ECONOMY WITHOUT INTEREST

In this chapter we focus on : what would the prohibition of riba/bank-interest do to a modern economy. How can a modern economy function without interest? How financial intermediation takes place in an interest-free environment? What alternatives are available to interest bearing loans in Islamic finance? Which institutions would help mobilize savings and channel them to users? How conventional banks and non-bank financial institutions may be restructured on an interest-free basis so as to function in accordance with shariah? Is it possible to have a functioning stock exchange in an Islamic financial environment? What will make capital flow across borders and how international finance will look like?

Liability Side of an Islamic Bank Theory of Islamic banking and finance: replaces rate of interest by profit-sharing ( i.e. the two-tier mudarabah model). The liability side : deposits (on the basis of mudarabah) as well as funds entrusted to the bank, with permission to use, but payable on demand. The assets side: comprises funds given to business enterprise on the basis of profit-sharing or partnership. But In practice this simple model was reinforced by admitting, on the assets side, some modes of financing that created debts.

Now, Islamic banks have two kinds of liability: demand deposits in the nature of loans to the bank and investment deposits. The former is like the current accounts in conventional banks guarantee of paying back the principal on demand but no profits.

NOTE: Many Islamic banks have saving accounts as distinct from current accounts. Unlike current accounts, no checks can be drawn on saving accounts. Saving accounts are guaranteed and carry no dividends. But some saving deposits carry the permission of their being used by the bank. These are treated like investment accounts and get some dividend.

Investment accounts are of different types with regard to their time horizon and their profitable use by the bank . Longer periods will lead to promised higher percentages of the profits generated by their use. In the beginning saving accounts constituted a majority of bank accounts but these gradually declined, investment accounts of all types taken together currently constitute majority of deposits in the Islamic banks.

The classical fiqh literature : rejects the idea of guaranteeing the capital in a mudarabah contract. Iranian banks do though. But practice in mainstream Islamic banking remains what it was since day one, i.e. no guarantee for capital in investment accounts.

If there is no guarantee, savers will seek to put their money in the best performing intermediaries. A guarantee will make people indifferent to monitor the performance of the intermediaries. These in turn, will tend to take greater risks in investing depositors money ( exp: Savings and Loan societies in USA and Credit Lyonnais in France).

Assets of an Islamic Bank Assets of an Islamic bank can, in the first instance, be divided in two categories: those based on sharing and those resulting into a debt owed to the bank.

Sharing Based Modes of Finance Musharakah, mudarabah, muzaraah: Musharakah, also known as shirkah, is partnership. It envisages both or all parties to the contract putting in some capital. Each partner has a right to participate in decision-making, i.e. management of the enterprise. Banks appoint representatives in the firm, or fully manage the firm which becomes owned by the bank. Mudarabah or sleeping partnership in which the financier cannot interfere in management except when there is a clear violation of the terms of agreement. The simple mudarabah contract provides for a once for all fixing of the ratio in which the entrepreneur will share the profits of a given project (realized using the capital provided by the bank ). It also provides a single ratio of profit-sharing irrespective of the volume or percentage of actually realized profits.
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translated literally would mean Muzaraah sharecropping. It is the crop itself and not the surplus after meeting the cost that is shared in muzaraah.

Trade-Based Modes of Financing These are the ones resulting in debt creation. In all these transactions there is an exchange of cash for commodity, but one of these, either cash or the commodity, is deferred. What is deferred becomes a loan, be it in cash or kind. Once a loan, its face value cannot be increased as that would be riba. These are murabahah, baymuajjal, installment sale and ijarah (leasing). Murabahah Murabahah, as practiced by Islamic financial institutions, is re-sale of a commodity with a mark-up on purchase price. Alternatively we can describe it as cost-plus. The financing bank sells to a customer the commodity the customer needs and the customer undertakes to pay the (higher than current market) price at a future date. The important difference in profit-sharing finance and murabahah finance: the former creates no debts, the later always does. Also, the financier has no share in the profits of a murabahah-financed enterprise. Murabahah based contract is superior to the financing arrangement based on interest. The financier is financing not a venture of uncertain results but the acquisition of a commodity of acknowledged utility and known current
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price. The mark-up on current price is tacked on the commodity, whereas in interest-based borrowing it is tacked on money capital (the principal). The fact that shariah does not allow any further increase in the contracted price, should more time elapse before the actual payment is made, clearly demonstrates that there is no price for the mere passage of time involving a sum of money. The risks borne by the financier: the risks associated with owning a real asset, e.g. a fall in its market price, destruction due to natural causes or theft, etc. He/she also takes the risks associated with relying on the other partys promise to buy, like the risk of bankruptcy of the would-be buyer or backing down on its promise to buy. Also, by selling on credit the financier is taking the risk of default by the buyer as well as forgoing any other opportunities of using the money that could have arisen as time passes. Equivalence and reciprocity principles are verified here: There is perceived equivalence between the commodity received by the buyer and the price received by the seller, as is the case in voluntary exchanges between commodity on one side and money on the other. Reciprocity inheres in the sellers advantage of a mark-up (attached to which are the risks mentioned above) being matched by the buyers advantage of getting the time and
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opportunity of using the commodity ahead of paying the price. But are not verified in interest baring contracts: Perception of equality is acceptable in place of objective equality in exchange of dissimilar things, as money and commodity, but it cannot be acceptable between the same things, i.e., in exchange of money for money. There it has to be measurable equality as there is no room for perception. There is no reciprocity either. What the lender gets is definite and known but what the borrower gets is neither definite nor known, should we consider the point of time the loan is repaid. Bay Muajjal is not very different from murabahah. It is sale on credit or deferred payment. The commodity is delivered now and the price is paid after some time. The price, higher than the spot price, must be determined now along with the date of payment. Salam is the opposite of baymuajjal, price is paid now and the commodity purchased is delivered in future. The price paid is lower than what is expected (by the buyer, at least) at the time the commodity is to be delivered. During the Prophets time it was generally applied to agricultural commodities. Modern Islamic finance has also adapted it for financing agriculture.

Applied to manufacture, salam becomes istisna. It may be called a pre-paid order for some commodity. The buyer specifies the commodity in quality and quantity and the seller undertakes to deliver it at agreed dates. The seller may or may not be the one who actually manufactures the commodity. The payment may be all in the beginning, at the time contract is made, or in installments, over time. The delivery of goods too may be staggered over time. Used for financing building schools and electrical power generation plants in Saudi Arabia. Ijarah in classical Islamic fiqh is sale of benefits, generally of a durable good. Its modern equivalent is leasing. Just as murabahah/baymuajjal has been adapted as a mode of financing the acquisition of goods, machinery, equipment, etc., leasing is used by Islamic financial institutions for enabling customers to use durable goods, equipments in productive enterprises without having to buy them. Murabahah, baymuajjal, installment sale, salam, istisna and leasing (ijarah) can be distinguished by the fact that in leasing the asset remains a property of the lessor, in our case the Islamic bank. In the other modes of financing listed above the ownership of the asset passes to the customer by virtue of a sale deed. The customer, the lessee, pays a certain amount in cash, yearly or monthly, as the rent of the asset.

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