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Islamic banking (or participant banking) is banking or banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics. Sharia prohibits the payment or acceptance of specific interest or fees (known as Riba or usury) for loans of money. Investing in businesses that provide goods or services considered contrary to Islamic principles is also Haraam (forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.


Interest-free banking seems to be of very recent origin. The earliest references to the reorganisation of banking on the basis of profit sharing rather than interest are found in Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952) in the late forties, followed by a more elaborate exposition by Mawdudi in 1950. The writings of Muhammad Hamidullah 1944, 1955, 1957 and 1962 should be included in this category. They have all recognised the need for commercial banks and their perceived “necessary evil,” have proposed a banking system based on the concept of Mudarabha – profit and loss sharing.

In the next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period. The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors.

The early 1970s saw institutional involvement. The Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, the First International Conference on Islamic Economics in Mecca in 1976, and the International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process.

The first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic image for fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime. The pioneering effort, led by Ahmad Elnaggar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamr in 1963. This experiment lasted until 1967 (Ready 1981), by which time there were nine such banks in country.

In 1972, the Mit Ghamr Savings project became part of Nasr Social Bank which, currently, is still in business in Egypt. In 1975, the Islamic Development Bank was set up with the mission to provide funding to projects in the member countries.The first modern commercial Islamic bank, Dubai Islamic Bank, opened its doors in 1975. In the early years, the products offered were basic and strongly founded on conventional banking products, but in the last few years the industry is starting to see strong development in new products and services.

Islamic Banking is growing at a rate of 10-15% per year and with signs of consistent future growth. Islamic banks have more than 300 institutions spread over 51 countries, including the United States through companies such as the Michigan-based University Bank, as well as an additional 250 mutual funds that comply with Islamic principles. It is estimated that over US$822 billion worldwide sharia-compliant assets are managed according to The Economist. This represents approximately 0.5% of total world estimated assets as of 2005. According to CIMB Group Holdings, Islamic finance is the fastest-growing segment of the global financial system and sales of Islamic bonds may rise by 24 percent to $25 billion in 2010.

The Vatican has put forward the idea that “the principles of Islamic finance may represent a possible cure for ailing markets.”

Shariah-compliant assets reached about $400 billion throughout the world in 2009, according to Standard & Poor’s Ratings Services, and the potential market is $4 trillion. Iran, Saudi Arabia and Malaysia have the biggest sharia-compliant assets.

In 2009 Iranian banks accounted for about 40 percent of total assets of the world’s top 100 Islamic banks. Bank Melli Iran, with assets of $45.5 billion came first, followed by Saudi Arabia’s Al Rajhi Bank, Bank Mellat with $39.7 billion and Bank Saderat Iran with $39.3 billion.Iran holds the world’s largest level of Islamic finance assets valued at $235.3bn which is more than double the next country in the ranking with $92bn. Six out of ten top Islamic banks in the world are Iranian. In November 2010, The Banker published its latest authoritative list of the Top 500 Islamic Finance Institutions with Iran topping the list. Seven out of ten top Islamic banks in the world are Iranian according to the list.


1. An Overview on the Review of Problems

The Islamic banks face a number of challenges. First, they have not yet been successful in devising an interest-free mechanism to place their funds on a short-term basis. They face the same problem in financing consumer loans and government deficits. Second, the risk involved in profit-sharing seems to be so high that most of the banks have resorted to those techniques of financing which bring them a fixed assured return. As a result, there is a lot of genuine criticism that these banks have not abolished interest but have in fact only changed the nomenclature of their transactions.1 Third, the Islamic banks do not have the legal support of central banks of their respective countries (except in Pakistan and Iran), which exposes them to great risks. Fourth, the Islamic banks do not have the necessary expertise and trained manpower to appraise, monitor, evaluate and audit the projects they are required to finance. As a result, they cannot expand despite having excess liquidity.

The future of Islamic banks hinges, by and large, on their ability to find a viable alternative to interest for financing all types of loans. They should recognize that their success in abolishing interest has been at least partial and they have yet to go a long way in their search for a satisfactory alternative to interest. Simultaneously, Islamic banks need to improve their managerial capabilities by training their personnel in project appraisal, monitoring, evaluation and performance auditing. Moreover, the future of Islamic banks also depends on developing and putting into practice such accounting standards which provide timely and reliable information of the type that the Islamic banks would require for profit-sharing, rent-sharing or for cost-plus financing. These standards are yet to be developed. The Islamic banks would have to work hard to pursue their clients to accept these standards so that a reliable information base is established.2

2. Issues and Problems in the Implementation of an Interest-Free Banking

The implementation of an interest-free banking raises a number of questions and potential problems if seen from the macro and micro operational point of view.

