Strategy for Eliminating Interest from the Economy

The gradual process of Islamisation of the banking system in Pakistan started in February 1979 when the President of Pakistan announced that interest was to be removed from the economy within a period of three years (CII 1980). In 1977, the government had appointed the Council of Islamic Ideology (CII) with the responsibility of preparing a blueprint of an interest-free economic system in the light of Islamic teaching. To assist in this task, CII set up a panel of economists and bankers consisting of 15 highly qualified economists, experienced central and commercial bankers and financial experts. Considering the complexity of the task of eliminating interest from the economy, the panel proposed a gradual approach. In the first interim report it recommended immediate removal of interest from those financial institutions whose transactions were relatively less complex and from where interest could be eliminated with the greatest ease. Thus three of the specialized credit institutions - the House Building Finance Corporation, National Investment Trust, and Mutual Funds of Investment Corporation of Pakistan were selected for removing interest from their financing operations immediately (Khan & Mirakhore 1989, p.15).

The final report contained recommendations for eliminating interest from all domestic financial transactions. The panel recognized the difficulty in eliminating interest from foreign transactions all of a sudden and advised reduction of dependence on interest-bearing foreign loans. The CII scrutinized both the reports, brought out changes in them in order to ensure complete conformity with Islamic injunctions, and submitted them to the Government in November 1978 and June 1980, respectively (IPS 1994, p.66).

The CII report emphasized that "the ideal Islamic techniques to replace interest in the banking and financial fields are profit-loss sharing and Qard Hasan. However, it gave due recognition to difficulties that may arise in changing the whole system to profit-loss sharing in one step and also the fact that there are certain spheres where it may not be possible to use the system of profit-loss sharing. It, therefore, gave qualified approval to certain other methods being used in conjunction with profit-loss sharing like leasing, hire purchase, Bai-Muajjal, investment auctioning and financing on the basis of normal rate of return. However, cautioning against the danger that such methods could be a back door for interest, it emphasized that their use should be kept to a minimum and that their use as a general techniques of financing must never be allowed (Ibid, pp.66-67).

The CII report further stressed that lack of proper accounting practice due to illiteracy and tendency to conceal profits on the part of the business concerns would act as a hindrance in widespread adoption of the system of profit sharing by the banks (Ibid, p.67).

Phased Transformation

The government of Pakistan planned to remove interest from the economy within a period of three years starting with the task from House Building Finance Corporation, National Investment Trust and mutual funds of the Investment Corporation of Pakistan. These specialized financial institutions took the necessary steps to re-orient their activities on a non-interest basis within few months of the announcement from the government.

Considering the complexity in converting operations of commercial banks into non-interest based operations, a longer period was envisaged. On July 1, 1979, the government introduced a scheme under which the nationalized commercial banks had to provide interest-free loans to small farmers for meeting their seasonal agricultural finance requirements.

The next major step towards the elimination of interest from the operations of commercial banks was taken in January 1981 when the government ordered banks to set up separate counters for accepting deposits on a profit-loss sharing basis in all five nationalized commercial banks. It was also announced that the deposits received on PLS basis would not be used by the banks in interest-bearing operations and that these accounts would be maintained separately. The parallel system, in which savers had the option to keep their money with the banks either in interest-bearing deposits or PLS deposits, continued to operate till the end of June 1985. In June 1984, the government announced that the parallel system would be discontinued during the course of 1984-85. Accordingly, the entire assets side of the banks was converted into non-interest-based modes of financing, except foreign currency deposits, which continue to earn fixed interest allowing their maturity according to the original terms of the contract. The other exception was foreign loans, which continued to be interest-based and governed by the terms of the loans. No banking company was allowed to accept any interest-bearing deposits after July 1, 1985 with the exception of foreign currency deposits. All banking companies were required to share in profit and loss from that day except deposits received in current account that were not entitled to receive either interest or profit.

It is observed that a circular of the State Bank of Pakistan permitted the use of mark-up technique in wide range of activities in the private sector. However, banks were instructed to discontinue the practice when wide spread criticism mounted on charging of mark-up over mark-up in case of default as it was considered incompatible with Islamic teaching. Other modes of financing specified in the State Bank circular were as follows: loans free of interest but carrying a service charge; Qard Hasan (loans given on compassionate grounds free of interest and repayable if and when the borrower is able to pay); purchase of trade bills on the basis of mark-down or mark-up in price; purchase of moveable property by the banks from their clients with buy-back agreement or otherwise; leasing; hire-purchase; financing for development of property on the basis of a development charge; Musharaka; equity participation and purchase of participation term certificates and Maharaja certificates; and rent-sharing in the case of housing finance (Ibid, p.70).1.3 Legislation

Mudaraba technique of financing was introduced as a result of enactment of the law "Mudaraba Companies and Mudaraba (Floatation and Control) Ordinance" in June 1980 followed up by issuance of implementation regulations in January 1981. Companies, banks, and other financial institutions, under this law, can register themselves as Mudaraba companies and mobilize funds through the issuance of Mudaraba certificates. Funds so mobilized are restricted for use in only such businesses which are permitted in Shariah requiring prior clearance from a religious board established by the government. The law safeguards the interest of the Mudaraba certificate holders by mandating quicker and simpler adjudication of disputed matters by a tribunal specially set up for this purpose. Moreover, the law provides a condition that the auditors will certify that the business conducted by the Mudaraba Company is in accordance with the objects, terms and conditions of the Mudaraba. Promulgation of the Mudaraba law paved the way for new type of financial instrument in the form of Mudaraba certificates and helped in broadening the dimensions of the newly emerging Islamic financial market.

Contending that the existing legal framework in the country could not adequately protect the banks against undue delays and defaults, the government enacted a law called Banking Tribunal Ordinance in 1984. According to this ordinance 12 banking tribunals with specific territorial jurisdictions, and each headed by a high-ranking judge to be appointed by the government and required to dispose of all cases within 90 days of the filing of the complaint, were to be set up. The law also provided for an appeal procedure under which the verdict of a tribunal could be appealed to the High Courts within 30 days.

