Future of Islamic Banking - Sayyid Tahir

Islamic banking and financing has gained a foothold both nationally in Muslim
countries and internationally in the financial world. Regular degree programs are also
being offered at the university level in both the East and the West. Now Islamic
banking industry faces issues of a different sort. That is, how to (1) consolidate the
gains made so far and sustain itself, (2) ward against any meltdown and (3) grow.
These issues determine the scope for our discussion.
The topic involves some futurology. Its nature requires interactive dialogue. We
propose the following list of questions for deliberation:

1. Will Islamic banking survive or not?
2. What shape might the Islamic banking industry take in the future?
3. What, or what type of, challenges might Islamic banking face in the coming
years?
4. What changes might Islamic financing bring about in the way people live,
businesses work and governments run public affairs?
5. How might development of Islamic financing affect the disciplines of Fiqh,
Accounting, Business Administration (in particular, Finance and Marketing
and Business Management), Economics and Public Policy?

We make here some submissions for further dialogue. It is pertinent to mention that
there are some similarities between this topic and the one on Current Issues in
Islamic Banking. This is because present determines the future, and future
considerations influence the present. Notwithstanding this, however, the future
concerns merit their own discussion.

1. Survival of Islamic Banking & Finance

Survival of Islamic banking depends on the following: (1) its economic viability, (2) its
stability, (3) its response to challenges to its identity, and (4) confidence of
depositors and savers. We discuss these four things in turn.

1.1 Economic Viability:

Economic viability of Islamic banking/financing is not an issue for two reasons:
• Professor of Economics, International Institute of Islamic Economics, International Islamic University,
Islamabad.
This discussion paper is prepared for COURSE ON ISLAMIC BANKING AND FINANCE, TEHRAN, IRAN, 2-6 March 2003,
organized by the Central Bank of the Islamic Republic of Iran and Islamic Research & Training Institute of the IDB, Jeddah.
Future of Islamic Banking 2
(1) Islamic banking is just another way of banking.
(2) Islamic banking offers a better financial architecture, on economic
grounds.
Let us take the case of a bank client (C) who actually needs to buy something for
which he does not have funds to meet the seller (S)’s demand for payment. Currently
a bank (B) comes in the picture as follows:
The prohibition of riba makes the loan option economically infeasible for the bank. It
can, however, still play a meaningful role and help the client to tide over his liquidity
problems as follows:
The above picture will remain by and large the same if the client needs something on
lease basis.1 However, if usage of funds involves several transactions at the client’s
end, Islamic bank can share its resources with the client under partnership
arrangements—modarabah or musharakah—to do the needful.
The above analysis implies that Islamic banks will always be able to address
financing concerns of their clients. And, in fact, they will have more than one distinct
option to do so.2 Note that financial tag for Islamic financial instruments need not be
an issue because numbers can always be worked out to show that cost of Islamic
financing remains the same as that associated with interest-based financing.
It is also noteworthy that Islamic financing implies direct linkage between financial
flows and real flows in the economy. That is, funds will flow from Islamic banks only
against real economic activity. Thus, investors will approach Islamic banks only
1 Of course, in that case lease agreement will replace sale agreement between the bank and the
client. And, if sub-leasing is involved, purchase agreement of the bank with supplier shall be
substituted by a lease agreement.
2 Interest-based banks use different variants of loan transaction. These instruments differ only in their
degree of complexity stemming from the nature of financing request.
B
Loan Cash Payment
Repayment of Loan The Thing
(Principal + interest)
Interest-based Solution: Bank as Lender
B C S
B
(4) Deferred Payment* (1) Cash Payment
(3) The Thing (2) The Thing
* Cash price + Bank’s margin
Islamic Solution: Bank as Trader
C B S
Future of Islamic Banking 3
when they have genuine needs. End in dichotomy between financing and the use of
funds will lead to integration of real and financial sectors in the economy. In this
sense, Islamic financial architecture will be superior to the existing interest-based
financing architecture.

1.2 Stability:

According to Dr. Mohsin Khan, in his 1985 article in IMF Working Papers, when there
is downswing in an interest-based economy depositors’ existing claims remain a
liability of the banking system. This forces the banks into debt management. That is,
creation of new and more costly debt against the banks—in the form of new deposits
and borrowings from other sources—in order to retire existing debt to the depositors.
This action reinforces the process of downswing, and hampers the pace of recovery
in the economy. As against this, Islamic banking has advantage that bank obligations
to depositors automatically adjust, both in downswing and recovery phases, due to
the principle of profit-and-loss sharing.
More recently, in an article on the web Dr Tariqullah Khan of the IDB has stated
the same point as follows. “A banking system would be unstable if it concentrates
asset risks on bank capital. Since Islamic banking principle is based on risk sharing
and it spreads risks between bank depositors and bank capital, it is inherently more
stable. If this inherent quality is coupled with prudential regulations and supervision
and with implementation of internationally acceptable standards of risk management,
transparency and corporate governance, Islamic banking can practically become an
ideal alternative to the traditional banking system in achieving equity, stability and
efficiency”.
It is also well-known in traditional finance literature that interest-based debt
finance is an important source of economic instability, as compared with equity
finance. Relevance of this point for our purpose needs no further comment.
Last but not the least, direct linkage between financing and application of funds
under Islamic banking will mean an end to credit or untied cash, as found in the
existing interest-based economies.3 Thus, an important cause of mismatch between
aggregate demand and aggregate supply in the economy will be removed. This will
mean less demand-pull inflation. On the other hand, linkage of financing to economic
activity will help in easing supply constraints in the economy. This will result in,
among other things, employment generation. These considerations lead us to
conclude that frequency, intensity and duration of business cycles will be less with
Islamic banking.
3 Note that there may be debt in an Islamic economy in lieu of transactions involving deferred settlements. But
there will be no credit, as commonly understood.
Future of Islamic Banking 4

