Islamic Banking: Issues of Islamic banking

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    Islamic Economics Sen"es - 4

    Issues in IslamicBanking

    Selected Papers


    The Islamic Foundation

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    @ The Islamic Foundation 1983/1403 H. Reprinted 1994/1415 H.

    ISBN(hard case) 0 86037 1182

    ISBN (paperback)0 86037 II74

    All rights reserved. No part of this publication maybe reproduced, stored in aretrieval system,or transmitted in any form or by any means, electronic, mechanical, photocopying, recordingor otherwise, without the prior permission of the copyright owner.


    Views expressed by different authors of books and studies published by the IslamicFoundation do not necessarilyrepresentthe views of the Islamic Foundation.

    Acknowledgements ................................................................

    Foreword - Khurshid Ahmad ..........................................Published by

    The Islamic FoundationMarkfield Dawah Centre

    Ratby Lane, MarkfieldLeicester LE67 9RN, UK

    Preface. . .. . .. ..

    . . .. ..................

    1. Islamic Approaches to Money, Banking andMonetaryPolicy ..:..............

    On the Nature ofMoney and its Role inthe Economy.... .. .. .Banking .................................................Short- Term Loans ...............................................................Bills of Exchange ,.............................Credit for the Consumer .....................................................Finance for the Government and the Public Sector ........Monetary Policy ...................................................................International Banking..........................................................

    Conclusion .......................................Postscript Review of Contribut ions During 1977-1981 . .. .Demand for Money.............................................................Discounting Future Values .................................................Indexation ............................................................................Creation of Credit and Seigniorage ...................................100%Reserves ...................................................................Profit-Sharing Ratio as an Instrument of Policy..............Islamic Banking in Operation :...........................


    Quran House, PO Box 30611,Nairobi, Kenya

    PMB 3193,Kano, Nigeria

    British Library Cataloguing in Publication DataSiddiqi, Muhammad Nejatullah

    Issues in Islamic banking - (Islamic economics series; 4)1.Banks and banking - Islamic countriesI . Tit le l l. Ser ies

    332.1 '097671 HGl573

    ISBN 0-86037-II8-2ISBN 0-86037-II7-4 Pbk

    Printed and bound inGreat Britain byThe Cromwell Press.Melksham. Wiltshire







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    2. Banking in an Islamic Framework 51Consequencesof Interest 54Interest and Bank Credit : 55Profit-SharingBanks 59Short-Term Credit 61Prospects 64

    3. Rationale ofIslamic Banking 67The Critique 69The InvestmentSector:InefficiencyofDebt Finance 69The InvestmentSector : InjusticeofDebt Fimmce 71Consumer Debt 74Public Debt 77InternationalDebt , 78Worsening Distributionof Income and Wealth 81Concentrationof Power , 83Tendency Towards Inflation 84

    The Alternative , 85Allocative Efficiency 85Stability in the Value of Money 86Increase in the Volume oflnvestment 88Justice and Equity in Distribution 89Finance for the Government 90Finance for the Consumer 91International Flow of Funds , 92Curbing Speculation 92Mobilisation ofSavings and Profitability oflnvestments 93Conclusion : 94

    Effects of Changesin the ExpectedRate ofEntrepreneurialProfits, p 105

    Responsivenessto Changes in p in Supplyand Demandof deposits ..... 109

    Effect of Variety in Profit Expectations 110Stabilityof the System ... 111Profit-Sharing in the Shares Market 113Other Avenues of Investment 114Allocation of Resources 115Fluctuations in the Rate of Profit 118Monetary Policy in a Profit-Sharing System 121Conclusion 122

    5. Monetary Theory of Islamic Economics 125

    6. Issues in Islamisation of Banking 133Profit-Sharing as the Chief Alternative to Interest 134Supplementary Methods of Eliminating Interest 137

    Action Plan for the Elimination oflnterest 143Towards the Goals of the Islamic Economy 144

    Index 147







    I4. Economics of Profit-Sharing 97

    The Rate of Profit 99Profit-Sharing 101The Ratios of Profit-Sharing 102Determinationofthe Banker'sRatioofProfit-Sharing, brp103Determinationof the Depositor's RatioofProfit-Sharing,

    drp 103From Interest to Profit-Sharing 105

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    Acknowledgementis gratefullymade to: Islamic banking is no longer a mere theoretical proposition.In

    excess of twelve national and international banks are nowsuccessfullyoperatingon an interest-freebasis in differentpartsof the world includingthe West This developmentis bound tohavefar-reachingconsequencesfor the futuremodeof bankinginthe entire Muslim world It is, therefore, important thatprofessionaleconomistsshouldengageinmore rigorousexamin-ation of the principles and practices of Islamic banking andparticipatecreativelyinthe processof this historicdevelopment

    Dr. M. N. Siddiqi,Faisal Laureate for 1982/1402 H. isamongst the leading pioneers of Islamic economics. He hasalready authored some twelve books on different aspects ofIslamiceconomicsandhis book Banking WithoutInterest, firstpublishedin 1969,wasthe firstfull and professionallythoroughtreatment of the subject Over the last decade Dr. Siddiqihaswrittenextensivelyoncertainaspectsof Islamicbanking,mainlyin theform of paperscontributedto internationalconferencesandseminarsonIslamiceconomics.He hasdone a valuableservicetothe academic communityin general and the studentsof Islamiceconomicsin particularby compilingthesepapersand lecturesintheformof Issues in Islamic Banking. I havebeen involvedwithmostof the conferencesand seminarsto whichthesepaperswerecontributedand I haveno hesitationin sayingthat Dr. Siddiqi'scontributionin clarifyingmanyissuesin the monetaryandfiscaleconomicsof Islamis originalas wellas sizeable.I am sure the

    present collectionis a significantcontributionto the dialogueonIslamic banking and anyone who goes through this work withopennesswillfindthat he presentsa formidablecase in favourofinterest-freebanking.It shouldalso convinceour friendsandfoesalikethatIshlmiceconomicsisnot anexercisein Muslimtheologyorfiqh but a newand livelyapproachto theeconomicproblemsofman.