Non-Banks within Pakistan

Prior to Islamisation of banking, investment companies in Pakistan offered an outlet for long-term funds generated in the economy. They invested in common shares and in long-term debt. As a result of the move to interest-less finance they exchanged the interest-bearing debentures they owned for common shares of the same companies. They thereby became fully-equity-based but were free to acquire Participation Term Certificates (PTC) a new kind of financial instrument developed on the basis of Musharaka. Ownership of their shares is legal for banks and other intermediaries, as well as individuals. New close-end companies formed in the future will add to the amount of long term funds available in the economy, and all companies of this type, old or new, will compete with commercial banks for the available supply of PTCs.

a)     Islamisation of Commercial Banking in Pakistan

The Islamisation of the banking system of Pakistan applies only to the domestic activities of its commercial banks: their foreign branches were free to accept deposits and make loans at interest. In their dealings within Pakistan, each of the 17 exchange banks were required to operate under Islamic codes of finance, following regulations of the State Bank of Pakistan.

b)    Commercial Banks as Intermediaries

Under the new banking arrangement, commercial banks are to accept funds on a no-interest basis, subject to withdrawal by cheque, and return of the principal amount of each deposit is guaranteed. For services provided in maintaining chequing accounts and in meeting customer needs for other services banks are to charge fees to recover administrative costs. In the case of allowing overdraft, it is required to be interest-free. The argument is that overdrafts allowed to current borrowers or to current account holders to enable them to meet the unspecified needs or in cases of genuine hardship are really benevolent loans.

On funds deposited into PLS accounts, banks participate in profit/loss outcomes with their depositors according to ratios stated in the contracts between depositors and banks. The percentage of profit/loss taken by the bank is supervised by the State Bank of Pakistan, which has the authority to reduce the ratio(s) in effect at a bank. For itself and the depositors, the bank negotiates a sharing of the profit/loss on the use of funds provided to users. This sharing must not be stated as interest or in a form that may be interpreted as interest; for example, the bank may not be guaranteed a stated amount or rate of return regardless of how successfully the funds were used. The share allocated to it and its depositors must always be related to the amount of profit/loss resulting from the use of funds provided (Harrington 1994, p.183).

In addition to funds provided for their depositors, banks also invest their own funds in loans provided to their customers. Banks thereby participate in the profit/loss results of their use, receiving the same proportionate results per unit of capital provided as their capital accounts do (Ibid, p.183).

i)        Financing and Credit Operation of Banks

While bank liabilities (other than foreign currency deposits) are composed of either current account deposits, on which the bank distributes no profit, or PLS deposits, three broad categories of non-interest modes of financing have been allowed to guide banks' asset operations. First, there is financing by lending, that is, loans not carrying interest, on which banks may recover a service charge, and Qard Hasan (interest-free loans on compassionate grounds). Second, there is trade related financing, including mark-up, purchase of trade bills, lending on a buy-back basis, leasing, hire purchase, and financing for development of property on the basis of a development charge.  The State Bank of Pakistan fixes minimum and maximum rates of charges from time to time. Third, lending can take place under investment financing, including Musharaka, equity participation and purchase of shares, participation term certificates, Mudaraba certificates, and rent sharing. While the State of Bank of Pakistan determines the ratio for sharing profits, losses are proportionately shared among all the financiers.

ii)        Participation Term Certificates

A Participation Term Certificate (PTC) is a transferable corporate instrument with a maximum maturity of ten years and allows for a temporary partnership or Musharaka. It is a financial arrangement between a financial institution and the business entity on the basis of profit-loss sharing over the maturity period of the certificate. It was introduced as an alternative to a debenture (which typically carries a fixed rate of return) for raising medium term financial resources. Conceptually, since the financial and economic relationship envisaged under PTCs is that of a partner in a business venture, portfolio selection for the banks requires extensive knowledge and experience with business involved. Funds under a typical PTC arrangement may be obtained either from a single institution or from a consortium. The business entity is expected to pay to the financial institution or bank, provisionally on a semi-annual basis, an agreed percentage of anticipated profits with a provision for final adjustment at the end of the financial year. In the event of loss, the financial institution shall refund the share of profit that it had received on a provisional basis. However, the loss sustained by an entity in any accounting year will first be adjusted against the reserves of the company, and the remaining loss, if any, shall be covered in the subsequent years by the two parties in agreed proportions. The financial institution is also permitted to convert up to 20 percent of the principal amount of the PTCs into ordinary shares at par value, so long as funds against PTCs are outstanding. Lending is secured by a legal mortgage on the fixed assets of the company.

So far, the specialized credit institutions, including the Bankers' Equity Limited and the Investment Corporation of Pakistan, have handled most PTC operations. PTCs can be traded on the capital market.

iii)                  Application of Musharaka in Pakistan

Like PTCs, no statutory definition of Musharaka has been specified. However, a Musharaka contract is bilateral between the financial institution and the user of the funds. Moreover, Musharaka contracts are not negotiable instruments and can be traded like the financial assets on the capital market. While Musharaka companies typically provide long-term capital for industrial investment, they have so far been used to fund the working capital requirements of the industrial and trade sectors not as a loan but as a cash credit or overdraft account in which operations could be carried out by depositing and withdrawing of funds. Musharaka companies are deemed to be temporary partnership under which the commercial bank and the client share in the profit or loss generated by the working capital supplied by each to the project. In practice, the profit sharing arrangement is drawn up on the basis of future profit projections that, in turn, are based on past averages, duly adjusted according to the future plans and projections and overall state of the economy and industry in which the firm operates. The client, for his managerial responsibilities, receives an agreed proportion of projected profits from the partnership, with he balance divided between the bank and the client in a mutually agreed ratio within the maximum and minimum ratios laid down by the State Bank of Pakistan. If a loss results, it is to be shared by the client and the bank in the ratio of their contributions to the funds employed in the project.

iv)                Mudaraba as Applied in Pakistan

Under the law authorizing the establishment of Mudaraba companies, Mudaraba can be floated to meet the term-financing needs of the private sectors. Under this arrangement, subscribers participate with their funds, and the manager of funds, with his efforts and skills. Profits on investments made out of Mudaraba funds are distributed among the subscribers on the basis of their contribution, the manager of the fund earning a fee for his services. Conceptually, a Mudaraba is an investment fund for which resources are obtained through the sale of certificates to subscribers. Commercial banks can serve either as managers or as subscribers. There can be two types of Mudaraba: multi-purpose, that is, a Mudaraba having more than one specific purpose or objective, and specific purpose. All Mudarabas, however, are independent of each other and none is responsible for the liabilities of, nor is entitled to benefit from the assets of any other Mudaraba or of the Mudaraba Company. The companies are subject to comprehensive regulations and safeguards under the Mudaraba Company Law including the requirements that (a) each must subscribe at least 10 per cent of the total amount of Mudaraba certificates offered for subscription, and (b) certificate holders must be provided detailed balance-sheets and profit and loss statements of the company at specified intervals.

