ISLAMIC BANKS: CONCEPT, PRECEPT AND PROSPECTS

Muhammad Nejatullah Siddiqi

Centre for Research in Islamic Economics

King Abdulaziz University

Jeddah, Saudi Arabia

Islamic Banks: Concept, Precept and Prospects*

Introduction

ÿÿÿÿMuch has happened in the world ofbanking andfinancesincethispaper was written in 1996. Then its focus was to convince shariahscholars and asection of laymen that financial intermediation was a necessity and the Islamic banks were there to perform that function. Now, beyond that, thereis a needtoemphasise'innovation' includinginnovative ways offinancialintermediation. Even though athoroughrevision of thepaperÿ has notbeenpossible anupdatinghas beendoneby adding a few lines as well as a post-script and many new references.

The Problem

ÿÿÿÿAre Islamic Banks losing credibility? Why they are not as efficient as other financial institutions in responding to the needs of their clients and earning good returns for their depositors? These two questions seem to have been in focus in several recent attempts at a review of Islamic banks.¹ The exercise is notmerely academic. At stake is the future of the most dynamic venture in Islam in the second half of the twentieth century, as also are billions of dollars entrusted to these institutions.

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*ÿÿÿThis paper was originally presented to a seminar organised by the Research Centre, Al Rajhi Banking and Investment Corporation, in June 1996. Its Arabic translation appeared in the Journal of King Abdulaziz University: Islamic Economics, Vol. 10, 1419/1998, pp. 43-59.

ÿÿÿÿWe do not propose toanswerthesequestionsdirectly in this brief exposition. Rather we look at the vision for possible deficiency and the current structure for possible fault lines, that may be at the root of these andother problems being confronted by the Islamic banks. The first question to be discussed is: are Islamic banks to be financial intermediaries or should they operate as traders, producersand business men in their own right.² Affirming their role asintermediaries we thenproceed to a close examination of what isinvolved infinancialintermediation. Identifying itsessence as the division of labour and specialization which have been the engines of progress throughout human history, its efficiency in promoting human felicity through expandingproduction and reducing costs is noted. It is argued that modern society cannot function without financial intermediation and that it is a must for any contemporary Islamic society. Islamic banks being best equipped to perform the function can not leave it to others. In practice they tend more and more towards involvement in direct business. This may ease the take over of financial services by aliens and marginalize Islamic banks. A change of course in called for.

Islamic Banks as Financial Intermediaries

ÿÿÿÿThere were Muslim traders, producers and businessmen before Islamic banks were established. Some of these were using other people's money by making them shareholders or sleeping partners. Trading in goods and services was not what Islamic banks were conceived for. Rather they were expected to supply Muslims with the same services the conventional banks were supplying, so that Muslims could avoid paying or receiving interest and still be able to earn profits on their savings or get finance for their business, etc.

/span>ÿÿÿÿ The business of bankshasbeenfinancialintermediation although they have also been doingotheroddjobs that go easily withtheirmain job without affecting it adversely. The main task is to mobilizeÿ savingsfrommillions of income earners in the form of deposits and to make funds available tothousandsofbusinessmenforinvestment. Even thoughsomeotherinstitutions also serve asintermediaries,as weshallseebelow, banks are the most easily accessible financial intermediaries for the common man. If banks do not perform thisfunctionaverylarge section of the population will suffer since onlybankstakewithdrawabledeposits which the common man has to have in any case. It is also difficult for a large section of population to handle shares, securities and other financial instruments. Let us have a closer look at financial intermediation.

Nature and Significance of Financial Intermediation

ÿÿÿÿThose who save and accumulate some money look for an opportunity for making more money by investing their savings. Those who are doingbusiness are looking for funds they could use. They are willing to bear the cost. In interest based system the cost is, more often than not, in the form of a predetermined rate of interest. In interest-free system it would be a share in the profits accruing on the use of the funds. Whether the system is interest-based or interest-free, if these two kinds of peoplewere to search for one another and make a deal they would have great difficulty. There would have to be a coincidence relating to the size of the funds and the time period for which they are needed and offered. A business man will have to deal with a number of fund owners before he can get the amount of funds required. This would take time. A fund owner would have to approach a number of businessmen before he can find one who accepts his money for the time period it is offered. Also, failing a perfect coincidence in time period for which funds are demanded and supplied it may be difficult to ensure continuous supply and use of funds. Then there are the more difficult matters related to risk. As we note below there are different kinds of risks involved in investing funds for profit, some of them not easy to comprehend. Given coincidence relating to size and time many projects may not suit a particular fund owner because of their risk profile. Apart from business risks there is also the risk of default, even the fear of outright fraud. Faced with these problems many small individual savers will be looking for some one they know and trust, some one in the neighborhood. All this couldcausedelay and results in (un intended) hoarding.

