Banking Regulations and Islamic Finance

Author(s): T. R. Bishnoi
Source: Economic and Political Weekly, Vol. 25, No. 48/49 (Dec. 1-8, 1990), p. 2687
Published by: Economic and Political Weekly
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Banking Regulations and Islamic
Finance
T R Bishnoi
S RAMACHANDRAN's paper on 'Bank-
ing Regulations and Islamic Finance'
(December 23-30, 1989) was interesting but
missed to note two important points: (1) The
concepts of interest and profits iri Islamic
finance are different from those of the
classical and Keynesian economics. (2) The
viability of Islamic finance or banking is in
doubt as the transformation of the entire in-
terest based banking into profit and loss
sharing (PLS) of Islamic type, as undergoing
in Iran and Pakistan, seems to be retro-
gressive in effect encouraging disintermedia-
tion process in the economy. The purpose
of this note is to substantiate these two
points.
The motivation for change to Islamic
banking is to abolish the interest (riba in
Islamic terminology) and replace it with pro-
fit and loss sharing principle. Assuming that
the conventional concepts of interest and
profit are well known and, therefore, it
avoids their presentation here. Thus, we
discuss only their counter-parts as given in
Islamic literature. In Islamic writing, the in-
terest is defined narrowly as well as broad-
ly. The narrow definition means only interest
charged on consumption loans. The broad
definition of interest (riba) is as "an increase
or excess (fadl) which, in an exchange or
sales of a commodity, accrues to the owner
(lender) without giving in return any equiva-
lent counter-value or recompense (iwad) to
the other party" [Khan, 1987, p 45]. All tran-
sactions those involve giving or taking this
excess are interest (ribawi) and thus, pro-
hibited. Without referring to a exhaustive list
of activities one can note that such an excess
can be possible in two types of transactions:
(1) Guaranteed return to asset owners with
no reference to productive use of assets; for
instance interest to financial asset holders
and rent on physical capital and land. (2) Ex-
cess predetermined remuneration arising out
of the ventures in the form of monopoly,
black marketing, hoarding and cornering,
etc.
The replacement of interest by profit and
loss concepts does not imply that conven-
tional profit concept is compatible with
Islamic profit. Therefore, we give definition
and type of profit consistent with Quranic
injunctions. In Islamic banking and finance,
the profit is defined as a reward for capital
and enterprise plus some kind of rent as
against the Schumpeter's profit resulting
from entrepreneurial innovations and the
Knight's profit from uncertainty. Profits
(losses) of a trade or industry are positive
(negative) differences between sales revenue
and costs [Siddiqi, 1983]. Since the prices
of products/inputs determined by different
market forces resulting in many variants of
profits, it needs to be mentioned that pro-
ductivity linked pure profits are permitted
to be shared. All other modes of profits with
origin in non-competitive markets are always
interest (ribawi) and hence, prohibited. More
precisely, consumhers and producers, for
compliance of Islamic norm, are required to
shun markets other than perfect competition
type to avoid occurrence of riba. In essence,
the substitute of interest in Islamic finance
is surplus and not profit alone.
Iran and Pakistan have attempted to
transform their financial sector on Islamic
principle under state control. Information
on Iran's financial sector is scanty, thus, the
comment is restricted to Pakistan's banking
where PLS deposits account for 61.6 per cent
of total deposits in March, 1985. The ques-
tion whether or not the Islamic mode of
banking is better than interest based bank-
ing, can be answered positively if profitabili-
ty (rate of return) or growth or both improv-
ed given the same risk. Unlike the profit
maximisation objective stated in the theory
of firm, the Islamic banks are guided to
operate on commission and fees basis and
to maximise profits for their depositors.
Therefore, it is appropriate to compare the
profit ratios declared on deposits during post
transformation period with the correspon-
ding interest rates prevalent before such
change. Table 1 shows that the Islamic banks
had marginally higher profit ratios than the
interest rates offered before transformation.
However, these differences were found in-
significant on statistical test. Moreover, even
if we accept differences on per cent point
basis, the profit ratios were not higher
enough to match with the increase in cor-
responding risk in Islamic banking. Rather
in Pakistan, interest rates were suppressed
and profit ratios on PLS deposits were
enhanced through administrative control.
The obvious evidence is the fact that the
government borrows directly from the public
at rates higher than that paid on the PLS
bank deposits. The risk adjusted differen-
tial in two rates (profit ratios and interest
rates) likely to drive deposits awaty from the
banking system, thus leading to disinter-
mediation.
Table 2 shows that the growth rate in
Pakistani Islamic banking tapers off after
1980-81. After transforrnation, mean growth
rate declined by 7.6 percentage points in total
deposits contributed by a fall of 5.3 percen-
tage points in term cdeposits and of 9.5
percentage points in saving deposits between
1975-76 to 1979-80 (prior to Islamic bank-
ing) and 1980-81 to 1984-85 (post-Islamic
banking). The attributing factors to this
decline in growth are political uncertainty
and bankers' risk aversion posture and
preclusion of sectors other than banking
from strict compliance of Islamic laws in
Islamisation process. The banking system
prefers short-term credit port folio (commer-
cial and trade transactions) to avoid risk of
bankruptcy and high cost of monitoring of
PLS investment projects [Khan and
Mirakhor, 1990]. And the depositors are not
high risk searching class of savers, and thus,
they avoid the high risk PLS deposits. For
these reasons, transformation of banking in-
to Islamic type is likely to affect adversely
intermediation process in the economy.
References
S R Khan (1987), Profit and Loss Sharing-
An Islamic Experiment in Finance and
Banking, Oxford University Press, Karachi.
Siddiqi, M N (1983), Issues in Islamic
Banking-Selected Papers, The Islamic
Foundation, Leicester, UK.
Khan, Mohsin S and Abbas Mirakhor (1990),
'Islamic Banking: Experiences in the
Islamic Republic of Iran and Pakistan',
Economic Development and Cultural
Change, Vol 38, No 2, January, pp 353-76.
TABLE 1: AVERAGE RATES OF INTEREST ON BANK DEPOSITS (r) AND AVERAGE DECLARED
PROFITS (p) ON PROFIT AND Loss SHARING DEPOSITS FIOR PAKISTANI BANKS, 1981 TO 1985
Year Saving Deposits Term Deposits
(June r p 1 to 2 Years 3 to 5 Years 5 Years and Above
End) r p r p r p
1981 7.57 8.65 10.48 12.75 - 13.95 - 14.75
1982 7.60 8.70 10.34 12.65 12.17 13.83 12.37 14.60
1983 7.64 8.25 10.49 12.15 12.14 13.25 12.44 17.65
1984 7.61 7.50 10.53 11.00 12.18 12.15 12.39 13.45
1985 7.54* 8.26 10.53* 12.24 12.03* 13.73 12.40* 15.20
Note: * March.
Source: Khan, S R (1987), Table 8.3, p 143.
TABLE 2: MEAN GROWTH RATE OF BANK DEPOSITS IN PAKISTAN, 1975-76 ro 1984-85
(Per cent per annum)
Period Demand Term Total
Deposits Deposits
1975-76 to 1979-80 (prior to Islamic banking) 22.3 23.3 22.7
1980-81 to 1984-85 (post-Islamic banking) 12.8 18.0 15.1
Source: Khan, S R (1987), Table 8.2, p 141 which is adopted from State Bank Annual Reports:
1981-82, 1982-83, 1983-84, 1984-85.
Economic and Political Weekly December 1-8, 1990
2687
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