Some Difficulties (Pakistan)

Major hurdles faced by Islamic finance houses are the absence of a necessary legal framework and the lack of adequate infrastructure in the banking and investment fields.

The modern banking system is based on the concept that money should be treated like any other factor of production and must earn some return over a period of time. It is argued that the establishment of large-scale enterprises, and hence material progress, is not possible unless there is an agency that can mobilise financial resources from the public by paying them some interest, while lending these resources to entrepreneurs. By charging these entrepreneurs a higher interest, these agancies were able to utilise the difference (called a spread) to meet their expenses and to make some profit for the owners of the agency (i.e. share-holders). Banks were established to fulfil this need and from the beginning were only authorised to perform this function. They were legally prohibited from entering into trade or industry. When the Government of Pakistan decided to introduce an interest-free banking system, this prohibition was removed. After a lot of in-house the banks were told in June 1984 that they were allowed to deal in only 1 to 12 means of financing (only two were classified as "Financing by Lending").

These two permitted lending without interest by charging the actual expense incurred by the banks to meet their cost of operation and Qarde Hasana. All the rest were either trade-related or investment-type models. These included the purchase of goods by banks and their sale to clients at an appropriate mark-up price on a deferred payment basis, in case of default there being no further mark-up. This sale of goods on mark-up is known as Murabiha. Other types of financing were hire-purchase, leasing, Musharika or profit- and-loss-sharing, equity participation and purchase of shares, etc.

Since Murabiha was the type nearest to lending and since it did not requre any expertise in buying and selling commodities, bankers limited most of their financing to this type. In order to eliminate the risk of prospective buyers refusing to accept goods purchased by the banks by reason of not being strictly in accordance with the specifications, banks were allowed to appoint the prospective buyer as their agent for the purchase of the goods and later for the sale of the goods to the buyer's firm. Furthermore, to give as much leeway to the banks, as safeguards of public money, as possible, the Ulama did not fixe a waiting period between the two stages of buying and selling.

The banks did not assume the role of trader and Morabiha degenerated into lending on mark-up. The banks rarely hired persons who knew even the basics of trading, nor did they train their existing staff to learn the art. They did not even bother to find out whether their agents had actually purchased the goods or not. The inability, or reluctance of banks and financial institutions to change over their operations from lending to trading has been a serious impediment to the Islamisation of the economy.

The blame does not entirely fall on the bankers. Depositors have become so accustomed to their money remaining safe and yet earning profit that if a bank had really ventured to trade and incurred a slight loss, then the depositors would have immediately demanded their money back causing the bank to go bankrupt. In the existing state of morality this was more likely to happen. It actually did happen to a few investment companies that had started with good intention, but could not go on giving away handsome profits to their depositors.

A lack of seriousness and dedication in those responsible for the implementation was also another great impediment to the achievement the goal of an interest-free economy. Many of these individuals thought that in the present world, there was no alternative to interest, yet something had to be done because of demands from the government. Some, who were more influenced by Western education and culture, thought that interest banking was not prohibited by Islam. Yet others thought that the efforts being made were only superficial and in reality the new system was no different from the existing system.

One weakness in the implementation of the proposals to eliminate interest from the system was that people were not sufficiently motivated to sacrifice a part of their financial interests for the sake of carrying out the commands of Allah (SWT), and The Prophet (SAW). Anyone attempting to change a well-established practice must be prepared to make some sacrifice for this, as arguably no noble cause has been achieved without any sacrifice. The prevailing level of public morality within the existing legal and taxation system of the state made it an up-hill struggle to rid the banking system of interest. And it remains so. Beyond this, there are many avenues of making profit that would have to be forgone and many types of modern banking services which which also could not be provided by a bank working strictly on Islamic principles. For example, they could not keep their surplus cash in fixed or saving deposits. In spite of these difficulties, those who were engaged in the task of Islamisation took it upon themselves to portray as successful the reforms, while those who pointed out the difficulties were labelled as either a cynic or an opponent of the new system. Anyone who uttered a word of caution was regarded as someone who did not want the experiment of Islamisation to succeed. As a matter of fact, reward in the Hereafter (aakhirat) should have been the main purpose of Islamisation. It might not have attracted many people, but the foundation would have been firm.

One great obstacle in the realisation of the goal of an interest-free economy has been absence of a proper environment. Unfortunately nothing has been done to produce an ideal or a near ideal Islamic environment by government or public leaders. The most important pre-requisite for the enforcement of Sharia'h is a'dl [translation!!!!!!]. Establishment of the rule of law and ensuring justice to aggrieved persons should be the first task of an Islamic state, yet nothing has been done to achieve this end.

