits differ with respect to the minimum required time limits, three months for short-term and one year for long-term deposits, and with respect to the minimum amount required, Rls 2,000 for short-term and Rls 50,000 for long-term accounts.

Although the banks can use their own resources, that is, their capital plus Qard al-Hasanah deposits, the priority must be given to investment deposits, that is, depositor resources. The banks can also use a combination of their own and depositor resources in an investment project, in which case the bank and the depositor share the resulting profits. A third possibility is for the bank to place the depositor’s funds in an investment project, that is, to serve as a trustee, in which case the entire resulting profits as well as any capital gains are returned to the depositors and the bank charges only a commission to cover the expense of administering the accounts. In this case the bank can guarantee and insure the principal amount of depositors’ resources.

When combined resources of the bank and the depositors are invested, the return to depositors is, in principle, calculated in proportion to the total amount of investment deposits (while the required reserve portion is subtracted from the base amount). The banks are required to announce their profit rates at the end of each six months of their operation, at which time the shares of the depositors’ profits are to be paid into each account. No profits are earned by deposits if they are either withdrawn before the minimum time required or reduced below the required minimum.

Financing and Credit Operations

The Law provides various modes of operation upon which the financing transactions of the banks must be based. A brief description of these modes follows.

Partnership (Musharakah). The Law recognizes two different forms of partnership: civil and legal. The first is a project-specific partnership of short duration in commercial, production, and service activities in which each partner provides a share of the necessary capital, and the assets and properties thus acquired are held as community property until the end of the life of the partnership. In these cases, the banks’ share in the partnership cannot exceed the share of the manager-entrepreneur initiating or directing the project.

The second form of partnership is a firm-specific venture of longer duration in which the bank provides a portion of the total equity of a newly established firm or buys into an existing corporation. The banks can take equity positions in such partnerships only after the technical, economic, and financial viability of the firm (or the project) has been appraised and the minimum expected rate of return from investment is deemed high enough to warrant such actions by the bank. Bank Markazi must determine the maximum amount of equity participation by the bank and the minimum amount of participation by other partners in the venture. The banks are allowed to sell shares that they have thus purchased whenever they deem it appropriate.

Direct investment. Banks can undertake to invest directly in any economic activities they choose so long as the following requirements are met: (i) banks cannot undertake to invest directly in projects in conjunction with the private sector and in projects that lead to the production of luxury and unnecessary commodities; (ii) the ratio of the initial capital of these ventures to total funds needed must not be less than 40 percent; (iii) the total fixed capital necessary for undertaking these projects must be provided for by long-term financial resources; (iv) undertakings of direct investment by banks must be based on well-documented evaluation and appraisal of the project, and use of bank resources and investment deposits in direct investment projects is allowed if, and only if, the expected return from these projects is sufficient to meet the minimum required rate designated by Bank Markazi; (v) banks must report to Bank Markazi the amount of their own, as well as depositors’, resources allocated to direct investment projects; (vi) once the projects in which the banks have directly invested have begun their productive activity, banks can sell shares to the public; and (vii) Bank Markazi is authorized to investigate and audit direct investment projects in which banks have invested.

Mudarabah. This transaction is considered a short-term commercial, contractual partnership between a bank and an agent-entrepreneur according to which financial capital is provided by the bank and managerial effort by the entrepreneur in order to undertake a specific commercial project. Banks are required to give priority in their Mudarabah activities to cooperatives. Moreover, banks are not allowed to engage in Mudarabah financing of imports with the private sector.

Salaf transactions. To provide firms with the needed working capital, banks can prepurchase their future output so long as the product characteristics and specifications are determined at the time of the purchase and the agreed price does not exceed the market price of the product at the time of the transaction.⁴¹ Banks, however, cannot sell the product until they have taken physical possession of the same. The delivery date of the product, which is to be established at the time of the transaction, cannot exceed one production cycle or one year, whichever is shorter.

Installment purchases

Banks are authorized to purchase raw materials, machinery and equipment for firms and resell the same to them on installment. The volume of raw materials cannot exceed that necessary for one production cycle and the repayment period for same cannot exceed one year. The price of the product subject to the transaction is to be determined on a cost-plus basis. The repayment period for machinery and equipment cannot exceed their useful life, which is considered to begin on the date of their utilization in the production process and the duration of which will be determined by the central bank. Residential housing can also be built and sold by banks on installment.

Lease-purchase transactions

Banks can purchase the needed machinery and equipment, or other movable and immovable property, and lease the same to firms. At the time the contract is entered into, firms have to guarantee to take possession of such property at the end of the contract period, if the conditions of the contract are fulfilled. The time period involved in this transaction cannot exceed the useful life of the property (to be determined by Bank Markazi). Banks, however, cannot engage in transactions in which the useful life of the subject property is less than two years.

Jo’alah (transactions based on commission)

Banks may provide or acquire services whenever they are needed and charge or pay commissions or fees for such services. The service to be performed and the fee to be charged must be determined at the time of the transaction.

Muzara’ah

Banks may provide agricultural lands that they own or are otherwise in their possession (e.g., as a trust) to farmers for cultivation for a specific period and a predetermined share of the harvest. Banks may also provide seed and fertilizer along with the land if they so choose.

Musaqat

Similarly banks may provide orchards or trees that they own or that are otherwise in their possession (e.g., as a trust) to farmers for a specific period of time and a predetermined share of the harvest.

Qard al-Hasanah loans

Banks are required to set aside a portion of their own resources in order to extend interest-free loans to (i) small producers, entrepreneurs, and farmers who would otherwise be unable to find alternative sources of financing investment and working capital and (ii) needy consumers. Banks are permitted to charge a minimum service fee to cover the cost of administering these loans.

In addition to the above modes of financing, banks are permitted to purchase debt instruments of less than one year’s maturity, but only if the debts are issued against real assets.

General Regulations Governing Asset Acquisition by Banks

The Law for Usury-Free Banking not only provides regulations to cover specific modes of transactions but also specifies additional regulations that govern asset acquisition by the banks.⁴² The most important of these regulations are the following:

1. Banks can only extend credits when they are reasonably assured that the principal sum granted and resulting profits are returned within a specific period of time.
2. Banks are responsible for the control and supervision of the activity to which their own resources and/or the resources of their depositors are contractuall...