2.1 Issues Related to Macro Operation of Islamic Banking System

2.1.1. Absence of Islamic Money Market:

In the absence of Islamic money market in Bangladesh, the Islamic banks cannot invest their surplus fund. Because the entire Government treasury Bills, approved securities and Bangladesh Bank bills in Bangladesh are interest bearing. Naturally, the Islamic Banks cannot invest the permissible part of their security Liquidity, Reserve and liquid surplus in those securities. As a result, they deposit their whole reserve in cash with Bangladesh Bank. Similarly, the liquid surplus also remains uninvested. As such, the profitability of the Islamic Banks in Bangladesh is adversely affected.

2.1.2 Absence of Suitable Long –term assets:

The absence of suitable long term assets available to Islamic Banks is mirrored by lack of short term tradable financial instruments. At present there is no equivalent of an inter – bank market in Bangladesh, where they could borrow to satisfy temporary liquidity needs. Trading of financial instruments is also difficult to arrange when rates of returns are not known until maturity. These factors place Islamic in Bangladesh at a distinct disadvantages compared to its conventional banking counterpart.

2.1.3. Shortage of Supportive and Link Institutions:

Any system cannot thrive exclusively on its built in elements. It has to depend on a number of link institutions so is the case with Islamic Banking. For identifying suitable projects, Islamic banking can profitably draw the services of economists, lawyers, insurance companies and so on. They also need research and training forums in order to prompting entrepreneurship amongst their clients. Such support services properly oriented towards Islamic Banking are yet to be developed in Bangladesh.

2.1.4. Organizing relationship with Foreign banks:

An issue closely related to the creation of financial instruments, which would be simultaneously consistent with Islamic principles and acceptable to interest-based banks, including foreign banks.

2.1.5. Long term financing:

Islamic banks as financial institutions as even more directly affected by the failure of the projects they finance. This is because the built in security for getting back their funds, together with their profits, is in the success of the project. Islamically, it is not lawful to obtain security from the partner against dishonesty or negligence, both of which are very difficult if not impossible to prove.

2.1.6. Liquidity

Islamic banking stands for the use of money as a medium of exchange. Conventional banking, on the other hand, emphasizes the need for maintaining liquidity and hence requires an adequate amount of reserves. The basic principle of Islamic banking being PLS-based financing and thereby having been exposed to increased risk; it would conceivably require higher liquidity and reserves. The reason is that its investment in assets has by nature lesser divisibility and reversibility. This means that reserve ratios for interest-free banking are to be calculated on the basis of risk calculation in various forms of investment.

ƒ Director (Planning and Development), Bangladesh Open University.

The complex problem in measuring liquidity is that liability management in the conventional banking system has been gradually replacing asset management to fund liquidity needs. At present, no such facilities exist under the Islamic banking system. As a result, these banks have to depend on their central bank to supply cash. The liquidity ratios required by the banking laws on demand and time deposits differ from country to country. In some countries, the supervisory authorities reserve the right to impose different ratios on different banks according to their location. At present, the liquidity ratio is 35% of demand and time liabilities in Pakistan.3

The existing lending operations of conventional bank for definite maturity are based on the doctrine of ‘anticipated income theory,’ where bank loans are not self-liquidating in the sense of ‘commercial loan theory.’ These loans are paid off out of the future earnings of the borrower, and are liquid according to their nature, guarantee, and marketability. Since Islamic banks are not based on the same principle, but are investing in assets represented by commodities, shares in companies or working capital of companies, the theoretical probability of these assets becoming liquid is more difficult to ascertain than in conventional banks. Also, greater fluctuations in the liquidity ratio due to the still largely agrarian nature of these economies will significantly affect the ability of Islamic banks to provide credit to private sector. This requires special attention when fixing liquidity ratios for each type of deposit and each kind of investment in order to allow a degree of liquidity higher than conventional banks.4

With regard to the elements comprising the liquid assets of Islamic banks, it would be necessary to allow these reserves to be held in the form of financial instruments. Similarly, the bank capital requirements under Islamic banking would be higher to protect the depositors against unexpected losses, if any, on the investment portfolios, increasing the requirement of legal and loss reserves that could provide additional safety cushion.

2.1.7 Valuation of Bank’s Assets

It is argued that Islamic banks may suffer a loss of value of its assets in the absence of a fixed positive rate of return. Further, without the provision of insurance Islamic banks may face trouble in making their system stable and avoiding liquidity crises. So far, under Islamic banking, no such insurance system exists.

Theoretically, Islamic banks are likely to face a dual risk: (a) the ‘moral’ risk due to lack of honesty and integrity on the part of the borrower of funds in declaring a loss, (b) the ‘business’ risk arising from unexpected market behaviour.

