IV Summary and Conclusions

Abbas Mirakhor, and Zubair Iqbal
Published Date:
March 1987
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No attempt has been made in this paper to analyze an overall economic system based on Islamic principles. Instead, the paper has focused on the implications of the most salient features of an Islamic financial system, in particular, the absence of fixed interest rates.58 The central requirement of an Islamic financial system is the replacement of the rate of interest with the rate of return on real activities as a mechanism for allocating financial resources. While prohibiting interest, Islam permits profit sharing. A variety of modes of transactions have been devised to permit the financial system to function without resort to contracts based on fixed interest. Models of Islamic banking decompose the bulk of the liabilities of banks into demand and investment deposits. The nominal value of demand deposits is guaranteed by the banks, but the deposits earn no return. Investment deposits, on the other hand, share in the profits earned by the banks. On the asset side, the banks provide financing to agent-entrepreneurs on the basis of profit sharing with explicitly stated sharing rules specified beforehand; the most important forms of such financing arrangements are Mudarabah and Musharakah. As the sharing of risk and incentive is a fundamental premise of Islamic banking, models of this banking system provide for the accumulation by banks of loss-compensating balances in periods of high profit, as well as for deposit insurance, asset diversification, and monitoring of projects to reduce the risk borne by investment depositors.

Theoretical models of Islamic banking foresee no reduction in the effectiveness of monetary policy or of central banks in the performance of their traditional roles. With the exception of the discount rate, all other traditional tools of monetary policy would be available to the central bank.59 Moreover, these models propose manipulation of the ratios that determine profit sharing between banks and depositors, as well as between banks and the agent-entrepreneurs as an additional monetary policy tool at the disposal of the central bank. These models also foresee that, in an Islamic banking system, the central bank could invest directly in the real sector and so long as securities do not have par value features and represent real assets, the central bank would have the ability to buy and sell securities, that is, engage in open-market operations.

The Islamic banking system is, in principle, compatible with a close correspondence between financial and real rates of return and an efficient allocation of resources. Moreover, it could be adopted without harming the effectiveness of official supervision of financial intermediation. It is, however, recognized that the efficient working of such a financial system requires properly organized primary and secondary markets.

All Muslim countries practice Islamic banking to varying degrees and interest-free banks have been operating in some non-Muslim countries. Islamic banking, however, is intended to operate within a totally Islamic system. Hence, a distinction can be made between interest-free banking operating within systems that lack essential characteristics of an entirely Islamic system and Islamic banking as an organic part of such a system.

For analyzing the operation of Islamic banking in practice, this paper draws upon the experiences of the Islamic Republic of Iran and Pakistan, which have recently attempted to introduce Islamic banking on a comprehensive basis. Each has chosen a different path toward the achievement of its objective. Pakistan has chosen the route of gradual Islamization, that is, a step-by-step replacement of its present economic instruments and institutions with their Islamic counterparts, beginning with the banking system. The Islamic Republic of Iran, on the other hand, has chosen the path of a complete, once-and-for-all transformation of the existing system into an Islamic one. Its experience with implementation of full Islamic banking has been shorter than that of Pakistan and has been constrained by enormous exogenous shocks to the economy. Even though it is far too soon to discern fully the impact of the adoption of the new system, the two countries’ experiences of the last few years appear to indicate that they have been able to replace the interest rate mechanism with non-interest-based modes of financial resource allocation without disrupting either the financial stability of the system or the effectiveness of monetary policy. There has been general acceptance of the new modes of financing and deposit instruments. Private sector deposits have continued to rise despite a shift from fixed interest to variable rates of return on deposits. Progress on the development of non-interest-based modes of financing, however, has been slower owing mainly to the need for changes in banks’ procedures and delays in the acquisition of new skills required for applying such modes; removal of these constraints is crucial to the further development of the financial system.

The implementation of the new system has been cautious and attempts have been made to avoid unnecessary disruptions in the orderly operation of the banking system. There has been some deregulation of the banking system, insofar as rates of return and charges on lending within broad ranges are to be determined according to certain objective criteria rather than by the monetary authorities. When diversified non-interest-based modes of financing become available, the capacity to influence credit creation and its allocation is likely to increase to the extent that the monetary authorities can alter profit-sharing ratios. Owing to the deviation of the requirements of an Islamic banking framework from the existing institutional and legal structures, the Islamic Republic of Iran and Pakistan have encountered, or are likely to encounter, difficulties in the effective implementation of the new banking system. Although many of their problems are different, they do share a set of common problems that have been investigated in this paper. These include concentration on short-term assets, difficulties in the acceptance of instruments based on the principle of profit-and-loss sharing rather than on a fixed rate of return, possible disintermediation for small-scale business, and difficulty in devising appropriate non-interest-based instruments for financing the government budget.

There are three important sources of these problems: (a) the lack of a legal framework that unambiguously specifies the domain and limitations of property rights and of contracts in accordance with an Islamic banking system; (b) the difficulty in devising non-interest-based sources for financing government deficits; and (c) the lack of adequate financial infrastructure, including trained banking staff, and more generally the means for dealing with higher information and transaction costs to both depositors and banks.60 The existence of these constraints can create acute uncertainties reducing the scope of long-term investment financing and leading to a further strengthening of the observed concentration of the portfolio of the banking system in short-term assets. At stake is stimulation and maintenance of a flow of financial intermediation high enough to support a rate of long-term fixed capital formation that fully exploits available social rates of return to long-term investment. Moreover, since both economies are characterized by market and informational imperfections, further persistence of these problems will increase the cost of information gathering, monitoring, and auditing for the banks. These higher operating costs require a larger spread between rates of return to the banks and to their depositors, thus undermining the full implementation of Islamic banking through a process of disintermediation away from the banking system and strengthening of the parallel markets. Moreover, business attitudes would have to change to allow for a transition toward investment-oriented financing, which is the ultimate objective of the Islamic system. Finally, distortions underlying the existence of large fiscal deficits would have to be corrected. Fixed-rate charges (e.g., interest paid by the government debt), while having no relationship to the productivity of expenditures financed by borrowed funds, would act as a floor for bank charges on other financing operations. Therefore, appropriate expenditure policies and tax rationalization would be needed to establish a closer relationship between rates of return and charges and thus promote a movement toward the acceptance of profit-and-loss sharing, which is essential for the growth of long-term financing by commercial banks.

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