The Islamic Banking System - Not Conductive to the Start-
Up of Young, Innovative Business Firms

by: Kathrin Nina Wiedl

TABLE OF CONTENT

1. Introduction 1

2. The Problem of the Prohibition of Interest (riba) and Alternatives 2

3. The Meaning of the Higher Supervisory Religious Board for Young Enterprises 4

4. PLS Concepts: Mudaraba and Musharaka – And Why Banks Shy Away From These Concepts 5

4.1. Mudaraba - “Sleeping Partnership” 5
4.2. Musharaka - “Sharing” 9

5. Other Forms of Loans in Islamic and their Limited Applicability for Young, Innovative Enterprises 13

5.1. Qard Hasan - “Credit Without Interest” - Not Available for Business Financing 13
5.2. Ijara – “Leasing” / Ijara wa-Iktina - “Hire-Purchase” - Just Suitable in Exceptional Cases 14
5.3. Murabaha – “Trade Financing” – Feasible Just for a Minority of Entrepreneurs and at the Cost of Deriviation from the Original “Halal” Concept 15

6. Conclusion and Proposals for Improvements Inherent to the System 17

Notes 19

Bibliography 23

Appendix A: The Three Main Principles of Islamic Economics
Appendix B: Institutions in Islamic Economy
Appendix C: The Islamic Banking System
 

1. Introduction

The contemporary Islamic banking system, a relatively young institution, gains influence not only in the Islamic world but also in non-Muslim countries with big Muslim communities. The first Islamic bank, Dubai Islamic Bank, was erected in 1975. Today about 265 Islamic finance institutions operate in more than 70 countries, and their assets have increased more than 40-fold since 1982 to exceed $230 billion. More and more western banks erect Islamic branches; the first was Citibank in 1996. ¹

We have to raise the question, what influence this banking system has on the start-up of young, innovative businesses, inside and outside of Muslim countries. A negative influence would hinder these businesses to develop – if not counterbalanced by other measures like state involvement, e.g. by providing special funds for these businesses. In non-Muslim countries, it would constrain religious Muslims from participating in the contemporary economical changes, determined by an opening-up of markets and privatisation, which require the start-up of new businesses.

The Islamic banking system operates according to Islamic law; hence several Islamic restrictions, the most important of which is the prohibition of riba=interest, limit its freedom to develop suitable financing instruments for the support of young, innovative businesses. These restrictions enlarge the risk of the bank, especially when financing these businesses, so the bank either avoids these businesses or tries to bend the Islamic law and tries to operate – de facto – like a conventional bank. In this case, however, the bank will face problems with the Religious Supervisory Board, an integral part of every Islamic bank, which may declare the bank to be in opposition of Islamic law (Sharia) and shut down its operations. The Islamic banking system is a relatively young concept and the scholars can be divided into three main camps. The first consists of Muslim scholars, like Chapra², Siddiqi³ or Ahmad⁴, who support the concept of Islamic banking and are concerned mainly with the theoretical and ideological aspect, but lack an analytical research. The second group analyzes Islamic Banking from a theoretical point of view, like Mirakhor⁵, Khan⁶ or El-Ashker⁷. The third group comprises Western scholars, like Wilson⁸, Nienhaus⁹, Kuran¹⁰ and Kazarian¹¹, although this topic was largely neglected by Western scholars for many years. Kazarian provided an interesting analysis of Islamic versus traditional banking. But also Muslim scholars like Al- Omar/ Abdel-Haq¹² provide us with studies and analysis from a practical point of view. This paper will not discuss the ways a government can balance these negative impacts of Islamic banking, e.g. by setting up public development institutions which provide special funds for young, innovative entrepreneurs. It is also not my aim to discuss whether the Islamic values create a better society, even at the cost of reduced development of innovative businesses. It is my aim instead to focus on the influence of Islamic banking on the financing of young, innovative businesses in the start-up phase.

In order to analyze these influences, I will first briefly describe the most important element that determines the religious framework of Islamic banks: The prohibition of riba, and the absence of interest-based financial instruments. I will prove that the institution of a Higher Supervisory Religious Board has a negative influence on planning reliability, both for banks and entrepreneurs, and increases transaction costs. Next, I will look at the interest-free financing instruments of Islamic Banking suitable for the start-up of young, innovative enterprises:

1) Musharaka (partnership) and mudaraba (silent partnership). I will analyze these Profit-loss Sharing (PLS) concepts and identify the factors that make them unattractive for banks, especially when financing young, innovative business, leading banks to avoid such financing.
2) Murahaba (Trade Financing) and ijara/ijara al-waktina (Leasing). I will analyze these mark-up activities and identify why these concepts – preferred by banks – are suitable only for financing very special cases of young businesses, and are not an option for the majority of young entrepreneurs.