The deposits under the PLS system are conceptually more akin to a mutual fund’s share certificate. These deposits would share in both the realised as well as unrealised gains and losses on the investment of Islamic banks. Typically under current Generally Accepted Accounting Principles, the investment portfolio is adjusted to market values in investment companies. An upward adjustment of the assets account requires an offsetting credit to either revenue or unrealised capital increment. Unrealised capital decrement requires recording of an unrealised loss on long-term equity securities as a contra item in stockholder’s equity.

The problem associated with proper valuation of Islamic banks’ assets has important implications for bank safety and bank regulation. Any specification of reserve or provision requirements laid down by the regulatory agencies will have to consider how far the glosses) on banks’ investments are passed on to the depositors. If in the extreme case, these gains and losses are fully reflected in the value of the deposits, the banks probably would be passing on all the risks to their depositors.

Another problem in determining the profit or loss to be distributed to the depositors of the Islamic banks relates to the periodic evaluation of their assets, especially in case of long-term investments, such as Mudaraba, or Musharaka. In the case of Participation Term Certificates (PTCs), market values could be observable if an active market in these instruments exists. Such a market for the PTCs is not fully developed in countries experimenting with the interest free banking system. The value of long-term investments would fluctuate with the changes in the expected cash flows as well as in the opportunity cost of capital. In the absence of an active market in these investments, the valuation process could be very imprecise and costly.

2.1.8 Credit Creation and Monetary Policy

The general perception is that most of the traditional policy instruments of the central bank are largely redundant under Islamic banking. These include: minimum cash reserve requirement, liquidity requirement, overall credit ceilings on lending activities of these banks, mandatory targets for providing finance to specific sectors, and moral suasion. Of course, equating the goals of monetary policy in Islamic banking to those of the free market economies would not be fair since there is a significant difference in emphasis of the two systems to economic values and socio-economic justice.

Monetary policy under Islamic banking assigns a somewhat passive role to money. Chapra opines that the central bank should adjust the money stock to keep pace with the secular growth of output. In his view the control of money supply can be accomplished by regulating the high powered money at the source. He suggested two alternatives. The first is to impose a 100% reserve requirement on the commercial banks, thus permitting the central bank to create credit, which will be channeled through commercial banks on a Mudaraba basis. The second alternative is to allow banks to create deposits. Given the Islamic emphasis on re-distributive justice, this may result in either nationalizing the commercial banks or forcing the banks to pass on to the state the net income arising from ‘derivative’ deposits after allowing for the share of the commercial banks. Under this alternative, he suggests a 15-20% statutory reserve requirement on only demand deposits without extending it to cover deposits, which constitute a part of equity in an Islamic economy. This alternative has its own conceptual problems of dividing ‘net income’ among the shareholders, depositors, and the state. Also, since the deposits will be invested in the long-run projects, which are likely to be more profitable, this scenario will pose greater liquidity constraints.5

M. Khan divides the sources of funds into demand deposits and investment deposits and places a 100% reserve requirement for the first category of deposits6. Such a restriction would reduce the power of banks to create credit. As investment deposits are used for risk-bearing activities, no reserve requirements are needed.

Al-Jarhi proposed a model, which he calls a “productivity-based financial and monetary structure” in which the central bank creates a fiat money through “sale and purchase of central deposit certificates” instead of issuing interest-bearing government securities7. According to


Jarhi the expansion in money must be justified by a possible contribution to real balances. The growth of money must go with the real growth of the economy. There are no fractional reserves in the model. The central bank issues certificates as liabilities and holds loan accounts and deposits in member banks. The banks hold assets in the form of cash, equity shares, PLS accounts, and leasing accounts, while their liabilities consist of non-interest bearing demand deposits, investment deposits and certificates issued to their customers. Thus, in Jarhi’s model, the indirect link between financial and goods market established by the financial intermediaries is replaced by direct participation of banks in productive investment projects. The growth and the past behaviour of inflation provide the central bank with necessary information on the expansion or contraction of money supply.

The consequences of Jarhi’s model are as follows: (a) there is no discount rate as a policy tool in such an economy. An economy-wide elimination of discount rate will entail profound structural changes, focusing on social justice in the light of existing economic conditions. In the absence of interest rate, and for the purpose of discounting future income streams for project evaluation, some mechanism in an Islamic economy must serve as a discount factor; (b) monetary policy becomes closely intertwined with the development policy of the economy. Therefore, his suggested policy questions the emphasis on the stabilization policy followed by conventional central banks in post-war period. (c) The above emphasis tends to encourage lending of funds on the basis of profitability of investment projects rather than solvency and credit worthiness of the borrower in the debt finance case. This would require trained banking personnel and expertise in project feasibility, evaluation and appraisal by the commercial banks, which may lead to increased monitoring costs for Islamic banks.