    We maybe condemnedas 'utopians' and' romanticists'butwebelievethat the best formof realism lies in challengingall thosesystemswhicharebasedonthe exploitationofmanin oneformor

    The InternationalCentre for Researchin IslamicEconomics,KingAbdulazizUniversity,Jeddah,forthepaperon 'Rationale ofIslamicBanking'originallypublishedbythe Centre in 1981, andfor 'Islamic Approaches to Money, Banking and MonetaryPolicy' presentedat a seminarorganisedby theCentre at Makkain 1977.

    The InternationalCentre for Researchin IslamicEconomics,King Abdulaziz University, Jeddah, and the Planning Com-mission, Governmentof Pakistan, for the twopapers on'Econ-omics of Profit-Sharing'and 'Issues in Islamisationof Banking'

    presented at a seminarjointly organisedby themat Islamabad in1981.The Islamic Council of Europe, London, for 'Bankingin an

    IslamicFramework'presentedat a conferenceinLondonin 1977and includedin the book The Muslim World and the FutureEconomic Order publishedby the Councilin 1979. The paperwas first publishedin the journal Islam and the Modem Age,New Delhi (Vol.VIII, No.4, November, 1977).


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    another and in seekingto establisha just socio-economicorder,whateverthe effortneeded to realiseit Dr. Siddiqidemonstrateswith cogent arguments that an Islamic economy is capable offreeingmodemman from the debt-riddeneconomyin whichhelives and of guidinghim towards a societybased onjustice andequity. He also demonstratesthat such an economywould also

    ensuregrowthandstability.I am sure Issues in Islamic Bankingisgoingtobe a valuablecontributionto thedebateon thefutureofbankingin our owntime.

    Instituteof Policy Studies,IslamabadSept., 1982 KhurshidAhmad



    The idea that Islam is a unique way oflife distinct from all otherisms and ideologies naturally extends to the economic lifeof theUmma. A determination to reshape the economy on distinctiveIslamic lines has been an important dimension of the Islamicresurgence visible allover the world oflslam. The areas ofmoney,banking and investment are regarded as crucial to the process ofIslamisation of the economy. Modem banking, based on interestand biased in favour of the capitalists and the rich and well-to-do,is rejected as un-Islamic because ofthe unequivocal prohibition ofribti by the Qur' an, which the consensus of Muslim jurists hasinterpreted as covering all kinds ofinterest, usurious or otherwise,irrespective of the nature and function of the loan. The Islamicemphasis on cooperation as the key concept in economic lifehasledto reliance on profit-sharing andparticipation as the alternativebases for banking and investment in the Islamic framework.

    Muslim society never legit imised interest : throughout thethirteen centuries of its history prior to domination by imperialistpowers, it managed its economy and carried on domestic andinternational trade without the inst itut ion of interest Profi t-sharing and various kinds ofparticipation arrangements served asadequate bases for savings and investment and considerable

    . capitalwasmobilisedformining,ship-building,textilesandotherindustries, as well as for maritime trade. Introduction of interest-based banking by colonial regimes in the Muslim countries duringthe nineteenth century failed to involvethe bulk ofthe communityunt il the legal framework made it almost impossible for anybusiness to thrive without such involvement Efforts of somepseudo-jurists to distinguish between ribti and bank interest and tolegi timise the lat ter met wi th almost universal rejection andcontempt Despite the fact that circumstances force many peopleto deal with interest-based fmancial institutions, the notion of its


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    essential illegitimacy has always remained. A sizeable section ofthe community still refuses to have any dealings wi th theseinstitutions despite the inconveniences involved

    Rejection of interest is seen as a necessary part of the rejectionofthe exploitative capitalist system which is to be replaced by thejust and equitable Islamic system. The recent literature on

    interest-free Islamic banking infact grew as a part ofthe literatureon the economic system of Islam in contrad istinction to thecapitalist and the socialist systems ofvarious hues. Now wehave anumber of books and articles in Arabic, English, Urdu, Turkish,Persian and Bengal~etc. Early writers mostly attempted a critiqueof modern banking, exposing the role of interest in the exploitationof individuals and nations. Then they proceeded to suggest thatpartnership and profit-sharing could form a viable basis forbankinJ. Some economists with adequate training in the Shafi'asciences worked out a detailed model of interest-free banking onthese bases. My earlier work Banking Without Interest (1973,

    first published in Urdu in 1969) belongs to this category. Sincethen the subject of Islamic banking has undergone considerabledevelopment Discussion is now conducted in the broader contextof economic analysis inspired by Islamic values and ends.Subjects such as the nature and functions of money, determinantsofthe demand for money and the alternative ways ofmanaging itssupply are also receiving attent ion. Fresh impetus has beenprovided by the establishment ofa number ofbanking institutionsoperating without interest , and some initial steps taken by thegovernments of Pakistan and Iran to phase out interest from theeconomy. The subject is now attracting the attention of the entire

    body of economists and bankers in the Muslim. world Theconference of the Governors of the Central Banks of 36 Muslimcountries held at Riyadh in September, 1980 was merely acknow-ledging the wind of change when it said that:

    'The Governors appreciated the desire to apply IslamicShan-

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    well as the allocation offinancial resources in direct response toproduction possibilities. Both affects strike at the very roots ofinflation. In international relations the change would force nationswith a surplus to invest to enter into participatory arrangementswith developing nations, expecting a return only to the extent realdevelopment takes place. While it cannot be claimed that these

    and other implications of the change have been fully worked out,discussion has largely centred around these issues inrecent years.The present writer had the opportunity of part icipating in thisdiscussion through a number of papers and notes some of whichare presented here. Their availability in oQevolume will be usefulfor those who do not have access to the journals or seminarproceedings where most of these papers were first published orread The volume also contains some hitherto unpublishedmaterial.

