Banking Regulations and Islamic Finance

Author(s): T. R. Bishnoi
Source: Economic and Political Weekly, Vol. 25, No. 48/49 (Dec. 1-8, 1990), p. 2687
Published by: Economic and Political Weekly
Stable URL: http://www.jstor.org/stable/4397070 .
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 Banking Regulations and Islamic The obvious evidence is the fact that the
governmentborrowsdirectlyfrom the public
at rates higher than that paid on the PLS
Finance bank deposits. The risk adjusted differen-
tial in two rates (profit ratios and interest
T R Bishnoi rates)likely to drive deposits awatyfrom the
S RAMACHANDRAN's paper on 'Bank- originin non-competitivemarketsare always banking system, thus leading to disinter-
ing Regulations and Islamic Finance' interest(ribawi)and hence,prohibited.More mediation.
(December23-30, 1989)was interestingbut precisely, consumhersand producers, for Table 2 shows that the growth rate in
missedto note two importantpoints:(1)The complianceof Islamicnorm, are requiredto Pakistani Islamic banking tapers off after
concepts of interest and profits iri Islamic shun marketsotherthan perfectcompetition 1980-81.After transforrnation,mean growth
finance are different from those of the type to avoid occurrenceof riba. In essence, ratedeclinedby 7.6 percentagepoints in total
classical and Keynesianeconomics. (2) The the substituteof interestin Islamic finance deposits contributedby a fall of 5.3 percen-
viability of Islamic finance or banking is in is surplus and not profit alone. tage points in term cdepositsand of 9.5
doubt as the transformationof the entirein- Iran and Pakistan have attempted to percentagepoints in savingdepositsbetween
to
terest based banking into profit and loss transformtheir financial sector on Islamic 1975-76 to 1979-80(prior Islamic bank-
ing) and 1980-81 to 1984-85 (post-Islamic
sharing(PLS) of Islamictype,as undergoing principle under state control. Information
to this
in Iran and Pakistan, seems to be retro- on Iran'sfinancialsector is scanty,thus, the banking). The attributing factors
comment is restrictedto Pakistan'sbanking decline in growth are political uncertainty
gressivein effect encouragingdisintermedia-
and bankers' risk aversion posture and
tion process in the economy. The purpose wherePLS depositsaccount for 61.6per cent
of this note is to substantiate these two of total deposits in March, 1985.The ques- preclusion of sectors other than banking
tion whether or not the Islamic mode of from strict compliance of Islamic laws in
points.
The motivation for change to Islamic banking is better than interestbased bank- Islamisation process. The banking system
prefersshort-termcreditport folio (commer-
banking is to abolish the interest (riba in ing, can be answeredpositivelyif profitabili-
cial and tradetransactions)to avoid risk of
Islamicterminology)and replaceit with pro- ty (rateof return)or growthor both improv-
bankruptcyand high cost of monitoring of
fit and loss sharingprinciple.Assumingthat ed given the same risk. Unlike the profit
PLS investment projects [Khan and
the conventional concepts of interest and maximisationobjective stated in the theory
And the depositorsare not
profit are well known and, therefore, it of firm, the Islamic banks are guided to Mirakhor,1990].
high risk searching class of savers,and thus,
avoids their presentation here. Thus, we operate on commission and fees basis and
they avoid the high risk PLS deposits. For
discuss only their counter-partsas given in to maximise profits for their depositors.
these reasons,transformationof bankingin-
Islamic literature.In Islamicwriting,the in- Therefore,it is appropriateto compare the
to Islamic type is likely to affect adversely
terest is defined narrowlyas well as broad- profitratiosdeclaredon depositsduringpost intermediation process in the economy.
ly. The narrowdefinitionmeansonly interest transformationperiod with the correspon-
charged on consumption loans. The broad ding interest rates prevalent before such References
definition of interest(riba)is as "anincrease change.Table1 shows that the Islamicbanks
or excess (fadl) which, in an exchange or had marginallyhigherprofit ratios than the S R Khan (1987), Profit and Loss Sharing-
sales of a commodity, accruesto the owner interestratesofferedbefore transformation. An Islamic Experiment in Finance and
(lender)withoutgiving in returnany equiva- However,these differences were found in- Banking, Oxford University Press, Karachi.
lent counter-valueor recompense(iwad) to significanton statisticaltest. Moreover,even Siddiqi, M N (1983), Issues in Islamic
the other party"[Khan,1987,p 45]. All tran- if we accept differences on per cent point Banking-Selected Papers, The Islamic
sactions those involve giving or taking this basis, the profit ratios were not higher Foundation, Leicester, UK.
excess are interest (ribawi) and thus, pro- enough to match with the increase in cor- Khan, Mohsin S and Abbas Mirakhor (1990),
hibited.Withoutreferringto a exhaustivelist respondingrisk in Islamic banking. Rather 'Islamic Banking: Experiences in the
of activitiesone can note that such an excess in Pakistan, interest rates were suppressed Islamic Republic of Iran and Pakistan',
can be possible in two types of transactions: and profit ratios on PLS deposits were Economic Development and Cultural
(1) Guaranteedreturnto asset owners with enhanced through administrative control. Change, Vol 38, No 2, January, pp 353-76.
no referenceto productiveuse of assets; for
TABLE 1: AVERAGERATESOF INTERESTON BANK DEPOSITS(r) AND AVERAGEDECLARED
instance interest to financial asset holders PROFITS(p) ON PROFITAND Loss SHARING DEPOSITSFIORPAKISTANIBANKS, 1981 TO 1985
and renton physicalcapitaland land. (2) Ex-
cess predeterminedremunerationarisingout Year Saving Deposits Term Deposits
of the ventures in the form of monopoly, (June r p 1 to 2 Years 3 to 5 Years 5 Years and Above
black marketing, hoarding and cornering, End) r p r p r p
etc.
The replacementof interestby profit and 1981 7.57 8.65 10.48 12.75 - 13.95 - 14.75
loss concepts does not imply that conven- 1982 7.60 8.70 10.34 12.65 12.17 13.83 12.37 14.60
tional profit concept is compatible with 1983 7.64 8.25 10.49 12.15 12.14 13.25 12.44 17.65
Islamic profit. Therefore,we give definition 1984 7.61 7.50 10.53 11.00 12.18 12.15 12.39 13.45
and type of profit consistent with Quranic 1985 7.54* 8.26 10.53* 12.24 12.03* 13.73 12.40* 15.20
injunctions.In Islamicbankingand finance,
the profit is defined as a rewardfor capital Note: * March.
and enterprise plus some kind of rent as Source: Khan, S R (1987), Table 8.3, p 143.
against the Schumpeter's profit resulting TABLE 2: MEAN GROWTHRATE OF BANK DEPOSITSIN PAKISTAN, 1975-76 ro 1984-85
from entrepreneurialinnovations and the (Per cent per annum)
Knight's profit from uncertainty. Profits
(losses) of a trade or industry are positive Period Demand Term Total
(negative)differencesbetweensales revenue Deposits Deposits
and costs [Siddiqi, 1983]. Since the prices
of products/inputs determinedby different 1975-76 to 1979-80 (prior to Islamic banking) 22.3 23.3 22.7
marketforces resultingin many variantsof 1980-81 to 1984-85 (post-Islamic banking) 12.8 18.0 15.1
profits, it needs to be mentioned that pro-
ductivity linked pure profits are permitted Source: Khan, S R (1987), Table 8.2, p 141 which is adopted from State Bank Annual Reports:
to be shared.All other modesof profitswith 1981-82, 1982-83, 1983-84, 1984-85.

Economic and Political Weekly December 1-8, 1990 2687