There is a recurring emphasis in Islamic banking literature on 100 percent reserve requirements. Though this permits the central bank a direct control of money stock, the emphasis is more pointed in favor of Islamic equity and against the notion of ‘hidden subsidy’ involved in the generation of ‘derivative’ deposits in the interest based banking system. Accordingly, credit creation is confined to the central bank, which extends credit to commercial banks on a PLS basis.

The fractional reserve system versus 100% reserves would have different policy implications. Under the former system, banks would have the ability to draw profits on funds that they have exerted no productive effort. Such earning is against the original spirit of Islamic banking. One solution may lie in the nationalization of commercial banks, which has already occurred in most of these countries. As regards the latter, we have a fair amount of theoretical insight from the western literature but do not have any valuable empirical observations on the operations of 100% reserves even in countries that have adopted Islamic banking. These Islamic banks are still operating under fractional reserve system. Hence, the operation of monetary policy under 100% reserves system needs further research.

In summary, according to the principle of Islamic banking private banks should not have the power to create money. The power to create money should be reserved for the government or its central bank.


2.1.9 Financial Stability

Conventional banking system based on the fractional reserve system has built-in instability as illustrated by western economists such as Hayek (1933), Mintz (1950), Fisher (1930) and Friedman (1957). The instability arises, as argued by them, from the lack of synchronisation between the decisions of commercial banks and the central bank thereby resulting in destabilising forces. Modern banking based on interest issues fixed value liabilities to its depositors. In the absence of deposit insurance the value of assets can fall below its fixed liabilities, resulting in bankruptcies. In the worst scenario, the welfare of each depositor depends on the action of other depositors.8For example, if one of the bank’s major borrowers default and a financial panic is triggered, each depositor will try to withdraw funds as soon as possible. This negative externality generated by the depositors can cause instability in the banking system. The provision of deposit insurance has reduced the problem of financial panics, but it has at the same time led to inefficiency in the intermediation process.

By that reasoning, lack of insurance coverage is considered to be a problem for Islamic banks. It is presumed that depositors in Islamic bank, due to the fear of capital and or profit losses in the event of having no insurance coverage, would not remain with the Islamic banks. Islamic economists argue that under Islamic banking, because there are no fixed liabilities, depositors feel encouraged to remain in the bank when it suffers a decline in the value of its assets. Hence, there is no externality created. It does not require the provision of deposit insurance. However, it would need some provision of insurance against fraud and theft in Islamic banking.

2.1.10 The Ownership of Banks

The ownership issue of Islamic banks relates principally to the distributional impact on the society. Particularly, credit creation power of commercial banks with fractional reserve ratio has been the point of debate, which has raised the question as to whether the ownership should be with public or private hand. The issue is still unresolved. Commercial banks in Pakistan are required to maintain fractional reserves and they are in the private sector. On the other hand, all commercial banks in Iran are nationalized. Further research is required in this regard to come to a clear conclusion.

2.1.11 Lack of Capital Market and Financial Instruments

Islamic banks working under conventional banking framework in different countries lacks capital market and instruments for investment of their surplus liquidity. Availability of Islamic capital market and instruments help growth of these banks. Growth of Islamic capital market and financial instruments also helps creating the environment for government financing.

2.1.12 Insufficient Legal Protection

A comprehensive system of Islamic banking requires legal protection. This means a thorough review of all relevant laws having a bearing on banking business is needed. Laws relating to companies, commerce, investment and the courts and legal procedures need to be reviewed and reformulated to suit the requirement of the efficient functioning of Islamic banks. It is not acceptable that company law continues to talk about bonds and interest while ignoring participation deeds and


profits. Investment promotion laws should accommodate rules and regulations, which permit Islamic banks to apply their profit/loss sharing modes so that they can participate in partnership businesses either in the form of Musharakah or direct investment.

2.2 Issues Relating to Micro Operation of Islamic Banks

2.2.1 Increased Cost of Information

Islamic scholars generally agree that the monitoring cost as well as the cost of writing and enforcing contracts would be higher in Islamic banking than in the interest-based system. This is because, with Musharaka, the bank finances the working capital of a business venture taking a quasi-equity position in the economy. In financing, a management company is formed which floats a negotiable security, or the bank may completely finance a project within the scope of its charter. Moreover, since the economies of countries implementing Islamic banking are generally characterized by market and informational imperfections, further persistence of these problems will increase the cost of information. This higher cost of information could be a major setback in the effective implementation of the PLS system.