ÿÿÿÿDirect finance in which there is a direct deal betweenfund owner (saver) and fund user (investor) is inefficient. Its inefficiency has rightly beencompared to the inefficiency of barter.³Also if fund owners have toseekoutfundusers andfund users haveto search for fund owners the net return to thefundownerswouldbe substantially lower than the gross cost of fundsto users. Fundowners willsubtractsearch costs together with any risk premiums due to theuncertainty about the fund users trust worthiness.⁴ Lower returns onfunds will discourage savings. High cost offundswilldiscourage investment. The overall consequences for the economy will be smaller volume of production, fewer jobs, lower incomes and a weaker economy as compared to what is achievable throughfinancialintermediation.Intermediation is rightly regarded to be welfare enhancing.⁵

Role of Financial Intermediaries

ÿÿÿÿFinancial intermediaries are able to remove the inefficiencies of direct finance in a number of ways. Financial intermediation enables aseparationbetween the decision to save and the decision to invest in real production. Since the latter requires much more information and expertise than available to ordinary savers, their division of labor and specialization increases the wealth ofnations. Separationÿ betweenthese two functions and a distancing betweenmanagement of the financial sector of the economy and that of its real sector has now become an inalienable feature of the modern economy. The real sector expands when those acting in that sector getcommandoverresourcesat acceptable terms. Acceptability has severaldimensions: time horizon, size of fund, risk, cost, speed and flexibility are some of these dimensions. The relative importance of a dimension differs from business to business. But competition makes entrepreneurs always to seek to improve upon the package they already have. Thecompetitivepressure originates mainly in the hearts and minds of people who are seeking better products at cheaper prices with such other services as make the deal attractive (guaranteed quality, quick delivery, maintenance and repair and continuity in supply etc.)

ÿÿÿÿInvolved in this separation is alsoaninstitutionalization ofthe process not known in earlier periods of history. Institutions rather than individual middlemen take over the mobilization of savings and their transfer to users in real economy. Thevarious steps involved in this process of transferringfunds fromultimate saver to ultimate user are divided and subdivided into functionsthroughwhichspecialized functionaries reduce costs, improve services and tailor the 'financial product' to the needs andpreferences of both parties: fund owners as well as fund users.

ÿÿÿÿIt is important for us, people in the Islamic economic and financial community, to realize that the above mentioned developments are neither caused by interest nor do they depend on interest. Separation of saving and investment and institutionalization of the process of transferring funds for use in real production are theoutcomeofdivision of labor and specialization. What is new is the unprecedented acceleration of the process because of the revolutionary changes in technology relating to communication and information. Financial services of almost every kind can be organized without interest. In fact many of these services already operateon bases other than interest e.g., commission, fees, share in profits, etc.

ÿÿÿÿBeside effecting separation between saving and investment and institutionalizing the process of transferring funds, financial intermediation attends to the obstacles in direct finance noted above i.e. those relating to time, size, speed in deal making, cost reduction, risks and moral hazard, etc.

ÿÿÿÿIntermediaries solve the problem of mismatch in the size of funds available with a saver and that required by a businessman by pooling. From a huge pool of deposits into which funds are pouring in continuously (assuming net growth in deposits despite withdrawals). They are thus able to offer the users the amount of money they want.

ÿÿÿÿFund owners are generally reluctant to tie their funds for long periods of time. Businessesneedfundsforlongerperiodsthan savers want to tie funds for. Intermediaries solve the problem by proper management of their portfolios learning from their past experience. In offering funds for longer periods of time than their deposits have been made for, intermediaries arebanking not only oncontinuedadditions to their pool but also on interbank facilities ensuring continued ability to meet withdrawals by depositors.

ÿÿÿÿThere is a wide variety of risks involved in investment. Production risks relate to particular projects. Price risks relate to the market. Exchange rate risks are important for export related industries while currency risks are important in view of cost of imported ingredients and due to its effects on domestic value of money. Credit risks relate to repayment of loans and amounts receivable. It is an expert's job to assess a particular risk, but the crucial factor is information which is generally availableonly at a cost. Intermediaries can afford the costs which individual fund owners can not afford. Competition between the intermediarieskeeps the cost oftheir services in line with cost of similar services.⁶

ÿÿÿÿOne important dimension of risk management is to transfer a risk, or part of it, from those not willing to take it to those willing to take it in expectation of profit. By doing so the financial intermediaries increase the volume of investment.

