Interest Free Banking System: A banking system formed according to Islamic principles and under Sharia Laws is called interest free banking system. The main principles of interest free banking system are elimination of interest and the concept of profit and loss sharing.
Interest free banking systems does not uses fixed interest rates but distributes profit on the deposits.
This system mainly focuses on equity financing in place of debt financing.
Interest free banking system operating rule is that lender has to be a partner in profit as well as the losses occurring to the borrower. Thus bearing risk is the main principle in Islamic banking.
The lender and borrower are partners in Islamic banking and the sharing of both profits and losses does not put a huge burden on the borrower.
(Riphah Center of Islamic Business, Islamabad.)
Objections on Interest Free Banking System:
According to Islamic principlesthere is no interest involved in lending, and investments can only be done on the basis of mudarabah (profit and loss sharing system). Therefore the first objection on interest free banking is that it has to make two separate systems, one for lenders and one for investors.
Interest free banking system is based on profit and loss sharing system but now a days Islamic banks do not invest completely in profit and loss sharing projects.(Beng Soon Chong, Ming-Hua Liu)
Principle-agent problems are also associated with interest free banking system (Dar and Presley, 2000). The bank acts as an agent for the lenders and management has the right to invest on their behalf, therefore poor management can cause the loss of investments. (Dar, H.A., Presley, J.R., 2000)
Another objection on interest free banking system is that it uses interest rate as a standard for determining its profits which makes these transactions not reliable from sharia point of view.
(Omer and Faizan)
Reservations on Interest Free Banking System: The main reservation on interest free banking system/Islamic banking is that its users think that this is not really an Islamic banking system but its name is only changed from the conventional system.
According to Omar Mustafa Ansari, The most common argument against Islamic banking is that Islamic banking and conventional banking is the same, and it is only a change of documents and names.
Another reservation on Islamic banking is that this system has only changed the name from interest to profit, but in fact they pay the same as market interest rates.
Evaluation of Objections and Reservations: All the objections and reservations are correct up to some extent but as we are operating in an interest based economy therefore Islamic banks faces problems in smooth Islamic operations as use of KIBOR as a standard for determining profit. It will take time in development of a complete Islamic banking system as Islamic banking is going through its evolutionary stages now a days.
Islamic Banking: A banking system which is based on Islamic law i.e. Shariah and is in accordance with the teachings of Holy Quran and Hadith is called an Islamic banking system.
Philosophy of Islamic Banking: The main philosophy of Islamic banking is that it can not make such transaction which involves riba/interest.
Risk sharing is also a fundamental principle of Islamic banking, in Islamic banking the lender is a partner and he shares both profits and losses.
Islamic banks can not deal in such transactions which includes element of Gharar or Maiser.
These banks also can not invest in such a business which is termed as Haram by Islam.
Development of Islamic Banking: From its inception Islamic banking is developing day by bay. Islamic banking was started with the birth of Islam itself when the Holy Prophet (S.A.W.W.) himself acted as an agent for his wife's trading operations.
The first Islamic bank was formed in a religious area of Egypt called Mit Ghamr in 1963.
In his book “Islamic Banking in Pakistan: A Review of Conventional and Islamic Banking†Prof. Dr. Khawaja Amjad Saeed explains the development of Islamic banking as under,
Many legislations including Companies Ordinance 1984, Negotiable Instruments Act 1882, State Bath Act and Recovery of Loans Laws were reviewed to bring these in line with the tenants of Islam.
Participation Term Certificates was introduced in 1980s which was lately replaced by Term Finance Certificate.
In Pakistan Musharaka was introduced on 1st July 1982.
In conventional banking system profit and loss sharing system was introduced on 1st April 1985.
On 23rd December 1991 it was announced that all banking transactions including interest will cease to have effect by 30th June 2001.
Areas of Operation of Islamic Banks: The operating area of Islamic banks is different from those of conventional banks because all financial transactions in Islamic banks are based on profit and loss sharing system and interest is strictly prohibited in it.
Following are some of the financial transactions through which an Islamic bank operates,
Mudarabah: In this kind of transaction one person provides capital for the business and the other person provides his managerial skills in order to operate the business. The person providing capital is called Sahib-ul-maal and the person operating the business is called Mudarib
Musharakah: It is a partnership agreement where two or more than two persons provide capital to operate a business and they share profits and losses in an agreed ratio.
Ijarah: It is a rental or lease contract where the lessor (owner) passes goods to a lessee but the ownership remains with the owner. Lessee pays rent in return for using the goods.
Al Wadiah: People deposit their money with Islamic banks in current account, savings account or fixed deposit account. Bank act as the agent of depositor and has unconditional right to invest the deposits and profits are then distributed among the depositors at an agreed ratio.
Ujrah: Under the contract of Ujrah Islamic banks provides certain services to its clients and in return they pay a fee for these services.
Investment Activities:
Conventional banks invest in such securities which have fixed amount of return guaranteed i.e. interest on bonds while Islamic banks as its name is self-explanatory cannot invest in such securities therefore Islamic banks in different kinds of Islamic financing instruments.
State Bank of Pakistan’s Shariah board has approved some essential Islamic modes of financing which are,
Murabaha Facility Agreement
Musawamah Facility Agreement
Lease Agreement
Salam Agreement
Musharaka Investment Agreement
Istisna Agreement
Agreement for interest free loan
Mudaraba Financing Agreement
Syndication Mudaraba Agreement
Social Activities:
Maslahah: Islamic banks should work for the public good.
Zakah: Zakah is the portion of asset that is made mandatory to be spent in the ways specified by Allah Ta’ala.
Islamic banks help poor and needy by distributing zakah in them. The main concept on the back of zakah is that to bring equality in the society.
Qard-e-Hasna: In Islam only gratuitous monetary loans are permissible which means no interest has to be charged on loan provided.
Financing under Profit and Loss Sharing System: In Islamic Banking the main concept is sharing of profits and losses. Mudarabah and Musharakah are the best examples of profit and loss sharing contracts.
Conclusion:
Interest free banking is emerging day by day, although there are many objections on it but it is playing a vital role in the economy. Due to refined government legislations Islamic banking has improved greatly and in future there are more bright opportunities present.