2.2.2 Control over Cost of Funds

An interest-based bank maximizes its profit subject to the cost of funds as it is in a position to know in advance, with a reasonable degree of certainty, the amount of profit it may earn in the short term. Through the use of hedging it can also determine the level of profits in the long run. Under the PLS system, on the other hand, there is no such scope to know the cost of funds beforehand. The depositors are paid a portion of the bank’s profits the volume of which is extremely uncertain. In this situation if profit rate expected by the depositors is not realized, the Islamic banks could face greater uncertainty in their profit base.

Ideally, Islamic banks are expected to calculate their rate of return on PLS deposits periodically. The usual practice is that the deposits are weighted to reflect differences in their maturity. The bank prepares a six monthly summary account of its operations and sends it to the central bank, which determines the individual PLS rate to be paid by each bank. In spite of that individual banks are allowed to marginally deviate from the proposed rate of return. In sum, it can be argued that Islamic banks have no control over the cost of funds.

2.2.3 Mark-up Financing

There is wide apprehension that little difference can be found between mark-up practised by Islamic banks and conventional banks. However, though not considered strictly interest-free by many Muslim scholars, mark-up was seen by

the banks as a tool to facilitate the transition to Islamic banking without disrupting the system. Because the ultimate objective of Islamic banking is investment-oriented long-term financing, the transition from mark-up to equity finance would also require a larger spread between rates of return to the banks and to their depositors.

It has been argued by a number of writers that the real substitute of interest in an Islamic financial system is the mode of profit/loss sharing along with qard al hasanah, while the other techniques like Murabahah, bai-muajal, ijara and ijara waiqtina cannot be of equal significance in achieving Islamic socio-economic objectives.9 The reasoning employed is as follows. Islam disallows the interest system because intrinsically it is a highly inequitabl


System. The feature that makes the interest based system inequitable is that the provider of capital funds is assured a fixed return while all the risk is borne by the user of these capital funds. Justice demands that the provider of capital funds should share the risk with the entrepreneurs if he wishes to earn profit. Financing techniques like Murabahah, bai-muajal, ijara and ijara wa

iqtina, which involve a pre-determined return on capital, cannot be regarded as commendable substitutes for interest, and should only be used when absolutely needed.

2.2.4 Excessive Resort to the Murabaha Mode

The repeated criticism against Islamic banks, which is valid in many counts, is that it takes recourse to excessive use of Murabahah mode in financing investment. Yet it is not a violation of Shari’ah as long as the Murabahah contract is correct from Shari’ah viewpoint and is free from intentional or nominal deception.

The objection is from two groups of people. The first group considers Murabahah to be the same as pre-determined rate of return i.e., rate of interest. But this is not true. Murabahah is different from interest based mark-up as the former has to satisfy the following requirements. First, it is necessary that profit margin (or the mark-up) the bank is charging must be determined by mutual agreement between the parties concerned. Secondly, the goods in question should be in physical possession of the bank before it is sold to the client. Thirdly, the transaction between the bank and the seller should be separate from the transaction between bank and the purchaser. There should be two distinct transactions. That is why Islamic banks effect a Murabahah transaction in two stages using two separate contract forms. The first form is a request to the bank through which the client informs the bank of his intention to carry out the transaction. In this contract, the client promises to buy goods from the bank. It should also be noted that a promise is not legally enforceable. Hence the client has a right to change his mind and the

bank runs the risk of losing the money it has invested in this particular transaction. The second contract deals with the sale of goods by the bank to the client on deferred payment basis, the terms and conditions of which are clearly spelled out in the contract form. Unfortunately, the bank violates the condition that the goods should be in physical possession of the bank.

2.2.5 Utilisation of Interest Rate for Fixing the Profit Margin in Murabahah Sales

It is also criticized that Islamic banks utilize the interest rate as a criterion for fixing the profit margin in the mudarabah sales. To be fair, there is no known way of avoiding the alleged link up as long as Islamic banks coexist with traditional banks. Still Islamic banks must avoid exceeding the prevailing interest rate or exploiting the clients through accounting methods as employed by some banks.10

2.2.6 Financing Social Concerns

Islamic banks are accused of following the same course of line as pursued by conventional banks as regards financing of social aspects. These banks are usually found to be interested in extending credit facilities to well-established commercial establishments which often obtain credit facilities from both conventional and Islamic banks without real commitment or attempt to free them from the prohibited means of finance. In this way, Islamic banks have in general become a figure that is added to the number of traditional banks, which do business in the country concerned. No clear prescription has so far emerged on the role of Islamic banks in the promotion of new projects needed by the society as follows:


Enabling those who have no property, providing employment opportunities to all categories of people;

Demonstrating the impact of Islamic investment on the solution of the unemployment problem; and,

Assisting the state in confronting these ever-increasing problems.

