anwar (2000) - islamicity of banking and modes of islamic banking

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    I S L A M I C I T Y O F B A N K I N G A N D M O D E S O FI S L A M I C B A N K I N G

    Professor Dr Muhammad Anwar*

    I N T R O D U C T I O N

    Financing on the basis of interest has been declared an illegitimate mode of financefrom an Islamic point of view. Therefore, several interest-free bankinginstitutions, called Islamic banks, have sprung up in many countries since theearly 1960s that cater for the banking needs of the Muslim population. Althoughthese banks have successfully replaced the practice of interest with other modeslike mudarabah , musharakah , bai murabahah , bai bithaman ajil , bai eenah , andijarah , doubts regarding their Islamicity still persist. The current study explainsthe reasons behind those doubts. In addition, the study also examines theIslamicity of the money creation role of the central banks and the commercialbanking system. It is found that the role played by the central banks and the

    commercial banking system is contrary to the teachings of the Quran. Thereforesome measures are forwarded that, if adopted, would enhance Islamicity of theentire banking system.

    The article proceeds as follows. Some intellectual and business developmentsare reported in the first part of the article that indicate an astounding success in thearea of Islamic banking. In the next part, it is demonstrated, on the basis of theQuran and Sunnah, that time value of money is riba . The definition of riba is usedto examine Islamicity of the financing modes applied by the Islamic banks.Validity of the money-creation role of the central banking and commercial banking

    system is discussed in the next parts, while measures to enhance the Islamisation of banking are presented in the last part of the article.

    I N T E L L E C T U A L A N D B U S I N E S S P R O G R E S S T O W A R D SI S L A M I C B A N K I N G : A N O V E R V I E W

    Declaring interest as riba led to the detection of certain interest-free financingmodes from the fiqh literature that, in turn, paved the way for the emergence of Islamic banks. Application of the interest-free financing modes has been a

    * Department of Economics, International Islamic University, Malaysia.

    Arab Law Quarterly, [2003]# 2003 Kluwer Law International. Printed in the Netherlands.

    62

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    remarkable success. The intellectual and business success covering a debate on thequestion whether interest is riba , discovery of interest-free modes for banking, anda business profile of Islamic banks are briefly reported here.

    A debate on riba

    All individuals who deal with banks in the capacity of depositors as well asborrowers are well aware of the practice of interest in banking operations. Interesthas been found to resemble riba . Resemblance of interest with riba naturally madedevout Muslims restless because of the prohibition of riba by the Quran in thefollowing words: ``give up whatever is left in lieu of riba if you are indeed believers.If you do not do so then take a notice of war against you from Allah and HisProphet. 1 This shows the importance of the debate that raged among thesupporters and opponents of banking interest on the question of whether interest isriba . Numerous studies have discussed the matter and scholars have advancedopposing opinions on this issue. A group of scholars opine that interest is not riba .For example, Hashmi claims that interest is nothing but mudarabah ,2 whileTantawi, the Grand Shaikh of Al-Azhar, declared that interest-based banking isakin to mudarabah and murabahah .3 However, the majority of contemporarywriters hold the view that interest is riba . Comprehensive discussions covering theviews and justifications provided by scholars in different camps are available in the

    Pakistans Federal Shariat Court Judgment on Interest4

    and the Supreme CourtJudgments on Riba .5

    Discovery of interest-free modes for financing

    Declaring interest as riba intensified the search for interest-free modes to conductbanking business. This pursuit has so far led to discovery of 21 operational modesto perform all types of banking transactions on an interest-free basis. These modescomprise: mudarabah , musharakah , musharakah mutnaqisah , ijarah , ijarah wa

    iktina , murabahah , bai salam , bai muajjal (bai bithaman ajil) , bai istisna , bai eenah ,muzaraa , musaqah , qardhul-hasan , wakala , service charge, sale on instalments,

    1 Quran, 2:278279.2 PLD, 2000, 654.3 Incidentally, the current study will demonstrate below that the nature of the returns accruing to the

    Islamic banks from application of the Islamic modes such as mudarabah and murabahah resembles thereturns accruing to the interest-based banks. If so, then all the evils ascribed to interest remain intactdespite shifting to interest-free banking, and all the criticism levied against the interest-based bankingsystem equally applies to the Islamic banking system in vogue today. A list of the moral, social andeconomic evils ascribed to the practice of interest is indeed very long. See PLD, 2000, 529537 fordetails.

