Guest Post by Muhammad Rizwan-ul Haque
Chairman, Dawood Family Takaful / Director of a Trust and S.E.V.P. at an Investment Bank

Islamic Bank Operations

Islamic banks claim that they operate as Mudaribs and manage funds of ‘Sahib-ul Maal’ or depositors. Whereas, in reality, they function just like conventional banks.

Strict Regulations

If Islamic banks were to strictly operate as per Shariah, then they have to forget about;

• Interest or Riba
• Inter-bank money market transactions
• Debt financing / lending and
• they would have to undertake real economic activities through; e.g. Musharikas, Ijara (whereby, the asset is owned and then rented-out) etc.

The Given Scenario

Under the aforementioned scenario, an Islamic bank will do business in the following manner.

1. We assume that an Islamic bank with Rs.100.0M capital; solicits e.g. Rs.500.0M worth of deposits.
2. In the next step, we assume it engages Rs.400M (i.e. Rs.350M of depositors and Rs.50M of its own) in four different economic activities of Rs.100M each.
3. While Rs.200M is kept by the bank to; (a) hedge the risk and (b) for contingencies.
4. In the absence of ‘interest’, an Islamic bank would not be able to earn any fixed return.
5. Instead, its cash reserves would deplete to meet its expenses, but to keep the assumptions simple, we have ignored these expenses.

Details of Business Ventures and Results

We further assume that Rs.100M each is invested in trading of cloth and sugar. While the balance amount of Rs.200M is invested in agri-farming and real estate in the same ratio.

After a year, we assume that the bank made a return of; 25% on sugar, 20% on cloth trading and 10%, as rental income via real estate investments. While, the agriculture activity resulted in a loss of 30%, which eroded the principal amount in this category down to Rs.70M.

Net Result From Investments: From the above data, we conclude that the bank made a net profit of Rs.30M for itself and its depositors; i.e. with help of Rs.400M employed in different economic activities. Thus rate of return = 30/400×100 = 7.5%.

Overall Return on Total Funds: While the overall return will be calculated by also including the set aside amount of Rs.200M, which was not engaged in any economic activity. Thus an overall return on funds, equals to; 30/600×100 = 5.0% p.a.

Accountability towards Depositors

Depositors or Sahib-ul Maal will have the right (which, the Islamic bank do not allow) to inquire about its investments and it may inquire from the Islamic bank that why did they enter into agri-business? and instead they should have increased their fund allocation in sugar trading.

Why Business Risk is Important?

In the above example, the Islamic bank operated strictly as per Shariah, but on a small scale, because it did not want to undertake business risks on a larger scale. It was primarily due to unavailability of ‘interest counter’ that this Islamic bank could not ensure a fixed and a risk free return. This example positively demonstrate the importance of business risk in an economy and highlights the significance of ‘interest’, which many of us think that it (interest) is merely a number.

Why Scale is Important?

In this example, the Islamic bank solicited only Rs.500M (and not; e.g. Rs.1.0bn), because had it acquired more funds from the depositors, then it may have exposed itself towards several business avenues. Hence, the rate of return may have further reduced, whilst undertaking various types of real economic activity. Therefore, it decided to be more prudent and undertook only a calculated risk.

Why Incentive is Importance?

In absence of ‘interest rates’; the Islamic bank had no incentive to solicit more funds beyond Rs.500M, because additional deposits would have become more of a liability and it would have been accountable to more number of depositors.

Easy Deployment

Whereas, in presence of ‘interest’, it is very easy for treasurer of an Islamic bank to profitably and promptly place / deploy, say; Rs.1.0bn over a fixed time period through; e.g. Murabaha and other interest bearing transactions.

What is the Reality?

The easy and prompt deployment of funds motivate an Islamic bank to keep-on soliciting fresh deposits to beef-up its liability side; just like a conventional bank, because it can earn stress free return to increase its profitability. An Islamic bank will equally compete to acquire additional deposits to earn a fixed spread due to permission given by its Shariah to deal in ‘interest’.

Conclusion

In view of the above, it can easily be concluded that;

1. An Islamic bank cannot profitably operate in absence of ‘interest’ on a large scale.
2. A real Islamic bank will discourage soliciting additional deposits to ensure that its rate of return is not diluted.
3. It is against human nature to make money for someone else; (a) when there is accountability attached to performance and (b) when, its own stakes are diluting.
4. That is why, it controls a company through board of directors and would not want to lose its majority stakes.
5. In Islamic banks, there cannot be any dilution, because capital and depositors’ money are kept separately; as equity and liability.
6. In an ‘interest rate’ scenario; as structured for Islamic banks, a bank can easily earn and survive on spread income, which is primarily generated from depositors’ money.
7. The ‘interest income’ does not allow the principal amount of depositors to erode. Therefore, savers are kept satisfied that they are earning a return equivalent to ‘interest income’ being distributed by conventional banks without losing their principal sum.

A Humble Request: If Islamic banks still claim that they are Shariah complaint, then we humbly request them to eradicate ‘interest’ from the system, as per commandment of Allah SWT. Then, they should show to the world that they can carry-on a profitable operation with a continued desire to solicit additional deposits from savers.

May Allah SWT guide us and our Shariah advisors to be more rationale in their approach on matter of defining Riba / interest, which is strictly forbidden (Ameen).