Islamic Banking and Finance
Islamic banking, a financial innovation, has come to be seen as the most ‘visible’ aspect of Islamization. Notwithstanding its novelty, it has made considerable progress, measured by the rapidity with which it has been adopted in the Muslim (even non-Muslim) countries in a relatively short period of time.
However, the progress made by Islamic banking is seen by some Muslim economists as more apparent than real because it is not being run exclusively (or even mostly) on the basis of the Sharicah-favored profit and loss sharing (PLS) principle; rather, the fixed-rate type of financial instruments, which are seen as a ‘deviation’ from the Islamic ideal, have proliferated. It is argued in this paper that there is no warrant whatsoever for this misplaced ‘financial puritanism’, which has obfuscated the subject and its manifestations.
Islamic Banking and Finance Essay Example
The fact of the matter is that, deviation or not, the fixed-rate financial instruments, duly approved by the Sharicah, form an integral part of Islamic banking; and that it would be counterproductive to limit the possibilities of this institution just to the PLS principle. Hence, respecting the preferences of the consumers, Islamic banks should aim to evolve a risk-minimizing ‘mixed’ investment portfolio, containing both the variable and fixed-rate of return types, without any ‘imperfection complex’.
Even more important, rather than pursue an ambiguous financial ideal, which cannot be reached, the focus of the future reform. Should be to produce something strikingly original which can win the acknowledgement of the people. To this end. Islamic banking should be informed with an earnest knowledge of the ethical objectives of an Islamic economic system, the truth of which can be established only by the quality of social justice and the primacy it accords to the needs of the underclass in society.
But as it was a mammoth task, the switchover plan was implemented in phases. The Islamization measures included the elimination of interest from the operations of specialized financial institutions including HBFC, ICP and NIT in July 1979 and that of the commercial banks during January 1981 to June 1985. The legal framework of Pakistan’s financial and corporate system was amended on June 26, 1980 to permit issuance of a new interest-free instrument of corporate financing named Participation Term Certificate (PTC).
An Ordinance was promulgated to allow the establishment of Mudaraba companies and floatation of Mudaraba certificates for raising risk based capital. Amendments were also made in the Banking Companies Ordinance, 1962 (The BCO, 1962) and related laws to include provision of bank finance through PLS, mark-up in prices, leasing and hire purchase. Separate Interest-free counters started operating in all the nationalized commercial banks, and one foreign bank (Bank of Oman) on January 1, 1981 to mobilize deposits on profit and loss sharing basis.
Regarding investment of these funds, bankers were instructed to provide financial accommodation for Government commodity operations on the basis of sale on deferred payment with a mark-up on purchase price. Export bills were to be accommodated on exchange rate differential basis. In March, 1981 financing of import and inland bills and that of the then Rice Export Corporation of Pakistan, Cotton Export Corporation and the Trading Corporation of Pakistan were shifted to mark-up basis.
Simultaneously, necessary amendments were made in the related laws permitting the State Bank to provide finance against Participation Term Certificates and also extend advances against promissory notes supported by PTCs and Mudaraba Certificates. From July 1, 1982 banks were allowed to provide finance for meeting the working capital needs of trade and industry on a selective basis under the technique of Musharaka. As from April 1, 1985 all finances to all entities including individuals began to be made in one of the specified interest-free modes.
From July 1, 1985, all commercial banking in Pak Rupees was made interest free. From that date, no bank in Pakistan was allowed to accept any interest-bearing deposits and all existing deposits in a bank were treated to be on the basis of profit and loss sharing. Deposits in current accounts continued to be accepted but no interest or share in profit or loss was allowed to these accounts. However, foreign currency deposits in Pakistan and on-lending of foreign loans continued as before. The State Bank of Pakistan had specified 12 modes of non-interest financing classified in three broad categories.
However, in any particular case, the mode of financing to be adopted was left to the mutual option of the banks and their clients. The procedure adopted by banks in Pakistan since July 1 1985, based largely on ‘mark-up’ technique with or without ‘buy-back arrangement’, was, however, declared un-Islamic by the Federal Shariat Court (FSC) in November 1991. However, appeals were made in the Shariat Appellate Bench (SAB) of the Supreme Court of Pakistan. The SAB delivered its judgment on December 23, 1999 rejecting the appeals and directing that laws involving interest would cease to have effect finally by June 30, 2001.
In the judgment, the Court concluded that the present financial system had to be subjected to radical changes to bring it into conformity with the Shariah. It also directed the Government to set up, within specified time frame, a Commission for Transformation of the financial system and two Task Forces to plan and implement the process of the transformation. The Commission for Transformation of Financial System (CTFS) was constituted in January 2000 in the State Bank of Pakistan under the Chairmanship of Mr. I. A. Hanfi, a former Governor State Bank of Pakistan.
A Task Force was set up in the Ministry of Finance to suggest the ways to eliminate interest from Government financial transactions. Another Task Force was set up in the Ministry of Law to suggest amendments in legal framework to implement the Court’s Judgment. The CTFS constituted a Committee for Development of Financial Instruments and Standardized Documents in the State Bank to prepare model agreements and financial instruments for new system. The CTFS in its Report identified a number of prior actions, which were needed to be taken to prepare the ground for transformation of the financial system.
It also identified major Shariah compliant modes of financing, their essentials, draft seminal law captioned ‘Islamization of Financial Transactions Ordinance, 2001’, model agreements for major modes of financing, and guidelines for conversion of products and services of banks and financial institutions. The Commission also dealt with major products of banks and financial institutions, both for assets and liabilities side, like letters of credit or guarantee, bills of exchange, erm finance certificates (TFCs), State Bank’s Refinance Schemes, Credit Cards, Interbank transactions, underwriting, foreign currency forward cover and various kinds of bank accounts.
The Commission observed that all deposits, except current accounts, would be accepted on Mudaraba principle. Current accounts would not carry any return and the banks would be at liberty to levy service charge as fee for their handling. The Commission also approved the concept of Daily Product and Weightage System for distribution of profit among various kinds of liabilities/deposits.
The Report also contained recommendation for forestalling willful default and safeguarding interest of the banks, depositors and the clients. According to the Commission, prior/preparatory works for introduction of Shariah compliant financial system briefly included creating legal infrastructure conducive for working of Islamic financial system, launching a massive education and training program for bankers and their clients and an effective campaign through media for the general public to create awareness about the Islamic financial system.
The Finance Minister of Pakistan in his budget speech for the FY02 declared the following: “Government is committed to eliminate Riba and promote Islamic banking in the country. For this purpose a number of steps are under way which are: 1. A legal framework is designed to encourage practice of Islamic banking by banks and financial institutions as subsidiary operations of their main operations; 2. Consultations and exchanges are undertaken with brother Islamic countries and renowned institutions of Islamic learning such as Middle Eastern countries and Al-Azhar University of Egypt, to learn more about their experiences and practices;