    4 PLD, 1992.5 PLD, 2000. In fact, the judgment delivered by a full bench of Shari`a judges is an authentic

    document that contains a comprehensive review of the present state of theoretical and appliedknowledge on Islamic banking. It also contains all shades of opinions expressed by prominent jurists,bankers, lawyers, statesmen and economists. It covers almost every aspect related to Islamic banking.That is why this study has heavily relied upon it.

    I S L A M I C I T Y O F B A N K I N G A N D M O D E S 63

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    development charges, equity participation, sale and purchase of shares, purchase of trade bills, and financing through auqaf . Institutions providing financing on thebasis of these modes are called Islamic banks. This change of name from bankingto Islamic banking may be seen as a worthwhile psychological achievement as

    participants in the banking industry now use Islamic terminology in their businessdiscussions. This is an important step towards the Islamisation of banking eventhough, as shown below, it is a change merely in form rather than the substance of banking business.

    As noted above, replacement of interest was conceived due to equivalency of interest with riba and a strong verdict against riba . Therefore, the supporters of banking business addressed the practical difficulties that could arise if interest wasrejected and sought solutions to resolve those difficulties. Their approach is to retainthe entire banking structure with all its ramifications except interest. In this pursuit,operational technicalities took precedence over other concerns. The approach led toa sort of Islamic banking that, as found below, also falls within the ambit of riba .However, whatever has been accomplished is laudable because the success of Islamicbanking compared with the interest-based occidental banking certainly indicates thepresence of a yearning for the adoption of an Islamic banking system.

    A Business Profile of Islamic banks

    Proportions of financing under each mode can indicate importance of eachtechnique to the Islamic banks. The minimum and maximum proportions in bankfinancing under each mode, averaged for 10 leading Islamic banks, are as follows:murabahah-cum-bai muajjal 4593 per cent, musharakah 120 per cent, mudarabah117 per cent, ijarah (leasing) 014 per cent and other modes 030 per cent. 6Husain reported Bank Islam Malaysia Berhads financing by mode for the yearended on 30 June 1999 as: murabahah-cum-bai bithaman ajil 91.55 per cent, ijarah3.41 per cent, musharakah 0.52 per cent, mudarabah 0.47 per cent, and qardhul-hasan 2.63 per cent. It is obvious from these figures that murabahah (including bai

    bithaman ajil ) is the most popular mode with the Islamic banks. Of course, onewonders why only murabaha has gained such prominence out of the 21 modeslisted above. This question will be addressed later in this study. A related questionis how the Islamic banks have fared?

    According to a report by the International Union of Islamic Banks, there are 176Islamic banking institutions in the world out of which 47 per cent are in the Southand South East Asia, 27 per cent in the GCC and the Middle East, 20 per cent inAfrica and 6 per cent in the Western countries. Deposits and total assets of theIslamic banks are US$112.6 billion and US$147.7 billion respectively. Islamicbanking is growing at a rate of 1015 per cent per annum compared with thegrowth rate of 7 per cent recorded by the global financial services industry. 7

    6 PLD, 2000, 308.7 PLD, 2000, 739740.

    64 A R A B L A W Q U A R T E R L Y

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    According to another account provided by M Iqbal Khan, head of the Islamicbanking division of HSBC London, there are over 200 Islamic banks operating in65 countries with a population of around 1.3 billion. Islamic banks capital isUS$90 billion that is growing at the rate of 15 per cent per annum. 8

    The latest available comparison of performance of Islamic banks withconventional banks is the one by Munawar Iqbal. He compared performance of both types of banks of equivalent size during 19901998 in terms of equity,deposits, investments, assets, capital-asset ratio, liquidity ratio, deployment ratios,cost-income ratio, return on assets (ROA) and return on equities (ROE). Heconcludes: ``Islamic banks as a group out-performed the former in almost all areasand in almost all years. For example, ROA and ROE for Islamic banks were 2.3