III Major Issues of Transition to Islamic Banking
- Abbas Mirakhor, and Zubair Iqbal
- Published Date:
- March 1987
Islamic banking is an integral part of a functioning Islamic economic system, but the Islamic economic system is only a part of an Islamic social system that possesses well-identified characteristics based on Islamic law. The criterion by which an economic system claiming to be Islamic can be measured is the extent to which Islamic law has been implemented and embraced by that society. For a society to adopt and implement an Islamic banking system, all members must be willing to accept it. Each will be required to internalize the Islamic value system, including honesty in business dealings, faithfulness to contracts, and the duty of sharing with others. The implementation of such a system requires considerable time, effort, and discipline on the part of all segments of the society, particularly when the society is accustomed to carrying out its day-to-day affairs on the basis of a value system that to a great degree cannot accommodate Islamic values. Herein lies the primary constraint on effectively implementing Islamic banking.
Transitional Issues in the Islamic Republic of Iran and in Pakistan
Notwithstanding different approaches to the Islamization process, the Islamic Republic of Iran and Pakistan have encountered a number of common problems. The authorities in the two countries are cognizant of these issues. For example, in both countries, bank lending has so far been concentrated on short-term trade financing rather than a shift toward PLS-type assets—contrary to the intentions underlying the establishment of the new system. Similarly, owing to problems in devising appropriate modes of financing budgetary deficits that would be consistent with the Shari’a, government borrowing requirements had to be met effectively on an interest basis. At the bank level, difficulties have been encountered in lending to small-scale enterprises, owing to increases in perceived risks; consequently, the distribution of credit tends to be skewed in favor of large-scale enterprises. Moreover, there has been a slower adjustment to new modes of financing than to those of deposits, in part owing to the fact that adjustments to new lending procedures and the requisite training of staff are time-consuming. Therefore, the cost of banking may have gone up. Bankers have also felt that there are insufficient instruments available in the market for asset diversification at present.
Apart from these common issues, effective implementation of the new system in the two countries may have been constrained by particular economic and legal environments. For example, in Pakistan the absence of precise legal definitions of various modes of financing is likely to influence the future evolution of the system. Similarly, the dispute settlement system will have to be closely watched to ensure the rights of banks and borrowers and to avoid defaults. Some banks also view the formula determining profit-sharing ratios for depositors as arbitrary, which could destabilize the movement of deposits between banks. There is also a need for more financing instruments to take care of the diverse needs of the private sector. In the Islamic Republic of Iran, the buildup of excess liquidity in the banking system has probably been caused by difficulty in quickly adjusting to the new modes of financing and in lending to the small-scale sector. So far, returns on deposits and profit-sharing ratios have been determined exogenously. Decisions with respect to rates of return have been guided by a desire to ensure adequate rewards to savers. The absence of a law explicitly defining property rights may also complicate the process of transition.
As indicated earlier, bank assets in both countries are concentrated primarily in a few short-term and trade-financing instruments, such as markup, installment sales, and short-term partnerships, rather than PLS-oriented transactions. Apart from being inconsistent with the objectives of the Islamization process, the heavy concentration in a few assets might adversely affect the stability of banks’ asset portfolios and increase risk.
Several factors have been instrumental in this development. First, the short-term modes of financing are more akin to interest-based banking, thus requiring minimal modifications of the old lending procedures. Second, as in most developing countries, the basis for lending continues to be the bankers’ knowledge of the client and his creditworthiness rather than the profitability of the project; banks do not have a high degree of expertise in the evaluation of project financing.54 The inability to evaluate the profitability of projects has tended to militate against investment-type lending, and persistence of this situation may retard the development process. Third, borrowers have not yet fully reconciled themselves to the changed environment. Their immediate concern has been to ensure that the cost of credit does not increase; short-term lending operations, such as markup, installment sales, lease-purchase, and the short-term Mudarabah, permit them and the banks to ensure this. Moreover, borrowers have been reluctant to agree to the sharing of information about their business with banks; yet this is an inevitable prerequisite for longer-term and investment-oriented financing operations. Fourth, short-comings in business ethics make it difficult to establish closer bank-client relationships—a precondition for successful Islamic banking. For example, clients either do not keep adequate records or keep fraudulent records of their operations. Until such time that business ethics improve and the banks develop sufficient capability to monitor and audit enterprises, such that they are assured of the accuracy of the reports on business activities, they will be reluctant to take equity positions in enterprises.
Finally, and most important, particularly in Pakistan, the perception of “unfair” taxation, and the consequent tax evasion, has tended to exacerbate the problem of business ethics, thus making it even more difficult for banks to participate in modes of lending other than short-term trade financing. In order to evade taxation, businesses are believed to underreport the size of their operations and income. Under these circumstances, they are unlikely to be honest with their financiers, thus discouraging investment-type lending operations. In the Islamic Republic of Iran, the general economic slowdown and uncertainty regarding medium-term prospects have also encouraged a concentration in short-term assets.