Moreover, Islamic banks did not pay much attention to the development of banking services in some socially desirable directions, except in very rare cases. The entire realm of the management of estates, trusts and orphanages, etc., has remained outside the area of interest of Islamic banks, in spite of the fact that a number of western banks have, since the sixties, begun establishing specialized departments for Estates and Trusts.

2.2.7 Lack of Positive Response to the Requirement of Government Financing

It is a well-known fact that the modern state is always in need of funds and resources to implement useful projects, such as the provision of schools, roads, electricity, and water and telecommunication services. Generally, governments resort to issuance of treasury bills with interest in accordance with the form used by conventional banks. Islamic banks are required to enter into this field so as to prove their ability to play their role in the financing of projects in a manner that conforms to the Islamic system through the issuance of deeds of Musharakah, advance-sale, salam and such other forms that satisfy the needs of the state for financing and, at the same time, benefit from investment of their idle liquid surpluses.

2.2.8 Failure of Islamic Banks to Establish Co-operation among Themselves

In spite of good intentions, Islamic banks are blamed for their lack of open-mindedness to one another, a state of affairs that obstructs the achievement of mutual co-operation among them. This is in spite of the persistent endeavors of the Islamic Development Bank to bring them closer to one another and unify their stands.


3. Problems of Islamic Bank Operating under Conventional Banking System

Problems faced by Islamic banks operating under conventional banking framework have been identified in a recent study as follows: 11

3.1 Failure of Islamic banks to finance high-return projects

Islamic bank fails to appropriate high profit from high-return projects since the owners of these projects prefer borrowing from conventional banks where cost of borrowing turns out to be lower. That means, only the projects with rates of return equal to or below the market rate of interest are left with the Islamic banks. At this situation, Islamic banks are not able to invest on the projects having rates of return below the prevailing rate of interest thereby limiting their capacity to utilise investment opportunity to the level of their conventional counterpart. This leads to limiting the application of profit-loss-sharing modes such as Mudaraba and Musharaka. In other words, Islamic banks, at that situation, switch over to other modes of financing such as Murabahah, hire purchase, leasing, etc.

3.2 Sacrifice of allocative efficiency

Allocative efficiency of Islamic bank, if it is truly a profit-loss-sharing bank, is built-in to its financing mechanism. It is not possible to achieve the desired level of allocative efficiency when entrepreneurs switch over from Islamic banks to conventional banks to avoid high cost borrowing. Profitability of projects being the ideal device of efficient resource allocation, at this situation, does not apply to Islamic banking system as it, considering the rational behaviour of the borrower, takes recourse to modes other than profit-loss-sharing. This situation continues as long as Islamic banks operate side by side with the conventional banks. Experts are very much worried about this situation of Islamic banking. Up till now no effective policy prescription is available to the Islamic banks to ameliorate the situation.

3.3 Loss of distributive efficiency

It has also been found that distributive efficiency of Islamic banking is lost when an Islamic bank starts operation under conventional banking framework. Any shift from profit-loss-sharing modes leads the system break the direct relationship between the incomes of the entrepreneurs, the bank and the depositors. The inefficiency of conventional banking about distribution is neither influenced nor modified by the introduction of Islamic banking in the economy.

4. Constraints Faced by Islamic Banks in Bangladesh

Constraints faced by Islamic banks in Bangladesh are analyzed below:

4.1 Problem with legal reserve requirement

Islamic banks in Bangladesh have to keep 10% of its total deposits as liquidity. Of this, 5% is required to be kept in cash with Bangladesh Bank and the rest 5% is to be kept either in approved securities or in cash (in case of problem with securities) with Bangladesh Bank. Legal reserve requirement for conventional banks is 18%.

They have to keep 5% in cash with Bangladesh Bank and the rest 13% is invested in Bangladesh Bank approved securities. Traditional banks can earn interest on their deposits with Bangladesh Bank but Islamic banks can not since they can not receive interest as earning. Compared to interest-based traditional banking, Islamic banks, in this case, are in a disadvantageous position.


However, Islami Bank Bangladesh Limited have been receiving interest against its deposit with Bangladesh Bank and crediting its sadaka fund since 1993. It should be noted that the interest earning is not considered as bank income and added to profit. The proceeds are spent on welfare activities.

4.2 Lack of opportunities for profitable use of surplus funds

Conventional banks can invest their excess liquid amount in approved securities and or in other bank in crisis. Islamic banks can not take this opportunity due to the existence of interest element in the transaction process.

4.3 Apprehension of liquidity crisis and possibility of liquidity surplus

Islamic banks have to be more cautious and vigilant in managing their funds since it can not resort to call money provision at times of fund shortages or crisis. As a result Islamic banks may have always left with a sizeable amount of cash as liquidity surplus. Conventional banks can borrow in the form of call money among themselves even at an exorbitant rate of interest.