So far Mudaraba have been managed primarily by the specialized credit institutions, specially the Bankers' Equity Limited, and have been for specific purposes. The first Mudaraba Company in the private sector was incorporated in November 1982 and floated its first Mudaraba enterprise in early 1985, valued at Rs 25 million. Mudaraba certificates are traded and quoted on the stock exchange.

v)                 Application of Mark-up in Pakistan

When financing on a PLS-basis is not feasible owing to difficulties in determining profits or the short-term maturity of funds required, banks have been authorized to lend on the basis of mark-up.  Under this arrangement, the margin of profit or mark-up to the seller is mutually agreed upon between the buyer and the seller in advance. The bank arranges for the purchase of the goods requested by the customer and sells them to him on the basis of cost plus the agreed profit margin. The payment is deferred and is made either in lump sum or in installments over a specified period. The mark-up is mutually agreed but must be within the minimum and maximum rates specified by the State Bank of Pakistan. The mode is of short-term in nature and oriented towards financing domestic and import trade, as well as financing input requirements.

While banks are authorized to charge a mark-up within the limits specified by the State Bank of Pakistan, they cannot charge mark-up on mark-up in the event of delays in repayment; mark-up on mark-up is viewed as interest.

vi)                Choice of Instruments

Although modes of financing are to be determined by agreement between the bank and the client, the authorities recommended certain preferred combinations of modes and types of transactions. Financing for trade and commerce, which is primarily short term, should be handled through mark-up and markdown operations, and through trade and loan on commissions and service charges. Fixed investment in industry, trade and commerce is to be financed through Musharaka, PTCs, leasing, and hire purchase; working capital requirements are to be met through Musharaka and mark-up. Given the varied nature of financing requirements in agriculture, modes available for this sector cover a broader spectrum than in other sectors. While short-term financing is to be provided largely on a mark-up basis, the choice of medium-term and long-term lending modes will depend on the purpose. Leasing and hire purchase are to be the primary instruments for purchase of machinery and equipment, and for dairy and poultry needs. Financing for land, forestry, etc., could be on the basis of development charges, mark-up or PLS modes, depending on the nature of development undertaken. Advances for housing are to be on a rent-sharing basis with flexible weights to banks' funds, or on a buy-back and mark-up basis; personal advances for consumers durable are to be on a hire-purchase basis. For purchasing consumer products, financing would be solely against tangible security with buy-back arrangements. Basis of financing in Pakistan against types of activity is grouped in Table-1 as below:

Table 1. Pakistan: Possible Modes of Financing for Various Transactions

Source: State Bank of Pakistan, BCD Circular No. 13 June 20, 1997.

 Central Banking and Monetary Policy in Pakistan

(a) Functioning of the Central Bank

The Federal Shariah Court judgment does not directly impugn the functioning of the State Bank of Pakistan except for section 22(1) of the State Bank of Pakistan Act, 1956. But this apparently minor repugnance to Shariah involves the most important role of the central bank that governs interest rate chargeable by all the financial institutions in the country, it cannot remain unconcerned with the judgment relating to:

     Negotiable Instrument Act XXVI of 1981.

     Agricultural Development Bank Rules, 1961.

     Banking Companies Ordinance (LVII of 1962).

     Banks (Nationalization) Payment of Compensation Rules, 1974.

     Banking Company (Recovery of Loans) Ordinance (XIX of 1979).

The court has declared that the sections in the above laws or rules involve charging of interest or mark-up which, according to the court, resemble interest. Interest rate is governed by the bank rate. Mark-up is one of the modes of financing which the State Bank recommended to the banks (Hasanuzzaman 1994, p.197).

(b)  Rates of Return and Charges

Rates of return on deposits and charges on bank financing, including profit sharing ratios, are ultimately to be determined by market forces. However, to ensure an orderly transition from the previous system, in which interest rates were closely regulated, the new system provides for a methodology to determine rates of return on PLS deposits and also lays down maximum and minimum charges for various types financing modes; banks and clients are free to negotiate charges within these limits.

 

Banks and other financial institutions receiving PLS deposits are required to declare rates of profit on various types of liabilities, including PLS deposits on half-yearly basis with prior authorization of the State Bank of Pakistan. To protect the interest of both borrowers and lenders, the State Bank of Pakistan is empowered to establish ranges within which financial institutions, including banks and specialized credit institutions, and borrowers would be permitted to negotiate rates of charges and profit-sharing ratios. The determination of these ranges is also guided by considerations relating to sectoral credit allocation priorities and the need to minimize dislocations arising out of a sharp change in the cost of funding for borrowers. Therefore, the concern so far has been to keep the costs of funding as close to those under the interest-based system as possible, while allowing market forces a greater role.

 

For financing by lending, where loans do not carry interest, banks may recover a service charge not exceeding the proportionate cost of the operation, excluding the cost of funds, provision for bad and doubtful debts, Qard Hasana and income taxation. The State Bank of Pakistan also specifies ranges of profit that should guide banks and the specialized institutions in their lending operations under both trade-related and investment-type modes of financing. Under the interest-based system, ceiling rates were specified for a wide variety of loan operations; under the new system considerable flexibility is given to the banks and the clients. Despite this flexibility, a large proportion of financing, according to banks, has so far been provided at about the same cost as under the previous system.