1.3 Challenges to Identity:

Let us take the case of Murabahah financing, i.e., financing via sale on deferred
payment basis. A reference to the diagram on Islamic Solution: Bank as a Trader
in section 1.2 above, clarifies how bank enters into the transaction process as a
trader. That is, it comes in the picture between the seller and the bank client: it first
buys the thing and then sells the same to the client. A simple way to do so is as
follows:
The numerals in the diagram show the sequence of events in the transaction
process. It is possible to define a financial instrument such that (i) there is little or no
time lag between creation of bank’s obligations to the supplier and its claims against
the client and (ii) physical commitments on the bank’s part are negligible.
As against the above, at present most of the murabahah financing work as
follows:
1. There is a promise/agreement between a bank and its client. This binds the
client to purchase thing(s) in question from the bank, creates a financing
facility in the name of the client, and authorizes the client to directly purchase
from the suppliers (though at the behest of the bank).
2. The client makes necessary purchase(s), and payment advices are sent to
the bank that the bank honors.
3. The client directly takes delivery of the good(s) from the supplier.
4. Once the thing(s) is (are) with the client, a sale-purchase agreement is made
between the bank and the client as follows. The client offers to buy (what is
already with him) and the bank agrees to sell the same thing!
5. The client discharges his payment obligations to the bank.
The above process is materially no different from that associated with Supplier’s
Credit currently in vogue in interest-based banking. Thus, if murabahah financing
works as above, sooner or later questions may be raised about its claim to a
separate identity. Change in labels and terms are unlikely to be a lasting defense.
Bank
Client
Supplier
1. Application
6. Installments
3. Sale Agreement
2. Purchase Agreement
4. Payment settled
5. Delivery
Future of Islamic Banking 5
As per the existing approaches as understood by us, there is little difference
between hire-purchase practiced by Islamic banks and financial lease condemned by
the fuqaha as a transaction of riba. Similar points may be raised about some other
financial instruments adopted by Islamic banks. The line of distinction between
Islamic financing and interest-based financing must always be above reproach in
order to avoid identity crisis for Islamic banking.

1.4 Confidence of Depositors and Savers:

Dr. Tariqullah Khan recently raised this issue as follows. “A bank licensed as an
Islamic bank may be running on a very sound financial footing. However, if the
depositors came to know that the bank has violated its Shari’ah mandate, the
depositors will lose confidence and the finding will trigger deposit withdrawal and
probably collapse of the bank. By contagion effect this can lead to financial instability
threatening economic development”.
One may add that success begets envy and, hence, scrutiny. Caution is,
therefore, warranted against any thing that creates doubts about the Shari’ah
credentials of Islamic banks’ transactions, especially on the financing side.

2. Likely Shape of Islamic Banking & Finance in Future
2.1 Islamic Banks as Pure Financial Institutions:

Islamic banks will become pure financial institutions that fill financial gaps standing in
the way of real economic transactions at the grassroots level. The following
economic factors will lead to this development.
Practitioners of Islamic banking will recognize that efficiency and gains lie in
specialization. They will, therefore, delegate to third parties responsibility for field
operations in lieu of a financing transaction, of course, in return for a charge. In some
cases, such as taking physical possession of a thing in trade- or lease-based
financing, this third party may be the bank’s client himself. This is likely to happen
because economies of scales enjoyed by third-party specialized institutions will
reduce operational costs for the banks. In the end, one expects Islamic banks
institutions to touch the economic landscape only on the financial plane, i.e., become
pure financial institutions—while acting as economic agents.
Notwithstanding the above, regulators also need to recognize the following
danger. Islamic banks, as already seen, will provide financing by coming in the
picture as traders, lessors or partners. This factor along with their ability to muster
sizeable funds can have potentially damaging implications. For example, if there are
no checks on the scope of trading operations of Islamic banks, mega traders will
emerge as the expense of small traders and businesses. This monopoly problem
can be addressed through limiting the role of Islamic banks to financing matters only.
Future of Islamic Banking 6
That is, for example, they may be permitted to enter into a transaction as trader in
order to facilitate a sale-and-purchase transaction at the grassroots level, they
should not be allowed to buy and sell things for themselves.

2.2 Islamic Banks will primarily be Economic Institutions:

Islamic banking will be ethical banking for, among others, the following reasons:
(1) Islamic banks will stay away from financing Shari’ah-proscribed
activities—producing alcohol or financing speculative activities, for
example.
(2) There will be transparency in their transactions with the clients—
depositors as well as fund-seekers—due to compliance with the
Shari’ah Ahkam on gharar.
Islamic banks will also contribute to social welfare of the economy to the extent
Ahkam on zakah would apply to them. But beyond this, generally they shall be pure
economic institutions established by their owners for profit earning. Of course,
individually some Islamic banks may specialize in participatory modes of financing
modes due to some religious convictions of their owners. But there is no Shari’ah
compulsion for this. Islam allows banks to exploit all halal ways to their advantage, of
course, subject to willing consent of the all concerned in a given transaction.
As for Islamic banks doing charity, the thinking needs to be set straight. A bank’s
money (deposits plus bank capital) belongs to its depositors and shareholders. Prior
permission of the ultimate owners is a must for any charity.4 The same principle
applies to profits earned through financing operations in which capital stakes of
depositors, and may be the bank’s shareholders, are involved. Technically speaking,
bank management may exercise some discretion for charity with prior permission of
the shareholders and the depositors. But getting such a mandate is practically not
possible because both the group of bank shareholders and that of bank depositors
continuously keep on changing.

2.3 Standardization of Islamic Financial Products:

Standardization is necessary, and it is bound to happen. This is because the world is
a global village. Costumers’ consciousness and competition among Islamic banks
will lead to standardization of Islamic financial products. Ultimately, barring
exceptional circumstances when large and long-term fund commitments and/or a lot
of financial engineering is involved, only price competition will rule in the Islamic
banking industry.
In passing, one may note that in the long run standardization in the financial
instruments will require consensus of fundamental Shari’ah principles for designing
4 This automatically happens in the case of charity by an individual out of his personal wealth.
Future of Islamic Banking 7
financial contracts. Unless this happens, Islamic banking may become a clash of
dogmas.

