Islamic banking : Concept, confusion and reality

Despite its spectacular growth, Islamic banking is still widely misunderstood by many.  Misconceptions about concepts and practices of Islamic banking persist in different circles.  
Sceptics sometimes go further to question if there is really anything called Islamic banking.  Some other questions also raised are:  How did   it emerge when there was no prototype of banking in the history of Islam? How do Islamic banks operate without interest which is nucleolus to banking system?  Why do some practices of Islamic banks are not in the line of the principles laid down in the original Islamic banking theory?
These questions, in fact, arise in the minds of many around the globe. This writeup is an attempt to find answers to all this.
Although the basic foundation and principles of Islamic banking and finance were drawn from the Quran, Sunnah and contemporary practices of financing during the pre-Islamic and Islamic era, the theory of Islamic banking as a new phenomenon started to appear in the fourth decade of  the 20th century.
The reason for such a late start compared to conventional  counterpart can be justified by the fact that Islamic governance system or  state started declining from the 11th century. After the decline of the Islamic state, there was a prolonged decay and deterioration of moral values coupled with western influence on the Muslim countries in the colonial period. As a result, the practice of finance in Islamic way was largely eclipsed.
With the achievement of independence and due to Islamic  resurgence throughout the Muslim world, which can be traced back to the  1940’s and 1950’s, a serious attention was given to the social , political and economical dimension of Islamic system. And in this process, the idea of Islamic banking or Interest-free banking arose.
One may raise a question as to   the basis of devising banking techniques in Islam as interest is prohibited in this religion and the theory of Islamic banking started to appear in the fourth decade of the 20th century as a recent phenomenon compared to the origin of Islam and its principles.  
This question is not unexpected. However, it can be answered on the basis of facts and information available. We must know that while Islam prohibits interest, it allows trade.   Trade has been ethically recognized  activity in human society for ages and all major religions approved it .Trade was the backbone of  Makkan  economy in the pre-Islamic era and even the Prophet (PBUH) himself was a trader before assuming his responsibilities as a prophet.  
Trade (bay’) occurs when there is a purchase and sale which is a lawful and a real economic activity in which something is exchanged (money or goods) for something (goods), which creates value.
 Keeping this in mind, the theoretician examined financing principles that existed in the pre-Islamic and Islamic eras.  The scholars in search of interest-free banking noted that although bank did not exists in the early Islamic period, the practice of financial resources of one party being used by another party in the conduct of business, trade or industry was widespread.
Financing in the pre-Islamic era in Arab world was predominantly interest-based and based on some sort of profit-or loss-sharing arrangement.  
The Holy Quran (2:275-280) indicates the deep-rooted practice of interest by the members of the tribes of the various clans in Makkah and Jewish communities in the pre-Islamic era. The two forms of profit-and loss-sharing arrangement which were popularly in use in the period of pre-Islamic period are known as mudarabah and musharakah.
The existence of profit-or loss-haring-based arrangement in the pre-islamic era can best be referred to the Mudarabah Enterprise of Prophet Muhammad (peace be upon him, PBUH) with Khadizah, who later became his wife, which started more than fifteen years before the beginning of the revelation of Quranic verses.  
 Mudarabah refers to a special kind of partnership where one partner provides money to another for investing in a commercial enterprise.  In this type of contract, the profit is shared at an agreed ratio between the provider of money or capital (rabb al-mal) and the entrepreneur (mudarib).
Musharakah refers to a partnership contract between two or more parties, each of which contributes investment capital. It resembles a partnership business contract in a conventional sense. In a  musharakah contract, all the  parties contribute share profit at a  pre-agreed ratio which not necessarily should be in proportion to their invested capital.
However, in case of loss, parties share it in proportion to their capital contribution.
Unlike with mudarabah, all the parties can participate in the management of the business. In musharaka, the liability is unlimited. Therefore, if liabilities of the business exceed and business goes into liquidation, all the existing liabilities shall be borne by all the partners on a pro rata basis.