4.4 Problems in capital market investment

Conventional banks can invest 30% of their total deposits in shares and securities. Islamic banks have their problem in this case as they avoid any transaction based on interest. Following examples may be cited for illustration. (1) Islamic banks do not purchase shares of companies undertaking interest-based business; (2) Shares of companies taking loan from commercial banks on interest are not also purchased by Islamic banks; and, (3) Islamic banks can not purchase shares of companies involved in businesses not approved by Shari’ah.

The above restrictive environment in the capital market of Bangladesh has limited substantially the investment opportunities for Islamic banks and hence the avenues of lawful earning. In the absence of Islamic money and capital market these banks can not obtain funds from capital market at times of need.

4.5 Absence of inter-bank money market

In spite of six Islamic banks functioning in Bangladesh, inter-bank money market within Islamic banks has not yet taken place. Of course, except Islami Bank Bangladesh Limited and Al-Baraka Bank Bangladesh Ltd., the rest of the Islamic banks have launched their operations very recently not exceeding even two years with hardly more than two branches. Still these banks can take initiative to form a money market among them. This may help minimising particularly the call money problem they are suffering from the beginning.

4.6 Predominance of Murabahah financing

Predominance of Murabahah financing in the portfolio management of investment funds by the present day Islamic banks of Bangladesh has been a hot agenda of debate. One study shows that Islami Bank Bangladesh Limited, Al Arafah Bank and Social Investment Bank Limited have used 54%, 76% and 65%, respectively, of their investment funds by resorting to Murabahah mode12. Murabahah though considered as a Shari’ah approved mode, the Islamic economists have traditionally prescribed for its limited application. Due to the legacy of traditional banking, and the lack of appropriate legal protection and standard accounting practice in business, Islamic


Banks in Bangladesh find Murabahah financing as suitable and Mudarabah and Musharakah as extremely difficult to apply.

4.7 Depression of Profit

Traditional banks can meet up losses arising from delay in repayment by the clients through charging compound interest. Islamic banks can not do that. What it does it realises compensation at the rate of profit. But the compensation so realised is not added to the profit income rather credited to sadaka account, i.e., amount meant for social welfare activities. This depresses profits of Islamic banks. This may place Islamic banks relatively in a weaker position in terms of profitability compared to conventional banks.

Moreover, Islamic banks are to make a compulsory levy equivalent to 2.5% of its profit earned each year and credited to Sadaqa account which also depresses banks’ profitability. This is unlikely the case with conventional banks.

4.8 Absence of legal framework

The amendment of old laws and promulgation of new laws conducive to efficient operation of Islamic banks are sin qua non for their healthy growth. Countries introducing Islamic banking should create an enabling environment for Islamic banks by modifying existing laws and regulations. Islamic banks in Iran and Pakistan have their legal supports. Pakistan has provided legal support to float Participation Term Certificate and conduct Mudarabah transaction by replacing “The legal Framework of Pakistan’s Financial and Co-operative System” on June 26, 1980. The Banking Tribunal Ordinance and The Banking and Financial Services (Amendment of Laws) Ordinance were passed in 1985 by amending seven Acts such as the Partnership Act, The Banking Companies Ordinance, the Wealth Tax Act, the Federal Bank Co-operation Act, the Income Tax Ordinance, The Registration Act and Capital Issues, 1974.

4.9 Absence of Sufficient Numbers of Islamic insurance company

Banking and insurance have to go hand in hand in matters of trade and business in order to protect investments of banks against unforeseen hazards and catastrophes. Unfortunately, Islamic banks have to depend on interest-based insurance companies in the absence of Islamic insurance companies.

5. Future Policy Directions

It is evident from research findings that Islamic banking could be the most efficient system if it were allowed to operate as a sole system in an economy13. However, when it starts operation within the conventional banking framework, most of its efficiencies are lost. The study demonstrates that it is not the inherent shortcomings of Islamic banking system that are responsible for its relative inefficiency; rather it is the continuation of legacies of the conventional banking system that jeopardizes an efficient operation and functioning of Islamic banks in the economy. The policy implication is not that Islamic banks should never be floated within the conventional banking framework; rather it is the conventional banking system whose operational mechanism needs to be reviewed into PLS-system considering beneficial impact of the latter on the economy. However, as long as Islamic banks are to operate within the conventional banking framework, the following recommendations are important for continued growth of Islamic banking.


