Islamic Finance

INTRODUCTION:

Islam is founded upon the notion of Tawhid, a total commitment to the will of God.

There are no concepts of "mosque" and "state" as specifically religious and political institutions. They are believed to be fused together (Mills, Presley). The Qu'ran explicitly deals with economic questions such as distribution of property on inheritance, hoarding, usury and the use of financial resources. The principles of the Islamic Financial system is based on a set of rules and law called the "Shariah", originating from the Qu'ran. Its characteristics are based on the prohibition of the receipt and payment of interest (riba) and a more equitable distribution of income and wealth. Islam promotes profit and loss sharing. In this paper, I will first give a background of the Islamic banking system by using the example of the experimental bank in Pakistan and the Mitr Gahms Saving bank of Egypt, which set the bar for the new emerging banks and allow for a broader financial structure. Then I'll give an historic of the principles underlying Islamic banking, followed by a clear explanation of the profit and loss sharing contract. And finally I'll talk about obstacles faced by the Islamic banking system and alternative institutional structures in place to overcome those obstacles and broaden the banking system.

I) Historical development

a. Background

At first Qu'ranic ideas appear to have had relatively little effect on financial development because most of the first bank established were European (to serve expatriate communities). There was some unease in states throughout the Middle East about the spread of western banking practices, but most of them were ready to drop any reservations they had for the sake of modernization but they were unhappy that the institutional framework and practice implied was incompatible with literal interpretations of the Qu'ran (Wilson). To a large extend modern banking bypassed the majority of local Muslims in the Middle East. Rural areas had no banks, and even the agricultural bank established in the Ottoman Empire, which charged interest, mostly served the richer landowners who lived near cosmopolitan settlements.

b. An experimental Islamic Bank (Pakistan)

Real debate about Islamic principles to commerce took place in Pakistan in 1950 and not in the Middle East. The merits of inserting a clause banning interest in the constitution was discussed in 1956 but the issue was put aside because of commercial considerations, although the question was raised numerously in the national assembly in Islamabad. Despite the failure to get a ban on usury enforced at the national level, an experimental local bank was founded in the late 1950's in a rural area of Pakistan which charged no interest on its lending. The bank was backed by a small number of pious landowner prepared to deposit funds without any interest reward. Credit was advanced to poorer landowners for agricultural improvements. No interest was charged but a small administrative fee was levied to cover the operating expenses of the bank.

They were no shortage of borrowers but depositors viewed their payments into the bank as a once and for all effort. The institution soon ran out of funds. In addition the depositors took a considerable interest in how their deposits were loaned out, and the bank officials didn't have much autonomy (Wilson). With no deposits forthcoming and problems over the recruitment of bank staff, which were unwilling to give up lucrative and secure career in city commercial banking for an uncertain venture in the countryside, the institution soon foundered. Once the staff left, existing loans were handled as bilateral arrangements between landlords, without any financial intermediation. They were mostly repaid by the early 1960s (Wilson).

Just as Pakistan venture was ending a new experiment was being tried in Egypt. Like the one in Pakistan the Egyptian institution was in rural areas.

c. The coming into being of interest- free bank (the example of Egypt)

The main leader was Ahmad El Naggar, who was the manager of the new institution called Mitr Ghams Savings Bank. He selected staff with good experience from commercial institutions. They gain the confidence of the conservative country community who saw that they were devout Muslims. The region's peasants were suspicious of outsiders and few had ever used commercial banks. The new bankers shared the same views and moral values as the peasants themselves, despite their education. The Mitr Ghams Savings Bank soon prospered, within 3 years the 1,000 depositors had been joined by further 59,000 (Wilson)

No interest was paid on deposits, but in order to receive an interest free loan, a borrower had to have a certain minimum sum in a saving account for at least a year.

This there was some financial motivation to deposit funds, as depositors and borrowers belonged to the same group, unlike in Pakistan. Loans were use for a variety of purposes such as house building and repairs, purchase of simple machinery. Loans were of short-term duration (1-3yrs) but some medium-term (up to 5yrs) was allowed. They were no grace periods on repayment. The emphasis was on keeping the money circulating, (following the Prophet teaching on the evils of hoarding).

The success of the bank resulted of the gain of personal support from a large number of farmers and villagers who considered the bank as their own. Problems of rural indebtedness were reduced, as borrowers no longer had to depend on the local money lenders, who charged high interest rate.

But despite the popularity of the Mitr Grahms Savings bank, it eventually got into difficulty as it did not share in the profit which the borrowers made. Borrowers were not required to pay more even if their financial position improved substantially. The amounts to cover administrative expenses were limited and bank salaries were unattractive. Still Ahmad El Nagar was encouraged to widen the experience by receiving state funding. This meant the new institution called the Nasser Social Bank, which had substantial resources to fall back on since the institution was on a much firmer financial position. The Bank operated under Islamic principles, all loans were interest-free, but only depositors could borrow funds.

The Nasser Social Bank had diversified its activities and help pioneer new Islamic banking methods. Its main activity remained in branch banking. The aim was to provide deposit facilities in many locations and grant a lot of small interest-free loans for