Information about Middle East Oriente Medio

I Theoretical Considerations

Abbas Mirakhor, and Zubair Iqbal
Published Date:
March 1987
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Increasing interest has recently been shown in the functioning of an Islamic banking system, particularly the implications of the absence of the interest rate mechanism for the economy and the operation of the financial sector. In all Muslim countries, Islamic banking has been practiced to varying degrees. In some, special banks operate on a noninterest basis; in others, the entire financial system is based on Islamic principles. This paper describes certain salient features of an Islamic banking system and analyzes the experiences of the Islamic Republic of Iran and Pakistan, two countries that have recently taken steps to bring their banking systems in closer concordance with Islamic principles. No attempt is made to present a comprehensive analysis of all aspects of an Islamic financial system and its relationship with a traditional system based on predetermined interest rates.

The paper is divided into four sections. Section I describes some theoretical aspects of an Islamic financial and banking system. Section II reviews the implementation of the new system in the Islamic Republic of Iran and in Pakistan; Section III identifies certain problems that have hindered or could hinder the effective implementation of the new system; and Section IV summarizes the analysis and conclusions of the paper. The Appendix reproduces laws and regulations governing Islamic banking in the two countries.

Islam possesses its own paradigm of economic relations within the context of an entire Islamic system based on injunctions and norms, derived from the Quran and Sunna (the actions and sayings of the Prophet), called the Shari’a. The Shari’a specifies, inter alia, rules that relate to the allocation of resources, property rights, production and consumption, the workings of markets, and the distribution of income and wealth. Similarly, rules and requirements have been specified that define the framework within which the monetary and banking system can operate. The core of this framework is that, as a mechanism for allocating financial resources, the rate of interest is replaced with the rate of return on real activities. To this end a variety of methods and instruments, based on risk- and profit-sharing, are suggested to satisfy the requirements of such a system.

The Shari’a provides a blueprint of how a society is to be organized and the affairs of its members conducted. Except for a brief time at the inception of Islam, it has never been applied in its entirety. Consequently, analysis of an Islamic economic system, its implementation in present-day economies, and its economic consequences are still relatively undeveloped. In partial analyses undertaken thus far, the idea of a banking system operating on a noninterest basis—as the most visible characteristic of an Islamic economic system—has received the greatest amount of attention.

Although the absence of interest is a central characteristic of an Islamic financial system, it is by no means its only characteristic. Without interest, questions arise as to how the system is to be implemented, how it will function, and what will be its economic implications. In what follows, possible answers are provided to some of these questions.

Explanation of Prohibition of Interest

In the Quran, the charging of interest is considered an injustice; this view has been the cornerstone of Muslim writers’ rationalizations of the prohibition of interest. The economic analysis underlying their arguments against charging a fixed interest, however, has, to a great extent, placed major emphasis on the alleged lack of a satisfactory theory of interest in the Western economic tradition.1 Muslim writers see the existing theories of interest as attempts to rationalize the existence of an institution that has become deeply entrenched 2 in modern economies and not as attempts to justify, based on modern economic analysis, why the money lender is entitled to a reward on the money he lends.3 For example, the notion that interest is a reward for saving does not in their view constitute a moral justification for interest, since such a justification only arises if savings are used for investment to create additional capital and wealth. When an individual saves, however, his saving may take the form of hoarding or purchasing a financial asset without a simultaneous increment in new investment. In the view of these analysts, the mere act of abstention from consumption should not entitle anyone to a reward.

Similarly, they argue that it is an error of modern theory to treat interest as the price of, or return for, capital. Money, they argue, is not capital, not even representative capital; it is only “potential capital” and requires the service of the entrepreneur to transform it into actual productive use; the lender has nothing to do with this conversion of money into capital and with using it productively.4

To the closely related notion that interest arises as an inevitable consequence of the difference between the values of capital goods today and a year hence, Muslim writers argue that the so-called pure rate (or own rate) of interest, resulting from the time factor in valuation, may never enter into the calculation of the suppliers of funds and it seldom, if ever, is paid as such. When forced into a position of identifying the pure rate of interest, the theorists always refer to the rates of return on “riskless assets” such as those paid on high quality government securities or the rate of return on debentures of highly successful corporations. But this is a rate of interest on debt, not a rate of return on capital assets. In the case of most successful companies’ debentures, the rates of interest are determined on the basis of the long-term success of these businesses, and if these corporations face difficulties and their profits decline, the “pure rate” ceases to prevail because their debentures are no longer considered “riskless.” Hence the pure rate of interest is only a theoretical construct that does not correspond to the actual return on capital assets. Even if the basis for time preference is the expected difference between the value of commodities this year and next, these writers argue, it seems more reasonable to allow next year’s economic conditions to determine the extent of the reward.