2.4 Structure of Islamic Finance Industry:

Islamic finance industry is likely to be divided into (1) normal banking institutions, (2)
development finance institutions, (3) microfinance institutions, (4) mutual funds and
(5) life insurance companies and their other equivalents.
Development finance institutions will specialize in financing based on divisible
and tradable financial instruments to address sizable financing needs with long
maturity periods.
Microfinance institutions shall emerge not only for economic considerations but
also as part to government strategy to exploit the potential of micro-financing for
poverty alleviation.
There will always be return-conscious depositors who want maximum flexibility in
investment and withdrawal of funds. Accounting and, may be, other costs
considerations at the level of the normal banks will give rise to institutions like mutual
funds or unit trusts. The quest for maximum responsiveness to their clients will force
these institutions to operate only in the secondary markets, such as Islamic stock
market (for Islamic shares) and Islamic money market (for divisible and tradable
Shari’ah-compliant financial instruments).
Life insurance companies and their other equivalents, such as Employees
Provident Funds and Private Pension Plans, are likely to emerge on the Islamic
financial scene in order to provide avenues for long-term capital accumulation to the
people. The existing Islamic Takaful model is expected to be working model for
these financial institutions. It is expected that Shari’ah considerations will force
development of separate institutions for other forms of insurance. For example, fire
insurance companies may also be required to take remedial measures for avoiding
the occurrence of fire. Accident insurance scene may be characterized by separate
Aaqila ( ÚÇÞáÉ ) for car, bus and truck insurance. And, so on.
3. Future Challenges for Islamic Banking & Finance

Some of these challenges are noted below.

3.1 Financial Innovation in Critical Areas:

Progress of Islamic banking will depend on its ability to innovate in the following
areas:
• Financial instruments yielding stable income flows for orphans, widows,
pensioners and other weaker segments of the society
• Financial instruments for meeting government’s financing needs
• Cover or security for financing, in particular Shari’ah-compliant alternatives for
penalty on payment defaults
Future of Islamic Banking 8
• Formulas for pricing of Islamic financial products

3.2 Competition:

Islamic banks should be ready to brace not only intra-industry competition but also
inter-industry competition from interest-based banks. The latter are already offering
Islamic financial products. The competition is likely to grow.

3.3 Misuse of Islamic Banking

Unless there are effective checks and monitoring, vested interests may use Islamic
banking to bypass the Ahkam on riba. For example, in the existing murabahah
financing banks do not directly come into the picture as buyers from the would-be
suppliers. This gives dishonest fund-seekers a window for getting credit from the
bank through fictitious purchases. Moreover, without effective checks and monitoring,
some bankers under financial pressures may be tempted to provide funds through
dummy transactions. For example, a person might get $1000 from a bank by the
bank first buying a bread—or something dirt cheap, not worth $ 1000—from the
client’s close relative and then selling the same to the client at a higher price.

4. Effect of Islamic Banking on Economy and Economic Life

The following effects are anticipated:
• The real and financial sectors in the economy will be better integrated, as
compared to what one finds in interest-based economies.
• Both what the governments do and the way in which they work, will change.
This will mainly stem from the fact that without tax revenues, governments
may address only those needs for which an economic transaction—other than
pure loan transaction—can be defined between the government and the
financiers. Economic considerations will in the long run lead to development
of “Fiqh for Government” that would regulate economic activity at the
government level.5
• Inter-bank money market and central banking will take new form. New matrix
of Shari’ah-compliant divisible and tradable financial instruments and the
Shari’ah parameters for contracts will give shape to this development.6
While the above happens, the regulators will also have to ensure
compliance with Basel requirements for international acceptability of Islamic
banking. In cases of no conflict between the Shari’ah parameters and the Basel requirements, there would be no problem. However, where conflict arises, there will be need (1) to design Shari’ah-compatible ways for
compliance with the Basel requirements and (2) to sell the same to the
international regulators.
• Accounting and financial management may undergo major changes. This
would happen because Islam has different position on ownership, rules for
transactions and the financial instruments.
• Islamic banking will lead to better business ethics because banks will
entertain only economically viable financing requests. Note that the said
transformation shall take place even without prior moral uplift of the society for
Islamic banking. Careful design of Islamic financial instruments will
discourage unscrupulous behavior by fund-seekers.

5. Effect of Islamic Banking on Various Disciplines

Fiqh: A change is already taking place. Instead of thinking within the narrow
domains of Hanafi, Maliki, Shafie, Hanbali and Ja’fari fiqhi schools,
contemporary fuqaha are joining hands and looking for common ground that
best suits contemporary needs.
OIC Fiqh Academy and AAOIFI provide formal international platforms.
Individual Islamic banks have either international representation on their
Shari’ah Boards or they are open to international influences.
Accounting, Financial Management, Marketing and Bank Management:
When full significance of the Shari’ah is recognized, these areas will change.
The impetus will come from, among other factors, Islamic concept of “rights”
(based on Islamic view of ownership) and permissible forms of transactions.
Economics: New economics will emerge for the new economic setup. Changes will
be more noticeable in the areas of macro and monetary economics.
Public Policy: A paradigm shift will take place due to changes in what
governments may do and the ways in which they would work.

6. Some Other Relevant Points

6.1 With Islamic banking gaining ground, new challenges are already emerging for
redrafting the rules for international trade and accommodating Shari’ahcompliant
foreign trade financing. A good deal of work has been done, but a lot
more is needed.
If Islamic financing is adopted at the state level, inter-governmental financial
flows will change, in both form and size.
6.2 Forces of the status quo will always resist change. Hence, every now and then
issues would be raised about what riba is or what it is not.
Future of Islamic Banking 10
6.3 Government finances will remain a problem in the way of Islamic banking until
sufficient new financing tools are developed and a consensus develops on the
economic and social role of government.
6.4 While the thrust of the present efforts in Islamic banking is on the financing side,
matters related to liability side of Islamic banks will become an issue in future.
The way in which Islamic banks look after interests of various groups of
depositors and what they actually do, both are likely to become an issue.