    The first essay on the Islamic Approaches to Money, Bankingand Monetary Policy is inthe nature ofa reviewofthe literature up

    to 1977. It sets the perspective inwhich later contributions can bemeaningfully studied It covers what Islamic economists havewritten about the nature of money and its functions, and thedemand for money in an Islamic economy. The nature of bankmoney or credit, i ts desirabili ty or otherwise, and the possibleways ofits management also come up for discussion. The idea ofhundred percent reserves is also examined in this context as arethe suggestions to confine creation of credit to the Central Bank.The essay surveys the major contributions to the subject ofinterest-free banking, reporting the various viewpoints on suchissues as supply of short.,.terminterest-free loans, billsof exchange,

    financing the consumer and fmancing the government The paperreviews the various writings on Central banking and monetarypolicy in an Islamic framework, examining the various policyinstruments discussed by our writers. This includes the suggestionto use profit-sharing ratios as an instrument of policy, besides thereserve ratio, selective credit control and open market operationthrough sale and purchase of shares, etc. Originally written for aseminar held in 1978, a postscript has been added to cover thecontributions up to 1981, covering issues not discussed earlier






    such as indexation and seigniorage.The next paper, Banking in an Islamic Framework, gives an

    exposition of the model of interest-free banking based on twcrtiermuqaraba that now forms the operational basis of Islamicbanking. It examines .such.evil consequences of interest-basedbanking as distribution of income and wealth and inflation and

    demonstrates the advantages ofIslamic banking which isfreefromthese evils, examining the creation of credit at some length. Someofthe other issues briefly dealt with in the first essay also come up

    . for detailed consideration.The third article, Rationale of Islamic Banking, answers the

    question why Islamic economists advocate a change from inter~stto profi t-sharing. It is argued that the interest-based system isinefficient as well as unjust It has an inherent tendency towardsinflation and it fails to provide a just and viable basis forinternational monetary relations. The change to a system based onprofit-sharing will contribute to allocative efficiency, justice and

    stability. It can also serve as a viable basis for internatienal flowoffunds. .The fourth paper, Economics of Profit-Sharing, covers entirely

    newground by discussing how the ratios of profit-sharing betweenthe depositors and banks, and between the banks and businessmenwillbe determined It studies the effects ofchanges inthe expectedrate of profits on these ratios and the alternative possibilities asregards the responsiveness ofsupply ofand demand for deposits tochanges in the expected rates of profits. It examines and refutesthe contention that a system based on profi t-sharing must ' beunstable and subject to wide fluctuations. The paper demonstrates

    that the system gains in efficiency by assigning the allocative.roletothe rate ofprofit without the disturbing interference fromrate ofinterest

    The brief paper on Monetary Theory of Islamic Economicsthat follows restates the main points made in the three precedingpapers in a summary formwitha viewto providing a synoptic viewof the subject It al so takes not ice of some fresh doubts on theviability of interest-free banking, being the report of a discussionin which non-Muslim professional economists were also partici-pating. 13

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    The sixth paper, on Issues in Islamisation of Banking, is acomment on the Report of the Council of Islamic Ideology onel imination of interest from the ~conomy, submitted to theGovernment of Pakistan in 1980. I have tried to make this notemeaningful to readers, to whom the Report itself may not beavailable, by addingexplanatory footnotes. The comment discusses

    such practices as Muraba!J.a and investment-auctioning proposedin the context of interest-free banking.

    These six papers along with thi s int roduction wil~ I hope,inform the reader ofthe current state ofdebate on Islamic banking.This willfacilitate understanding ofmuch that isbeing reported insomejournals and a section of the Press. To students of Islamiceconomics in general , and of Islamic banking in particular, i tprovides a comprehensive up-dated report on the subject andidentifies possible subjects forfurther research. It ishoped that thepublication of this volume will provoke further deliberations onthis vital subject .


    Islamic..Approaches to

    Money, Banking andMonetary Policy

    King Abdulaziz University,Jeddah Muhammad Nejatullah Siddiqi

    Muslim societyhad beenusingmoney sinceits inceptionandsomeformofbankingwas alsoin existence.Butissuesrelatingtomoney, banking and monetary policy posed themselves in anentirelynew perspectivein the twentiethcentury. EmergenceofmodembanksandotherfmancialinstitutionsinMuslimcountries,introduction of paper currency, increase in public debt andcommercialdealings in securitiespresentedthe jurists withnewquestions to answer. A review of newly introduced western

    institutionswas followedby attempts to devise alternativesfreefrominterest andotherfeaturesrepugnantto Shari'a. As Muslimcountriesregainedpoliticalindependence,their elitewere calleduponto managetheir ownaffairs.Interest in Islamic injunctionsrelevantto the managementofmoneyand financeincreased,andthe desire to spell out the distinctively Islamic approach, incontrastto those of capitalismand socialism,ledto a numberoffresh formulations.

    The mainjuristic issuesdiscussedinthe earlystageswere Ribaand interest, gamblingand speculation,transactions involvinggharar( chanceand uncertainty),forwardsales. foreignexchangetransactionsand transactionin debt While theproblemposedbythe introductionofpaper currencywassoonsettledby acceptingitas a substituteforthe familiargoldandsilvercoins,the remainingissuescontinueto be debated

    We shall not be ableto reviewthe wholeofthis debatein thispaperas it involvesdetailedjuridicaldiscussions.Our focusisonthevery recentwritings,mostlyby economists,on the natureandroleof money,bankingfreeof interestand monetarypolicyin anIslamic framework.

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    On the Nature of Money and its Role in the Economy

    Islamic writers concede the advantages of money as a mediumof exchange and favour the transit ion from bar ter to a moneyeconomy. They interpret the injunction ofthe Prophet against riblial-fa(j/ as a step, in the early days of Islam, I towards such atransition, as well as being a measure directed at making barterrat ional and eliminating in it the possibil it ies of injust ice andexploitat ion. Similarly, the prohibition of interest is vital forridding the money economy of injustice and exploitat ion andmaking it rational.

    This isborne out by examining the function ofmoney asa storeof value. Making a reference to Keynes's General Theory(chapter 17: Properties ofInterest and Money) Mahmud Ahmademphasises the distinction conferred on money as compared toother assets bythe institution ofinterest: ithas a liquidity premiumbut no carrying costs. On the other hand its elasticity ofsubstitution iszero, sothat a rise inits demand must raise the rate

    of interest.2 Should interest be abolished the liquidity premiumwould go and the speculative motive for holding cash woulddisappear. Liquidity premium is not the cause but the effect ofinterest Speculative hoardingof money is at the root offluctuationsin the demand for money which isthe cause of trade cycles. Todiscourage hoarding and bring money on a par with other assets(commodities) it should be subjected to a carrying cost, besidesbeing divested of liquidity premium by abolition of interest The2~% per annum Zaklit levy is regarded as a measure ensuringsuch a carrying cost Abolition of interest coupl~d with Zaklil isexpected to ensure that money serves i ts primary function of a

    medium of exchange.The abovepoint, made by several other writers beside Mahmud

    Ahmad, is further elaborated by Mahmud Abu Saud When barter


    INtir aI-Drn aI~Itr: 'Illat ribii'I-FaQI', al way al-Isliimi(Kuwait) (116) Aug. 1974,pp.51-53; andAhmad Safiuddin,'Iwad: 'Ta~awwur Jadid li-riba'l faQI', alHay al-Islomi'(Kuwait) (Ill) Mar. J974, pp.57-b9