They maintain that when a person lends money, the funds are either used to create a debt or an asset (i.e., through investment). In the first case, Islam considers that there is no justifiable reason why the lender should receive a return simply through the act of lending per se. Nor is there a justification, either from the point of view of the smooth functioning of the economy or of any tenable scheme of social justice, for the state to attempt to enforce an unconditional promise of interest payment regardless of the use made of the borrowed money. If, on the other hand, the money is used to create additional capital wealth, the question is raised as to why the lender should be entitled only to a small fraction (represented by interest rate) of the exchange value of the utility created from the use made of the funds; the lender should be remunerated to the extent of the involvement of his financial capital in creating the incremental wealth.

Islam, Muslim writers argue, does not object to, in fact it encourages, true profit as a return to entrepreneurial effort and to financial capital. Only the identification of money with capital and the justice of interest as a reward for the mere act of refraining from consumption is denied. The lender who advances money for trade and production can contract to receive a share of the profit, because he becomes part-owner of capital and shares in the risk of the enterprise. He is a partner in the enterprise and not a creditor. There is a fundamental difference between an ordinary share-holder and a creditor. The shareholder is one of the proprietors of the enterprise, liable for its debts to the extent of his investment, and receives a dividend only when a profit is earned. The creditor, as a debenture holder, lends money without the risk of owning and operating capital goods and claims interest regardless of the profit or loss position of the enterprise; a risk is run by the creditor, but it is one of solvency of the borrower, not of success or failure of the enterprise.

Islam permits a wide freedom of contract, assuming that the terms of the contract are not in violation of the precepts of the Shari’a; in particular, it permits any arrangement based on the consent of the parties involved so long as the shares of each are contingent upon uncertain gains. This aspect of the arrangement is crucial, since the Shari’a condemns even a guarantee by the working partner to restore the invested capital intact, not only because it removes the element of uncertainty needed to legitimize the agreed distribution of possible profits, but also because the lender will not be remunerated to the extent of the productivity of his financial capital in the resulting profit.

The law prohibiting interest may perhaps be clarified by considering Islam’s position on individual property rights and obligations and its concept of economic justice. Islam recognizes two types of individual claims to property: (a) property that is a result of the combination of individuals’ creative labor and natural resources, and (b) property whose title has been transferred by its owner as a result of exchange, remittance of rights of others in the owner’s property, outright beneficent grants by the owner to those in need, and finally, inheritance. Money represents the monetized claim of its owner to property rights created by assets obtained through either (a) or (b). Lending money, in effect, is a transfer of this right, and all that can be claimed in return is its equivalent and not more. Funds lent are used either productively, in that they create additional wealth, or unproductively, in that they do not lead to creation of incremental wealth by the borrower. In the first case, when the funds are used in combination with the creative labor of the entrepreneur to create additional wealth, the lender may bargain for a portion of this incremental wealth but not for a fixed return, irrespective of the outcome of the enterprise.5 In the second case, since no additional wealth, property, or asset is created by the borrower, the money lent—even if it is legitimately acquired—cannot claim any additional property rights, since none is created.

Permissible Forms of Transactions

In disallowing interest and permitting profits, the Shari’a has developed two specific forms of business arrangements, Mudarabah and Musharakah, as means of earning profit without charging interest. In Mudarabah, one party provides the necessary financial capital, and the other supplies the human capital needed for successful performance of the economic activity undertaken. Mudarabah traditionally has been applied to commercial activities of short duration. Musharakah, on the other hand, is a form of business arrangement in which a number of partners pool their financial capital to undertake a commercial-industrial enterprise. Musharakah is applicable to production or commercial activities of longer duration. These profit-sharing arrangements may be applied either to the whole enterprise, where each partner takes an equity position, or to a particular line of activity within an enterprise; that is, they can have either whole-firm or project-specific orientation.6

Projects for funding through partnerships are expected to be selected primarily on the basis of their anticipated profitability rather than the creditworthiness or solvency of the borrower. This factor, along with the predominance of equity markets and the absence of debt markets, has led to the general conclusion that in an Islamic system there is potential for (a) more varied and numerous investment projects for which financing is sought; (b) more cautious, selective, and perhaps more efficient project selection by the suppliers of funds; and (c) greater involvement of the public in investment and entrepreneurial activities, particularly as private equity markets develop, than in the traditional fixed-interest-based system.