7 CONCLUDING OBSERVATIONS:

“Highly ethical, well-regulated and beneficial Islamic financial architecture is possible.
Indeed, working in this field with more transparency, with effective corporate
governance and with better interaction with relevant international, regional and
national institutions, will definitely help all [those] who want to contribute to the
welfare of their community as well as to the welfare of the world as a whole.8

Any source

Green box does distort trade, claims Indian study

A report commissioned by the Indian Department of Commerce and carried out by UNCTAD's Indian team challenges the EU's argument that decoupled aid payments have only a minimal trade distorting effect. According to the researchers' model, EU farm exports would fall by a massive 45 per cent if Green Box subsidies were removed and production would fall by close to 6 per cent.

The EU, US and Canada would all see exports decline by upwards of 40 per cent in the absence of Green Box payments, while Swiss and Japanese exports would fall by over 60 per cent. However, most developing countries would see exports increase by around 20 per cent.

The Green Box issue remains open within the suspended Doha Round negotiations. However, given the EU's attachment to its decoupled Single Farm Payment system, the bulk of which falls into the Green Box, it is unlikely that any Doha Round settlement will lead to changes in the Green Box. However, there could be provision for further discussion of what can legitimately be placed in the box, putting a time bomb under the whole CAP.Any source

Subsidy data to be made public

EU citizens in all member states should soon be able to find out who gets what in terms of farm subsidies, following a decision by Coreper. This may help to create further public pressure for CAP reform.

Ambassadors agreed 'in principle' to open national farm accounts to public scrutiny. However, the decision requires agreement from the European Parliament which hopefully can be obtained by the end of November. It remains unclear whether the Commission or member states will be responsible for publishing the subsidy data, the Commission being reluctant to take responsibility for publishing information it cannot verify.

France is continuing to demand that no subsidy disclosures are made before 2009 when the presidential elections will be safely out of the way. Jack Thuston from the transparency campaign farmsubsidy.org commented, 'It's great news that European governments are endorsing transparency. But it is quite wrong that we should be kept in the dark until 2009, as the French government is reported to be insisting upon. It now falls to elected Members of the European Parliament to stand up for the rights of those they represent. European citizens have a right to know who gets what from the EU and why. Secrecy is bad for European civil society and bad for the reputation of European institutions.'

Even if the public do become indignant at the size of the handouts given to already prosperous farmers, fundamental reform is likely to encounter continying resistance from the Commission. Commissioner Mariann Fischer Boel has dismissed Defra's reform document as 'incoherent' with 'a complete lack of analysis behind this paper' in an appearance before the House of Commons Environment, Food and Rural Affairs select committee. When I appeared before the committee, I argued that the paper was a strong one, but the problem was the lack of a political strategy to put it into effect.

Fischer Boel insisted, however, that many farmers would be unable to survive without the direct payments scheme and would start to abandon their land with adverse environmental consequences.

Visit farmsubsidy.org at Subsidies Any source

Estonians to pay €35 a head sugar stockpile fine

Estonia will have to pay in full the €46 million fine imposed by the EU for stockpiling sugar in the months before accession in 2004, farm commissioner Mariann Fischer Boel has insisted. The fine amounts to the equivalent of about €35 per person.

Estonia has contested the fine at the European Court of Justice, arguing that a large part of the sugar surplus of 91,464 tonnes have been hoarded by private households in preparation for a national frenzy of jam making. Making jam and syrup at home is a common practice in the Baltic state.Any source

Funding new railways

Ben Webster in The Times (12th October 2006) reports that developers are proposing to open a closed railway line between Oxford and Cambridge (UK). They are trying to strike a deal with planners: The £100m needed would be paid for by a new 'roof tax' on new homes near the opened line. Even with the extra cost the homes would be attractive because of the new railway.

Fred Harrison in Wheels of Fortune (2006. Institute of Economic Affairs) writes that London's Metropolitan Railway was funded in a similar way in the early 1900's. The land values near the route doubled as soon as a proposal was made and doubled again when it opened (p.157). The developers of the railway bought land near their proposed route and were left with good profits from selling land for housebuilding and for paying for the railway. In the modern case above, let us suppose that a developer has plots of agricultural land totalling 100 hectares bought at £5000 /ha along the 75 mile route between Oxford and Cambridge. With planning permission for housing the land value would be £3,500,000 / ha. For an investment of £0.5m the gross profit would be £350m. Deduct the land and railway costs (£100.5m) and the net profit is £249.5m. Every £1 invested multiplies to £499! For up-to-date land prices see the official property market figures on : www.voa.gov.uk .

The term 'roof tax' is misleading, as what is proposed is actually 'land value tax'. Fred Harrison has written several books on the topic including Power in the Land (1983); Boom and Bust: House prices, banking and The Depression of 2010 (2005). His latest is available at www.shepheard-walwyn.co.uk Ricardo's Law - House prices and the great tax clawback scam. Subtitle: Why Tony Blair's Project failed.

The Free Lunch shows that that many factors trigger land price rises and house price gains.
Anyone thinking about investment in property needs to read it, see: www.the-free-lunch.com .Any source

Islamic Economics & Banking

Islamic Economics & Banking

Introduction

Why did Islam prohibit interest? What is the logic behind that? What types of interest has Islam prohibited? These are certainly the questions that face a lot of both Muslim and non-Muslim economists. When Islam was introduced 1400 years ago, one of the main issues discussed, was Riba or interest. How interest made people manipulate poor people, and how interest made the rich richer and the poor poorer. It also made people work less because of their guaranteed return. Those were the assumptions back then. Still many issues and arguments had come to life after the death of prophet Mohammed, may peace be upon him, of what is Riba and when it is prohibited. As the world economy made the transition to a market economy after the industrial revolution, it is not very hard to see when Riba applies and when it does not. Perhaps the transition to a market economy is not made to fit different religions or morals. What is the logic behind the prohibition of interest, when does it apply, is it better and how could we continue in a market economy through banning interest? To address these issues, I will rely more on the Qur'an rather than the hadeeth because of the uncertainty in some of the hadeeth of whether it was actually the prophet's words.

