Issues in Islamic Banking by Prof. Dr. Muhammad Nejatullah Siddiqi is an enlightening work which sheds light on what were the important issues and challenges encountered by Islamic banking in early years. It can help to understand that have these issues been resolved overtime or have they been forgotten or overlooked.

It can also reveal that what are the outstanding issues now and whether they were also present then or not in the early years of Islamic banking.  

The author aptly discusses the issues in Islamic banking. In the early years of Islamic banking, there was much enthusiasm and expectations to come up with a holistic and distinctive Islamic financial system which can develop and grow on its own terms and principles and replace the existing financial system and institutions or at least significantly transform them.

The vibes in initial years were reluctant for a compromise over a dual banking system which eventually became an unwelcome reality. Regulators encouraged Islamic banking and paved its way to enter the financial system, but they remained apprehensive of giving it the center stage or the whole stage to carry out its vision. 

Part of the apprehension rose from the fact that Islamic banking had product structures to integrate into commercial banking, but the foundational work on solid and holistic replacement of current monetary system, monetary regime and central banking was lacking in the view of regulators.

Prof. Siddiqi writing in the early years provides the thoughts Muslim economists shared on how the central banking and monetary management could work. T-bills could be replaced by participation based sovereign instruments. Investment requirement to meet statutory liquidity ratios can be met through investment in these sovereign securities or in the shares of public enterprises.

Cash reserve ratio requirement can be replaced by Qard ratio. Allocation of current account deposits to interest free loans provision can enable inclusivity in Islamic banking which is lacking in interest based conventional system.

The author shows through mathematical model that profit sharing ratio could replace the interest rates. Profit sharing ratio can help in efficient allocation of resources without creating tussle between supplier and demander of funds.

The author gives an example that if multiple projects are ranked first on the basis of expected profitability and then on the basis of creditworthiness, then it is quite possible that interest based finance is provided more substantially to the large enterprises with more creditworthiness while profitable, but new or small ventures will remain unfunded. This retards growth in the real economy as well as keep access to finance inequitable and unjust. 

The author argues that abolition of interest together with Zakat can help in stable currency as well as ensure sufficient availability of investment funds with profit sharing ratio playing the role of price mechanism to clear the market.

The author argues that entrepreneur has no choice than to seek high profits in interest based financial system in order to cover the cost of capital. There is greater chance of more defaults, gluts, less innovation and misallocation of resources since the interest rate and actual profitability of these enterprises could be very different ex-post. However, in the Islamic model, profit sharing ratio distributes profits equitably.

In interest based system, there is flow of wealth from the borrower to the lender in the form of interest even in case of loss. In case of loss, there is no additional wealth created by the borrower, but he is still obliged to share his existing and diminished wealth with the lender.

In Islamic model, the wealth transfer is equitable. Only profits are exchanged and shared between investors and entrepreneurs.

The author writes that the profit-sharing entrepreneur is free from the constraint of realizing interest costs as his sole commitment to the supplier of capital is that of sharing the ex-post profit with him. 

The author thinks that two tier Mudarabah based banking can be more inclusive, equitable and stable. It can check monetary expansion within the limits and bounds of real economic growth. When monetary expansion is linked with real economic growth, it will not lead to the inflationary spirals which are common in interest based monetary system.

The author is aware of the issues of dealing with short term financing requirements and consumer finance. Such financing needs may require the use of other instruments which are suited for asset acquisition needs and short term financing needs. The author shares the view that Murabaha, Ijarah and Diminishing Musharakah can be used for asset acquisition needs in consumer finance.

In short term financing needs, the author thinks that either short term Mudarabah or interest free loans shall be used.

Since Islamic banks mobilize current account deposits as well, it is not inappropriate to ask and expect them to provide some percentage of deposits in the form of interest free loans. Regulators can also bring impetus by making it compulsory and linking it with statutory liquidity requirements.

In international finance, the author suggests to strengthen regional and global cooperation among Muslims majority countries and strengthen the capacity and role of Islamic development bank.

Since the book is written when it was not apparent that Islamic banking would only remain a small market player in a dual banking system, the author is buoyant in expecting the government to pave way for Islamization of whole financial and economic system.

Overtime, the scenario changed as compared to what was expected. Islamic banking had to operate in a dual banking system environment in which Islamic banks did not have many facilities which conventional banks had.

For instance, conventional banks remained the major lenders to the government, money market mainly remained busy in transactions involving interest-based instruments and Islamic banks lacked facility of the lender of last resort.

That is why, Islamic banks were forced to remain price competitive in order to survive as a small player in a dual banking system. On one hand, it made it difficult to use equity based modes of financing which were considered riskier and on the other hand, it promoted the use of such instruments and structures which can help in generating stable cash flow streams as in interest based finance.

Efforts were made to keep the instruments and structures free of interest with success. However, the economic character of Islamic banking practice could not change the distributional impact of Islamic banking and keep it distinct from the conventional banking.

However, the author argued that diversification of investments would keep the overall portfolio of equity investments in enterprises secure from unsystematic risk. Only the systematic risk would be borne which is borne by portfolio managers in mutual funds and venture capital funds anyways.

Thus, the author suggests that on one hand, the investors need to develop readiness to bear entrepreneurial risk. Any positive rate of return ex post is better than negative 2.5% return which is paid in Zakat if the investible wealth having potential of growth is kept idle.

On the other hand, the fund managers in Islamic banking institutions need to develop sound investment screening, monitoring, accounting and auditing methods to improve their investment judgement. Lastly, the regulators need to provide a sound regulatory framework which provides disincentives for wrong reporting.

The author is in favour of using equity based modes of financing as the major and dominant source of financing and limiting the use of other modes in consumer finance, short term finance, international finance and trade finance on need-basis. This vision and strategic direction is also recommended by eminent scholars like Maulana Mufti Muhammad Taqi Usmani.

However, the practitioners in Islamic banking face a paradox to balance market realities and this vision. As of now, the practice is adamant on not compromising on Shari’ah compliance, but knows that as small players in this commercial market, they cannot be price uncompetitive. Hence, Islamic banks currently are achieving at least the bare minimum of the vision by providing a Shari’ah compliant interest free solution to the banking needs in a way so that they are price competitive in a dual banking system which is dominated by interest based conventional banking.