In the Islamic profit-sharing arrangement, while the profit is shared between the agent-entrepreneur and the owner of financial capital based on a predetermined share parameter, the financial loss is borne only by the owners of the funds and not the entrepreneur. Since human capital (as representative of present work and effort) in this arrangement shares equal status with financial capital (as representative of monetized past labor and work), the agent-entrepreneur loses his time, effort, and labor, but nothing more.

Recognizing that partnership may not be applicable in all circumstances, the Shari’a has specified other modes of permissible transactions. These modes are discussed in detail in Section II.

The Banking System

In an Islamic system, banks, although constrained by the rules of the Shari’a, essentially perform the same functions as those in a conventional system; that is, they act as administrators of the economy’s payments system and as financial intermediaries. They are needed in both systems for the same reason—for the exploitation of imperfections in financial markets.7 These imperfections include imperfect divisibility of financial claims, imperfect information, transaction costs of search and acquisition, diversification by the surplus and deficit units, and existence of expertise and economies of scale in monitoring transactions. Financial intermediaries in an Islamic system can reasonably be expected to exhibit economies of scale with respect to these costs, as do their counterparts in a conventional system. Just as in the latter system, the Islamic depository financial intermediaries transform the liabilities of business into a variety of obligations to suit the tastes and circumstances of the surplus units.

Prohibition of interest and the fact that the banks have to rely primarily on profit sharing leads to a major difference between the two systems: Islamic banks have to offer their asset portfolios of primary securities in the form of risky open-ended “mutual fund” type packages for sale to investor-depositors, while banks in a conventional system keep title to the asset portfolios they originate. Banks fund these assets by issuing deposit contracts, a practice that results in solvency and liquidity risks, because the asset portfolios entail risky payoffs and costs of liquidation prior to maturity, while deposit contracts are liabilities that are often putable instantaneously at par.

In an Islamic system, because the return to banks’ liabilities is a direct function of the return to their asset portfolios and because the assets are created in response to investment opportunities in the real sector, the return to the lender is removed from the cost side of a company’s income and expenditure statement. It becomes instead an allocation of profit and thus allows the rate of return to financing to be determined by the productivity in the real sector.

Muslim scholars and economists have developed alternative models of a banking system within the framework of Islamic requirements. Based on a principle called the Two-Tier Mudarabah, the most widely accepted model integrates the asset and liability sides of the balance sheet.8 It envisages depositors entering into a contract with a banking firm to share the profits accruing to the bank’s business. The bank, on its asset side, enters into another contract with an agent-entrepreneur who is searching for investable funds and is agreeable to sharing the profit with the bank in accordance with a predetermined percentage stipulated in the contract. The bank’s earnings from all its activities are pooled and are then shared with its depositors and shareholders according to the terms of its contract with them. The profit earned by the depositors is thus a percentage of the total banking profits. According to this model, the banks are allowed to accept demand deposits that earn no profit and that may be subject to a service charge. This model, though requiring that current deposits must be paid on the demand of the depositors, operates on a fractional-reserve basis. It further stipulates that the bank is obligated to grant very short-term interest-free loans (Qard al-Hasanah) to the extent of a part of the total current deposits.9

In this model, the losses incurred as a result of investment activities by the banks would be reflected in the depreciation of the value of deposits. However, the probability of loss is minimized through diversification of the investment portfolios of the banks and careful project selection, monitoring, and control. The proponents of the model have suggested loss-compensating balances built up by the bank out of its earnings in good times and deposit insurance schemes launched in cooperation with the central banks as a means by which the probability of such losses could be reduced.10 In addition, and perhaps more important, the probability of losses by the depositors will be further reduced by banks having direct and indirect control on the behavior of the agent-entrepreneur through both explicit and implicit contracts. The banks can exert control through both the formal terms of their contract and through an implicit reward-punishment system by refusing further credit to or blacklisting the agent-entrepreneur. The nature of the contract permits the banks to focus their attention on the probability of default, expected rate of return, and promotion and control of the firms in which they invest.