/span>ÿÿÿÿ Profit sharingbased transfer of funds from owners to users will require monitoring of the actual use⁷, the account keeping of the project concerned, etc. While it will be impossible for individual fund owners to do so, especially for the small fund owners, financialintermediariescould afford to do so as the cost would be spread over large number of funds. They can also devise special ways and means of monitoring with the cooperation of fund users and the authorities supervising and regulating financial markets.

As we noted above, direct deals between fund users and fund owners would be slow. Not sowithfinancialintermediation. Pooling, a continuous stream of deposits and the safety net provided by the financialindustryand the supervisory and regulatory authorities enables them to be ready to respond quicklyto users', aswellas fund owners' call any time, any where.

ÿÿÿÿAll this makes financial intermediation not only superior to direct finance but also a condition for progress.Modern economies can no longer suffer the slow, high cost and risky financing that would obtain in the absence of financial intermediation.

Financial Intermediation in Islamic Society

ÿÿÿÿFinancialintermediationinan Islamic economy is a must in today's competitive global economy. A fast growing modern economy is unimaginable in a society without financial intermediaries. It will be no exaggeration to say that the fate of a society that eliminates financial intermediationwould be no different from the fate of a society that seeks to abolish the use of money.

ÿÿÿÿLet us posit a contemporary Islamic economy that has no financial intermediaries. People save.Islamic banks mobilize these savings through investment accounts and use these funds to do business, directly or in partnership with other businessmen. Two things will follow.

/span>ÿÿÿÿ Firstly,Islamic banks will be exposed to all kinds of risks to which business is exposed and this exposure will be carried back to depositors ininvestment accounts. The subdivision and dispersion of risks that a number of institutionalized risk takers make possible will not be feasiblebecauseof the direct deal between Islamic banks in custody of depositors' money and producers,businessmen in the real sector. Given a spectrum of risk aversion, saving will decline.

ÿÿÿÿSecondly,innovators,entrepreneursand businessmen may find it hard to finance their projects since financiers (Islamic banks) would generally avoid taking big risks. Also Islamic bankswouldpreferexercisingsomecontrol over the projects through partnership, forexample.Inany case finance from Islamic banks to real business would notflowaseasilyandquicklyasincaseofintermediation.Asaresultofall this real investment will decline.

ÿÿÿÿIf it were a closed economy business would shrink, production decline, employment go down and incomes fall.Butthereneitherisnorcan be a closed economy in today's world. So businessmen who could not strike a deal with Islamic banks will look elsewhere for finance. Also depositors averse to risk levels involved in investment accounts will look elsewhere for parking their savings.NonIslamicfinancial institutions will step in to take advantage of the situation. Islamicbanking will be marginalized, soon to be competed out of the main market. Itsvestigeswillberelegatedtothebye lanesofthebazaar with a captive market of its own.

/span>ÿÿÿÿ No bodywantsthatscenario. Islamic banks were supposed to provide a model which could by emulated by others and adopted by the authorities in the Muslim majority countries, to begin with. It is not advisable they eschew a function so vital for the society and be content with the minor role of doing business to earn some profit for their depositors.

ÿÿÿÿWe suggest thatfinancialintermediation is anecessity (darurah) in the full technical sense of the Shariahterm.If an Islamic society does not have financial intermediaries it will either become weak andwither away or people alien to that society will take over the function of financialintermediation with dire consequences for its financial as well as monetary system.

ÿÿÿÿWe also suggest that Islamic banks are theinstitutions most qualified to perform the function of financial intermediation. No other Islamic institution can do so. No other conventional institution (stock market, insurance companies, mutual funds, etc.) can do it in the Islamic way.

ÿÿÿÿIt follows that Islamic banks are duty bound to perform financial intermediation. An Islamic society is duty bound to be of sound economic health so that the basic needs of its people are fulfilled and it can defend itself frominternaldeviationsand external agressions.⁸ There can be no sound economic healthwithoutfinancial intermediation. 'What is necessary for discharging a duty is itself a duty'.⁹Thisdutyfalls on those equipped to do it.

ÿÿÿÿThis in our view is a sufficient argument making it obligatory for Islamic banks to perform financial intermediation. Our case is further strengthened by the fact that financial intermediation is not entirely unknown to Islamicsociety in its early centuries. Direct finance was no doubt the dominant mode of finance. But the practice of one obtaining finance on the basis of profit-sharing then giving it to another person, the actual user of funds, on the basis of profit-sharing is also recognized.¹⁰

Non bank financial Intermediariesÿ

ÿÿÿÿBanks are not the only actors in the financial market. Stock markets, Mutual Funds, Insurance Companies, PensionFunds, Savings and Loan Societies or Building Societies, etc. also serve as financialintermediaries. Theydeserve a brieflookbefore we return to our main subject, intermediation by Islamic banks, especially because their role is on the increase whereas the role of commercial banks may decline¹¹.