    2Sheikh Mahmud Ahmad: .Man and Money', Islamic Studies ( Is lamabad) IX (3) Sep t1970, pp.217-244.



    is replaced by the use of money as a mediumof exchange,'itbecomespossibleto leavethe processofexchangeincompletebywithholdingthe money obtained from sale of a commodity, .. .because money obtained represents half an exchange transaction,the value of money related to itself in terms of present time asagainst a future t ime becomes different This is the basis of the

    "time preference" theory.'1 The deficiency ofmoney as a measureof value also derives from this phenomenon as the value ofmoneyis unstable because its supply cannot be controlled in view ofthemoney holders' power to withhold it from circulation. 'Unless westandardise our money and stabilise its value, letting the values ofthe measured objects fluctuate, no economy can beheld ina soundwholesome state, and nobody can rightly claim that money isthe"standard ofvalue" orthe real unit ofaccount'2 As Abu Saudsees

    it , 'In terest i s gained because somebody does not purchaseimmediately on receiving the proceeds of his sales, because thissomebody lrnows that ifhe abstains from spending he would gain


    The key to a solution lies in subjecting money to the natural lawof depreciation over time to which all o ther commodities aresubjected This is the purpose of the Islamic principle of Zaktitwhich makes all forms of private wealth 'depreciate' from theviewpoint of the private owner, by about 2.5% per annum. Thiswill discourage hoarding and make all money circulate. Moneywill serve as a medium of exchange and remain stable in value,thus serving as a standard measure of value.

    Najjar has also discussed the nature and role ofmoney indetail,concluding that hoarding, interest rates, and reckless spending by

    governments, are the main obstacles in the way of money playingits proper role in the economy. 4

    IMahmud Abu Saud: 'I nt erest Free Banki ng', p. 20. Paper pr esented at !he Fir stInterna tional Confe rence on Isl amic Economics held a t Makka , 1976.

    2ibid. p.20.3ibid. p.91.

    4Najjar, Ahmed: a l Madkhal i li i' l-na~ariya t a l- iq ti1adiyah j i' l-minhaj a l- Is il lmi.Bei ru t, Dar a I-Fikr, 1973, pp.125-153.


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    Economic literature abounds in evidence to the effect thathoarding and speculative holding of money is a source of muchtrouble in the economy causing instability in the value of money,fluctuations in output and employment, and result ing in mal-distribution of wealth. Islamic economists have scored a validpoint by demonstrating that Zaklit will discourage hoarding. Theview that the institution of interest has something to do withspeculative holding of money is also substantially correct Aboli-t ion of interest and the consequent disappearance of the bondsmarket will leave little room for the type of speculation prevalenttoday. Savings willhave tobe invested incommon stock(ordinaryshares) or deposited in the 'profit-sharing' accounts of the'interest-free banks' ( ie . advanced to entrepreneurs), throughbanks, on a profit-sharing basis). This will still leave some roomfor holding cash in expectation of a r ise in the expected rate ofprofit, or in anticipation of better opportunities for investment

    This does not, however, decrease the weight of the Islamiceconomists' argument noted above, nor does it seek substantiallyto modifyit It isonlymeant toput onrecord something which theyhave failed to note in the context ofthe above discussion. In sofaras the 'speculative motive' would still be operative in an Islamiceconomy, it wi ll no longer be capable of generating the widefluctuations experienced at present With expected profi ts thesaver would have to weighthe possibility ofloss which in a profit-sharing banking system would devolve entirely on him. Shackle'sfocus gain-focus loss hypotheses can be invoked to demonstratethat fluctuations in profit-expectations may be counter-balance,dby accompanying loss-expectat ions and the net -result may bemovement within not too wide a range. In an economy wherespeculative demand for money is a function ofthe rate of interestthe story is entirely different

    Money in a money economy must not cease to per form thefunction of a store of value. Although the carrying costs involvedin Zaklit would certainly make an impact, they cannot obliteratethe precautionary and 'speculative ' motive (as function of thechanging profit-loss expectations). Abolition of interest and theZaklit levy would eliminate wide fluctuation, but there would still


    be need for a monetarypolicyto ensure stability.The institution of credit.and bank money has been another

    object of scrutinyby the Islamic economists.Early writerssawsomethingmorally wrong in it Some doubted its need andascribeditsproliferationtothe vestedinterestsofthe banks.Morerecentlyit hasbeenrealisedthatinterestis thevillainofthepiece.

    Abolition of interest will, to a large extent, curtail the harmfulfeatures of the creation of credit by banks. However, strongargumentshavebeenadvancedagainstallowingprivatecommercialbanks to create credit in an interest-freebankingsystem.

    'Banks gaina lotoutofthin airorof noair at all.Theycreateanartificialpurchasingpowerand take advantageofthe demandforit Thisdemandisalsoillicitlycreatedbythosewhohavemanagedto liquidate their assets and preferred to enjoy a guaranteedincome against their withheldmoney.' I Havingso pronounced,Mahmud Abu Saud sees no need for bank created money as realmoney can take care of all t ransactions. As to the extra money

    needed for financing innovations, the Central Bank can issueadditional currency for this purpose which will have a temporaryinflationary effect and no further harm will be done.2 S.M Yusuf,while suggesting a 100% reserve system seems to take a similarposition. 3

    The anti-credit verdict based on the alleged undeserved profitsofthe bank isfurther strengthened by themore valid argument thata credit economy is inevitably an inflationary economy. Over-expansion incredit caused by thelure ofeasybanking profitsleadsto an untenable situation with the inevi table downturn aIiddepression.4The crucial question is related, however, tothe roleof

    interest in such a credit system. As Mahmud Ahmad sees i t, theinstitution ofinterest and not credit creation as such isthe cause of

    I Ma hm ud A bu S au d, op. cit , p.91.

    2ibid., pp.91-93.