Financial Markets

One difficulty that might arise in an Islamic financial system is that with the division of the liability side of the balance sheet of the banking system into investment deposits and demand deposits, wealth owners would channel only part of their savings into the accumulation of physical capital and the remainder would be allocated to the accumulation of idle balances. To be sure, the buildup of idle balances runs counter to the Islamic exhortation against the hoarding and accumulation of money (i.e., keeping money idle without corresponding transactions demand for it).11 Moreover, these balances not only cannot earn any return, but also, if kept for a full year, they become subject to a compulsory levy of 2.5 percent, thus imposing relatively high opportunity costs on idle balances.12 Nonetheless, since the alternative to idle balances is risk-bearing deposits, it may be worthwhile for the depositors to maintain a considerable portion of their savings in the form of either money or demand deposit balances.

Perhaps the most challenging issue in the implementation of an Islamic financial system is how to devise risky return-bearing instruments that can provide the investors a sufficient degree of liquidity, security, and profitability to encourage their being held. Proposals along this line rely on the development of instruments corresponding and parallel to the permissible forms of transactions. These include such instruments as Mudarabah and Musharakah certificates, short-term profit-sharing certificates, and leasing certificates.13 Additionally, proposals have been made for the development of specific instruments that may be issued by the central bank as well as by the government, particularly relating to its specific investment projects.14 Generally, any risk-bearing instrument reflecting a real asset and earning a variable rate of return tied to the performance of the asset is considered to be consistent with Islamic law.

Once appropriate instruments are designed, markets are required so that the instruments can be traded. For this reason, Muslim writers have pointed out the desirability of primary, secondary, and money markets.15 The existence of a secondary market is essential to a well-functioning primary market. All savers in an Islamic system, to some degree or another, have a liquidity preference, as in any other system. To the extent that savers can, if necessary, sell securities quickly and at low cost, they will be more willing to devote a higher portion of their savings to long-term instruments than they would otherwise. Since primary securities in the Islamic system are normally tied to particular projects and enterprises, there are various risks that must enter into the portfolio decisions of the investor. Therefore, creation of a secondary market will stimulate investment in such securities by giving investors the option to buy or sell at any time. Given that a proper securities underwriting function is performed by some institutions in the system (e.g., the banks), firms could directly raise the necessary funds for their investment projects within the stock market, thereby providing a second source of funding other than the banks.

Furthermore, to facilitate the provision of needed liquidity through financial intermediaries, an interbank money market is desirable.16 In a conventional interest-based system, financial institutions adjust their balance sheet positions through the money market, correcting for the imperfect synchronization between payments and receipts. The money market, in this case, is a source of temporary financing in which transactions are mainly short-run portfolio adjustments. In an Islamic financial system, a principal activity of money markets is the channeling of surplus funds of one financial institution into profit-sharing projects of another. Since banks in an Islamic system acquire assets within the constraints imposed by the structure of their liabilities, it is conceivable that some banks may, at times, have excess funds available but no assets—or no assets attractive enough in terms of their risk-return characteristics—on which they can take a position. At the same time, some banks may have insufficient financial resources to allow them to fund all available investment opportunities or have certain investment opportunities for which risk sharing with other banks is preferable. There should therefore be the opportunity for the development of a market for interbank funds.

Effects on Saving and Investment

Concerns have been expressed that the adoption of an Islamic financial system may lead to a reduction of saving and retardation of financial intermediation and development. Increased uncertainty in the rate of return is one argument that supports this assertion.17 The few studies that have considered the question have tended to compare the effects on saving of a fixed and certain rate of return with those of an uncertain rate of return, implicitly assuming the same mean rate of return with greater variability. The result, obviously, shows a reduction in saving. The conclusion, however, is far from obvious when both risk and return are allowed to vary.

The results of an analysis in which risk and return variability have both been taken into account depend on assumptions regarding the form of the utility function and its risk properties, for example, the degree and the extent of risk aversion, the degree to which the future is discounted,18 whether or not increased risk is compensated by higher return, and finally the income and substitution effects of increased uncertainty. It has been shown, for example, that when future noncapital income is subjected to risk, decreasing temporal risk aversion is a sufficient condition to increase uncertainty about future income and to decrease consumption and increase saving.19 With respect to capital income, the combined substitution and income effect of increased uncertainty is shown to be indeterminate.20 Other studies have shown that under reasonable assumptions, in the face of uncertainty, households will increase their saving as a precaution.21 Theoretical analysis has not, therefore, provided a clear-cut testable hypothesis in this regard, and it becomes an empirical question whether saving will increase or decrease in an Islamic system. It can, however, be reasonably expected that “a rational planner may make more provision for the future when the future becomes more uncertain.”22 There is no strong theoretical reason to believe that on balance savings will decline as a result of introducing an Islamic economic system.

