Islamic Banking Revisited
Mahfuzur Rahman clarifies some of the misconceptions behind Islamic banking
Islamic finance has expanded rapidly in recent years. Assets held by Islamic banks worldwide were said to have been over $800 billion at the end of the past decade. In Bangladesh, Islamic banking remains small in comparison with mainstream banking in the country. The first Islamic bank of the country was set up in the early 1980s, and in more recent years, a number of other banks have been established in quick succession. Business has increased rapidly.
The expansion of Islamic banking has also been matched by a spate of Islamist fervour in the writings of its proponents. Much of these writings have been couched in terms of denouncing mainstream banking practices, based as they are on the principle of charging interest on loans, something that is considered un-Islamic.
A great deal of these writings and public relations literature also explicitly see Islamic banking as a major step to the establishment of a sharia-based, interest free, Islamic political system. In discussions on Islamic banking, its proponents have the field pretty much to themselves. Sceptical voices have been strangely absent.
To go briefly over the basics: the Koran explicitly forbids "riba." But what is riba? The crux of the issue lies in that question and has been endlessly debated. Proponents of Islamic banking now tend to take it for granted that <>riba<> means interest irrespective of its rate.
This is quite untrue, and a number of Islamic scholars have interpreted riba as usury, which is oppressively high rates of interest, and not interest per se. Yusuf Ali, Maulana Muhammad Ali, and A.J. Arberry, for example, all of them of unquestionable scholarship and piety, use the term "usury" in their translations of the Koran.
Let me make something clear: there is no ambiguity in the Koran in its denunciation of usury. This finds its strongest expression in verse II:275: "Those who devour usury will not stand except as stands one whom the Evil One by his touch hath driven to madness …" (Translation, here and in the next two verses, is by Yusuf Ali).
Hardly less clear are, for example: "God will deprive usury of all blessing, but will give increase for deeds of charity ..." (II:276);
"O ye who believe! Devour not Usury, doubled and multiplied; but fear God…" (III:130)
"And what you give in usury, that it may increase upon the people's wealth, increase not with God; but what you give in alms, desiring God's face, those -- they receive recompense manifold" (XXX:39) (Translation by Arberry).
The edict in Verse III:130 strengthens the argument that it is very high rates of interest, rather interest, that has been prohibited.
Like many other edicts in the Koran, the issue of riba needs to be seen in the historical context in which it was proclaimed. A crucial context here is that in seventh century Arabia, and perhaps in most of the world then, loans were sought and given mainly for current consumption purposes.
In post- hijrat Medina, the vast majority of the population lived on the margins of subsistence. Poverty was pervasive. To those who sought a loan to sustain themselves, the rate of interest charged on it was indeed important. Their economic survival depended on it. That was why usury was discouraged in the Koran in the strongest terms.
Poverty must have also necessitated emphasis on charity. Indeed some of the verses relating to usury directly link it to charity: better to give the needy person goods or money as gift than lend them to him.
None of the above will of course sway the protagonists of Islamic banking, nor is it meant to. To them, interest is evil and will remain so. Detractors of interest would rather engage in trade than in interest-based banking.
This, indeed is their starting point, without reference to the context: God has permitted trade and forbidden interest (proclaimed in II:275), usurious or not. Conventional banks, on the other hand, do not trade in goods, do not involve themselves in risks associated with trade, but trade in money, lending at pre-determined rates of interest. The emphasis is on an alleged absence of any risk taking by the banks and the impression given is one of powerful banks, capable of setting a rate of interest at will, exploiting the hapless borrower.
This picture is, of course, a caricature. Banks take considerable risk in their business transactions, as evidenced by bank failures, the recent financial upheaval in the West, and the more recent near default by Dubai World on their Islamic bond, or sukuk, that almost shook a number of creditor banks. The interest rate that most banks charge is set in a macro-economic framework beyond the control of individual banks.
Furthermore, banks are subject to regulation, and borrowers are not always the weaker party -- some corporate borrowers are more than a match. Note also, in passing, that the modern capitalist system, for all its failings, has created far more prosperity than any other economic system so far, and has done so through industry and trade, for which interest-based finance is the prime mover. And it has lifted people out of poverty -- the very phenomenon that led to the emphasis in the Koran on charity rather than lending in the first place.
On their part, Islamic banks make a concerted effort to anoint all their activities as trade rather than interest-based banking. This deserves a close look. How truly Islamic are their activities?
Islamic banks offer an array of banking products. The names given to these products are sometimes rather confusing, have overlapping meaning, and do not describe the product well. The following products account for the bulk of an Islamic banks business: Al-wadia (meaning, variously, to preserve, deposit, subtract, or forsake, according to one writer) is akin to non-interest bearing current account deposit in mainstream banks; Mudaraba (literally, to travel on business), operationally, profit-sharing ventures; Musharaka (literally partnership, which is necessarily also profit-sharing ); Bai Murabaha, or simply Murabaha, literally to buy and sell at profit (a definition that can describe almost any business); and the more easily recognisable Ijara, or lease financing. All of these instruments, excepting Al-wadia, are geared to generating profit, which is permissible, and are not supposed to have anything to do with interest.