What is Riba?

The following definition and discussion of what is Riba is one that is derived from many books that seem to have the same definition. According to these books, Riba is seen as an unjustified earning where a person could receive a monetary advantage in a business transaction without giving a just counter value. Riba was also seen as a misallocation of resources, erratic growth, and economic instability in light of the contemporary crisis. Riba literally means increase, addition, expansion or growth. It is however, not every increase or growth, which has been prohibited by Islam. Riba technically refers to the premium that must be paid by the borrower to the lender along with the principle amount as a condition for the loan or for an extension in its maturity. In this case, Riba obviously means interest. Riba is a sin under Islamic law, and even those hired to write the contract or who witness (and thus confirm) the contract are a party to the sin. Furthermore, prohibition of Riba means that money can be lent lawfully only for either charitable purposes (without any expectation of return above the amount of the principle), or for purposes of doing lawful business--that is, investment on the basis of profit and risk sharing--an investment of the kind that seeks profit while sharing the risk is encouraged in Islam, indeed it is commended.

Islam made a clear distinction between trade and Riba where trading is welcomed and Riba is prohibited. Islam does not consider money as a commodity such that there should be a price for its use. Money is a medium of exchange in asset-oriented economy, and a store of value. The prohibition can be expressed in more technical terms by saying that while money is recognized in Islam as a means of exchange it may not lawfully be regarded as a commodity for exchange. The important difference between trade and Riba is that the business risk in trading is allocated more evenly among all the parties involved, whereas in Riba operations the business risk lies heavily, if not solely, on the borrower (I disagree from a Finance major stand point). In its widest general implication Riba signifies any increase of capital not justified by a risk taken.

Part II: Two Kinds of Riba

What is Riba?

According to the different books I have studied and the different Islamic schools, there are two kinds of Riba: Riba al-Nasi'ah, and Riba al-Fadl.

Riba al-Nasi'ah

The term nasi'ah means to postpone, defer, or wait and refers to the time that is allowed for the borrower to repay the loan in return for the addition or the premium. Hence Riba al-Nasi'ah refers to the interest on the loan. It is in this sense that the term Riba has been used in the Qur'an in the verse "God has forbidden interest" (2: 275). This is also the Riba which the prophet, peace be on him, referred to when he said: "There is no Riba except in nasi'ah."

The prohibition of Riba al-Nasi'ah essentially implies that the fixing in advance of a positive return on a loan as a reward for waiting is not permitted by Islam. It makes no difference whether the return is a fixed or variable percent of the principle or an absolute amount to be paid in advance or on maturity, or a gift or service to be received as a condition for the loan. However, if the return on principle can be either positive or negative depending on the final outcome of the business, which is not known in advance, it is allowed provided that it is shared in accordance with the principles of justice laid down in Islam.

Riba al-Fadl

Islam, however, wishes to eliminate not merely the exploitation that is intrinsic in the institutions of interest, but also that which is inherent in all forms of dishonest and unjust exchanges in business transactions. Riba al-Fadl applies to hand-to-hand purchases and sale of commodities. It covers all spot transactions involving cash payment in one hand and immediate delivery of the commodity on the other. To avoid Riba al-Fadl, people have to exchange commodities equally. For example, gold for gold and silver for silver.

It appears to be both hard and ambiguous to understand why anyone would want to exchange a given quantity of gold or silver or any other commodity against its own counterpart. What is essentially required is justice and fair play in the spot market and spot transactions. The price and the counter-value should be just in all transactions where cash payments are made by one party and commodities or services are delivered reciprocally by the other. Anything that is received as extra by one of the two parties to the transaction is Riba al-Fadl, which can be defined as all excess over what is justified by the counter-value.

Justice can be rendered only if the two scales of the balance carry the same value of goods. This point was explained in hadeeth by the Prophet Mohammed, peace be upon him, in a most benefiting manner when he referred to six important commodities and emphasized that if one scale has one of those commodities, the other scale also must have the same commodity, "like for like and equal for equal." To ensure justice the Prophet, peace be upon him, even discouraged barter transactions and asked that a commodity for sale be exchanged against cash and the cash proceeds be used to buy the needed commodity. This is because it is not possible in a barter transaction, except for an expert, to visualize the fair equivalent of one commodity in terms of all other goods. Hence, the equivalent may be established only approximately thus leading to some injustice to one or the other party. The use of money as a medium of exchange could therefore help reduce the possibility of an unfair exchange.

Murabahah

Murabahah is the Islamic version of a just or equal profit where no one is hurt nor damaged during business transactions. It is one of the alternatives for a just monetary system. Murabahah is a cost-plus contract in which a client, wishing to purchase equipment or goods, requests the Islamic bank to purchase the Items and sell them to him at a cost plus declared profit. By this technique a party needing finance to purchase ceratain goods gets the necessary finance on a deferred payment basis. The finance provider does the purchasing of the required goods and sells them on the basis of a fixed mark-up profit, agreeing to defer the receipt of the value of the goods even though the goods can be delivered immediately. The need for finance of the one in need is thus met.

This financing technique is sometimes considered to be the same as interest, however, in theory, the mark-up is not in the nature of a compensation for the time or deferred payment, even though the entire cost had to be incurred because the needy person did nt have at hand to make the purchase he wanted. Rather, the mark-up is for the service that the finance-owner provides, namely, seeking out and locating and purchasing the required goods at the best price.

Part III: Consumption vs. Commercial Loan

There are continuous debates between economists on the issue of where Riba applies in the case of loans. Still Moslem economists have managed to solve this situation. In their perspective, Riba applies to both consumption and commercial loans. The following section of this article is dedicated to illustrate their perspective and theories.

The argument that interest was prohibited because during the prophet's days there were only consumption loans and interest charged on such loans caused hardship is invalid because it is factually wrong. During the prophetic period, the Moslem society had become sufficiently inspired to adopt simple living and shun conspicuous consumption. There was hence no question of borrowing for either self-display or for unnecessary consumption needs. It had also become adequately organized to fulfil the basic needs of the poor and those in hardship due to some natural calamity.