Institutional structures are also not fully developed to facilitate the growth of investment-type lending. In particular, the private capital markets in the two countries have neither the depth nor the breadth to accommodate transactions in such instruments on a large scale.
Devising means and instruments for financing the budget deficit without violating the prohibition of interest is proving difficult, but resolution of this problem is central to a further evolution of the Islamic banking system, since the government accounts for a major component of demand for credit. In the case of the Islamic Republic of Iran, it has been decreed that financial transactions between and among the elements of the public sector, including Bank Markazi and commercial banks that are wholly nationalized, can take place on the basis of a fixed rate of return; such a fixed return is not viewed as interest. Therefore, the Government can borrow from the nationalized banking system without violating the injunctions of the Law. While no preferential rates are charged on lending to the Government in Pakistan, not all government financing is being handled through noninterest modes. To a large extent, this reflects the Government’s difficulty in raising additional revenues and containing expenditures. In addition, problems in devising non-interest-based instruments of financing have also been responsible for the emergence of this apparent conflict between fiscal policy objectives and the Islamization of the financial system. Continued borrowing on a fixed rate basis by the Government would inevitably index bank charges to this rate rather than to the actual profits of borrowing entities.
Lending to Small-Scale Enterprises
Given the comprehensive criteria to be followed in granting loans and monitoring their use by banks, small-scale enterprises have, in general, encountered greater difficulties in obtaining financing than their large-scale counterparts in the Islamic Republic of Iran. This has been particularly relevant for the construction and service sectors, which have a large share in the gross domestic product (GDP). The service sector is made up of many small producers for whom the banking sector has not been able to provide sufficient financing. Many of these small producers, who traditionally were able to obtain interest-based credit facilities on the basis of collateral, are now finding it difficult to raise funds for their operations. Although in the case of bankruptcy the lender can claim a share of the remaining assets of a failed company corresponding to the share of his investment in total capital, the commercial banks do face an element of moral hazard owing to the nonexistence of systematic bookkeeping in this sector. Additionally, the reluctance of small producers to submit their operations to bank audits and the perceived enormous cost of auditing and monitoring relative to the small size of potential credits makes banks unwilling to extend credit on the basis of the new modes of financing to these small producers. The reduced lending to small producers may also explain the existence of excess liquidity in the banking system.
Although the Law establishing interest-free banking in the Islamic Republic of Iran is comprehensive, the lack of a proper definition of property rights may have constrained bank lending. Thus far, there has been no precise legislative and legal expression of what is viewed as “lawful and conditional” private property rights.55 This may also have militated against investment lending in agricultural and industrial sectors and thus encouraged increased concentration of assets in short-term trade financing instruments.
In Pakistan, the new system has been introduced without fundamental changes in the existing laws governing contracts, mortgages, and pledges. Similarly, no laws have been introduced to define modes of participatory financing, that is, Musharakah and PTCs. It is presumed that wherever there is a conflict between the Islamic banking framework and the existing law, the latter will prevail. In essence, therefore, the relationship between the bank and the client, that of creditor and debtor, is left unchanged as specified by the existing law. This may be a useful solution to the short-term problems of transition, but an orderly evolution requires concordance between the law and the banking framework. The existing banking law was developed to protect mainly the credit transactions; its application to other modes of financing results in the treatment of those modes as credit transactions also. Banks doubt whether some contracts, though consistent with the Islamic banking framework, would be acceptable in the courts. Hence, incentives exist for default and abuse. The authorities recognize the potential problems arising out of this legal inconsistency and are keeping the issue under constant review so as to seek solutions when and if needed. By contrast, in the Islamic Republic of Iran all permissible financing modes are explicitly defined, the bank-client relationship is clear, and all contracts are legally enforceable.
Determination of Rates of Return and Charges
The rates of return on deposits and charges on financing operations in the Islamic Republic of Iran are at present determined exogenously, based on those prevailing prior to the introduction of the new system, which could lead to misallocation of resources. While each bank is, in principle, expected to announce rates of return on investment deposits based on its profits, so far uniform rates of return have been decreed for all banks, irrespective of their profit levels. This was intended to avoid a withdrawal of deposits and large-scale deposit migration among banks. Similarly, minimum and maximum rates of profit sharing applying to various modes of financing are, at present, fixed on the basis of rates of interest prevailing prior to the introduction of the new system; these rates may therefore be inconsistent with sectoral growth priorities and credit demand pressures. The authorities are aware of this problem.