Finally I will present ideas on how to improve the system without violating Islamic law, but also show the limits of this system.

2. The Problem of the Prohibition of Interest (riba) and the Alternatives

Literally translated riba means ‘usury’ and not ‘interest.’¹³ Other authors claim that riba literally means increase, addition, expansion or growth.¹⁴ The ban of riba is one of the most important pillars of Islamic Economy. It is mentioned in many verses in the Quran and reduces the forms of loans available for young, innovative enterprises to PLS concepts, which bear a high risk for the bank in case the enterprise fails.¹⁵ Originally this prohibition arose from the days of Mohammed. During that period it was common to double and redouble debts when the debtor could not pay back in time. This procedure led to effective enslavement of a substantial number of people; hence the purpose of the Quran was to ban this ancient Arabic practice of riba.¹⁶ It did not differentiate between consumer credits and investment credits.¹⁷ Today the prohibition of riba means predominantly a prohibition of interests and not a prohibition of usury. Other forms of usury, for instance overpriced sale of commodities, are not forbidden by the prohibition of riba.¹⁸ In the early days of Islam, however, it was not clear if riba means all kinds of interest or just usury.¹⁹ Islamic Economists today tend to include all kinds of interest in the prohibition of riba²⁰ , led by the general conviction that interest promotes all kinds of egoistic behaviour, opposed to what a good Muslim society should be like. Financial institutes, who lend out money to a higher rate than offered for depositors are regarded by one scholar as “abominable creatures who fatten on the labour of others.”²¹

It could be argued, regarding the problem of inflation that did not exist when the Quran was written, that the prohibition of riba applies to real interest, not to nominal interest. The prohibition of riba has one main advantage for the bank: The Sharia-conform operation of the bank will attract Muslims that are not allowed to use other banks. Hence, advocators of this prohibition argue, as seen above, only in religious and ethical ways. But opinions about the main goal of an Islamic bank differ. We see these contradicting goals i.e. in the official purposes of the Jordan Islamic Bank, which claims that its goals are to make profit, but also to keep the laws of the Sharia.²²

From a purely economical point of view, however, this system causes several problems. The bank has to develop loans without interest, which are nevertheless profitable for the bank. These concepts are Islamic-conform Profit-Loss-Sharing concepts or mark-up activities. For the latter, the banks are only allowed to demand a “service fee”, which is not allowed to be connected to the amount of money given as a loan but only to the service provided, so it can only cover, if at all, short-time loans of a low value.²³ The prohibition of riba does not only cover interests for regular forms of loans, but also forbids the bank to pay interest on bank deposits, which are de facto credits given to the bank. Hence the prohibition of riba influences the financing by banks as well as the refinancing of banks.

Regarding the lending-out of money, a conventional form for innovative, young business to finance the start-up, the A.L.M. Abdul Gafoor claims: “… these types of loans bring no income to the banks and therefore naturally they are not that keen to engage in this activity much. That leaves us with investment financing and trade financing. Islamic banks are expected to engage in these activities only on a profit and loss sharing (PLS) basis. This is where the banks’ main income is to come from and this is also from where the investment account holders are expected to derive their profits from.”²⁴ Schumpeter takes a common point of view, when he claims that conventional bank credit is necessary for industrial development.²⁵ The director of the Pakistan Institute of Development Economics, Syed Nawab Haider Naqvi doubts that an interest-less economy will invest optimally and claims that state intervention is necessary for the optimal allocation of resources.²⁶ Optimally allocation of resources means, as seen above, the promotion of young, innovative businesses, which are necessary for economical growth. The role of innovative entrepreneurs for economical development is a common point of view, as stated in the principles of the Gründerforum, a German institute for furthering young entrepreneurs: “Innovative entrepreneurs, however, are the root of economical growth, because an economy can only develop by regularly innovations”.²⁷

[...]