One very important requirement of an ideal evironment is an inflation-free economy. Inflation erodes the real value of money, meaning that when a person gives a sum of money on loan and receives the same amount back after one year, he has made a net loss. A major source of inflation is deficit financing. The printing of notes to meet budgetary deficit is in fact an injustice to the public, since the real value of their money is consequently eroded. In this respect too, the government's performance is very discouraging. Government borrowings at high interest rates and the quantum of the government's domestic and foregn debts has reached a level which cannot be sustained. There has also been no effort to change the taxation structure so as to bring it to conform with Shari'ah.

Musharika

Musharika represents the most desirable form of Islamic financing arrangements. Yet, in terms of its ability to be an effective and efficient instrument for replacing interest-based transactions, it poses formidable problems.

The salient features of the Musharika agreement, as practised by the commercial banks, were as follows:

1. It was a short-term financing arrangement specific only to the parties to the contract.

2. Investment by the banks was made in the form of the sanctioning of a funding limit to the client and the degree of employment of funds was determined on the basis of daily product of outstanding balances due to the bank.

3. All participative funds, including equity, reserves and other non-debt capital was included in the definition of capital qualifying for profits.

4. Profit sharing ratio was determined through negotiations within the boundaries specified by the SBP.

5. Profits for the purpose of sharing were to be determined after apportioning a share of net-income as a management fee to the firm.

6. Provisional profits, based on projected profits, were to be paid to the bank on quarterly basis, subject to a final adjustment on the basis of actual profits or losses.

7. Shortfalls or excess profits were to be settled through the creation of a [participation] reserve fund, which would attempt to smooth out the payments to the bank.

8. Losses, if any, were to be shared in strict proportion to the bank's investment in the total capital of the firm.

9. Against the apportioned loss of the bank, ordinary shares were to be issued, which qalified for reconversion in Musharika investment under the original terms of the agreement in case profits accrued in future.

10. Standard securities in the form of pledging and hypothecation stocks or the mortgaging of properties were required against Musharika financing.

Some of these features of the instrument attracted criticism. For example, the profit sharing arrangement did not strictly conform to the requirements of Sharia'h particularly in the treatment of losses and the payment of provisional profits or their adjustment through the participation reserve. Secondly, despite being a sharing arrangement, the actual agreement was cast within the framework of a creditor-debtor relationship, and was also protected as such in law. Three, Musharika also demanded securities which were akin to the relationship between a creditor and debtor. Finally, in the absence of a legal framework regulating the operation of Musharika, there was no standardisation of the agreement, and the terms and conditions of various agreements varied considerably.

Modaraba

Modaraba represents another of the more desirable forms of Islamic financing arrangements.

The salient features of Modaraba companies and their operations are as follows:

1. Only registered companies or those established under specific laws are eligible to register as Modaraba companies.

2. Modaraba can either be specific purpose or multi-purpose and can either be for a fixed term or in perpetuity.

3. On fulfilment of certain conditions, and with the prior approval of the Registrar, Modaraba companies may float Modarabas on the stock exchange, and their certificates of issue will be tradable securities.

4. Each Modaraba will be a separate business and its operations must conform to those approved under the injunctions of Sharia'h.

5. A Religious Board, to be periodically constituted under the ordinance, will be empowered to declare whether the operations of Modaraba were in conformity with the provisions of Sharia'h or not.

6. Many disclosure requirements, similar to those applicable to listed companies, are applicable to Modarabas, including statutory audit, annual meetings and investments and loans to and from the directors of the Modaraba company.

Evidently, the entire scheme was an elegant formulation of the simple relationship required under a modaraba contract between labour (darib) and capital (rabbul ma'l). The management company was to be renumerated through a fixed management fee paid out of the net income of the modaraba and the remainder was to go to modaraba certificate holders, with adequate provisions for retained earnings to ensure future growth.

CONCLUSIONS

To outline the broad features of a strategy which holds the promise of successfully implementing an Islamic system of finance are as follows:

1. The process has to be guided by basic legislative efforts covering all the essential elements of the proposed programme.

2. The legislation would define Riba and prohibit transactions connected with Riba.

3. The application of the law would be unqualified and without exception, thus the entire financial sector, covering banking government finance and foreign transactions would be covered in its ambit.

4. Given the unqualified and non-exceptional nature of the proposed law, even existing relations will have to be converted into permissible forms, for which a suitable time frame, within a phasing-in period, will be allowed.

5. The law should also provide for the Constitution of a Sharia'h Board which would assist the SBP to formulate permissible means of financing. Such means, specified with the prior approval of the Board, will only be illustrative and no restrictions will be placed on banks and financial institutions to design means of financing which are free of Riba.

6. A major portion of the law will have to be devoted to a plan of restructuring the fiscal policy which comprises a scheme for the privatisation of public sector assets and the use of its proceeds for the settlement of the outstanding stock of public debt.

The proposed strategy is based on the clear recognition of the scope implied by the prohibition of Riba. This is critical, for otherwise the solution will continue to elude us.