In Pakistan, some commercial banks contend that the formula determining profit-sharing ratios between banks and depositors is arbitrary and may lead to destabilizing deposit flows between banks. The weighting system that determines returns to liabilities according to their maturity structure leads to higher rates of return from banks with a relatively larger share of equity. Foreign banks, which are characterized by a relatively higher share of equity in their liabilities, particularly have voiced these concerns. So far no such migration of deposits has been observed, but persistently higher returns in some banks, simply because of their maturity structure of liabilities, could be destabilizing.
Dispute Settlement Procedures
Guarantees for banks and dispute settlement procedures may also adversely affect the operation of the new system in Pakistan. Understandably, security of banks’ investments and depositors’ interest needs to be guaranteed in the transitional period, but such guarantees could be counterproductive. For example, in the event of losses under the PTC arrangement, the financial institution is protected by the fact that the borrowing entity sustaining losses must adjust them first against the reserves of the entity and only the remaining losses can be apportioned. Such a measure may be viewed as a deterrent against malpractice, but it may also be viewed by borrowers as unfair and aimed at protecting the financial institutions against all losses. Similarly, attachment of more than proportionate weights to banks in sharing profits under Musharakah arrangements may be viewed as inconsistent with equal treatment of partners in an enterprise. While such unequal treatment may be deemed as desirable in the transitionary period, it could become institutionalized, in which case it would be inimical to the growth of Musharakah in the future.
Apart from the establishment of 12 banking tribunals in Pakistan, which are required to resolve disputes relating to delays in repayments under the markup mode of financing, the dispute settlement system has been left unchanged. While little is known about the experience of the tribunals in settling disputes and ensuring speedy repayments, their small number may inhibit timely decisions and thereby generate a premium on defaults. Hence, the success of the new system will hinge on the availability of legal recourse to the banks and borrowers as a safeguard against defaults and other abuses.
Sources of Problems and Suggested Solutions
There are three primary reasons for the difficulties faced by the two countries as enumerated above. They relate to the legal framework, fiscal policy objectives and instruments, and the inadequacy of financial infrastructure required to fully implement the system. Successful implementation of an Islamic banking system will, therefore, require correction of these inherent problems. Specific solutions would naturally be shaped by the institutional characteristics of each country.
Some of the problems faced by both the Islamic Republic of Iran and Pakistan stem from the lack of a well-defined legal system, specifying the domain and limitations of property rights and of contracts, that fully corresponds to the established banking system and the Islamic law. In both countries, this lack may have strengthened the environment of uncertainty, limited long-term investment, and forced the banking system to concentrate its asset portfolios in short-term transactions.
The problem appears in different forms in the two countries. In Pakistan, it has forced the Government to establish special banking tribunals to deal with contracts based on Islamic modes, since the regular court system, as well as existing contract and corporate laws, cannot handle Islamic-based contracts. This is a short-term remedy and the problem will continue to persist and become more complex until the legal system and the underlying corporate and contract laws have become more attuned to the legal requirements of the new banking system. In the Islamic Republic of Iran, where the legal system is fundamentally based on Islamic law, the difficulty lies in the absence of a legislative definition of the rights and limitations of private property which would explicitly determine the extent and intensity of the private enterprise activities in the economy. Although the existing banking regulations require that all banks must make it clear to all their customers that all contracts mutually agreed to by both parties are presentable to the courts as legal documents, lack of a clear and legislatively sanctioned definition of rights and limitations of private property has induced a reluctance on the part of both the entrepreneurs and the banking system to engage in long-term and Islamic-based profit-sharing project activities. Hence, there is a need for a law explicitly defining the property rights of individuals.
Government Deficit Financing
Another problem and one that up till now has proved to be quite intractable has been the inability to formulate non-interest-based instruments for financing budget deficits; thus the government, which is the major exponent of the implementation of the Islamic system, is forced to raise funds through borrowing on the basis of a fixed rate of return. Islam requires an efficient and responsible fiscal policy under which the government can justify and rationalize all its expenditures. Under such a fiscal policy, there is a clear distinction between a government’s general expenditure and its “welfare” expenditure. The welfare expenditure is to be financed through mandatory levies imposed on income and wealth of the individual members of the society, based on the Islamic law. If the resources raised in this manner are deemed insufficient, the state is empowered to meet the resource gap through additional taxes. The revenues needed for the undertaking of general expenditures are to be raised through the management and operation of the society’s resources that the Islamic law has placed at the disposal of the state, for example, underground mineral resources. Writers on the Islamic fiscal system are of the opinion that if the government were to conduct its affairs strictly in accordance with Islamic prescriptions, if ordinances regarding the duty of sharing were to be strictly observed, and if inefficiency and waste were to be eliminated from government expenditures, then such a government would carry not only a much smaller fiscal burden than at present, but would also have to justify all expenditures. If it is still necessary for governments to finance deficits from borrowing, the question becomes one of devising proper non-interest-based instruments that can be used to raise the necessary funds.