 

Achievements and Failures in Islamising the Banking System of Pakistan

 

Pakistan initiated a process of the Islamisation of its financial system in 1979. Though the financial system of the country had undergone significant changes since then, the process of Islamisation is yet to take its full course. The measures adopted for this purpose have been characterized by a number of shortcomings and deficiencies. The Federal Shariah Court in November 1991 declared that a number of existing financial laws and practices were repugnant to the injunctions of Islam and called upon the government and other concerned agencies to take appropriate measures to bring them in conformity with the Islamic tenets by the end of 1992.

 

Over a decade passed away by now that the first step towards Islamisation of the financial system of Pakistan was put forward. The period 1979 to 1985 saw a fairly active policy on the part of the government to Islamise the financial system. The original intention of the government was to eliminate interest from all domestic banking and financial transactions within a period of three years beginning from February 10, 1979. It appears that the time frame was not practicable yet the government was earnest to move speedily towards attaining the goal of an interest-free economy. It has been mentioned that a parallel system was introduced in which savers had the option to keep their savings with interest-bearing mechanism or in profit-loss sharing savings scheme. In June 1984, it was announced by the government that the parallel system would end in course of 1984-85 in so far as operation of commercial banks and other financial institutions were concerned. All banking companies were actually forbidden to accept any interest-bearing deposits as from July 1, 1985, except foreign currency deposits. Banks were also instructed to invest their PLS deposits only in interest-free avenues of investment and financing. Serious consideration was seemingly being given to the issue of eliminating interest from government transactions in 1984-85 as the then finance minister stated in his budget speech that the government proposed to consult scholars on the subject. However, the matter was not pursued vigorously and the movement towards a completely interest-free economy lost its dynamism and even its sense of direction after 1984-85 (Z. Ahmed 1994, pp.71-72).

The movement towards an interest-free economy suffered a setback when in August 1985 banks were allowed to invest even their PLS deposits in interest-bearing government securities. The present position is that the return on PLS deposits contains a substantial element of interest.  Since 1984-85, there has been no policy pronouncement as regards elimination of interest from government transactions. To achieve the goal of interest-free economy it is necessary that government should end its dependence on interest-based borrowing. There are no indications so far this aspect has been given due consideration in formulating government budgetary and other policies. In fact, instead of reducing dependence on interest-based borrowing there has been increased resort to such borrowing in recent years.

 

The Islamisation in the field of banking and finance in Pakistan has been marked by another serious deficiency in that no institutional mechanism exists for a continuous scrutiny of the operating procedures of banks and other financial institutions from the Shariah points of view. Individual scholars examining these operating procedures have pointed out several areas where the actual banking practices show deviation from Shariah even in the case of modes of financing. Thus, even Musharaka agreements, which banks ask their clients to sign, contain features that have been called into question by several commentators. The provision, for example, that in the event of a company suffering a loss in any accounting year, it would be first adjusted against the existing reserves of the company has been found inconsistent with the spirit of the Shariah.        

 

Although the idea of floating PTCs was fine, no legislative framework was provided for standardizing the features of this new financial instrument in the light of principles of Shariah. The CII report had provided a broad outline of the features of such financial institutions but the actual form in which PTCs have been issued does not fully conform to the suggested outline. Some features of PTCs as introduced by certain financial institutions have been widely criticized as being inconsistent with the requirements of Shariah. Provisions made for payment of a pre-production discount rate during the gestation period of a project and the stipulation of the share of profit, equivalent to a percentage of the outstanding PTC funds, have evoked strong criticism in this respect.

 

Among the 12 modes of financing allowed by the State Bank to replace interest-based lending, banks have made predominant use of what has popularly come to be known as mark-up financing. Mark-up financing has taken two main forms. The first form is similar to Mudaraba financing being practiced by a number of Islamic banks in other countries. Under this form, a transaction takes place in the following manner:

 

a)  The client approaches the bank with the request to purchase for him certain specified goods;

b)  The bank makes the purchase;

c)  The bank sells these goods to the client at a price, which includes a mark-up over the cost of the goods and agrees to receive payment at a future date in lump sum or in installments; and

(d)  The client pays the amount due as agreed in lump sum or in installments and the 

      transaction comes to an end.

The second form involves a buy-back agreement. The practice followed is that a client sells his goods to the bank for cash and simultaneously buys back the same goods from the bank at a higher mark-up price payable at a future date either in lump or in installments. The second form of mark-up financing has been severely criticized by scholars well versed in Shariah and the Federal Shariah Court in its judgment has held it to be manifestly against the Islamic teaching.

 

Though it is generally agreed that Mudaraba and Musharaka are the ideal substitutes for interest in an Islamic economy, no special efforts have been made to accord prominence to them in the policies adopted. This seems to have given rise to an attitude of passivity on the part of the banks and led them to use mostly such modes of finance, like mark-up, that are more akin to interest-based banking and require the least modifications in the old lending procedures.

 

The liability side of the banking system has undergone a comprehensive change since the introduction of interest-free banking in Pakistan. Saving and time deposits no longer earn a fixed return. Banks declare profits payable on these deposits at six-monthly intervals based on their operating results and these vary from period to period and from bank to bank. The rates of profit are worked out by a formula that determines net profit accruing to a bank and allocates them to the remunerable liabilities according to their maturities. Allocations are based on differential weights assigned to liabilities according to their maturities. The system has in general been found to be compatible with Islamic teachings except that, as mentioned earlier, profits declared by banks contain a substantial element of interest.

 

Experts in Shariah and other writers on Islamic banking have identified certain other challenging features of the present state of the Islamisation of banking in Pakistan that also deserve attention. Some of the observations as reported by Ziauddin Ahmed are as follows:

 

"A tendency seems to have developed to replace PTCs by TFCs (term finance certificates). As against PTCs, which are based on the concept of Musharaka, TFCs are based on a system of fixed mark-up. This has been considered a retrograde step as the objective should be to expand profit-loss sharing modes of finance rather than to restrict them further".

 

Financial institutions undertaking leasing business are making greater use of financing lease than of operating leases. Experts in Shariah consider financing leases to be incompatible with Islamic teaching.