ÿÿÿÿThe stock market offers an opportunity to buyandsell shares. Savers invest for profit by buying sharesthroughlicensedbrokers. Business firms acquire finance by floating sharesthroughspecializedagencies. Transferoffunds from its owners to its users through this channel is indirect andmorerisky ascompared to that by banks. But the stock market performs a usefulservice ofassessingthecurrent value of a company byputtingapriceonitsshares. This'information'isavailable to all free of cost. It helps individual savers, institutional fundkeepers (e.g. Provident Funds, Pensions Funds etc.)andÿ foreigninvestorstodecideÿ where toplacetheirsavingsinordertobenefit from expected dividends and capital gains.

ÿÿÿÿMutual Funds or Unit Trusts offer the service ofmobilizing savings and investing them in shares and otherfinancialinstruments.Individualscan generally deal with the Fund or Trust directly. Because of a policy of diversification investing in units or mutuals is less risky than playing on the stock market. But, theoretically at least, shares are more liquid than units since the former have a ready market.

ÿÿÿÿOther nonbankfinancial intermediaries also perform a similar function. They take our savings and putthemwherethey earn a profit. But they do not do any business directly -- They do not 'produce' goods and services.

ÿÿÿÿWhatdistinguishesabankfromanonbank financial intermediary is deposit taking.Nonbankfinancial intermediaries take our money and give back a paper, a 'financial instrument'.Sometimesthisinstrumenthas a market. In that case it is more liquid than financial instruments which must be held till maturity, to be redeemed by the issuing institution. Bank deposits arethemostliquid.Financial instruments also differ from one another in divisibility,transaction costs and price predictability.¹² Bank deposits are perfectly divisible and, generally speaking, have no transaction costs.

ÿÿÿÿAll this made commercial banks the ideal financial intermediaries in the past. But things are changing. In advanced economies the /span>role of typical commercial banks in transferring funds from fund owners to fund users is declining. Banks are losing ground to other financial institutions which are marketing innovative 'financial products'. Banks have responded, where the law permits¹³, byenteringthe securities business. Structured securitised credit is fast replacing simple bank loans.¹⁴

Securitisation is taking a step backfrompure financial intermediation¹⁵. This and other recenttrendstowards 'disintermediation'¹⁶should not,however, create the false impression that the days of pure intermediation are over. The complex needs of an ever expanding global diverse economy is givingbirth to other new varieties of intermediation. Modern society needs that whole range of options be available to savers and funds users: pureintermediationthroughnonpure forms to direct finance. Disappearance of any option would entail loss of opportunity and decrease in savings and investment.

Non Pure Financial Intermediation

ÿÿÿÿReserving the term 'pure' financial intermediation to what has been described above we shall now proceed toexaminefinancialintermediationthrough some traditional Islamic contracts like Bai'bithaman 'Ajil (credit-sale) salam, istisna (pre-paid purchase) and ijara (leasing).

ÿÿÿÿAs we noted above the essence of financial intermediation is transfer of funds from their owners to theirusers,involvinginbetween a 'transformation' in term of time horizon, size of funds, risks profile etc. to tailor the offers to the needs of various users. Those effecting this transfer andtransformationarecalledintermediaries.But it is obvious that the contracts mentioned above were, in the first instance, contracts made directly by owners of money capital with users of money capital. No intermediation was involved. In their original form all the four contracts mentioned above are cases of direct finance.

ÿÿÿÿAn intermediary can come into these contracts thesame way as in al mudarib yudarib. In that case the intermediary A takes money from the fund owner B with the promise ofputtingit toprofitable useandsharing the profit with him. He gives the money to the fund user C who invests it in his industrial or commercial project promising to share the profit with A. Profits accruing to use offunds, i.e.increase in value realized by investing B's savingsareshared by C, B, and A. Cgets it because of hissuccessful effort tocreatemorewealth, B gets it for his funds which were not only saved but exposed to risks and A gets it for his selection of the right business to put B's money in -- a task rightly characterized as an act ofentrepreneurship.¹⁷Thesamemodel can be applied to salam and istisna. Some producers (among them C) are looking for some one who would pay for his product now and take delivery in future. Some traders or users of that product with funds (among them B) are looking for opportunity of ensuring future delivery of that product at (aprobablylowerthan current) price paid now. Direct deals are slow and costly. A steps in to make money by dealing with Bs and Cs. He enters into salam / istisna contracts with C as well as B. For B he isasellertakingmoney in advance. For C he is a buyer paying moneyinadvance.Ahimself is neither a producer nor a user of the product concerned. He is an intermediary likeA in the example given in the previous paragraph.