Under Mudaraba, deposits are accepted by the bank and are then used by entrepreneurs for investment (such as in a trade venture). The depositor, who does not himself participate in any venture, is given a portion of the profit. The rate of profit, given out by the bank from the total fund of profits derived from all Mudaraba ventures intermediated by the bank, is not fixed and varies with circumstances.
However, the rate of profit a depositor receives also depends on the term of the deposit, that is, on the length of time the depositor keeps his money with the bank. The longer the term, the higher the rate of profit: a three-year deposit earns a higher rate of profit than a three-month deposit, for example.
It is useful to recall here the economic significance of interest. Interest is essentially compensation for current consumption deferred. Normally, the longer the period of deferral or waiting, the higher the rate of compensation is. This is reflected in long-term rates of interest being higher than short-term rates. Risks too increase with time and call for generally higher rates of interest on longer-term loans than on shorter-term funds.
There is a great deal of similarity with Mudaraba deposits here. The longer the period of waiting, the higher is the rate of "profit."
The rate of "profit" looks surprisingly like the rate of interest, except for the fact that the profit rate is not predetermined. Islamic banks proclaim that they "do not trade in money", as one author put it. But here is the bank accepting deposit (of money) from a depositor who does not trade, giving out profit (in money) at a rate that partly depends on the length of time the money deposited is kept in the bank, just as with mainstream banks. If the bank itself is not actually trading in money, it is providing the intermediation for the depositor to do so.
Musharaka is very similar to Mudaraba, except that the supplier of finance (the depositor) also takes part in the business venture. A relatively small proportion of Islamic banking business conforms to the strictly Islamic profit or loss sharing principle, such as Mudaraba or Musharaka. Only about 2 percent of Islami Bank of Bangladesh's investment income in 2008 came from these two instruments, according to its latest audit report.
Far more important are the Islamic banks' business conducted on the principle of pre-determined profit. Under Murabaha, the most important investment vehicle used by Islamic banks is the bank's purchases goods of various descriptions on behalf of its client and selling them to him on a cost-plus profit basis. The rate of profit is predetermined, making the transaction risk-free for the bank, as is the period within which the client must make full payment on the goods purchased. For the bank to be seen as engaging in trade, rather than merely financing it, it must own the good before selling it to the client. The step between owning (by the bank), and selling (to the client) needs close scrutiny, however.
In an important book, provocatively entitled Islamic Banking: A $300 Billion Deception, Muhammad Saleem, a career mainstream international banker with intimate knowledge of Islamic banking practices explains:
"In Murabaha … the central problem is that the banks keep their ownership periods very short. It may not account to more than a few seconds for a vast majority of transactions are closed simultaneously much in a way [of] a back-to-back letter of credit is handled by the banks. What is more, since their ownership period can be measured in seconds, the banks do not assume any operational risks, normally associated with trading activities.
"Indeed in practice the banks purchase the commodity or goods only after the customer has agreed in writing to purchase it from the bank at a profit. The bank does not assume any risk, including the risk of the goods. The bank however gets a pre-determined fixed rate. This is clearly interest, concealed in Islamic garb and therefore not conforming to the requirements of the Sharia, certainly the spirit of the Sharia."
Under Ijara, the bank purchases, for instance, a piece of equipment and leases it to a client at a predetermined rent. On the nature of this transaction, here again is Dr. Saleem:
"The rental rate reflects the cost of the equipment as well as the time value of money interest. The Islamic scholars have blessed this Sharia compliant because at least in theory there is some risk sharing because of the ownership of the equipment by the bank. However, in practice the Islamic banks require the equipment to be insured (with the insurance premiums to be paid by the client) and banks, like their counterparts in the West also require that the client put up some of the money -- in practice financing no more than about 90 per cent of the cost of the equipment."
About 60 per cent of the investment income of the Islami Bank of Bangladesh in 2008 came from Murabaha, and another 30 per cent from hire purchase/Ijara, according to its audit report. Globally, Murabaha and Ijara account for an overwhelming proportion, probably over 90 per cent of the business of Islamic banks. It should be clear by now that the bulk of the business of these banks is based on the principle of interest, no matter what name Islamic banks might bestow on it.
To sum up: Starting from a dubious premise -- that interest and not just usury is banned in the Koran -- and the Koranic preference for trade in goods rather than in money, Islamic bankers have devised a number of banking products that are said to conform to Islamic principles of shunning interest and accepting trade risk.
In practice, much of Islamic banking looks like an elaborate charade that presents products cloaked in Islamic garb having little to do with those principles. An army of Islamic scholars sits on well-paying sharia boards of Islamic banks around the world, or engages in lucrative consultancies, advising banks on sharia compliance of bank investments. They only contribute to the charade. Questions about the true Islamic credentials of Islamic banking remain.
Mahfuzur Rahman is a former United Nations economist and occasional contributor to The Daily Star. He has greatly benefited from discussions with Dr. Muhammad Saleem in writing the article. Responsibility for the conclusions is entirely the present author's.