5.1 Banking Philosophy

There seems to be a gap between the ideals and actual practice of Islamic banks. In their reports, booklets, bulletins and posters these banks express their commitment to striving for establishing a just society free from exploitation. Actually, however, little or no progress has been achieved so far to achieve that objective. Though this failure is attributed mainly to the pervasive influence of conventional banking system itself, the lack of vigilance of the promoters of Islamic banking in realizing the objective is no less to blame. The shortcomings need to be identified. Particularly, it has to be seen whether there is any scope to open up alternative avenues to arrest the causes of efficiency erosion. There should be a thorough review of policies that have been pursued by these banks for about a decade, and points of departure have to be identified to redesign their course of action. This is a very crucial issue because of the fact that people at the mass level find very little difference between the banking operations of Islamic banks and that of their conventional counterparts. Until and unless a quick change in policy followed by clear actions takes place, the credibility that Islamic banks have achieved so far may be tarnished away very soon.

The first action that deserves immediate attention is the promotion of the image of Islamic banks as PLS-banks. Strategies have to be carefully devised so that the image of Islamic character and solvency as a bank is simultaneously promoted. The following strategies are suggested for immediate application:

(a) Pilot schemes in some selected areas should be started to test innovative ideas with profit- loss-sharing modes of financing as major component. This type of scheme may be experimented both in urban and rural areas. The strategy will serve as a ready reference that Islamic banks are in the process of transforming themselves as PLS-banks. Side by side, they will gain experience from real situation as to the problems that might come up while implementing profit-loss-sharing modes on trial and error basis.

(b) Islamic banks should clearly demonstrate by their actions that their banking practices are guided by profitability criterion thereby establishing that only Islamic banking practices ensure efficient allocation of resources and provide true market signals through PLS modes.

(c) Islamic banks should continuously monitor and disseminate through various media the impact of their operations on the distribution of income primarily between the bank and the other two parties: the depositors and the entrepreneurs, and then on different income groups of the society. These presuppose the establishment of a fully equipped research academy in each Islamic bank.

5.2 Vying for Distributional Efficiency

The task is more challenging for Islamic banks as they have to promote their distributional efficiency from all dimensions together with profitability. Islamic banks, step by step, have to be converted into profit-sharing banks by increasing their percentage share of investment financing through PLS-modes. The Islamic banks, to do that, can be selective in choosing clients for financing under PLS modes.


Islamic banks should establish a direct functional relationship between the income of the bank and that of the depositors and between the income of the bank and that of the entrepreneurs. The relationship improves with the share of bank financing under PLS modes increasing. Islamic banks should immediately take measures to revert the trends of resource transfer from both low-income groups to high income groups and from rural to urban areas. This is extremely important from the viewpoint of their banking philosophy as well as for their tacit commitment for distributional equity. They should develop a monitoring mechanism by which the distributional impact of their banking operation could be traced out and necessary policy can be formulated to continuously improve the equity situation.

The Islamic banks should actively consider utilizing the rural potentials from both efficiency and equity grounds in the context of the present-day socio-economic conditions of Bangladesh. Strong commitments and stepping up through experiment and implementation of innovative ideas are the appropriate ways to do that.

5.3 Promotion of Allocative Efficiency

The Islamic banks can improve their allocative efficiency by satisfying social welfare conditions in the following manner. (a) They should allocate a reasonable portion of their investible funds to social priority sectors such as agriculture (including poultry and fishery), small and cottage industries and export-led industries such as garments, shrimp cultivation, etc. (b) When the percentage shares of allocation of investible funds are determined, profitability of the projects should be the criterion for allocating loanable funds. The criterion would be best satisfied if more and more projects were financed under PLS modes.

6. Conclusion

Islamic banks can satisfy most of the efficiency conditions if they can operate as a sole system in an economy. Conventional banking, on the other hand, does not satisfy any of the efficiency conditions analyzed above. However, when Islamic banks start operation within the conventional banking framework, their efficiency goes on decreasing in a number of dimensions. The deterioration is not because of Islamic bank’s own mechanical deficiencies; rather it is the efficiency-blunt operation of the conventional banking system that puts a negative impact on the efficient operation of Islamic banks. This does not mean that the survival of Islamic banks operating within the conventional banking framework is altogether threatened. Evidence from Bangladesh indicates that Islamic banks can survive within the conventional banking framework by switching over from PLS to trade-related modes of financing.

Even under the conventional banking framework Islamic banks can operate with certain level of efficiency by applying in a reasonable percentage the PLS modes – the distinguishing features of Islamic banking. This has been possible in some countries of the Muslim world where the management of Islamic banks was cautious about possible impacts of every policy measure. Particularly, the management of these banks was judicious in selecting major sectors or areas of their operations. Sudan Islamic Bank is a typical example in this respect. Islamic banks in Bangladesh have much to learn from the experience of this successful Islamic bank.

Having considered the pro-efficiency character of Islamic banking and its beneficial impacts on the economy, government policy in Muslim countries should be in favor of transforming the conventional banking system into Islamic banking.