Can a Banking system function properly without interest rate?

We will start this discussing with some background. During the times of Islam it continued with the system of gold and silver currency which are real define money. Hazrat Usman R.A was very rich among other companions and had all of his trade and savings were in the form of bullion. Now a days were are boasting to be rich on the base of paper / plastic currency which is not even backed by gold and it is dependent on the decree of government, remember the case of Germany hyperinflation. Gold currency had one advantages that the value of gold cannot depreciate and hence there is no concept of inflation which can affect our savings. But for the case of paper currency it has no intrinsic value and it is highly sensitive to inflation though it is advocated to be more liquid and easy to manage. The main idea behind Islamic economic and Islamic banking is that both saver and investor should be involved in the investment / production process. Islam indicated that when more money is held in fewer hands than the deterioration of the system will start to happen, which in order word advising people mobilize their saving. According to demand and supply forces of investment capital, higher the mobilized savings lower the interest rate in the market. So we can say that higher interest rate is the responsibility of the savers, if they cannot invest themselves then at least used banks as intermediate institute.

Before discussing about the asked question that can a bank survive without interest rate? First we have to explain what interest rate is and what is the problem with it? If it is bad then what is the alternate of this?

In economics, interest rate is called the price of capital like wage for labor, rent for land and normal profit for entrepreneur effort in production procedure. But it is considered bad because it does not represent any effort or liability being put it. Without utilization saving does not benefit in anyway, it will breed value (surplus) when it is invested in any project or production process. As interest rate is the extra money which is taken without any effort performed or value created, hence it decreases the allocative efficiency of the capital from which interest rate is charged.

Interest rate is also called the opportunity cost of the money / asset capital, hence currently it is used as reference for investment returns. So for any investment project whose profit margin is less than opportunity cost will become un-viable, which means that investment in many of the very long term or social fields of life whose financial returns are very low will stop, thus decreasing welfare.

On the other side, this positive guaranteed return tends to exploit the people who are needy and poor, using money for consumption or faced a loss in investment, this act leads to immoral outcomes. Due to this fixed positive return, it does not matter what will be the result of the investment where the capital is used lender will always get his reward.

Many people say that profit not the interest rate is the price of capital. If profit is used as the price of the capital then the return of the lender will me coincide with the return of receiver hence both are motivated to increase the expected profit / outcome. This procedure is expected to improve the efficiency, remove the exploitation of the needy through the interest rate and it fulfills all the moral and economic laws if followed can result in global welfare.

But critics are against them they say that of interest rate system is removed then it will abolish the economy because people save and supply money for the loans because of the interest rate (S = f ( i )). This claim was itself rejected because Keynesian consumption theory states saving (income left after consumption) is the function of income not the interest rate. People save because they want to consume this surplus income it in future and somehow expand their capital at present. Expansion of capital can be efficiently done by sharing ratio of profit not the interest rate. Sharing profit ratio will motivate investor to participate with the receiver for better profit means in this case the return is variable and has no upper limit as compared to interest rate which is fixed.

Interest rate is mainly used in practice by modern or conventional banking system. They charge interest rate due to their claim that they are transferring risk to the borrower. But as per finance risk can be minimized by portfolio investment in technical words it is also called diversifying risk. If profit or loss is shared then risk will be distributed to both parties equally.

Survival of a bank depends upon the solution of some problems. For example if interest rate is removed form the banking system then what will be the way of giving loans and financing as maximizing profit is usually main objective of any firm and interest rate is the main source of income of the bank? If interest rate is removed how can an interest free bank can deal with other interest baring institutions?

If interest rate is removed from banking system it will mean, they are giving loans for free, now instead of exploiting others they are exploited. In Shariah, an alternate of interest baring loans is given which is called PLS (profit loss sharing) method. This method says that instead of giving loans on interest, it should be given on any agreed ratio of profit and loss that will be shared in business investment and for consumption loan only time value of money (indexed for the depreciation through inflation or price of GOLD) should be asked in return also it discourages loans taken for consumption. This method removes exploitation for both parties and if handled properly can result more profit directly or indirectly to institution and economy than the interest rate. For the case of running expenses bank can use its equity as investment as use its returns or charge minimal processing fee which can vary on basis of popularity of the instrument just like price of product varies on the base of demand and supply.