However, even if it is assumed that, in spite of simple living and the socio-political commitment of the Moslem society to fulfil the basic needs of those hard-pressed, consumption loans restored to, these must have been limited and for small amounts, and fulfilled primarily through no interest loans. According to an eminent Moslem scholar, the late Shaykh Abu Zahrah:

There is absolutely no evidence to support the contention the Riba that had taken place during before the Prophet, peace be upon him, was on consumption and not on commercial loans. The circumstances of Arabs, the position of Makkah and the trade of the time of the Prophet, all lend support to the assertion that the loans were for production and not consumption purposes.

Hence, the Qur'anic verse about remitting the principle in the event of the borrower's hardship does not refer to only consumption loans. It refers essentially to interest-based business loans where the borrower had encountered losses and was unable to repay even the principal, let alone the interest. It is only in this context that one may be able to understand the argument of the people during the Prophet's era that trade is like interest. The Qur'an clearly stated that trade and Riba are not alike. This is mentioned in the Qur'an (Surah al-Baqarah, verses 275). "Those who benefit from interest shall be raised like those who have been driven to madness by the touch of the Devil; this is because they say: Trade is like interest. While God has permitted trade and forbidden interest. Hence those who have received admonition from their Lord and desist, may have what has already passed, their case being entrusted to God; but those who revert shall be the inhabitance of the fire and abide therein for ever." From those words of God, one can see the link between forbidding interest and allowing trade as a clear and obvious reference to commercial loans. From the previous it is healthy to say that commercial loans were mentioned in the holy book.

Furthermore, trade provides risk where entrepreneurs incur the risk of either making profit or losing. In contrast to this, interest offers no risk to the lender. Financiers who do not wish to take the risk are entitled to only the principal and nothing more. Apparently, Riba is essentially in conflict with the clear and unequivocal Islamic, Marxian, and Keynesian socio-economic justice.

The principle reason for why the Qur'an has delivered such a harsh verdict against interest is that Islam wishes to establish an economic system where all forms of exploitation re eliminated, and in particular, the injustice perpetuated in the form of the financier being assured of a positive return without doing any work sharing the in the risk, while the entrepreneur, in spite of his management and hard work, is not assured of such a positive return. Islam wishes to establish justice between the financier and the entrepreneur.

Rationale

The essential feature of Islamic banking is that it is interest-free. Although it is often claimed that there is more to Islamic banking, such as contributions towards a more equitable distribution of income and wealth, and increased equity participation in the economy, it nevertheless derives its specific rationale from the fact that there is no place for the institution of interest in the Islamic order.

Islam prohibits Muslims from taking or giving interest regardless of the purpose for which such loans are made and regardless of the rates at which interest is charged. To be sure, there have been attempts to distinguish between usury and interest and between loans for consumption and for production. It has also been argued that Riba refers to usury practiced by petty money-lenders and not to interest charged by modern banks and that no Riba is involved when interest is imposed on commercial loans, but these arguments have not won acceptance. Apart from a few dissenting opinions, the general consensus among Muslim scholars clearly is that there is no difference between Riba interest.

The prohibition of Riba is mentioned in four different revelations in the Qur'an. The first revelation emphasizes that interest deprives wealth of God's blessings. The second revelation condems it, placing interest in juxtaposition with wrongful appropriation of property belonging to others. The third revelation enjoins Muslims to stay clear of interest for the sake of their own welfare. The fourth revelation establishes a clear distinction between interest and trade, urging Muslims to take only the principal sum and to forgo even this sum if the borrower is unable to repay. It is further declared in the Qur'an that those who disregard the prohibition of interest are at war with God and His Prophet.

The prohibition of interest is also cited in no uncertain terms in the Hadeeth. The Prophet condemned not only those who take interest but also those who give interest and those who record or witness the transaction, saying that they are all alike in guilt.

Some scholars have put forward economic reasons to explain why interest is banned in Islam. It has been argued, for instance, that interest, being a pre-determined cost of production, tends to prevent full employment. In the same vein, it has been contended that international monetary crises are largely due to the institution of interest, and that trade cycles are in no small measure attributable to the phenomenon of interest. None of these studies, however, has really succeeded in establishing a casual link between interest, on the one hand, and employment and trade cycles, on the other. Others, anxious to vindicate the Islamic position on interest, have argued that interest is not very effective as a monetary policy instrument even in capitalist economies and have questioned the efficacy of the rate of interest as a determinant of saving and investment. A common thread running through all these discussions is the exploitative character of the institution of interest, although some have pointed out that profit (which is lawful in islam) can also be exploitative. One response to this is that one must distinguish between profit and profiteering, and islam has prohibited the latter as well.

Some writings have alluded to the "unearned income" aspect of interest payments as a possible explanation for the islamic doctrine. The objection that rent on property is considered halal (lawful) is then answered by rejecting the analogy between rent on property and interest on loans, since the benefit to the tenant is certain, while the productivity of the borrowed capital is uncertain. Besides, property rented out is subject to physical wear and tear, while money lent out is not. The question of erosion the value of money and hence the need for indexation is an interesting one. But the islamic jurists have ruled out compensation for erosion in the value of money, or, according to Hadeeth, a fungible good must be returned by its like: "gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt, like for like, equal for equal, and hand to hand." The Islamic ban on interest does not mean that capital is cost-less in an Islamic system. Islam recognizes capital as a factor of production but it does not allow the factor to make a prior or pre-determined claim on the productive surplus in the form of interest. This obviously poses the question as to what will then replace the interest rate mechanism in an Islamic framework. There have been suggestions that profit-sharing can be a viable alternative. In Islam, the owner of capital can legitimately share the profits made by the entrepreneur. What makes profit-sharing permissible in Islam, while interest is not, is that in the case of the former it is only the profit-sharing ratio, not the rate of return itself that is predetermined.