ÿÿÿÿTakingadvantageofpooling risk, better information and faster communication A is likely to offer better terms to C as well as B, yet earn money for himself.

ÿÿÿÿTo the best of my knowledge there is no specific prohibition of intermediation in Salam/ Istisna. A is not violating any rules of Shari'ah.¹⁸

ÿÿÿÿIt should be noted however that the intermediary in this case is taking business risks not involved in 'pure' financial intermediation based on two tier mudaraba.¹⁹

ÿÿÿÿThesamemodel is applicable to simple sale on credit. There are Cs looking for buyers and Bs lookingfor sellers but Cs want to sell cash where as Bs want to buy on credit,knowingfullywellthatcreditpricesareÿ generally higher than cash prices. Direct deals are not possible due to lack of coincidence. In comes A with some money (which could belong to other fund owners) A buys cash from C and sells on credit to B at a higher price to be paid at a future date.

ÿÿÿÿIn this case too the intermediary takes direct business risks. He is not a 'pure' intermediary.

ÿÿÿÿIs this the murabaha we are familiar with in Islamic banking?Yes and no. Yes because A seeks profits through purchase and resale with amarkup.No because A's activity need not depend on B's promise to buy. An amir bi'l Shira' (one who orders a purchase) is not absolutely necessary for financial intermediation through sale on credit. There seems to be nothing wrong,however,inreceiving such promises, even seeking them, as long as the promise is not part of the sale contract.

ÿÿÿÿLeasing too is vulnerable to the same kind of manipulation. There are fund owners seeking opportunities of making some profit. There are would be users of durable goods (cars, air planes, oil tankers, etc.) not ableornotwilling to buy the durable but ready to rent it. Steps in the intermediary A who takes fund owners' (B's) money on profit-sharing basis, buys the durable and leases it to the user (C).The rent charged would be high enough to pay the purchase price before obsolescence of the durable, meet insurance and maintenance costs and leave profits comparable to those obtainable through other similar business activities.

ÿÿÿÿIn this case also A is taking business risks to which fund owners (B) would also be exposed. The risks are reduced substantially by the practice of buying the durable only after a firm 'request' for lease is received from a client.

ÿÿÿÿIt is important to note that in all cases of financial intermediation in Islamic framework the funds owners are not guaranteed their principal. Since the fund owner's contract with the intermediary is always based on profit-sharing (mudaraba) he is always vulnerable to loss. There can be no guarantee of principal amounts for profit seeking fund owners. To maneuver that guarantee through third party intervention or deposit insurance is an entirely different matter.

Current Practice of Islamic Banks

It is sometimes asserted²⁰ that in the beginning, that is in mid seventies, Islamic banks tried to practice profit-sharing with their clients but it did not work for a number of reasons. No documentary evidences is, however,available tosupport this claim.²¹Whatever the history, currently the practice ofprofit-sharing is insignificant.Despite a claim that it is increasing,²² Islamicbankingremainsdominatedby murabaha followed by leasing. Islamic bankshave alsobeendealing in real estate,bullion and currencies. Most of the losses sustained by Islamic banks in the past originated in the latter dealings.

ÿÿÿÿSo far as fund owners (savers) are concerned their contract with Islamic banks is based on profit-sharing as assumed in our earlier discussion. But the similarity ends here. Contrary to what issuggestedaboveIslamicbanks are not using credit sale, salam, istisna and leasing as vehicles of intermediation. They are doing the real thing themselves. In fact they have been increasingly pushed into doing so by Shari'ah scholars who found them using thesecontractualforms toensurepredetermined returns on the fundsinvolved often through such dubious practices as buy back and mark down!

Real Business Versus Intermediation

ÿÿÿÿWhy did the Islamicbanksnottake the course of intermediation - pure as well as non pure -- outlined above? What would be the consequences if they do not return to intermediation and continue with murabaha, leasing and also add salam / istisna to these practices?

ÿÿÿÿIt ishardlypossibletoanswerthesequestions inthisbriefpresentation which is nearing its limits. I venture, however, to suggest the following explanations.

1.ÿÿÿ The theory of interest-free banking expounded innonArabic writings focused on pure financial intermediation based on two tiermudarabatotheneglect of non pure forms of intermediation²³,somethingwhichresulted in that theory being side lined by some practitioners.