    3S.M Yusuf . Economic Jus ti ce in I sl am, Lahore, She ikh Muhammad Ashra f. 1971,p.51.

    4Muhammad Uzai r: An Outline of Interestless Banking, Dacca, Raihan Publications,1965. Reprinted in the author' s Interest Free Banking, R oya l B ook C o. , K ar ach i, 1 978 ,pp.195-217.


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    trade cycles. The entrepreneur has to aim at a rate ofprofit whichisthree times as highas the rate ofinterest or even higher: ' ... highpitching of profitsis a compulsive phenomenon emerging from theinstitution of interest The essential highprofits can only be madeby either raising the price of the product or lowering the wages.Whatever proport ion is assigned to either of the alternatives,effective demand is slashed.'1 The remedy suggested by him is'toreshape the credit structure so that loans cease to command anyinterest and profi ts get reduced to the level where they will payonly forthe labour ofthe enterprise. Pure profits willtend to reachzero at zero rate of interest '2 It is difficult to agree with the lastpart ofMahmud Ahmad's statement, but that does not concern ushere. But he isrightin his vision that withthe abolition of interestthe structure of credit will be directly governed by profits fromenterprise.

    It takes only one further step to conclude that possibilities ofover-expansion in that case willbe severely limited, especially asthe liabili ty to losses wil l attach to the banks - the creators ofcredit As Siddiqi has argued, in the I"slamicsystem of.bankingwithout interest, 'credit would be created only to the extent thereexist genuine possibilities of creating additional social wealththrough productive enterprise. Demand for profit-sharing advanceswill be limited by the extent of the available resources and banks'ability to create credit willbe called into action only to the extentof this demand, subject to the constraint imposed by profitexpectations that satisfy the banks'3 and their depositors. Earlier,Uzair must havehad the same point inmind whilearguing that thepossibi li ties of over-expansion of credit can be eliminated by

    making capital and enterprise move together through abolition ofinterest. 4

    This important clarification justifies Hasan Homud'sacclamation of credit in an interest-free system I and leaves nocase for scepticism regarding credit per se as harboured by Kahfland some early writers on the subject Some of these misgivingswere rooted in the vague notion that credit was in some way thechild of interest This is far from being true. As Siddiqi demon-strated a decade ago,3banks' ability to create credit is independentof the terms on which it is created, depending as it does on thepublic's habit of keeping only a par t of its income in cash anddepositing the rest with thebanks. Credit willtherefore continue tobe created even after the switch from interest to muq.iiraba (profit-sharing)as the basis of bank advancesto businessmen.

    While rulingthat commercialbanksare notpermittedtocreatemoney which shouldbe a monopolyof the state in an Islamiceconomy, Kahf fails to examine yvhethersuch permission tointerest-free commercial banks, operating on the basis ofmuq.iiraba (profit-sharing)willstillbe againstpublicinterest,andwhethertheMonetaryAuthoritywillorwillnotbe abletoregulatetheir activities in the public interest It is not clear how hissuggestioncan beput intopracticewithoutnationalisingcommer-cialbanks. He envisagesprivatecommercialbanksoperatingwith100% reserves as 'service institutions'.If the commercialbanksoperate with 100% reserves,their only earningswillbe servicecharges on checkingdeposits and fees charged for transfers,

    . safekeepingandother services.Theywillbeobligedto raisetheircharges to meet their administrativecosts and earn competitivereturns on bank's capital. In order to justify this additionalburdenon thepublic,onemustarguethatthemainobjectiveofthe

    J00% reservebanking,i.e. control of the total supplyofmoney,cannot be secured in any other way. This Kahf fails to do. TheChicagoplanforbankingreform,whichadvocated100%reserves


    .Sheikh Mahmud Ahmad: 'Monetary Theory of the Trade Cycle', p.176.Islamic~Studies (Islamabad) XII (2) Sept. 1973, pp.159-178.

    2ibid.3Muhammad NejatuUahSiddiqi: 'Banking in an Islamic Framework'rP.IO. Islam and

    the Modem Age (New Delhi) 8(4) Nov. 1977. Reproduced belowas the next paper inthisvolume. See p.55.

    4MuhammadUzair: InterestFreeBanking, p.20,Royal Book Co., Karachi, 1978.

    I S am i Ha san A hm ad Ho mud: Tat wi r al -a ' mal al m as raj iya h b im a y at tq fi qu wa 'l -$hari'at al-Islamiyah. Oar a l i tt il }1d a i'ArabY I i' l \ iba' ii b. 'Ca iro 1976, p .361 .

    2Monzer Kahf: The Islamic Economy, pp.74-75. The MSA, Pla in fi elds , Ind iana , 1978.3Muhammad Nejatullah Siddiqi:ghair sudi bank kari, Lahore and Delhi, 1969, Chapter

    :5. English translation: Banking Without Interes t, Lahore, I sl amic Pub li ca tions, 1973,Chapter 5 . New rev ised edi tion pub li shed by The Isl amic Foundat ion, Leicester, 1982.

    20 21"


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    duringthethirties,hasbeenthoroughlydebated A reconsiderationof the idea in the context of Islamic banking requires a moredetaileddiscussionthanis availableto date inour literature.Moreon this point in the postscriptbelow.

    Kahf suggestsestablishmentof Finance Houses for handlingmuq.araba fundsfor investmenton a profit-sharingbasis. Buthedoesnotinsistonit since,accordingtohim,'bothcan bethoughtofas one body providing two separate services.' I It may be desirabletocombinethetwo institutionsinviewofthefact that a separationwillleave the commercialbanksin a very weakpositionas profitmakinginstitutions.

    announced in advance. .Profits received by depositors inmuq.araba accountsare, therefore,a percentagepart ofbankingprofits which mainlyaccrue to the bank as a percentageof theprofitsof enterprisesfmallcedby it

    Depositsare alsoacceptedinthecurrentaccountswithpromise

    to pay on demand No profits aredistributedto these depositorsfromwhoma servicechargemayor maynotbe realised.Thebankis obligedto grantveryshort terminterest-freeloansto theextentof a part of total depositsin its current accounts.