It has been argued that profit-sharing can help allocate resources efficiently, as the profit-sharing ratio can be influenced by market forces so that capital will flow into those sectors which offer the highest profit-sharing ratio to the investor, other things being equal. One dissenting view is that the substitution of profit-sharing for interest as a resource allocating mechanism is crude and imperfect and that the institution of interest should therefore be retained as a necessary evil. However, mainstream Islamic thinking on this subject clearly points to the need to replace interest with something else, although there is not clear consensus on what form the alternative to the interest rate mechanism should take. The issue is not resolved and the search for an alternative continues, but it has not detracted from efforts to experiment with islamic banking without interest.

Part IV: Flaws in the theory of interest & roots of the crisis

Muslim economists have always searched and are still searching for flaws in an economy that is driven by interest so that they could justify their theories of a just monetary system. After intense reading of different publications regarding flaws in the theory of interest that are written by Muslim scholars, I did not find a well-constructed argument supporting the flaws in interest rates that is worthy of extracting the idea of adding it to this research.

The general consensus that I found on this issue of a macroeconomics level is the harm which interest rates have contributed to thus far. Muslim economists continually refer to the global economic crisis as a result of interest rates from the great depression to the crisis in Southeast Asia. Huge budgetary imbalances, excessive monetary expansion, large balance of payments deficits, insufficient foreign aid, and inadequate international cooperation can all be related to flaws in the theory of interest, which is also the root of the crisis. Muslim economists see the demand for economic growth as parallel to inflated interest rates and global economic crisis. It is healthy to say that most countries, which make the transition to a market ecomony, had developed some kind of crisis in the early stages. Inflation often occurs as a result of a fast growing economy, hence, contracting the monetary policy is a must to offset inflation. This increase in interest rates would only add to the unemployment level. The Keynesian school had emphasized the problem of high interest as a contributor to unemployment, therefore, stressing the need of reducing interest rates to the lowest possible. But the question is what is the optimal rate of interest? Or should interest exist? The answer of both these questions would be discussed at the end of this article where I will conclude with my own opinion and insight.

Goals of Islamic Economics

The money and banking system should, like all other aspects of the Islamic way of life, be made to contribute richly to the achievement of the major socio-economic goals of Islam. The system should also continue to perform the usual functions that relate to its own special field and which other banking systems perform. From the previous arguments in this project, I came up with a list of goals and functions in the framework of Islamic banking which is illustrated in the following:

1. Broad-based economic well-being with full employment and optimum rate of economic growth.
2. Stability in the value of money to enable the medium of exchange to be a reliable unit of account and a stable store of value.
3. A just return is ensured on investment and development projects.
4. Effective rendering of all services normally expected from the banking system.
5. Socio-economic justice and equitable distribution of income and wealth.

Aspects of an interest free system & its efficiency

A banking system is a must for any economy to flourish or to stay in shape. The primary function of banks is to allocate capital to support entrepreneurs or industrialists in seeking economic prosperity. But, from the Islamic perspective, this kind of support from banks in the form of lending, has to be done without charging interest and, hence, being a risk taker instead of risk averter (Islamic economists point of view). From that, Islamic economists came to an interest free banking system which will supposedly replace the current system and will be more efficient.

An interest free system is a system that relays heavily on profit sheering. This system is derived from the Arabic term Mudarabeh. Mudarabeh is the kind of system where both the lender and the borrower are equally exposed to risk because of the fact that the lender shares profits or losses with the borrower are equally (partnership). The profits in this case are the substitute for the interest. But one might ask, how would banks have the capital that is necessary to lend, when banks do not pay interest for savings accounts or capital providers. Banks will have the funds that are necessary for lending, because according to Islamic economics there would be a triangle or three way system where all participants are mutually beneficial or not beneficial from engaging themselves in projects. Those are 1) the bank, 2) the supplier of saving or funds, 3) the actual user of capital or the entrepreneur. Now, it is obvious that not only banks and entrepreneurs are exposed to risk but also the supplier of funds. After discussing the previous, one might come to the conclusion of what is the role of banks. Why don't we cut the middle man (banks) and maximize profits by having only a lender, borrower and a regulatory force in the form of a central bank. The lender would be a venture capitalist who is interested in profit sharing. But, the major argument in which Islamic economists see the need for banking services, is that banks can study applications of borrowers and, hence, extend credit, offer portfolio investment for lenders, and undertake foregone-trade services.

Islamic economics alternatives to the current system

Business financing in an Islamic economy would of necessity have to be equity-oriented where the financier shares the profit or loss of the business financed. Such financing would not only distribute equal returns between the financier and the entrepreneur, but will efficiently allocate risk. Equity financing in an Islamic ecomony may thus have to be of joint stock companies or shares in partnerships, or a definite (short, medium, or long) period as it is in the case of borrowed capital. Since borrowed capital would also be on the basis of profit and loss sharing and could not be interest-based, it would be in the nature of temporary equity financing and would mature on the expiry of the specified period. Such financing would hence not carry the same connotation as it does in the capitalist economies. It would, like equity, not enjoy any lien on the assets of the firm.

The liability to secure a lien on the assets of the businesses financed, possible in the case of interest-based lending, would make the financier more careful in evaluating the prospects of the business and cautious in providing the necessary financing. Moreover, it would be difficult to find medium or long-term financing in an Islamic economy without sharing the ownership and control of the business. Expansion of the business would hence be closely related to the distribution of ownership and control. Similarly it would not be possible for anyone to earn an income on savings without being willing to share the risks of business. Thus, we would see a more efficient allocation of risk in an Islamic economy.

As previously mentioned, an Islamic economy is an economy that always puts full employment as the first priority. Also, Islam is a religion which degrades and prohibits unwanted or unnecessary consumption. for both of these two reasons, one could say that consumption loans are not a big issue, but if a family or an individual found him or herself in need, there is always the Islamic tax on fixed assets (Zakat) to provide for any consumption or human need. Zakat is a 2.5% tax on fixed assets. It is paid annually to people in need. Zakat is a practice in which every Moslem who enjoys excess wealth must pay to fulfil the Islamic obligations.

