We can have interest free banking

We can have interest free banking

Fayaz Ahmad Lone writes on the concept of Islamic Banking which attempts to replace interest by other modes and instruments both for mobilizing savings and for putting those savings to productive use.

Introduction:
Islamic banking as a concept is a burning topic in the context of India, even Prime Minister (who is also an Economist) set up a committee to look about the feasibility of this bank in India. The committee headed by retired governor of Reserve Bank of India has not yet submitted the report. It is a banking which can provide rate of interest from “0” to “100”percent annually. This is the best solution to eradicate the unemployment from India.

In any economy there is a need to transfer funds from the savers to investors because people who save are frequently not the same people who have the ability to exploit the profitable investment opportunities. This function is performed either by means of direct finance through securities markets or through the process of financial intermediation in the financial markets. The importance of financial intermediation can be seen by the fact that around two third of new investment passes through this process in most countries.

Financial intermediation enhances the efficiency of the saving investment process by reducing transactions costs and eliminating the mismatches inherent in the needs of surplus and deficit units of an economy. Since the savers and investors are usually different units, they require a considerable amount of information about each other. This information is not free. Therefore, the process of channeling funds from savers to investors involves transactions costs. Moreover, due to asymmetric information, it also gives rise to the problems of adverse selection and moral hazard.

Financial intermediaries can benefit from economies of scale and hence reduce transactions cost of transferring funds from surplus units to the deficit units. For the same reason, they are also in a better position to tackle the problems arising from asymmetric information. Similarly, the process of financial intermediation removes some mismatches in the tastes, maturity terms and size of needed funds between the two sides. The surplus units are often small households who save relatively small amounts and the deficit units are the firms who often need relatively large amounts of cash. Financial intermediaries remove this size mismatch by collecting small savings and packaging these to make them suitable to the needs of the users. In addition, users of funds in general need funds for relatively long-term deployment, which cannot be met by individual suppliers of funds. This creates the mismatch between the maturity and liquidity preferences of individual savers and users of funds.

The intermediaries resolve the conflict again by pooling small funds. Moreover, the risk preferences of small suppliers and large users of funds are also different. It is often considered that small savers are risk averse and prefer safer placements whereas the fund users deploy the funds in risky projects. Therefore, the funds cannot be directly supplied. The role of the intermediary again becomes crucial. They can substantially reduce this risk through portfolio diversification. Furthermore, small savers cannot efficiently gather information about investment opportunities. Financial intermediaries are in a much better position to collect such information, which is crucial for making the investment successful.

The role and functions of banks outlined above are indeed highly useful and socially desirable but unfortunately interest plays a central role in each of these functions. Islamic financial intermediation endeavors to replace interest by other modes and instruments both for mobilizing savings and for putting those savings to productive use. The functions that the banks perform are important whether the economy concerned is secular or Islamic. People need banking services. Since the banking services are needed but interest is prohibited in Islamic economies. Therefore, such economies have to find alternative ways of performing various banking functions. This challenge provides the rationale of Islamic banking.

The functions of Islamic banks and other financial intermediaries are similar to their conventional counterparts. Theoretical studies have used alternative Islamic modes of finance to build models through which those functions can be performed. Some studies have shown that Islamic models can perform those functions in a better way. Some of those models are briefly described below.

1. Murabaha (cost-plus financing):

Under murabaha, the Islamic bank purchases, in its own name, goods for an importer or buyer who cannot afford to pay directly, and then sells them to him at an agreed mark-up. This is the sale of a commodity at a price, which includes a stated profit known to both vendor and purchaser (a cost plus profit contract).
Let us take the case of bank client (C) who actually needs to buy something for which he does not have funds to meet the seller (S)’s demand for payment. Currently a bank (B) comes in the picture as fallows: The prohibition of ‘riba’ (interest) makes the loan option economically infeasible for the bank. It can hire, and still play a meaningful role and help the client to tide over his liquidity problems.

2. Mudaraba (profit sharing):

This implies a contract between two parties whereby one party, the rabbul-mal (beneficial owner or the sleeping partner), entrusts money to the other party called the mudarib (managing trustee or the labour partner). The mudarib is to utilize it in an agreed manner and then return to the rabbul-mal the principal and the pre-agreed share of the profit. The mudarib (bank) keeps for itself what remains of such profits. The division of profits between the two parties must necessarily be on a proportional basis and cannot be a lump sum or guaranteed return. The investor is not liable for losses beyond the capital he has contributed (if loss occurred). The mudarib does not share in the losses except for the loss of time and effort.

3. Musharaka (partnership financing):

This is a partnership, normally of limited duration, formed to carry out a specific project. It is similar to a Western joint venture, and is also regarded by some as the purest form of Islamic financial instrument, since it conforms to the underlying partnership principles of sharing in, and benefiting from, risk. Participation in a musharaka can either be in a new project, or by providing additional funds for an existing one. Profits are divided on a pre-determined basis, and any losses shared in proportion to the capital contribution.

Every Islamic bank has a committee of religious advisers whose opinion is sought on the acceptability of new instruments and who provide a religious audit of the bank’s accounts. In Islam moral and equitable values form an integral part of the law governing contractual and financial relations to such an extent that the relationship between equity, law and religion is central to all business.

Banking Regulations in India:

Indian banks are governed under the Banking Regulation Act 1949, Reserve Bank of India Act 1934, Negotiating Instruments Act and Co-Operative Society Act. Banking regulations provide working framework for banking companies, which accept deposits from public for lending or investment. The deposits are withdrawable on demand or after a fixed maturity period. Banks’ provide cheque facility, drafts etc and generates deposits through deposit multiplier. Thus they create money supply and add to monetary liabilities in the system. Indian banks have been subjected to a number of banking regulations and guidelines as prescribed by the RBI .Banks in India have to maintain cash reserves ratio. Statutory Liquidity Ratio (SLR) is another important condition to be met by the banks. Liquidity assets comprise investment by the banks in central government securities and other approved securities, which earn market determined interest. The Central Bank uses CRR and SLR as instruments of monetary control. The RBI has used CRR frequently to control the monetary liquidity in the economy. The Central Bank has used Bank Rate to encourage or discourage bank credit demand in the economy. The above instruments cannot be used for Islamic banks as they do not function on the basis of interest. Other sets of conditions which banks have to meet are capital adequacy and assets classification.

It is perhaps worth emphasizing here that for Islamic banks resource mobilization and investment through units/equity need, well functioning equity exchanges market without any tax or penalty on frequent trading. An important development in Indian financial market is the emerging and widening strong capital market with a broad based regulatory system in favour of investors. Now Islamic banks can use two-way routes i.e. on one hand they can mobilize capital resources by issuing equity shares and on the other can invest in equities of corporates and financial institutions. The setting up of mutual funds is another important route. Nowadays Islamic banks can float mutual funds schemes offering dividend on units and these funds can be invested in corporate shares.

Those who have done extensive research on Islamic banking in India are Najatullah Siddiqi, M.Y. Khan , Javid Ahmad Khan, Awsaf Ahmad etc. What is needed is that more and more research should be done on this topic so that this type of banking would commence in India.

(The writer can be mailed at fayaz_naira@yahoo.com)

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3 responses to “We can have interest free banking

  1. Pingback: Client Finance » Blog Archive » We can have interest free banking

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