Report on “Interest Free Banking”

Council of Islamic Ideology

This report published in the form of a book in Pakistan by the Council of Islamic Ideology was a monumental effort in the journey towards interest free banking in the country. It had great impact on policymaking regarding Islamization of the economy. It got translated into Arabic as well as in other languages spoken in the Muslim world.

Arab countries as well as South East Asian countries also gave attention to this report in implementing Interest Free Banking in their respective countries. The reason why this report got a lot of attention was its policy-oriented focus. It was a policy blueprint to Islamize the financial system.

The report envisaged a gradual approach to evolve an interest free banking and economy through a series of step-wise reforms. It had a well-thought out plan keeping in view the open economy framework and international commitments. It provided specific suggestions to Islamize the functions of central bank, development finance institutions, commercial banks, specialized banks and non-banking financial institutions, such as mutual funds, insurance companies and investment companies.

In its gradual approach, the report suggested that the process of Islamization of the financial system shall be carried out in a linear step-wise reform process.

First, the element of interest shall be avoided in transactions between federal government and provincial government and between government and central bank. Then, the government institutions shall be reformed to eliminate the element of interest.

The loans provided by House Building Finance Corporation (HBFC) and other specialized banks and Development Finance Institutions (DFIs) run by government shall be made free of interest. The investment schemes offered by National Investment Trust (NIT) and Investment Corporation of Pakistan (ICP) were to be reformed to eliminate the element of interest.

Then, in the next phase, the report recommended that interest shall be eliminated in commercial banking by replacing the interest based loans with Islamic finance schemes and finally by replacing interest based deposit mobilization with profit-loss sharing based investment deposits.

In the last phase, the report stated that the external loans from governments and international DFIs shall be reformed to eliminate interest. Since there is less legislative control in such engagements, the process of elimination of interest will involve convincing the international DFIs to use Islamic finance schemes.

This linear step-wise approach was a logical one. It started from reforms in institutions in which government has ownership. Then, it extended the efforts of eliminating interest in institutions in the domestic economy where legislation and market power can be utilized. Finally, it suggested reforming transactions and engagement with rest of the world where there is less legislative control for reforms.

In retrospective lookback, the approach envisaged in the report can be appreciated given the present scenario. After the publishing of report, in later years, government kept on using interest-based public finance options and allowed Islamic banking in private sector in parallel to conventional banking without eliminating interest based banking through legislation.

Thus, conversion of conventional banking into Islamic banking slowed down. More importantly, the use of debt based modes of financing and especially the close connection to interest based benchmark in pricing could not be avoided. Hence, even the Running Musharakah product could not avoid interest based benchmark in a scenario where majority share in banking is held by conventional banks and who get major share of business from government when it sources funds in public finance utilizing the conventional interest based sovereign securities.

Another important aspect of the report is its elaboration of the Islamic finance schemes and discussing their applicability in different functions of different governmental and non-governmental institutions.

The report categorically mentions that the ideal interest free alternatives of finance include Musharakah and Mudarabah. Both are inclusive modes of finance which are not only free from interest, but free from indebtedness. The redistributive impacts of these Islamic equity based modes of finance are substantively and meaningfully different from interest based lending. 

However, the report realized that moral hazard and adverse selection are major problems in equity based modes of finance. Moral hazard implies that the clients who are provided with capital know that the risk to capital is borne by the capital provider, i.e. banks. Hence, if they understate profits or show loss in their accounts, they will be able to reduce their financing cost or avoid it altogether.

Furthermore, in the presence of debt based financing at a predetermined rate or mark-up, only the risky commercial clients who are not able to afford or obtain debt financing will come to Islamic equity based modes of financing. Those who are liquid and profitable will not want to share their higher returns on investments with Islamic banks in profit-loss sharing contracts. This is the problem of adverse selection.     

To overcome this, the report suggests that transparency and audit is very important. Where it is difficult to ensure standardized audited accounts, the debt based modes of Murabaha Muajjal (Deferred payment sale) and Ijarah Muntahiyya Bit-tamleek (Ijarah resulting in asset ownership) can be used. In working capital finance of farmers, Bai Salam (advance payment sale with deferred delivery) can also be used.

The report suggested that in priority financing to the micro-borrowers, interest free loans can be used. Since banks obtain a significant portion of their deposits in current account, they can be obligated to share a certain percentage of these deposits in providing credit to low-income borrowers. The report allowed a fixed service charge as application fee, but discouraged its overuse, especially at variable rates where service charge becomes a function of maturity of contract and the amount of fuds borrowed.

In the similar vein, the report also discouraged the use of inflation indexing as it may become a norm. The report stated that loan contracts shall be non-compensatory. If the financial institution wishes to benefit from investing funds, it shall use Musharakah and Mudarabah or at least Islamic debt based financing schemes, such as Murabaha and Ijarah. In short term working capital finance, Murabaha and Salam can be used. But, in providing credit, it shall avoid any predetermined profit. To cover its administrative expenses, banks can only charge a fixed application fee.

The report also suggested that the DFIs can use venture capital financing and private equity. They can provide financing through auction of investment shares in the enterprises. The debentures can be replaced with Participation Term Certificates (PTC) which will operate on the principles of Musharakah.

The report also discussed the operational complexities. In determination of profits, it recommended the use of profit determination on daily product basis. In some cases, where financing is provided to micro-enterprises which do not keep proper records of business, a pre-announced profit rate can be used. However, in principle, actual profit distribution shall be based on actual profits when they are made available.

Profit sharing based on predetermined profit rates shall only be used in a limited way where microenterprises do not maintain business records. In situations where the microenterprise is able to provide evidence of loss, banks shall share in loss and do not demand fixed profit based on pre-announced rates.

The report also recommended that instead of compounded interest on late payment, the banks shall introduce penalty which is paid to government or third-party to avoid profiteering on liability due.

For ensuring stable rates of profit distribution to the depositors, the report suggested that nationalized banks shall determine their profits by combining asset pools. This will ensure that commercial displacement risk is avoided. However, implementing it in private sector banks is not feasible.

In specific issues, such as loans to employees, the report recommended the use of interest free loans. Staff loans are already heavily subsidized. Hence, interest free loans will not burden the employing organizations since they already provide fringe benefits to their staff. Profit payment on provident fund can be announced as a unilateral bonus until the fund is properly transformed on Islamic investment principles.

In insurance, the report suggested the use of mutual co-insurance and avoiding the element of interest in investment operations. The investment schemes offered by insurance companies shall also only utilize Islamic investment options like it was recommended for NIT and ICP.  

The report recommended that in order to ensure that deposit mobilization through profit-loss sharing shall not result in people avoiding banks to park their savings, the government can provide deposit protection for some definite period to instil confidence and avoid financial exclusion.     

In multiple places, the report categorically stated that the debt based and sale based modes of financing shall only be used where Mudarabah and Musharakah are not usable. The report discouraged a prolonged and significant use of debt based financing schemes in all types of contracts and needs.

However, since the government did not increase its use of Islamic financing schemes in sourcing funds itself and reopened the case on prohibition of interest at the legislative level, the conventional banking could not be contained and transformed quickly enough. Thus, private sector Islamic commercial banks could not significantly move towards Mudarabah and Musharakah as much as was expected and desired in the report.