2.ÿÿÿ Arabic writings, with only a few exceptions,²⁴ suggested mobilizing savings on the basis of mudaraba and using thefundssoacquired to earn profits through trade, commerce and industry²⁵ a tendency reflected in the charters of early Islamic banks.²⁶

3.ÿÿÿ IndividualIslamicbanks inArabcountrieswere established as small companies with little support from the legal system and the banking authorities. This made it difficult for them to deal with clients (businessmen) as intermediaries. They opted for either doing business themselves or seeking guaranteed returns through murabaha and leasing.

4.ÿÿÿ Islamic jurists have never been comfortable with the role of middlemen regarding it as superfluous if not positively harmful fortheinterests of the consumers as well as that of the producers. The failure to distinguishbetween beneficial intermediation and middlemen seeking monopoly control may well have been rooted in certain historical circumstances. Trade, which has been lauded in Islam, is itself intermediation between producers and consumers.

5.ÿÿÿ Shari'ah scholars approached the issue not in macroeconomic terms of the Islamic society's need for financial services required in a modern expanding economy but at the micro level of how a financial firm,theIslamicbank, should conduct itself according to the familiar fiqh rules of transaction.

ÿÿÿÿAll this keeps Islamic banks focusedondoingwhatthey are not equipped to do -- real industrial or agricultural production, trade, commerce, etc. It also keeps them away from what they would be able to do as financialinstitutions --- doing financial intermediation and offeringrelatedfinancialservices. I do not think Islamic banks are going to gain by reinforcing their role as 'real traders'. It will only accelerate their marginalisation and facilitate thetakeover of financialintermediation byinterest based multinationals.

Structure of the Islamic Financial Community

ÿÿÿÿSome of the current travails of Islamic banks are related to the internal structure of the group. The structure as it exists grew unplanned. As at present it is not conducive to efficiency and growth. It may be also wantinginfairness. Since we have already run out of space I will confine myself to putting on record the main points causing worry.

1.ÿÿÿ Banking companies handling public money must be properly supervised. How can conventional central banks discharge this function and to what extent there is a need for some supranational agency advising national authorities in view of the special nature of Islamic banks, needs attention.

2.ÿÿÿ Shari'ah boards came up toensureShari'ahconformity in operation and enhance the credibility of Islamic banks. But their multiplicity, confidentiality and other aspects of their functioning are raising many questions. A review and restructuring is needed.

3.ÿÿÿ Islamic bankingpracticelackstransparency.Whateveritsjustification in the infancy of Islamic financialmovement, it is now doingmore harmthan good. Islamic banks must follow internationally recognized practices of reporting and openness.

ÿÿÿÿStandardization of accounting procedures which is already underway, increased transparency, propersupervisionanda fresh approach to ensuring Shari'ah conformity will go a long way in improving efficiencyand restoring credibility of Islamic banks. But it will not solve the tricky issue of depositors' participation in management. The nature of investment account is different from the savings and time deposits in conventional banks. Depositors' vulnerability to risk of lossmakesitnecessary to give them a say in the running of Islamic banks along with the shareholders. Some special arrangements have to be made for this.

Where do we go from here?

ÿÿÿÿA correction of course seems to be inevitable. A return to financial intermediation should be on top of the agenda. Greater cooperation among Islamic banks and pooling of resources to meet liquidity needs, etc. are preconditions totheir successful practice of profit-sharing on the assets side. Cost reducing innovation and bringing new financial products to the market based on securitisation should also receive professional attention. Economy thrives by competition not command. Competitiveness can be boosted by decentralization of management and encouragement to innovation. Ensuring conformity from above does not provide the right environment for these. Internalization of Islamic norms coupled with a minimum of ground rules would be more conducive to survival and growth.

Post Script*

ÿÿÿÿIt is time to put the question of theneed offinancialintermediation behind us. As we enter the new century we must consider how to makeÿ financialintermediation in Islamic framework meet the challenges posed by a globalize, hence more competitive environment. Thiscanbe possible only through innovation. It has been financial innovationsenhancingliquidity,transference of risk and generation of revenues which havechangedthe market environment in recent years²⁷. To be able to survive in the market, "Islamic finance must find a way to perform certain functions of conventional finance if it is to compete successfully. Among these are functions achieved by risk management devices, marketable securities, accounts receivable financing , preferred stock and a futures market."²⁸

ÿÿÿÿHopefully, several recent studies affirm the possibility of innovative financial engineering in Islamic framework²⁹. This framework is definedbyclearlyrecognizedpropertyrights, well defined limits e.g. prohibition of interest on loans and a mandate to promote the good (maslaha). There is ample scope for both adapting conventional instruments by cleansing themoffeaturesnot acceptable in Islamic framework or designing new oneswithin Islamic perimeters.