 

Many 'development finance institutions' (DFIs) are mobilizing savings through schemes that give returns, which are hardly distinguishable from interest. Grey areas are developing even in the operation of institutions like National Investment Trust, which were previously thought of having eliminated interest completely. It seems that there is no agency to oversee the working of the various schemes being employed by DFIs to mobilize savings from the viewpoint of Shariah.

 

Lately, the State Bank of Pakistan has laid down the minimum and maximum rates of profit a bank can share in the case of Musharaka or purchase of PTCs or Mudaraba certificates. Experts in Shariah consider such a stipulation incompatible with Islamic teachings. Due attention has not been paid to eliminate un-Islamic features characterizing the operations of several constituents of money and capital market in Pakistan other than banks and DFIs. Nothing has been done so far, for example, to reform the insurance business and the stock exchange operations in the light of Islamic teaching.

Introduction

Following the revolution in 1979, the Iranian authorities took steps to transform the banking system of the country in a way that it fully corresponds to Islamic Shariah. In February 1981, Bank Markazi (the central bank) took some administrative steps to eliminate interest from banking operations. As a result, interest on all asset-side transactions was replaced by a 4 per cent maximum service charge and by 4 per cent to 8 per cent minimum "profit" rate, depending on the type of economic activity. Interest on the deposits was also converted into a "guaranteed minimum profit". In the mean time, preparations got underway for enacting comprehensive legislation to bring the operations of the entire banking system in compliance with the Shariah. The legislation, prepared by a high-level commission (comprising bankers, academicians, businessmen, and religious scholars), was passed by the Parliament in August 1983 as the Law for Usury-Free Banking, henceforth to be referred to as "the Law". The Law required the banks to convert their deposits in line with the Shariah within one year, and their total operations within three years, from the date of the passage of the Law, and specified the types of transactions that must constitute the basis for asset and liability acquisition by banks (Iqbal & Mirakhore 1985).

Bank Liabilities under the New Law

According to the new Law, liabilities acquired by the banks were required to be based on two kinds of transaction:

Qard Hasan deposits: According to the Law, Qard Hasan constitutes current and savings deposits as in the conventional banking system except that they earn no returns. Of course, the banks can offer different kinds of incentives like non -fixed prizes and bonuses in cash or in kind; an exemption from, or a discount in, the payment of commission or fees; and priority in use of banking facilities.

If seen from customers' perspective, the purpose of these accounts would be to serve as a means of transaction, payment, and liquidity. Banks are to consider the money received in the form of current and savings deposits as "their own resources" and accordingly they can use it but no profits are to be given to the depositors. However, the full nominal value of the depositors is required to be guaranteed by the banks.

Term investment deposits:  Banks are authorized to receive two types of investment deposits, short-term and long-term. The deposits differ with respect to the required minimum time limits, three months for short-term and one year for long-term deposits, and with respect to the minimum amount required, Rls. 2,000 for short-term and Rls. 50,000 for long-term accounts.

Banks have to give priority on investment deposits, i.e., depositors' resources over their own resources, that is, their capital plus Qard Hasan. Banks are also allowed to use a combination of their own and depositors' resources in an investment project, in which case the bank and the depositor share the resulting profits. A third possibility is for the bank to replace the depositor's bank in an investment project to serve as a trustee. In this case the profits as well as any capital gains are returned to the depositors and the bank charges only a commission to cover the expenses of administering the accounts. The bank can guarantee and insure the principal amount of depositor's resources.

In the cases where combined resources of the bank and the depositors are invested, the return to depositors is calculated in proportion to the amount of invested deposits after subtracting the required reserve portion from the base amount. The banks are required to announce their profits at the end of each six months of their operation and transfer the shares of the depositors' profits to each of their accounts. Deposits withdrawn earn no profits before the minimum time required or reduced below the required minimum.

Modes of Financing and Credit Operations

The Law provides a number of modes of operation upon which financing and credit operations are to be based. The following are in brief the discussions on each mode of operation:

Musharaka (Partnership): The Law recognizes two different forms of partnership: civil and legal. The first is a project-specific partnership of short duration in commercial production, and service activities in which each partner provides a share of the necessary capital, and the assets and properties acquired are held as community property until the end of the life of the partnership. In these cases, the bank's share in the capital cannot exceed the share of the manager-entrepreneur initiating or directing the project.

The second form of partnership is a firm-specific venture of longer duration in which the bank provides a portion of total equity of a newly established firm or buys into an existing corporation. The banks can participate in the equity of such partnership only after the technical, economic, and financial viability of the firm (or the project) has been appraised and minimum expected rate of profit from the investment appears to be high enough to warrant the undertaking of the venture by the bank. The Bank Markazi determines the maximum amount of equity participation by the bank, and the minimum amount of participation by other partners. The banks are allowed to sell and purchase shares whenever they deem it appropriate.

Direct investment: Banks can invest directly to any economic activities they choose so long as the following requirements are met: (i) banks cannot invest directly in projects in collaboration with the private sector, or in projects that lead to the production of luxury and unnecessary commodities; (ii) the ratio of the initial capital of these ventures to total funds needed must not be less than 40 per cent; (iii) the total fixed capital necessary for undertaking these projects must be provided for by long-term financial resources; (iv) undertakings of direct investment by banks must be based on well-documented evaluation and appraisal of the project, and use of bank resources and investment deposits in direct investment projects is allowed if, and only if the expected return from these projects is sufficient to meet the minimum required rate designated by Bank Markazi; (v) banks must report to Bank Markazi the amount of their own, as well as depositors' resources allocated to direct investment projects; (vi) once the projects in which the banks have directly invested have begun their productive activity, banks can sell shares to the public; and (vii) Bank Markazi is authorized to investigate and audit direct investment projects in which banks have invested.

Mudaraba:  This is a short-term commercial, contractual partnership between a bank and an agent entrepreneur according to which financial capital is provided by the bank and managerial effort by the entrepreneur in order to undertake a specific commercial project. Banks are required to give priority in their Mudaraba activities to co-operatives. Moreover, banks are not allowed to engage in Mudaraba financing of imports with private sectors.