According to Dr. Ziauddin Ahamed, former Deputy Governor of the State Bank of Pakistan, the jurists of the Islamic period developed a corpus of juridical opinion in regard to Mudarabah and Musharakah  to be Shariah-complaint by examining the features and fiqh literature on these two modes as found in the early Islamic period. And based on those juridical opinions, scholars in search of a new banking system expounded   variety of proposals for Islamic banking.  
The earlier scholars proposed mudarabah and musharakah principles for Islamic banking.
The abundance of juridical opinions of these two types of arrangement actually laid the foundation of the modern Islamic banking theory and the earlier scholars in modern times discussed the possibility of Islamic banking on the basis of these very principles.
Thus, the primary theory of Islamic banking appeared, which was on the profit-and loss-sharing basis. In this process, if we put simply, depositors will deposit money in the bank to invest.  Bank will invest this money and share the profit or loss within the guidelines of Shariah.
According to this theory, bank as a financial intermediary, in modern setting, will have PLS arrangements with both the depositors and the users of the bank funds.
However, while PLS  remained central features of all the Islamic banking models developed, it was also challenged by scholars in terms of its application in modern settings. Homoud (1985) summarized  these criticisms as follows :
The classical mudaraba was bilateral in nature, while in case of banking, as it deals with a large number of depositors, the very character of this bilateral arrangement is compromised. Rather, in banking system, it is a collective or multilateral mudraba which does not exist in classical theory.
 In classical mudarabah, when the entire transaction concludes, the principal is recovered and the remaining surplus is treated as profit which is an exception in modern financial intermediation as it is done on the basis of evaluation of the present value of a pool of investment instead of liquidation of mudarabah.
 PLS arrangement essentially lacks the ability to provide financing for consumer goods and goods supplied to government and industry etc.
Therefore, during the 1970’s and 80’s, a significant development occurred in terms of  propounding other principles that are shariah-complaint on the one hand and are capable of meeting the demands of growing customers who wanted the same sort of  products they used to get   from conventional banks  on the other.
This development was also infused by the fact that the strong foothold is needed for Islamic banking to be an alternative system to an age-old and dominating system. For this to happen, instead of introducing something completely new, the existing system should be made shariah-compliant by making necessary adjustments.
The most significant development during that period was the introduction of sale-based principles. Based on the Quranic verses (2:275) which clearly distinguished between bai’ & riba - the two very common transactions in the pre-Islamic era—and comments on various shariah scholars in this regard, it was concluded that bai’ can be spot or deferred.
The Fiqh scholars mentioned following  five forms of deferred sales  which became cornerstone of  non-PLS principles in Islamic banking and granted added capacity to Islamic finance to offer liability-creating financing or debt-based financing :
Salam Sale: In this type of sale, the price is paid at the time of contract and the object of sale becomes due as debt in kind
Muajjal Sale: The object of sale is delivered at the time of contract but the price becomes due as debt.
Istisna Sale: The price is paid at the time of contract while the object of sale is manufactured and delivered later.
Ijarah Sale: Sale of the usufruct of the assets in exchange for periodic rentals  
Murabaha: Sale with known profit which may or may not create debt.
It is clearly understandable from the above, although there was no prototype of banking in the Islamic era, the financing activities such as Mudarabah and Musharakah existed during the time of the Prophet. The Islamic banking has evolved gradually on the basis of various financing principles that existed in the Islamic era and   abundance of Fiqh literature regarding Islamic financial transactions.
Incorporating border objective of Islamic economic system into the formation of financing   principles for banking, theoreticians originated the idea of Islamic banking on the basis of profit and loss sharing.
The profit-and-loss-sharing principles can be regarded as an original idea which emerged as idea without the physical existence of any Islamic banks while the non-PLS-based financing emerged gradually after the inception of the real operation of Islamic banks.