In conventional banking financing in investment was done in many ways, interest rate was included in all of then in different names and methods. If interest is to be removed from the banking system then all conventional banking practices should be replaced with some alternate that is free from interest. There are some alternates for interest free financing in investment. It can be done through following ways:

  • Sale and buy back agreement (Bai’ al-Inah)
  • Deferred sale (Bai Bithaman)
  • Credit sale (Bai Muajjal)
  • Bai Salam
  • Gift (Hibah)
  • Leasing (Ijarah)
  • Hire Purchase (Ijarah Thumma Al Bai)
  • Ijarah Wal Iqtina
  • Cost Plus (Murabahah)
  • Musawamah
  • Joint Venture (Musharaka)
  • Good Loan (Qarad Hassan)
  • Islamic Bonds (Sukuk)
  • Islamic Insurance (Takaful)
  • Safe Keeping (Wadiah)
  • Trust Financing (Mudarabah)

These all are the practices (mostly developed and under practice) that I found and can be used because it does not contain any type of interest rate. All these techniques require lesser risk and better liquidity options. There is some criticism involved in some of the practices (which are being gradually eradicated). The banks which are based on these instruments will be called Islamic Bank (Bank free of Interest bearing system).

A bank while converting from the conventional to interest free banking faces problems in converting their balance sheet. For the solution of this problem bank can rely on a tawarruq instrument (being developed and polished) in order to convert an existing loan (bearing interest) into an interest free instrument.

A tawarruq is a contract whereby a customer requests a bank to acquire a specific commodity (e.g. metal or wool) on his behalf. The customer will repay the bank the cost of the commodity plus an agreed margin in installments. The customer then requests the bank to sell the commodity right away in the commodity spot market. Hence, through this transaction, the customer can obtain immediate financing (via the spot sale of the commodity) which will be repaid at later dates (via the installment payments to the bank).

Certainly when a bank in providing returns on the basis of PLS then it is sure that its returns will not be smooth, their will be some year when the rate of return is very high and some with very low. To solve this problem of in consistency in return, banks started saving some reserve of profit from the boom years to be distributed in the low rate of return years. This term is called undistributed profit and first introduced in 1965 in Jordan. On the other side Banks also invest their equity capital with other investment so being experienced they will try to maximize their returns / minimize losses hence it will ensure stable returns for depositors plus also the confidence of the depositor /  lender in best possible returns.

The last problem is dealing with other interest baring institutions. While performing interest free bank must require interacting with other interest baring institutions because there are many inter bank transactions occurring in the world. For this problem central bank can provide help and make some laws to help and support interest free system.

The solution of some problems does not mean that interest free banking in completely evolved. It is still facing many challenges and criticism. There are many issues that need to be addressed like managing LIBOR and KIBOR base returns, through intellectual thinking and guidance if Islam. Now a day, this young concept is facing a tough competition with the conventional banking sector. For this Central Bank of Pakistan is running a parallel banking system with gradually shifting toward Islamic Banking.

The practical examples of many interest-free banking are available in the real economy like America (very low interest rate) and Japan. They are working well and enjoying profit with very low interest rate. The trend of interest free banking in developing very fast many of the conventional banks of Muslim as well as non-Muslim countries are also introducing interest free products. They all are offering competitive rate of return through PLS as compared to interest rate system.

Conclusion:

We can conclude Islamic economics has proposed system which is welfare promoting and finance mobilizing examples available in agricultural instruments. Through this analysis we can say that an interest free bank can not only survive without interest rate but also could be helpful in achieving the objective of development with distributive justice by increasing the supply of finance and capital in the economy, facilitating capital formation, and growth of fixed assets and real sector business activities.

Sources used:

Ainley, M., Mashayekhi, A., Hicks, R., Rahman, A. & Ravalia, A. (2007). Islamic Finance in the UK: Regulation and Challenges. Financial Services Authority.

Ayub, M. An Introduction to Takaful – An Alternative to Insurance. State Bank of Pakistan.

Homoud, S. H. Progress of Islamic Banking: The Aspirations and the Realities. Islamic Research and Training Institute.

Iqbal, M. (2001). Islamic and Conventional Banking in the Nineties: A Comparative Study. Islamic Economic Studies, 8(2)

Iqbal, M. & Ahmad, A. (2005). Islamic Finance and Economic Development. Islamic Research and Teaching Institute

Kaleem, A. & Wajid, R. A. (2009). Application of Islamic banking instrument (Bai Salam) for agriculture financing in Pakistan. British Food Journal, 111 (3), 275-292.

Khattak, N.A. & Rehman, K. U. (2010). Customer satisfaction and awareness of Islamic Banking System in Pakistan. African Journal of Business Management, 4(5) , 662-671.

Mirakhor, A. (1997). Progress and Challenges of Islamic Banking. International Monetary Fund.

Obaidullah, M. (2005). Islamic Financial Services. Islamic Economics Research Center

– This document is based on learning from studies mentioned and subject for imperfections and improvements.

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