Salaf transactions:  To provide firms with the needed working capital, banks can pre-purchase their future output so long as the product characteristics and specifications are determined at the time of the purchase and the agreed price does not exceed the market price of the product at the time of the transaction. Banks, however, cannot sell the product until they have taken physical possession of the same. The delivery date of the product, which is to be fixed at the time of the transaction, cannot exceed one production cycle or one year, whichever is shorter.

Installment purchases: Banks are authorized to purchase raw materials, machinery and equipment for firms and resale the same to them on installment. The volume of raw materials cannot exceed that necessary for one production cycle and the repayment period for the same cannot exceed one year. The price of the product is to be determined on a cost-plus basis. The repayment period for machinery and equipment cannot exceed their useful life, which is considered to begin on the date of their utilization in the production process and the duration of which will be determined by the central bank. Residential housing can also be built and sold by banks on installment.

Lease-purchase transactions:  Banks can purchase the needed machinery and equipment, or other moveable or immovable property, and lease the same to firms. While signing contract agreement the firm has to provide guarantee to take possession of the property at the end of the contract period, if the conditions of the contract are fulfilled. The time period involved in this transaction cannot exceed the useful life of the property (to be determined by the Bank Markazi). Banks, however, cannot engage in transactions in which the useful life of the property is less than two years.

Ju'alah (transaction based on commission): Banks may provide or receive services on requirement and charge or pay commissions or fees for such services. The service to be performed and the fee to be charged must be determined at the time of the transaction.

Muzara'ah: Banks may provide agricultural lands that they own or are otherwise in their possession (e.g., as a trust) to farmers for cultivation for a specific period and a predetermined share of the harvest. Banks may also provide seed and fertilizer along with the land if they so require on the same basis.

Musaqat : Banks may also provide orchards or trees that they own or that are otherwise in their possession (e.g., as a trust) to farmers for a specific period of time and a predetermined share of the harvest.

Qard Hasan loans: Banks are required to set aside a portion of their own resources for extending interest-free loans to (i) small producers, entrepreneurs, and farmers who would otherwise be unable to find alternative sources of financing investment and working capital and (ii) needy consumers. Banks are permitted to charge a minimum service fee to cover the administrative cost.

Permissible modes of operation corresponding to different types of economic activities may be summarized as below:

Table 2. Islamic Republic of Iran: Modes of Permissible

Transactions Corresponding to Types of Economic Activity

In addition to the above modes of financing, banks are permitted to purchase debt instruments of less than one year's maturity on condition that debts are issued against real assets.

General Regulations Governing Asset Acquisition by Banks

The Law of Usury-Free Banking, along with the promulgation of regulations concerning modes of transactions, specifies additional regulations that govern asset acquisition by banks (Ibid, p.108).

Banks can only extend credits when they are reasonably assured that the principal sum granted and resulting profits are returned within a specific period of time. Banks are responsible for the control and supervision of the activity to which their own resources and/or the resources of their depositors are contractually committed.

Credit can be extended, conditional upon observance of proper procedures that ensure the security of the financial resources extended by the banks. Banks must ensure that the value of physical assets obtained through the use of their resources by their clients and the value of collateral is, at all times, equal to the remainder of the outstanding principal. To this end, banks may take steps to ensure the value of such assets or collateral during the lifetime of the project.

While banks may engage in joint venture projects with other banks, one specific bank must assume the responsibility of supervision and control of the project undertaken. Banks must take necessary steps to ensure that their clients understand that contracts mutually consented to are binding legal documents and will be treated as such by the courts.

Supervision of the Banking System

The Law placed the responsibility of supervision of the entire banking system of the country with Bank Markazi. Bank Markazi can exercise the following means for exercising its authority.   It determines: 

(a)      Legal reserve requirements for various types of bank deposits of the banks;

(b)      Bank-by-bank credit ceilings on aggregate and sectoral credit;    

(c)      Minimum and maximum expected rates of return from various facilities to the banks;

(d)      Minimum and maximum profit shares for banks in their Mudaraba and Musharaka activities   

(e)      Maximum rates of commission the banks are to charge for investment accounts for which   they serve as trustees;   

(g)      The maximum amount of credit facility granted by banks to each applicant; 

(h)      The ratio of credit facilities granted by each bank to various deposits; and  

(j)            The maximum amount of commitment made by each bank emanating from open    letters of credit, endorsements, issuing guarantees, as well as the type and amount of collateral for such commitments (Ibid, p.109).

Moreover, Bank Markazi is authorized to audit and inspect banks' accounts and documents and is further empowered to devise additional regulations to enhance its supervisory authority as the need arises to ensure and safeguard against threats of banks' insolvency. Bank Markazi has developed procedures based on these guidelines for commercial banks to follow their transactions.

The New Monetary Policy

The new Law and its by-laws and regulations have maintained the powers and rights of the monetary policy so far as they are not in contradiction with Islamic principles. In Iran, monetary policy is implemented independently of fiscal policy and follows the same objectives as those followed by classical monetary policy (Mahdavi 1986). To implement monetary policy, except the rate of interest, all monetary policy instruments, such as legal deposits, the global and sectoral ceilings of credit facilities, discount rates, and so on are still applicable in Iran (Mahdavi 1995, p.226).

Along with the elimination of interest rate certain other completely new monetary instruments have been created by the Law and put at the disposal of the monetary authorities. A number of these new instruments included in the Law to perform functions similar to those of the interest rate in implementing monetary policy may be described as below:

Minimum Anticipated Rate of Return (MARR): Anticipated return is future net income arising from certain banking operations. MARR is a yardstick by which to judge the acceptability of credit applications submitted to the bank. In fact, MARR, which reflects the opportunity cost or hurdle rate to finance the opportunities, is one of the new instruments incorporated in the Islamic banking regulations in Iran. The rate may play a major role in implementing monetary policy. Banks are authorized to finance if, and only if, the anticipated calculated rate of return on such financing is at least equal to MARR. In other words, projects whose anticipated calculated rate of return is below MARR are rejected (Ibid, p.227). That means, an increase or decrease in MARR will lead to contraction or expansion of the credit volume granted by banks.

Maximum Rate of Profit (MRP): Another new monetary instrument embodied in the Law is MRP.  The monetary policy authorities determine the rate. MRP is used by Islamic banks in Iran as a "mark-up" or "cost-plus" on the price of the assets and/or commodities sold to customers on credit. The MRP has the similar kind of impact as that of the MARR so far as its use as monetary tool.