    The abovemodelisbasedon.a two-tier muq,araba contract Alarge number of depositors enter into individual muq,arabacontractswitha bankingcompany,organisedon thebasis ofsharecapital, the contractsstipulatingthe sharingof the profitsof the'business of banking' . The bank undertakes two kinds of'bus iness'.Firstly, it offers banking services earning fees and commissions.Secondly, it assumes the role of a financier-entrepreneur makingjudicious selection of businessmen who seek capital from it,stipulating that they share with it the profits of their productiveenterprise. Liability to loss in a muq.a aba contractattachestothefinancier only, the working party bears no part ofthe loss accruingto capital extended by the financier. As shown by Siddiqi, allschoolsof Islamic Law are unanimouson this point I It followsthat the loss incurred by an individual entrepreneur working withcapital advanced bythe bank willbe borne by the bank. The bankhas, however, advanced capital to a large number ofentrepreneurs,diversifying its investments as far as possible. Losses incurred onindividual advances are l ikely to get absorbed by some of theprofits accruing to the bank from the successful entrepreneurs. Aslong as the totality ofprofits accruing on bank advances plus thefees and commissions earned by the bank remain a positivequantity, i.e. as long as the banking business as a whole does notend up in loss, the depositors' interests are safe. But what ifthe netrevenue ofthe bank isa negative quantity? This willmean a loss, tobe distributed equally on share capital and muq.araba deposits.


    ~srep6fted earlier,2the"iaeaofinteresm-reeb~J! Q.l!eqonwlIslaffiiclegal cOiicepts~of =shirka (pIlrt.nersh1p)~d ..mUllE.~

    (p1'ofit':shai'iIig)radually evolved during the last thirty years,leadingto a fairlycomprehensivemodel of bankingby the earlyseventies.

    A bank is conceived, in the first instance, as a financialintermediarymobilisingsavingsfromthe public on the basis ofmuq,araba and advancingcapital to entrepreneurson the samebasis.Profitsaccruingtoentrepreneursonthe capitaladvancedbythe bank are sharedby the bank accordingto a mutuallyagreedpercentage.Thebank alsoperformsa numberof familiarbankingservicesagainst a fee or a commission.The bank's own sha~ecapitalalsogoesinto its businessofofferingbankingservicesandadvancingcapitalon a profit-sharingbasis.Makingallowanceforadministrativecosts,the netrevenueon allthesecountsconstitutesthe profitsof business.This is distributedover the entirecapitalinvolved - public deposits on the basis of muq.araba and thebank's share capital . The percentage profi ts so worked out arethen shared with the depositors according to a proportion

    1Monzer Kahf: Th e I sl ami c Ec on om y. o p. Ci L, p.76.

    2Muhammad Nejatullah Siddiqi: Muslim Economic Think ing: A Survey ofCon temp-orary Literature, The Isl amic Foundat ion, U.K. 1981, pp.28-37.

    IMuhammad NejalUllahSiddiqi: Shirkat aur mu4iirabat ke shar7 u~aL Delhi, Lahore,1969, pp.25-30.

    22 23

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    The possibi li ty is merely theoret ical , both on economic andempirical grounds. But according to the nature of a muq,iirabacontract, the depositors in muq,iiraba accounts do stand liable toloss should such a possibility materialise.

    Islamic economists in search of a viable alternative to interest-based banking have, quite understandably, felt uneasy about this

    conclusion. They have sought to absolve the depositors of thisliability in different ways.

    The bank may build loss compensating reserves, ou t of i tsearning in good times,to meetany net loss in bad times,so thatdepositors can always be sure ofgettingtheir deposits back infull,if not with any profit A deposit insurance scheme may belaunched withthe backing ofthe Central Bank and participation ofall banks and their depositors. This is the approach of Siddiqi),Irshad Ahmad2 and N aijar3 among others.

    Baqi r al -Sadr seeks to abso lve. the depositors of even thetheoretical liability to loss by denyingthe status ofthe bank as the

    middle l ink in a two-tier muq,iiraba out lined above - a statusthey enjoy according to Abdullah al Araby,4 SiddiqiSand themajority ofwriters onthe subject According to Baqir, the bank isan agent working for the depositor for a special kind of reward,akin to a prize, calledju'iila in Islamic law.>Muq,iiraba contracttakes place only between the bank and the entrepreneurs. Havingabsolved the depositors of the liabili ty to loss, Baqir seeks toensure that banks too do not incur any losses by stipulating somekind of a wage contract between the bank and the entrepreneurs. 7

    In his recent work, Sami Hasan Homud8 concludes that



    IMuhammad Nejatullah Siddiqi: Banking Without Interest, Lahore, 1973, pp.45-47.2Shaikh Irshad Ahmad: Interest Free Banking, O ri en t Pr es s of P aki st an, n .d .3Najjar, Ahmad: a l-Madkha l, op. c it , p.179.4Muhammad Abdul lah a l Araby : 'Contempora ry Bank Transac tions and Isl am 's Views

    Thereon' Islamic Thought (Al igarh) I I (3,4) July 1967, pp. l0 -43.sop. cit.

    6Muhammad Baqir al-Sadr: Isldmf Bank, pp.83-87 and pp.l87-189. Jamali Publi-cations, Bombay 1974 (Urdu Translation of al bank al-LiirabtfliJi I-Isllim.

    7Por a critical review of Baqir's moael see Siddiqi, M.N.: "lslami Bank', Islam Qur'Asr-e-Jadld (New Delhi) 7(2) April 1975, pp.106-126.

    8Sami Hasan Ahmad Homud: op. cit.. pp.341-448.

    ..1 24

    individual contracts of muq,iiraba discussed by early juristscannot be expanded to provide for collective type of investmentsinvolved in interest-free banking. He too seeks to modifythe two-tier muq,iiraba model described above in such a manner thatliability to loss in the depositor-bank relationship attaches to thebank only. The bank's share in the profi ts actually accruing to

    entrepreneurs can be justified only on the basis of assuming thisliability, he thinks. The only other basis ofa right to profits couldbe supply of cap ital or work (enterpr ise). The bank providesneither ofthese two as capital comes from depositors and workisdone by entrepreneurs.) The bank's share in profits, in the modeloutlined above, could therefore be justified on the basis of i tsl iabili ty to losses in respect of the depositors' money which itadvances to the entrepreneurs.