ÿÿÿÿA healthy financial market for trading in instruments such as common stock, Ijara bonds³⁰, service bonds³¹, financial papers based on salam and istisna and other securities acceptable within the Islamic framework is also necessary for the efficient functioning of Islamic banks and other financial intermediaries. For one thing, such a market will provide

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*ÿÿÿDecember 1999

the needed outlet for institutional investors -- mutual funds, pension funds and insurance companies - whose role is increasing day by day. But even more important is the need of the intermediaries, including deposit taking intermediaries like the Islamic banks, for such a market³². That such a market does not exist at the present is because of a number of causes. The Islamic financial community is, relatively speaking, too small. The needed leadership for making quantum jumps is not in sight. The required marriage of shariah expertisewith financial professionalism is yet to consummate. And, above all, the environment in the larger Islamic community, of which the financial community and its appendages e.g. shariah boards,researchers,conference makers etc, are but a part, still feels ill at ease with innovation.

ÿÿÿÿAs we have noted else where³³ the malaise is deep and requires a long term comprehensive strategy for its cure. Yet the pincer head may well be the needs of the financial community. After all it is Islamic finance that is,ontheeve of the 21^st country, the most visible offshoot of the Islamic resurgence spanning the last two centuries. The necessity of innovation within Islamicframeworkfor survival may well provide the big push for which ijtihad /span>has presumably been waiting all these centuries!

Footnotes

1.ÿÿÿ Attiyah, Jamaluddin,al Bunuk of Islamiyah bain al Hurriyah wa'l Tanzeem, al Taqleed wa'l Ijtihad, al Nazariyah wa'l Tatbeeq.

/span>.ÿÿÿZineldin, Mosad, The Economics of Money and Banking: A Theoretical and Empirical Study of Islamic Interest-Free Banking.

/span>.ÿÿÿKazarian, Elias, Finance and Economic Development: Islamic Banking in Egypt.

/span>.ÿÿÿSiddiqi, Mohammad Nejatullah, Mushkilat al Bunuk al-Islamiyah fi'l waqt al Hadir.

/span>.ÿÿÿAl Hussayyen,Shaikh Saleh, "al Bunuk al Islamiyah Muhadedadah bi'l Tawaqquf".

/span>.ÿÿÿMuhammad, Yusuf Kamal, al Masrafiyah al Islamiyah, al Azmah wa'l Makhraj.

2.ÿÿÿ We ignore questions specifically related to Islamic banking at the national level in Pakistan, Iran,Sudanand,partially,Malaysiasince the space assigned for this study can not accomodate the relevant issues.

3.ÿÿÿ Pierce, James L., Monetary and Financial Economics, p. 89.

4.ÿÿÿ Fry, Maxwell J., Money, Interest and Banking in Economic Development, p. 235.

5.ÿÿÿ Townsend, Robert M., "Financial Structure and Economic Activity"in American Economic Review, Vol. 73, December 1983, page 909.

6.ÿÿÿ Bryant,Ralph C., International Financial Intermediation,pp. 8-11 for these and other advantages of intermediation.

7.ÿÿÿ al Mudawi, Baqir, "Placing Medium and Long Term Finance by Islamic Financial Institutions"

ÿÿÿÿalso see Waqar Masood Khan, Towards an Interest-Free Islamic Financial System.

8.ÿÿÿ See Chapters one and two, Role of State in the Economy, An Islamic Perspective, by the present author.

9.ÿÿÿ Ibn Taymiyah, al Siyasah al Shar'iyah fi ahwal al Ra'i wa'l Ra'iyah.

10.ÿÿ This is the well known case ofal mudarib yudarib. For a discussion see the present author's, Partnership and Profit-Sharing in Islamic Law, pp. 57-63.

Some of the original Fiqh sources are

.ÿÿÿÿ al Sarakhsi, al Mabsut, Egypt, Matbaa Saadah, Vol. 22, pp. 98-104.

.ÿÿÿÿ al Kasani, al Bada'i Wa'l Sanai', Vol. 6, p. 97.

.ÿÿÿÿ al Sawi, Bulghat al Salik li Aqrab al Masalik, Vol. 2, p. 232.

.ÿÿÿÿ al Firozabadi, al Shirazi, Kitab al Muhadhdhab fi fiqh Madh hab al Imam al Shafa'i, Vol. 1, p. 290.

.ÿÿÿÿ Ibn Qudama, al Mughni, 1347 H. Vol. 5, p. 161.

11.ÿÿ Allen, Franklin and Anthony M. Santomero, What Do Financial Intermediaries Do? p. 2.