While the above discussion may clear any doubts regarding the origin and basis of Islamic banking, the other questions that float around are related to some of   the current practices of Islamic banking.  This author assumes that readers are equipped with the knowledge that, like any conventional banks, Islamic banks primarily mobilizes savings (deposits) from savers and use these funds to finance   entrepreneurs.  
They also   provide other services as required for smooth running of personal and economical activities such as transfer of funds, facilitation in international trade, consultancy services, safekeeping of valuables, and any other service for a fee.  And Islamic banks provide all these banking services through an array of financial tools and techniques that do not violate the norms of Islamic jurisprudence (Shariah).
An article was published in the Financial Express, titled ‘Islamic Banking: Some misconceptions’. Written by Khaled Mahmud Raihan, it discused  how Islamic banks collect funds , deploy these funds in to various investment activities, earn profit and share that with the depositors. Therefore, this writeup will not repeat the discussion rather will cover some other issues that are not discussed in that article   but relevant to current Islamic banking practices and have generated curiosity among many Muslims.
One of the  questions that is  often asked by many  relates to how Islamic banks deal  with other banks  which might not be Islamic banks in terms of  providing international trade transactions .  It is to be noted here that not all the practices (various service charges/ commission/fees) of conventional banks are conflicting with Islamic principles. Those which are not conflicting with Islamic principles are being replicated   by Islamic banks and for those which are not compatible with Islamic principles,   Islamic banks have developed alternative techniques and mechanisms based on the opinions of Islamic scholars .
For dealing with international  trade transactions, Islamic banks have developed alternatives which are being followed by many Islamic banks across the globe.  A renowned Islamic banking lawayer, Dr. Mohamed Ibrahim M. Adam (2006), observed the following practices by many Islamic banks across the globe in this regard:
 For dealing with corresponding banks in case of financing international trade transactions and covering letter-of-credit- confirmation facilities banks need to have deposits with the corresponding banks. It is recommended that Islamic banks should deal with Islamic banks. But it is highly impossible in the era of globalization and due to lack of sufficient number of Islamic banks worldwide.
Since conventional dealings in letter-of-credit transactions expose Islamic banks to paying or receiving interest, some Islamic banks normally develop an arrangement with foreign correspondent banks, in which a correspondent bank agrees to grant the Islamic bank a non-interest bearing loan in the required currency.  As per the agreement, Islamic banks will clear the loan the same day with respect to spot transactions and thereby the Islamic bank avoid being indebted to the foreign corresponding bank overnight.  
Other arrangements to deal with similar situation by Islamic banks  involve Islamic banks opening with foreign correspondent banks  non-interest bearing accounts on the understanding that it shall be covered in case of overdraft instances, whenever the foreign correspondent bank notifies the Islamic bank thereof.  
Sometimes, Islamic banks agree with foreign correspondent banks that interest-free overdraft facilities shall be made on mutual understanding  where  Islamic banks will not  receive interest on their credit balance with the foreign corresponding banks and the corresponding banks will not charge interest where the credit balance in the Islamic bank’s favour  falls short.
For providing Letter of Credit (LC) facility, Islamic banks have developed their own shariah-compliant method.  Normally, an LC requires the issuing or confirming banks to obligate itself to accept or purchase the beneficiary’s draft for the amount mentioned in the letter of credit, either upon the beneficiary tendering the documents called for under the credit, or otherwise complying with the terms and conditions on which the credit was established.
Conventional banks normally charge a fee for confirming a credit in proportion to the amount involved. But, in case of Islamic banks, the banks treat confirmation of a credit as a kind of guarantee for which a fee should not be charged. Instead, Islamic banks charge a fee to cover only the administrative expenses involved in the process of confirmation. These expenses are not calculated in relation to the amount of the credit.
In some cases, Islamic banks and the clients agree that the amount of the guarantee represents a percentage in the share capital of the project subject of the guarantee. In this case, the bank agrees to participate in the profits and losses involved.