This is the conclusion of Nadeem Ul Haque and Abbas Mirakhor in a recent theoretical study in which variations in riskiness, as well as in the rate of return, are taken into account.23 The study derives an unambiguous condition that must be satisfied if saving is to decline when both the risk and the rate of return are allowed to vary: the rate of return after the introduction of risk must not be higher than its level before the introduction of the risk. The paper equates the elimination of an interest rate with the removal of a risk-free asset from the investor’s portfolio. Using this interpretation it posits that if the decline-in-savings argument regards the move to an Islamic banking system equivalent to moving to a system where the only available assets are those representing risk-equity participation projects, then the conclusion of a decline in savings is unrealistically strong.24 Structural changes accompanying the adoption and implementation of an Islamic financial system may have positive effects on the rate of return.

For example, in a conventional system where a saver (investor) can choose from a range of assets (e.g., certificates of deposit, treasury bills, money market funds, blue chip stocks, future contracts, and options), a portfolio can be made to suit his needs—the more diversified the assets of the portfolio are, the lower will be the risk. Should the society decide to eliminate all risk-free assets, then the degree of risk in the portfolio will change so that the starting value on the risk spectrum will be positive. The portfolio owner may now wish to rediversify his assets and include more low-risk assets to replace the eliminated risk-free assets. Instead of lowering aggregate savings or investment, the elimination of risk-free assets may simply result in a rediversification of portfolios among the risk-bearing assets.25

Another recent study that analyzes investment in an interest-free economy concludes that investment likewise will not necessarily be reduced:

[T]he level of investment may actually increase under certain conditions. Intuitively, this . . . result seems plausible as the move to a profit-sharing system does away with the distinction between the entrepreneur and the lender. A fixed cost for capital is no longer required to be met as a part of the firm’s profit calculations. The marginal product of capital can therefore be taken up to the point where maximum profits are obtained without the constraint of meeting a fixed cost on capital. Both the owners of the firm and the lenders to it are now residual income earners.26

The development of a financial system in most developing countries is impeded by numerous difficulties, such as discrimination against small and indigenous entrepreneurs,27 shallow financial markets, and limited availability of asset choices for savers. The introduction of an Islamic financial system will not automatically eliminate these difficulties. Studies of the financial repression hypothesis have emphasized the need for a positive and relatively high rate of return to mobilize savings and to integrate financial markets. While the integration of financial markets should present no special difficulty in the Islamic system, provision of a positive high rate of return, although not requiring any arbitrary decision by the authorities to increase the nominal yield, necessitates efficient project selection and allocation of financial resources based primarily on the expected profitability of projects.28 If the existing bias against small entrepreneurs persists, financial resources will continue to flow to well-established and large entrepreneurs, financial markets will remain narrow, and asset choices will remain limited; under such circumstances, adoption of an Islamic financial system could be expected to have only limited success in promoting economic development.

Central Banking and Monetary Policy

The main task of central banking in an Islamic financial system is the provision of an institutional framework necessary for the smooth operation of financial markets in compliance with the rules of the Shari’a. The central bank would need to take the lead in promoting financial institutions, deposit and loan instruments, and a yield structure conducive to the efficient mobilization of savings and allocation of resources. In particular, the central bank has the task of fostering the development of primary, secondary, and money markets. As explained above, mere adoption of Islamic rules of finance will not necessarily create the impetus for financial and economic development where shallow financial markets and lack of attractive financial instruments limit financial intermediation.

Another function of the monetary authorities is the enforcement of Islamic regulations concerning contracts and property rights, as they apply to financial and capital markets.29 Such enforcement reduces the uncertainties that tend to discourage private investment and to encourage lending of funds on the basis of viability and profitability of investment projects rather than the solvency, creditworthiness, or collateral strength of entrepreneurs.30 Reduced uncertainty in the structure of contracts and property rights is desirable because prohibition of interest by itself creates a moral hazard problem embedded in principal-agent contracts; without a stronger legal framework, such contracts will involve an increase in the cost of monitoring investments and reduction in overall investment itself.31 In fact, one may venture the opinion that, if the Islamic rules regarding contracts and property rights are not enforced, the main risk of adopting an Islamic financial system, particularly in the initial stages, would not be lower saving but lower investment.