    The question that Homud fails to raise and answer i s: howcould the depositors be ent itled to a share in profit s when thereturn oftheir 'capital' isguaranteed to them? They have ceased to

    be suppliers of'capital', having become suppliers of'loan' insteadA lender withguarantee ofrepayment isnot entitled to any profits.Secondly, Homud is mistaken inhypothesising that the bank does.not supply work or enterprise. The entrepreneurial activity of thebank lies in scrutinising the projects the businessmen present to it,making a choice of whom to advance its capital , and keeping aneye on the progress of their productive enterprises. Siddiqi refersto F.H. Knight's classic work on Risk, Uncertainty and Profit insupport ofthe view that the essence of entrepreneurship lies inthechoice of men who would conduct the actual business. 2

    As regards the loss incurred by an individual entrepreneur on

    capital obtained from the bank, i t has already been noted abovethat this attaches to the bank. Some scholars seem to question thisprinciple on'practical grounds', but we have not come across anyreasoned statement of their case.

    The two-tier muq,iiraba model has been further extended by

    I ibid., p.448.2Muhammad Nejatullah Siddiqi: Islam ka Nazariyah-e-Mi/kiyat, Vol. I, Lahore,

    1967, p.163.


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    i~' .:IIL1


    1:I i 'i 'ilili



    "'I! ii!l'1ii:1illiil11'1"




    providing for partnership contracts between the bank and anentrepreneur. The bank would participate, through its employeesor commissioned agents, in the actual conduct of business, alongwith the entrepreneur, who invests his own capital also. Losses, ifany, would be shared by both part ies in proportion to capi talsupplied. Profits of thejoint venture would beshared according to

    anagreedpercentage. Somewriters, especially Najjar', would likethis to bethedominant form of banking operations. Najjar's banksseek a marriage between development banks and commercialbanks. They would promote savings and effect their usefulemployment, mainly in the rural sector. He has reported in detailthe successful operation of such banks in Egypt 2

    Some of the recently established interest-free banks have goneinto productive enterprise directly too. The Dubai Islamic Bank isa case in point The model of banking outlined above admits ofsuch an extension, but the economic advisability of mixing thisfunction wi th the other funct ions remains to be thoroughly

    examined by our economists.As regards the numerous banking services, such as safekeeping, transfers, let ters of credit, etc., performed for a fee orcommission, these would continue to be performed as interest isnot involved Several wr iter s have examined them in detail.Homud, finding some commissions similar to interest, has sug-gested certain modifications. 3

    A number of quest ions relating to the accounting aspect ofprofi t-sharing arising out of the variety in size and duration ofmUf:jiiraba deposits have been discussed by several writers butthey need not detain us here. Of special interest, however, is

    Homud's suggestion relating to the term structure of the rates ofprofit-sharing between the banks and the depositors. The bankmay give a larger percentage share from profi ts accruing to it tothose depositors who commit their deposits for a longer period of

    IAhmad' Abdul' Azjz ai-Najjar. Buniik biliifawii'id. Jeddah. 1972 and Manhaj al-$abwah al-Isliim(vah: also al Madkha~ op. cit ., pp.157-184.

    2Najjar, A.A.A.: Manhaj al'$a~wah al-lsliimiyah. Jeddah, 1977.

    JSami Hasan Alunad Homud op. cit, pp.350-387.



    time.'We do not endorse Honiud's view, based on some legal texts

    pertaining to individual muq.iiraba contracts, that costs of bankadministration should be met out of therevenue from commissionand fees only, sothat profits earned through advancing depositors'money are not affected.2It is not necessary to do so ifwe take the

    entire business ofbanking as the activity inwhich both muq.iirabadeposits and share capital are invested Moreover it is not apractical suggestion.

    Since this model began to be seriously discussed a number ofpractical problems have attracted special attention. The supply ofshort term interest-free loans, discounting of bills of exchange,supply of credit to consumers and the related problem ofinstalment credit (in hire-purchase), ~d lastly, the financing ofthe public sector are the main issues which merit mention.

    Short-Term Loans

    I t is agreed that, as far as possible, al l advances to businessparties should be on the basis ofprofit-sharing. Insofar as itis notpossible to dothis, as inthe case ofcall money and loans for a fewweeks ' durat ion, provision for interest-free loans to businessbecomes inevitable. Many writers on the subject have suggestedthat banks should be obligedto earmark part ofthe total deposits intheir current accounts for interest-free loans. This supply would,however, be limited, though there is some scope for augmentingthis supply by the Central Bank in a manner explained later on.The crucial problem ishow to control the demand for interest-free

    loans from business soas to ensure anequilibrium between supplyand demand.'Much ofthe demand for callmoney and very short term credit

    emanates from within the financial sector i tself and is l ikely todisappear when that sector shrinks in consequence of abolition ofinterest In the production sector. the total demand for short tenn

    I ibid., pp.485-487.

    2 ibid., pp.492-497.


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    credit depends on the volume of long term investment and theextent of trade credit (credit extended by one firm to another)prevalent Credit needs for theweek orthemonth can be estimatedat the macro level. This could be done bythe Central Bank whichwould then ensure a supply commensurate with the demand bymanipulatingthe ore-financeratio' and the 'lending ratio'. I Thetask of allocating the loanable funds at the micro level wouldthenbe performed by the individual banks on the following criteria:

    1. Specific credit needs of a firm.

    2. Social priority attaching to the enterprise.

    3. Nature of the security offered against loan.

    4. Whether the credit seeker has also obtained long termadvances from the bank for the same enterprise.

    5. Annual, monthly or weekly average of the applican t'sbalance in current account with the same bank.'2

    Bills of Exchange

    Bil ls of exchange pose a special problem for interest-freebanking. Two solutions (proposed long ago) are: to advance aninterest-free loan against the bill; or to advance cash to the buyer(who would have written the bill) on the basis of muq.iiraba,claiming a share in the profits from sale of the merchandiseinvolved. No discounts are involved in either case. Recently,however, Ali Abdur Rasul has justified discounting bil ts ofexchange, citingsome Malikijurists on the validity of'leaving part

    ofa loan to(be appropriated by)the one whosecures repayment ofthe loan (from the borrower) as a reward ofthis serviceof securingrepayment' .3 It fol lows that if the loan is not actually repaid no

    IBo th these ins truments o fCent ra l Bank pol icy a re exp la ined in the nex t sec tion .2Muhammad Nejatul1ah Siddiqi: 'Banking in an Islamic Framework', pp.16-17 .Islam

    a nd th e Mo de rn A ge (New Delhi ) 8 (4 ), November, 1977.