Much thought has been given to the idea of devising instruments that would allow government borrowing on the basis of a nonfixed rate of return. Briefly, these suggestions include (a) permitting the central bank to make available to the government a portion of demand deposits on a noninterest basis; (b) removing the fixed rate of return on government borrowing by providing a variable rate of return tied to the rate of growth of the nominal GDP; (c) creating a mutual fund pool out of a class of government-financed projects and using their average rate of return as a basis of reward to the lenders; (d) floating nominal-value-indexed bonds adjusted to various indices, such as the value of the U.S. dollar, gold, SDR, or some other index; and (e) issuing bonds for investors in higher income brackets with large tax liabilities and borrowing that money at the cost of a tax; that is, the lender would not be taxed for income invested in these bonds if they are held for a specific period of time. This last measure may not only solve the problem of borrowing at no interest but may also help shrink the size of the informal market. The bonds could be transacted in the market place.56
Whereas the question of proper procedure and instruments needed to finance government borrowing is crucial, the more fundamental problem is the structure of taxes and their rationalization. The problem is particularly acute in Pakistan, where tax evasion has motivated businessmen to maintain multiple account books and to not disclose their true profits. In turn, banks have become reluctant and less likely to take risks when undertaking projects on a profit-sharing basis. Thus, the problems of moral hazard and of monitoring, which tend to be a characteristic of principal-agent type contracts epitomized by Islamic- based and profit-sharing arrangements, are made even more complex with these additional constraints.57 The authorities in Pakistan, aware of the need for tax reforms and its beneficial effects on the Islamization process, have established a Taxation Reform Commission to pursue this matter.
The economic consequence of the moral hazard problem is potentially serious in that (a) it can lead to allocation of credit and of financial resources away from long-term investment projects and toward short-term trade-financing arrangements; (b) it can lead to financial disintermediation away from the banking system and to the growth of informal financial markets, particularly when the service sector is a major contributor to GDP; and (c) it strengthens and perpetuates the existing bias of the banking system toward large enterprises and against small and indigenous entrepreneurs. If the financial needs of small businesses are not accommodated by the banking system, they will be forced to seek sources of financing in the informal sector. This will not only perpetuate interest-based financing in the private sector but may also weaken the effectiveness of monetary policy. The remedy, besides tax rationalization, provision of the necessary legal framework, and the removal of incentives for tax evasion, is an improved monitoring and auditing system, which can be undertaken only at heavy initial cost. This can be effected by setting up banking and financial institutions, perhaps in the form of subsidiaries to the existing commercial banks, which can specialize in the provision of credit and financing to the service sector and small business. Such institutions, whose operations may need to be subsidized initially, can then concentrate on dealing with the particular problems of these sectors. This action would need to be concomitantly supplemented by legislative action, which would provide sanctions against financial transactions on an interest basis in the private sector to guard against the growth of the informal sector and financial disintermediation.
The problem of infrastructure has a general and a specific dimension. Its general dimension relates to the lack of familiarity of businessmen and entrepreneurs with the requisites of Islamic business ethics that, in turn, emanates from their lack of knowledge regarding Islamic ethical rules. Its specific dimension relates to the long-standing problem of inadequate education and training on the part of the staff and personnel within the banking system. Even though the latter problem is formidable by itself, the former is by far the more difficult and complex, and requires an enormous amount of time and effort to overcome. The authorities believe that the inculcation of Islamic business ethics in market participants will take considerable time, but it is clear that without the internalization of the rules and norms of economic behavior that Islam requires, the intervention in, and guidance of, the economy by the state will be extensive.
The specific dimension of the problem and the extent of the necessary commitment to its solution has been recognized by the authorities in both countries. To carry out detailed project appraisals and to monitor these projects when undertaken, the banking personnel must not only have a high degree of expertise in banking and finance, they must also be familiar with various modes of Islamic financial transactions and their requirements. It is likely that, for a considerable period during the transition, banking personnel will have to play a major role in informing and educating their clients in the various modes of Islamic transactions and providing financing packages most suitable to their clients’ needs. At the present, the major share of the burden of this training has been carried out in-house by the banks in both Pakistan and the Islamic Republic of Iran. In the latter, Bank Markazi undertook the initial phase of the training of banking personnel in Islamic modes of finance and, through the combined efforts of Bank Markazi, commercial banks, and specialized banks, almost one third of the personnel have been trained and the training of the rest is continuing. The technical training in portfolio management and in project appraisal and monitoring has not been formally undertaken.
It is also important to undertake steps aimed at resolving technical difficulties in developing and putting into operation new instruments, so as to facilitate a more diversified approach toward asset-portfolio management for the banks. These instruments should cover all maturities and be marketable enough so that the problem of excess liquidity and asset management is resolved.