What is the economic evil of interest? Most will agree that it is distributive injustice. Let us see whether Islamic banks do anything different from an economic standpoint before we delve deeper on discussing the Islamic Fiqh basis of current Islamic finance practices.
In Pakistan, Islamic institution's banking spread is 8.80 percent as compared with 6.90 percent for the overall industry. So, on average, Islamic banks are costlier than conventional banks. Financing the same asset, a customer pays more to an Islamic bank than to a conventional bank. Also, on average, they share lesser profits with their depositors as evidenced by higher banking spreads. Reportedly, Islamic banks finance a limited number of small and medium enterprises. Islamic banks have not fully ventured into microfinance.
Islamic injunctions require that Islamic banks should take market risk. But, unilateral undertaking, which is legally binding as well, enables the bank to completely avoid the price and market risk in Islamic banking. The bank locks the price and by way of unilateral undertaking, which is legally enforceable, it also binds the customer, and this is all done before the bank even thinks about purchasing the asset, let alone having an inventory of tradable assets.
Fact of the matter is that a bank does not commit a single penny unless it has taken a unilateral undertaking from the customer, and through this, the bank gets the customer to agree to the quoted rentals or markup price (calculated from the same present value of the annuity formula).
If the customer does not give that undertaking, his request for finance is not accepted and processed further. The question is: what does that undertaking include? By way of this undertaking, the customer is forced to buy the asset from the bank and agree to a particular price stated in the payment schedule. That payment schedule calculates the markup price using the same present value of the annuity formula and while amortizing the particular cost for the bank, it includes all the costs, like insurance cost, etc. As a matter of fact, all ownership related costs are also paid indirectly by the customer through transfer pricing and the payment schedule represents a higher price for a higher time to maturity i.e. the more delayed the payment, the more will be the price.
Islamic scholars have explained at length how this is permissible.
The question that I am trying to raise here is that where does the Islamic bank take on risk? By monetizing its funds using asset backed financing provisions, the Islamic bank all of a sudden becomes a seller of every Halal type of asset without bearing any market/price risk and without managing and keeping any sort of an inventory or warehouse. An Islamic bank becomes the seller of millions of Halal goods, from laptops to refrigerators to caterpillar equipments; it can sell them all to you. Is doing business that easy? No, but the business of banking is.
If it is the seller of all different types of goods, why not buy everything from the bank? Some of us may think it will be cheaper as well. Let us see what happens if we lease a car from an Islamic bank. The rent will be more if we were to lease it for a short period of time than for a longer one. Why is that so?
An Islamic bank basically amortizes all its costs through rentals. It is acting as a financial broker looking to amortize an investment made in the form of an advance. For the same asset or property, the bank will charge higher rentals for a short-term lease and a lower one for a long-term lease. It is because bank is willing to amortize all costs and simply be acting as a financial broker.
Being financial intermediaries, Islamic banks are using the same benchmark for pricing. They are already not charged GST on their sale of assets to clients in the second leg of a transaction as the government regards an Islamic bank not as a trading house but as a financial intermediary. In Pakistan, Islamic banks are maintaining the highest banking spreads in the world's major countries, which basically creates that lack of comfort about the rationale for the prohibition of interest.
Most definitely, between trade for profit and lending for interest exists a sea in between. They are different from all perspectives: legal, economic, social and even when it comes to psychological implications and effects. But, when Islamic banks use the concept of trade and lease, they use it in such a specific way that many questions arise about the substance behind these transactions. Indeed, as this article argues, it seems that Islamic banks do not, in a practical sense, take on market/price risk meaningfully.
It is very important to appreciate that the Arab practices from which some scholars have tried to gain the legitimate basis of Murabaha Muajjal did not involve any financial intermediary doing the transactions. If a trader sells on cash as well as on credit and has been in the business taking on price and market risk of the business in its normal course and charges a higher selling price in credit transactions, this still takes on all relevant risks required of him as a trader.
What an Islamic bank does is to take only this permissibility of charging higher price in credit transactions as a support for its operations, monetize the asset and purchase it only when the customer signs an undertaking which enables the bank to earn the level of profit which is not representative and reflective of average profits on the sale of such assets, but earn a level of profit which the conventional bank earns. This is ensured by making KIBOR/LIBOR as a benchmark and lamentably, this is not the end of the story. Since Pakistani Islamic banks' spreads are 8.80% and higher than the 6.90% for conventional banks, Islamic banks earn on average even more profits from their clients and share lesser with their depositors..
What I am questioning is the practice of Islamic banks and not the validity of trade and lease. I take 'Salam' and 'Istisna' for further clarification of my viewpoint. Salam is the exceptional sale that Prophet Muhammad (pbuh) Himself allowed. This is mentioned in authentic Ahadith and there is a common agreement on this.
But, let us analyze how the Salam and Istisna are practiced in Islamic banking nowadays.
In Salam, and before paying the Salam price, if a unilateral undertaking is taken from a third party for a parallel Salam or Istisna, and if the client is made the agent (sometimes a guarantee is also taken from him to provide surety that the third party will provide payment on time in a credit sale of Istisna commodity), where is it that the Islamic bank is taking on the business risk?
Usually, in all types of sale and lease contracts, the goods do not remain in bank's physical possession at its own premises. They remain with the client who holds them as an agent of the bank. But, the bank locks the price and obtains a unilateral undertaking from the client by which the client becomes obliged to purchase the asset at the stipulated price. Through the stipulated price, the bank is able to amortize all its cost to earn profits which exceed the interest usually earned by conventional banks.
Islamic banks usually provide finance to blue chip companies. Their negligence to provide finance to Small & Medium Enterprises and philosophy to copy conventional finance products and Islamize them is also highlighted by the central bank in Pakistan. While maintaining the highest banking spreads (at 8.80%) among the major countries of the world, all economic arguments in favor of Islamic banking are also equally supportive to conventional banking. The asset-backed financing provision is used in monetizing assets and because of it, Islamic banks have no provision to finance health, the consumption needs of the poor and businesses in distress which do not have a need to purchase assets. Apart from the exorbitant banking spreads, Islamic banks in Pakistan also maintain the lowest advances to deposit ratios. This all means inefficiency.
About the Author
Salman Ahmed Shaikh is a researcher in Islamic Economics. He is author of "Proposal for a New Economic Framework Based on Islamic Principles". He has also written 20 papers and more than 60 articles on Islamic Economics. He can be contacted at salmanahmed_hyd@hotmail.com
© Business Islamica 2012