The major objection to an interest-free economy is that, in the absence of interest, it would not be possible for the government to finance its budgetary deficits by borrowing from the private sector. Government budgetary deficit, is an important means of generating growth and improving living standards. How will the government budgetary deficits be financed after interest has been abolished?

Unfortunately, Moslem scholars have reached a conclusion, on government borrowing, which has a mixed signal, or in other words, not convincing. Moslem economists, feel that the government should work in a very efficient matter in terms of their spending. If there was a deficit situation, the government should resort to a contractual fiscal policy or borrow money from the central bank. But in terms of government borrowing, I have a different theory which came from past experience. Islam is a religion that always encourages Zakat and other types of spending by the private sector for poor people, institutions, and infrastructures. So that, in my opinion, may lessen or reduce the burden on government spending and hence solve for budgetary deficits. Islam seldom discusses spending as a government task, rather, Islam stresses that spending for increasing standard of living is a task that should be performed by the private sector.

Part V, Conclusion: Challenges facing Islamic Banks

Islamic banks certainly face many challengers today which are due to the fact that we live in an economy that is driven and manipulated by interest. The following is an illustration of the different challenges facing Islamic banking.

In a market economy, the banking sector is supported and regulated by the central bank. One could see this kind of support in terms of discount rates on loans given by the central bank to commercial banks in times of need. Also, the central bank to commercial banks in times of need. Also, the central bank regulates commercial banks, which will add to the health of those commercial banks. Unfortunately, Islamic banks in the region, do not enjoy such privileges. Because of the fact that most countries have a central bank which operates in a market economy, there is no support to Islamic banks. Islamic banks debunk the theory of interest and hence will not operate or do transactions with the central banks. This lack of support situates Islamic banks in an unenviable position. No one would want to save or invest in a bank that has no means of support or acts solely. This would hence create the problem of the lack in liquidity which is vital to a bank's existence.

Another hurdle, is the absence of liquidity instruments, such as bonds and other marketable securities, which could be utilized to either cover liquidity shortages or to manage excess liquidity. This problem is aggravated since many Islamic banks work under operational procedures different from those of the central banks; the resulting non-compatibility prevents the central banks from controlling or giving support to Islamic banks if a liquidity gap should occur.

The previous were the most important or serious challenges for an Islamic banking system. I think that these challenges and many others are a result of trying to build an Islamic banking system in economies and banks that operate and literally exist around interest. In my opinion, building Islamic banks in a market economy is an obvious failure. Islamic banks can survive only in a Christian, Jewish, or Islamic economy that abolishes interest.

Final comments & Perspectives

The idea of Islamic banking is certainly very interesting and a must in the case of the three holly-book religions. An interest free system could work and provide unlimited prosperity but certainly, absolutely, and undoubtedly it will not work under the current system. The whole economic system should be altered and changed in order for the Islamic framework to succeed.

There are several points in which Islamic scholars could be criticized. First, is their theory of risk. Islamic scholars and economists claim that the lender bares absolutely no risk. This fact could be proven wrong. In finance we constantly deal with risk calculation for the lender. For example, we use the Capital Asset Pricing Model (CAPM) to calculate the risk based on the two factors. 1)The risk free securities i.e. Government securities and 2)The market risk i.e. Beta. The formula is: K = K risk free + (K market - K risk free) Beta where K is the required rate of return. Also, there are risk calculations for small lenders by calculating the standard deviation of their investment which pays interest. There are also many kinds of calculations done by the lender for risk analyses. Although the previous risk calculations may be convincing in terms of the lender also claiming risk, the question is, how many times do lenders do not receive their principal + interest? I think nominal in this day and age.

Another thing that I am critical of is the new Islamic version of profit in Islamic banks (Murabahah) where if a person wants capital from a bank, the bank would buy it and a finance it for the entrepreneur at a predetermined profit margin. This kind of transaction is thought of lawful by Moslem economist because God has banned interest and allowed trade. In my opinion, this type of transaction only adds to the theory of unequal risk and inefficient allocation of risk because the lender of capital has claimed or decided the profit margin in which the entrepreneur would pay to obtain the necessary capital. I do not think that God meant this type of trade or transaction to be allowed in reference to the holly-book. Unfortunately, Islamic banks today take full advantage of their deliberate misunderstanding of fair trade and build on such a propaganda by advertising to the public that their way is the right and religious way, hence, attracting capital to their banks on the expense of the uneducated individual. Islamic banks in Kuwait charge profit margins that are extremely higher than interest rates in conventional banks and justifying it by their deliberate misunderstanding of religious guidelines.

There are also unsolved or not understood issues for example, why does a pre-determined cost of capital prevent full employment, how would the government borrow money, and how could we solve for global financial crisis. It is a possibility that no crisis or hardships would take place in an Islamic system, but the main point, is that it is impossible to see the Islamic system work as a sub-system to the current market economy, and we can not provide Islamic economic solutions under capitalism.

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Sweden tops new CAP transparency index

On the day when the European Court of Auditors has for the twelfth year running refused sign off the European Union’s annual budget because of concerns about fraud and poor controls, farmsubsidy.org is launching a new Common Agricultural Policy transparency index. The index is based on a comprehensive scorecard that rates all member states according to whether they have released data on who gets what from the EU’s Common Agricultural Policy (CAP). Sweden tops the index with a score of 95%, followed by Denmark (91%) and Slovenia (87%). So far twelve EU member states have released data to farmsubsidy.org.

Criticising poor controls in the EU budget, the Court of Auditors said that 'Beneficiaries — farmers, local authorities, project managers — claim more than they have the right to claim'. Most of the problems occur with payments made by member states not by Brussels, because 76% of EU payments are delegated to member states.

Jack Thurston, co-founder of farmsubsidy.org said:

'Transparency is a guard against fraud and maladministration and a way of reconnecting citizens with their governments. Transparency leads to more legimate and effective policy-making. We hope this scorecard will be used to praise the few EU member states who have embraced transparency and shame the many who continue to hide farm subsidies behind a veil of secrecy. All European citizens pay for farm subsidies, they should have a right to know who gets what - and why.'

Read the CAP Transparency Index report:
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