For discounting bill of exchange under letter of credit, Islamic banks have devised their own alternative as Islamic banks treat the discounting of a bill as sale of a debt for a price less than its original amount, which is not permissible in Islam. Therefore, some Islamic banks pay the full amount of the bill on grounds of a pre-agreement between the bill-holder and the bank to the effect that the amount to be paid by the bank will be financing on banks part as a co-financer, whereby, the bank also participates with the bill holder on the profits and losses of the transaction in connection of which it agrees to convert the bill into ready cash.
Some banks provide interest-free loan. In this case, the Islamic banks      may charge only the managerial expenses involved.
In this way, Islamic banks are trying to offer a faith-based banking by devising compatible alternatives that may best suit Islamic principles.
There are still a lot of existing and emerging areas that need to be addressed by Islamic banks. But this responsibility does not lie with Islamic banks only. It involves government, regulatory authority, legislation and customer as well. For example, one of the criticisms that Islamic banks face is its relative share of PLS-based mode of financing which is considered as an original idea of Islamic banking. It is very insignificant compared to the use of non-PLS modes which are more recent innovation.
Large-scale application of various non-PLS modes by Islamic banks has confused many Muslims. Some claim that Islamic banks want guaranteed profit and prefer  risk-free fixed-payment-based non-PLS modes over PLS-based mode. But this is not the fact in most cases.
While non-PLS financing is also developed by Shariah Scholars and there is no problem in using these modes, still the bulk of financing by Islamic banks should be equity-oriented in order to achieve the broader objective of Islamic economic system.
This reluctance towards use of   non-PLS mode is not intentional; rather it is essential at this stage.  At the beginning of Islamic banking, some banks tried to use PLS as a mood of financing, but without any success.  The underlying reasons for such a failure are un-ethical accounting practices to hide true profits to the banks, due to high rate of illiteracy and host of other reasons.  
Under the PLS- based financing, banks wants that in case entrepreneurs earn profit from the financing provided by banks, these must be shared with the banks. Banks do not directly run the business or participate in management decision while remaining dependent on information provided by an entrepreneur who is an agent of the Islamic bank.  But in many cases, banks do not receive desired information which may create agency problem and its associated costs due to conflict of interest, asymmetric information problem.
Besides, there is a general tendency among depositors to be risk-averse and do not want to take long-term and risky position with banks, and it is difficult for banks to find depositors who are willing to take the risk of PLS.
Moreover, there are few credible institutions available to conduct common monitoring and to share information of credit rating on borrowers and entrepreneurs. Therefore, the responsibility for increasing PLS-based financing lies not only with Islamic banks, but also with other stakeholders.  
The above discussion clarifies the fact that Islamic banking is a distinct type of banking which is trying to cater the needs of millions of Muslims in a shariah-compliant way.
The areas where it has been able to find Islamic alternatives, it has implemented those. Besides,  Islamic banking is relatively new compared to conventional banking and so it needs more time to get a strong foothold like conventional banking.
Therefore, any misconception or confusion over Islamic banking system is not justifiable. Rather, this sector needs to be regulated to make sure Islamic banking is being practiced in line with the principles it developed.  
In Bangladesh, Islamic banking was introduced in 1983, much earlier than many Muslims courtiers in the world. Since then, this sector has grown significantly. There is a still scope for further growth of Islamic banking in the country because the Muslims of this country are predominantly pious and prefer to satisfy their banking needs in a Shariah-compliant way.
Hence, it is essential to ensure a proper regulatory  framework for Islamic banks in the country to ensure their practices adhere to the principles and techniques this particular industry  has  developed  over the years and, of course,   in line with international best practices.
A combined effort from all and a proper enabling regulatory framework will not only help Islamic banks to grow more but also clear the mist of any confusion and misconception about it.
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The author is working in a private bank in Bangladesh and has a postgraduate degree in Islamic Banking, Finance and Management from the United Kingdom.
Email: akbar.chowdhury@yahoo.com