Muslim writers have stressed the need for policies to maintain the stability of the value of currency.32 They see monetary policy as playing an active role, not only in maintaining a stable value of the currency but also in promoting full employment and growth.33 These objectives would be fostered by monetary and credit policies conducted by the central bank.34 But much of the effectiveness of monetary policy in an Islamic economy will depend on which scheme for Islamic banking is adopted. Under a fractional reserve system, monetary policy would operate as under a conventional banking system, and the formulation of a financial policy package for stabilization purposes would be akin to the traditional stabilization programs typically supported by the Fund. In the model requiring a 100 percent reserve requirement, the effectiveness of monetary policy would be weakened, as the central bank would be unable to alter the reserve requirements. To that extent, stabilization targets would have to be realized through control of the monetary base rather than credit.35

Moral suasion would in any event remain an instrument of policy to be exercised by the central bank. Moreover, the suggestion has been made that the central bank can regulate the ratios for profit sharing between banks and enterprises on the one hand and between banks and their depositors on the other. While the adoption of this policy instrument would undoubtedly strengthen the control of the monetary authorities over the volume of credit creation, it would affect resource allocation and put limitations on the freedom of contracts and on the sharing of losses by partners (as stipulated in the Shari’a).36 Problems of distributional equity may also arise if the profit-sharing rules imposed by the central bank require a lower proportional share in profits than the prescribed share in losses.

The usual regulatory, supervisory, and control functions of the central bank with regard to the banking system could be expected to be continued and rein-forced in an Islamic financial system. A further opportunity for enhancement of the control of the banking system is available to the central bank through its purchase of equity shares, not only of the banks but also of other financial institutions. This possible instrument, together with those already discussed, should leave the central bank in a position to carry out its traditional leadership role in the financial system.

Summary and Issues

The implementation of an economy-wide Islamic banking system in which all types of fixed return on assets are excluded raises a number of issues. First, in the absence of interest rates, information costs will increase for those wishing to place funds in investment deposits. Depositors will have to evaluate the relative performances of various banks in order to decide where to invest, rather than simply placing their deposits in time and savings deposits with a known interest rate. Information costs can be reduced if secondary markets exist in which instruments such as investment deposit certificates issued by the banks can be traded.37

Second, since the alternative to holding money or demand deposits is risk-bearing investments, the individual’s liquidity preference can be expected to be strengthened and idle balances increased. Availability of non-interest-based instruments, as well as the existence of primary markets in which such instruments can be traded, can help offset a tendency for idle balances to accumulate.

A third issue relates to the asset side of the banking system. Absence of debt instruments, and the fact that the criterion of creditworthiness must be changed to place more emphasis on the viability and profitability of specific projects, places greater demands on a commercial bank’s project evaluation and appraisal and requires a procedural framework for processing, monitoring, supervising, and auditing various projects. Profit-sharing transactions require trained banking personnel experienced not only in project evaluation but also in Islamic modes of financial transactions. All these requirements tend to increase transaction costs of the banks. It remains an open question whether such costs can be compensated by more profitable investments being undertaken by banks under an Islamic system.

A fourth area relates to the legal system required to support an Islamic financial system. Unless a legal framework is developed to reduce the risk of moral hazard, a further problem could be created by banks being forced to concentrate their asset portfolios in short-term non-profit-sharing transactions, thus constraining capital accumulation.

A fifth issue relates to the way in which monetary policy is expected to operate in an Islamic system. Instruments of monetary policy that rely in any way on the rate of interest would not be available to the authorities. In economies where the discount rate has been used as an effective tool of monetary policy, the elimination of interest can lead to a weakening of the effectiveness of monetary policy unless suitable substitutes, such as variation in the profit-sharing ratio, are developed.

A sixth issue is that of government financing. To the extent that rates of return on government expenditures financed by borrowing cannot be determined, it may be difficult to devise non-interest-based financing to facilitate government borrowing. The implications of this issue with reference to the implementation of Islamic banking in the Islamic Republic of Iran and Pakistan are discussed below.

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