1 www.politikforum.de; www.islamicbanking-finance.com

2 Chapra, M.U., Nature of the Economic System in Islam; in: Islamic Quarterly, Vol. 14, No.2; See also: Chapra, M.U., Objectives of the Islamic Economic Order

3 Siddiqi, M.N., Muslim Economic Thinking: A Survey of Contemporary Literature; in: Ahmad, K., Studies in Islamic Economics; See also: Siddiqi, M.N., Islamic Approaches to Money, Banking and Monetary Policy: A Review, in: Ariff, M (ed.) , Monetary Policy in an Interest-Free Islamic Economy – Nature and Scope, in: Ariff, M.(ed.), Monetary and Fiscal Economics of Islam, International Centre for Research in Islamic Economics

4 Ahmad, K. (ed.), Studies in Islamic Economics, The Islamic Foundation

5 Khan, M. S./ Mirakhor, A. (eds.), Theoretical Studies in Islamic Banking and Finance

6 ibid

7 El-Ashker, A.A., The Islamic Business Enterprise

8 Wilson, R.(1995), Economic Development in the Middle East; Wilson, R.(1990), Islamic Financial Markets;

9 Nienhaus, V., The Performance of Islamic Banks Trends and Cases; in: Mallat, C.,Islamic Law and Finance; Nienhaus, V., Islam als Urasche von Unterentwicklung; in Paraskewopoulos (ed.),Wirtschaftsordnung und wirtschaftliche Entwicklung“, pp. 362 – 376

10 Kuran, T., The Economic System in Contemporary Economic Thought; in: International Journal of Middle East Studies, Vol. 18 No. 2, pp. 135-164; Kuran, T., Behavioural Norms in the Islamic Doctrine of Economics; in: Journal of Economic Behaviour and Organisation, No. 4

11 Kazarian, E. G., Islamic Versus Traditional Banking

12 Al-Omar, F. /Abdel-Haq, M., Islamic Banking

13 It is written in the Quran: “But Allah hath permitted sale and forbidden usury” (Q11:275)

14 Al-Omar, F. /Abdel-Haq, M., Islamic Banking, p. 8

15 Those verses claim: Those who devour riba will not stand except as he stands who has been driven to madness by the touch of Satan. This is because they say: trade is only like riba, but Allah has permitted trade and forbidden riba…Allah will deprive riba of all blessing (Q 2:275-276). “O Ye who believe! Fear Allah and give up what remains of your demand for riba, if you are indeed believers: If you do not, take notice of war from Allah and its Apostle, but if you turn back, you shall have your capital sums; deal not unjustly, and you shall not be dealt with unjustly. If the debtor is in difficulty, grant him time till it is easy for him to repay. But if you remit it by the way of charity, that is best for you if only you knew (Q 2:278-280). O you who believe! Devour not riba, doubled and multiplied, but fear Allah, that you may prosper! (Q 3:130)

16 Kuran, T., The Economic System in Contemporary Economic Thought, p. 149

17 Hildebrandt, W.P., Islamische Wirtschaftsideologie, p.13

18 But they would probably be opposed to the principle of work and productivity, a basic principle of Islamic Economics, that claims that wages have to be related to the amount and category of the labour performed. Concerning the balance out of expenditures and income the Quran says “ Do not let thy hand be mancled to thy neck, nor open to its fullest extend ( Q 17:29)

19 The extensive doubts of the early Muslims about this topic are documented by Fazlur; see: Fazlur,R., Riba and Interest, Islamic Studies,3,1, pp. 1-43; in: Kuran, T., The Economic System in Contemporary Islamic Thought: Interpretation and Assessment, p.149, in: International Journal of Middle East Studies, Vol. 18, No.2 (Mai, 1986). Pp. 135-164

20 Nienhaus,V. Islam als Ursache von Unterentwicklung, p.362

21 Yusuf, S.M., Economic Justice, p. 86; in Kuran,T., The Economic System in Contemporary Islamic Thought, p. 149

22 www.jordanislamicbank.com. The purposes of this bank are named on the official internet page as follows: 1. Optimizing the profit of the shareholders and depositors 2. increasing the banks´ market share 3. maintaining the strength of the bank’s financial position 4. enhancing the ethical values and performance standards, which Islamic banks set high in their statements of mission

23 and even in this case it violates the Sharia because a service fee has to be connected just to the service provided, deriving from the principle of work and productivity that connects work to earnings and prohibits any exceeds. So a bank is not allowed to limit the amount of the loan with arguing that it would have to increase the service fee, if the client asks for a higher loan.

24 Gafoor,A. A.L.M. Interest-free Commercial Banking, published online: http://users.bart.nl/~abdul/chap4.html#4.1.1, first published 1995

25 Schumpeter,J., Wirtschaftliche Entwicklung, p. 148

26 Naqvi, S.N.H., Interest Rate and Intertemporal Allocative Efficiency in an Islamic Economy, in: Ariff, M. (ed.) Monetary and Fiscal Economics of Islam, International Centre for Research in Islamic Economics, pp. 75-95

27 www.gruenderforum.de