12.ÿÿ Pierce, J.L., Monetary and Financial Economics.

13.ÿÿ The Repeal of Glass-Steagall in the US removed the last hurdles in this regard.

14.ÿÿ Bryan, Lowell L., 'Structured Securitized Credit: A Superior Technology for Lending' in Donald Chew (ed.), New Developments in Commercial Banking, p. 55.

ÿÿÿÿAlso in the same book 'The Future of Credit Securitization and the Financial Services Industry' by Juan Mocampo and others.

15.ÿÿ Allen, Franklin and Anthony M. Santomero, What Do Financial Intermediaries Do? p. 6.

16.ÿÿ Goldberg, Harold H., et. al. 'Asset Securitization and Corporate Financial Health' in Donald Chew (ed), p. 94.

17.ÿÿ Knight, Frank H., Risk, Uncertainty and Profit, Chapter 11, 12, and 13.

18.ÿÿ It may be noted that even though one can not sell what he does not posses, it is permissible to undertake delivery of a commodity in future not in possession of the seller and not being produced by him as long as supplies are available in the market.

19. It is possible, however, to hedge against these risks, but we can not enter into discussion of that possibility in this study.

20.ÿÿ Attiyah, Jamaluddin, al Bunukal Islamiya . . . ., pp. 108-112.

21.ÿÿ Mumammad, Yusuf Kamal, al Masrafiyah al Islamiya . . . ., pp. 104-105.

22.ÿÿ Shaikh, Samir Abid, Secretary General, International Association of Islamic Banks, Press statement in response to Shaikh Saleh al Hussayyen, op. cit.

23.ÿÿ Uzair, Muhammad, An Outline of Interestless Banking.

ÿÿÿÿSiddiqi , Mohammad Nejatullah, Banking Without Interest, For other references see the present author's, Muslim Economic Thinking.

24.ÿÿ Al Araby, Mohammad Abdullah, "al Mu'amalat al Masrafiyah al Mu'asarah wa Ra'y al Islam fih", pp. 79-122.

25.ÿÿ Al Jammal, Gharib, al Masarif wa Buyut al Tamweel al Islamiyah, pp. 46, 59, and 65-69.

26.ÿÿ See the Charters ofDubaiIslamic Bank, Kuwait Finance House, Faisal IslamicBank of Sudan,and Faisal Islamic Bank of Egypt clauses numbers 2, 2, 4, and 2 respectively.

27.ÿÿ Iqbal, Zamir, 'Financial Engineering in Islamic Finance', pp. 542-43.

28.ÿÿ Vogel, Frank, and Samul L. Hayes III, Islamic Law and Finance: Religion, Risk and Return, p. 236.

29.ÿÿ Kamali, Mohamamd Hashim, 'Prospects for an Islamic Derivatives Market in Malasiya'.

.ÿÿÿÿ ______________________, Islamic Commercial Law: Analysis of Futures.

.ÿÿÿÿ ______________________, Islamic Commercial Law: Analysis of options.

.ÿÿÿÿ Ebrahim, Muhammad Shahid, "Integrating Islamic and Conventional Project Finance'.

.ÿÿÿÿ Obaidullah, Muhammed, "Financial Engineering with Islamic Options".

.ÿÿÿÿ Bacha, Obiyathullah Ismath, "Derivative Instruments and Islamic Finance: Some Thought for a Reconstruction".

.ÿÿÿÿ lqbal, Zamir, "Financial Engineering in Islamic Finance".

.ÿÿÿÿ Kotbi, Hussain E., Financial Engineering for Islamic Banks.

.ÿÿÿÿ Khan, Mohammed Fahim, Islamic Futures and Their Markets

.ÿÿÿÿ Bin Eid, Mohammad Algari, 'Stock Exchange Transactions: Shariah Viewpoints".

.ÿÿÿÿ Usmani, Muhammad Taqi, An Introduction to IslamicFinance,especiallypp. 157-232.

30.ÿÿ For this instrument and those based on salam and istisna, see Ahmad, Ausaf and Trariqullah Khan (eds.), Islamic Financial Instruments for Public Sector Resource Mobilisation, Chapter 5 to 10.

ÿÿÿÿAlso

ÿÿÿÿHaque, Nadeemul and Abbas Mirakhor, "The Design of Instruments for Government Finance in an Islamic Economy".

31.ÿÿ Monzer Kahf, 'Service Bonds for Financing Public Utilities'.

32.ÿÿ Vide Allen, Franklin and Anthony M. Santomero, p. 1.

33.ÿÿ Siddiqi, M.N., "Towards Regeneration: Shifting Priorties in Islamic Movements".

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