Unique Features of Islamic Banking in Iran

The unique features of Islamic banking in Iran may be identified in the following contexts (Ibid, p.227).

a)    Banks' Credit Portfolio

One of the main features of an Islamic bank in Iran is the content of its portfolio. Each bank's portfolio is composed of a vast number of investments in a variety of economic activities e.g., agricultural, industrial, mining, housing, etc. Certainly, such a portfolio is well diversified. The risk and return on such a portfolio would seem to be very close to those of a market portfolio. A portfolio with this feature signifies minimum risk and maximum return. This finally leads to an assured and stable return to the bank's depositors.

Efficiency is another feature of the said portfolio. Each investment project and/or subject accepted by the bank complies with the standards set up by the monetary authorities. One of the standards is MARR. Thus, the projects with highest rate of return, i.e. the highest efficiency, have priority in credit facilities.  Such procedures will eventually force the economic units concerned, and the economy as a whole, towards efficiency.

b)    Probability of Losses on Capital

A stable return with low risk on an Islamic bank's portfolio makes the profit-and -loss account of such a bank in Iran less vulnerable. Hence, the risk on equity capital of these banks will be minimized. Moreover, one should bear in mind that the depositors in an Islamic bank will receive, proportionately, the bank earns. This, in turn, can help banks in avoiding even more losses.

c)   Distribution of Income

An Islamic bank's portfolio in Iran contains a huge volume of investments in the activities of society.  The income of those activities is shared, firstly, between the banks and the customers and, secondly, between investment depositors, i.e., a large number of the population in the society.

d)   Uses of Banks' Resources

The mechanism of Islamic banking is such that the resources are used for the purpose of granting credit facilities. The credit facilities are supplied indirectly in the form of assets and/or commodities. Based on these procedures, the financial needs of any sector of the economy are supplied by the banks in exactly the volume dictated by the monetary authorities. As a result, the method of financing of the type as in Iran is of great assistance to the achievement of monetary policy objectives.

e)   Supervision and Control

The Islamic banking system in Iran has its built-in supervision and control in both use and repayment of credit facilities. The following phased out procedure automatically facilitates supervision and control. In the phase of study and examination of the application, confirmation of the feasibility of projects and conformity of the application with the rules and regulations ensure the necessary control. During the stage of use of funds, banks act as buyers and sellers, which also gives them control. During the last period of financing, however, supervision is rather difficult. During this stage, the resources if not controlled, may be diverted to other uses. Hence the supervision at this stage needs to be tighter.

Implementation of the Law

Much of the trend in Islamic banking in Iran has been influenced by factors, which have their roots in the pre-Revolutionary economic structure, as well as post-revolutionary external and internal political developments. The post revolution economy had inherited a host of difficult economic problems. Before the revolution, the Iranian economy had become highly dependent on oil revenues as well as on the imports of raw materials, intermediate goods and food. The industrial sector was organized without due attention paid to efficiency or comparative advantage and with very weak forward and backward linkages to the rest of the economy. The agriculture sector, which was producing surplus commodities until late 1960s, began to contract and there was a massive migration of farmers into the cities (Khan & Mirakhore 1989, p.8).

The revolution brought with it a host of economic problems including, inter alia, massive capital flight, which almost led to the collapse of the banking and financial system (Bank Markazi). The problems began to multiply for the economy at a rapid pace as the revolution took place. The economy, already vulnerable to internal and external shocks, faced the freezing of foreign assets, economic sanctions, interruption in production, the influx of nearly two million Afghan refugees, and the war with Iraq, drastic reduction in oil revenues (Behdad 1988, p.p.3-4). Concurrently, the constitution of the Islamic Republic of Iran specified objectives for the economy to be pursued-such as income redistribution, self-sufficiency in production, strengthening the economy, and reduced reliance on oil revenues-all of which required fundamental restructuring of the society's economic behavior and institutions. The fall in oil revenues, plus the political objective of non-reliance on external financial resources, inevitably meant that the banking system would have to be relied upon to play a role far broader than that of pure intermediation (Khan & Mirakhore 1989, p.8).

The banking system has been used as an instrument of restructuring the economy-away from services and consumption toward production-in four ways. First, credit to the service sector, which constituted 55 percent of the GDP (1984-85), has been drastically reduced to halt its expansion in the short-run and curtailed its size in the medium-term. The policy went into effect during the second phase and continued in the later phase. Second, using all available modes of Islamic financing to help farmers improve and expand production has used bank credit to encourage the growth of the agriculture sector. Coupled with substantial government subsidies for seed, fertilizer, machinery, and crop insurance, the credit policy of the banking system is aimed at reviving the agriculture sector. This policy was initiated during the first phase and strengthened in the later phases. Third, Islamic banking has been used to create incentives for the development of a cooperative sector spanning agriculture, industry, and trade (Ibid, p.9). Cooperatives are given priority in credit allocation and in direct investment as well as in Musharaka financing by the banking sector.

The banking system also has been used as an instrument of income redistribution through the provision of Qard Hasan loans for the needy, financing for the building of low-income housing, and financing for small scale agro-business and industrial cooperatives often without stringent collateral requirements. Additionally, the banking system has financed government deficits, which obviously has distribution impacts. It is clear that with reduction of oil revenues from 27 percent of GDP in 1977/78 to only 4 percent in 1986/87, the banking system has been a major source of finance for achieving many of the social and economic goals of the Islamic revolution.

Given the extraordinary circumstances in which the Iranian economy has found itself since revolution, the performance of Islamic banking since its implementation in 1984 has been remarkably smooth (Ibid, p.9).

Introduction

Unlike the experiences of Iran and Pakistan, Islamic banks in Sudan have been operating in a dual system, i.e., alongside conventional banks. Because of their history and circumstances associated with the inception of some of them, Islamic banks in Sudan do not share the same experience. The Faisal Islamic Bank, Sudan (FIBS), for instance, being the forerunner, started operations in 1978 under a special decree that extended some privileges to it. These were represented by tax holidays, exempted from exchange restriction, exceptions from those articles in the Bank of Sudan law pertaining to interest imposition and exemption from some articles of the Labor Act provided that it adopted a generous pay system (Mudawi 1995, 1995, p.246).

Five Islamic banks are found operating in Sudan as per information published by International Association of Islamic Banks. The banks along with their year of establishment are as follows:

1)   Sudanese Islamic Bank, 1983

2)   Islamic Bank of Western Sudan, 1983

3)   Al-Baraka Bank, Khartoum, 1983

4)   Islamic Co-operative Development Bank, 1983

5)     Al-Tradamun Bank, 1984.

Although the FIBS was allowed special privileges and it was found to be operating without apparent problems, the rest of the Islamic banks were not provided those facilities. Still they got experience from the operation of FIBS. Their operations were largely prompted by the success of FIBS. FIBS provided these banks with trained manpower and training facilities.

The Islamisation of Banking System
Islamisation of banking system in Sudan was initiated by a presidential order from President Numeiry instructing the Governor of the Bank of Sudan to implement the process immediately. This resulted in an immediate instruction from the Governor to the conventional banks to turn themselves Islamic as from July 1, 1984 allowing them two months' times. This left virtually no time for advance studies or preparations to be taken by  the conventional banks to convert themselves into Islamic. As a result, most of the banks could not do much more than to replace the word "interest" with the word "profit". The basis of all contractual agreement was made Murabaha. No committee conversed in religious guidance was formed and consulted. Lack of carefulness was also noticed by the incident that no supervisory techniques for Islamic banks were designed by the central bank.

Further, it was the requirement that the central bank would change its philosophy and structure and the way it formulates monetary policy and manages monetary affairs within the framework of Islam. The Bank of Sudan was with the trend but lagged behind since it did not seek right advice in right form at the right time. In spite of that the circulars issued by it had been referring frequently to Islamic financial modalities but the name rather the spirit seemed to be the essence.

The Bank of Sudan maintained the conventional instruments for regulating the money supply. It mainly relied on quantitative control by fixing a random credit ceiling and imposing an across-the board cash ratio on all types of deposits. This has not proven to be an effective way of controlling money supply nor conducive to economic development.

Islamic banks in Sudan have been found to be prudent. They diversified their activities by project, client and economic sector in order to minimize their risky operations in an environment of legal and economic constraints. In spite of the Islamisation of the entire banking system of the country, Islamic banks were singled out and subjected to severe attack. The attack came from official as well as from private circles. This antagonistic environment for Islamic banks in Sudan started under the rule of President Numeiry and prolonged until the military government of Al-Mahdi. During the Numeiry rule the attack did not go beyond accusations by the news media that these banks were behind the famine that struck the country at that time and also behind the shortages in foreign exchange and the high prices of foodstuffs. During the transitional military government and Al-Mahdi government intensity of accusations mounted and tribunals were set up to investigate the accusations.

Problems of Islamic Banks in Sudan

The Islamic banks in Sudan operate in isolation. That means these banks are in the grip of a legally supported system based on a monetary authority (the Bank of Sudan) and subject to many other laws that control activities of the banks.

The first problem come across by these banks was the laws and regulations that were not modified to accommodate their operation.  They faced the same types of control and supervision as has usually been used for regulating the activities of the conventional banks. Islamic banks had continuously been pursuing the Bank of Sudan to appreciate that they were different and had to be dealt differently-at least that the reporting forms and their terminology should now be in language used for credit restrictions and cash ratios. As a result of that the Bank of Sudan introduced the terms Musharaka and Mudaraba into its credit policy directives.

Another aspect of the isolation of Islamic banks operating in an interest-based financial setting such as Sudan is the absence of any arrangements for receiving financial support from the Bank of Sudan. This, along with quantitative, restrictive credit policy exercised by the Bank of Sudan, caused those banks to end up with excessive opportunities for utilizing their excess liquidity for very short periods of time or overnight (Ibid, p.247).

Another difficult situation which Islamic banks faced was in the area of staff recruitment. All Islamic banks drew on the staff of the conventional banks to varying degrees when they started their operations. The qualities required by Islamic banks are not only proficiency and integrity, but commitment and sense of belonging. This subjected these banks to the demanding task.

• Ahmed, Ziauddun (1994). "Present State of the Islamisation of Financial System in Pakistan". In Elimination of Riba from the Economy. Islamabad: Institute of Policy Studies

• Bank Markazi Jomhouri Islami Iran (1984). Quoted in Mohsin S. Khan and Abbas Mirakhor.. op. cit.

• Behdad, Sohrab (1988). "Foreign Exchange Gap, Structural Constraints, and the Political Economy of Exchange Rate Determination". International Journal of Middle East Studies, Vol. 20,  Iran.

• The Council of Islamic Ideology (1980).

• Harrington, John Jr. (1994). "The Islamisation of Banking in Pakistan". In F. R. Faridi (ed.): Essays in Islamic Economic Analysis. Delhi: Genuine Publications Limited.

• Hasanuzzaman, S. M. (1994). "Practical Options for Central and Commercial Banking". In Elimination of Riba from the Economy.  Islamabad: Institute of Policy Studies.

• Institute of Policy Studies (1994). Elimination of Riba from the Economy, Islamabad.

• Iqbal, Zubayr and Abbas Mirrakhor(1985). Islamic Banking. Al-Tawhid, Vol. IV, No.3, Islamic Thought and Culture.

• Khan, Mohsin S. and Abbas Mirakhor (1989). Islamic Banking: Experiences in the Islamic Republic of Iran and Pakistan. Working Paper WP/89/12, Research Department, International Monetary Fund.

• Mahdavi, Hussain (1986). "The Impact of New the New Banking System on the Instruments of Monetary and Credit Policy in the Islamic Republic of Iran"  Paper presented in an International seminar held in Tehran.

• Mahdavi, Hussain (1995). Islamic Banking in Iran. In Encyclopedia of Islamic Banking, London: The Islamic Foundation.

• Mudawi, Al-Bagkir Youssef (1995). The Experience of Islamic Banks in Sudan. In Encyclopedia of Islamic Banking (p. 246), London: The Islamic Foundation.