    3Al i Abdur Rasul : .Bun ilk b il a fawa' id ', p .2 . Paper p resented a t the F ir st Interna tionalConfe rence on Isl amic Economics . Makka 1976.



    reward can be given. This view failed to find any support in theliterature. It has been cri ticised on practical as well asjurist icgrounds. It has rightly been characterised as allowing a paymentsimilar to interest I There ishardly any need to adopt this adviceas a muq.iiraba. advance;,'stipulating a comparatively smallerproportion of profits, would suit most buyers who are presently

    meeting their obligation to the seller by writing a bill of exchangeduly underwritten by a bank.

    Credit for the Consumer

    Interest-free banks can play only a marginal role in supplyingloans to needy consumers. This is a serv ice which shoulp beorganised as part of a comprehensive social security progranUne.Proposals to allow banks to collect Zakiit and disburse theril byway of grants and interest-free loans have not found favour withmost writers and can at best be looked upon as a transitory

    'arrangement in response to state failure to discharge this function.Banks could grant in terest-free loans to their deposi tors asoverdrafts, for short periods of time.

    A more active role has been envisaged for interest-free banks inrelation to facilitating the purchase of durable goods by consumerswho can pay for them only in easy instalments. Uzair hassuggested that commercial banks should finance the supply sideand share profits with sellers.2Recently Sami Hasan Homud hassuggested financing the demand side in a manner that would bringsome profits to the bank. Consumer A approaches the bankrequesting it to purchase a durable item which A iswillingto buy

    fromthe bank, stipulating payment in instalments. The bank buysitforhim and sells itto A at a two orthree per centprofit on its ownpurchase price. Homud cites a precedent from Shafi'j in hissupport 3 Though it is not mentioned by Homud, the consumer

    I S ami H asa n A hm ad H om ud , op. cit .. p .378 and Siddiqi , M.N.: Muslim EconomicThink ing, op. c it .. p.36.

    2Muhammad Uza ir : op. cit ., p.3430p. cit .. pp.479-480.


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    ! H

    I may have to pledge a security to the bank til l al l instalments are .paid up. The operational difference between it and the prevalentpractice is that the seller will get the fullprice ofthe item and theconsumer will be under obligation to pay the instalments to thebank. Economic consequences ofthe change willbe substantial asthe banks will have to operate within the constraints of liquidity

    imposed by the system. Instalment credit willbe part of the creditsystem operated through the banks under supervision of theMonetary Authori ty. I t wil l not .have an uncontrolled growthoutside the system and, in all probabi lity, wi ll be much morerestricted than at present

    I[ ;0








    Finance for the Government and the Public Sector

    One ofthe major evils ofthe interest-based system, accordingto Islamic economists, has been thephenomenal growth in publicdebt A switchto an interest-free system willcurtail this growth to

    a very great extent Costs of administration, defence and other'non-productive' services ofthe state will have to be met throughfiscal measures including compulsory borrowing from owners oflarge surpluses. Public sector projects may be financed throughissue of 'shares ' promising part of the profi ts to shareholders.Funds could flow into the public sector projects on the basis ofmuejflraba or shirka directly from the public or indirectly throughthe commercial banks. I Our writers envisagea sizeable flow ofinterest-free loans to the government, especially in the event of awar or national calamity. Exemption .ofmoney lent to the statefrom Zakflt could be an added incent ive to the lenders. Some

    other tax concessions have also been suggested2

    The above model of interest-free banking has not evoked anyserious criticism from professional circles. Doubts have beenexpressed, however, mainly on one point the possibility ofcheating by businessmen who would, it is alleged, find it to theiradvantage to understate their profits, or even show losses, with a

    I. ,

    ISiddiqi, M.N.: Banking Without Interest. Chapter 7 .

    2ibid.. pp.156-166.




    view to surrendering a smaller part .oftheir profits to the banks, .oreven avoid surrendering any pr.ofitat all.This they may viewofthe condition that banks can claim only a share of actual profitsofbusiness and, incase ofa loss, haveto bear the entire loss. Ithasrightly been pointed .out;-ho.wever,that such practices will becontrary to the interests of the businessmen themselves. I t wil l

    destroy their creditworthiness and ruin their chances ofgetting anyfurther advances fr.omthe banks. The banks, in select ing theirbusiness partners, will naturally be guided by their past recordThose with a record .ofinv.olvingthe bank in a loss wil lbe poorcandidates for a fresh advance. Those with a record of ploughingback positive returns to the banks onthe advances made byit willhave a better chance of fresh arrangements. Those who havereturned higher percentage profits to the bank, as bank's share ofbusiness profi ts , wil l have the brightest chances of obtainingadditional capital. It will be, therefore, in the interest ofbusiness-men to str ive to make highprofits and yield attract ive returns to

    their fmancier banks.Furthermore, the modern techniques of audits and accountswillbe used, preferably under the patronage of the Central Bank,to eliminate the possibility .ofcheating from the system. It is alsohoped that moral standards in an Islamic ec.onomy will besufficientlyhigh as to c.ounteract such tendencies towards cheating.

    A total rejecQonof the muejflraba-based model has come fromMuslehuddin. He thinks that muejflraba as envisaged by Islamicjurists cannot provide.a basis for the depositor-bank and bank-businessmen relations envisaged in the above model. This view isbased on a narrow interpretation ofthe legal texts involved, which

    makes h im conclude that the muejflraba contract can be onlybetween two persons, the w.orkingparty (muejflrib) cannot investany capital ofhis ownin thebusiness financed bythe bank; and theIslamic bank will n.otbe able to make advances t .o firms whichhave already invested their own capital in their business. Lastly,

    JMuhammad Muslehuddin: . n te rest F ree Banking and the feasibi li ty o f mU9arabah '.Paper presented at theFirst International Conference onIslamic Economics, Makka 1976;and Banking and Islamic Law. Islamic Research Academy, Karach~ 1974, especiallyChap. XIV.



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    he finds that the condition that the riskofloss incase of mu4iirabawould attach to the bank alone rules out thepossibility of successfor these banks.

    Unfortunately, Muslehuddin fails to suggest a viable alternativeto the mu4iiraba-based model. His Islamic banks I will beconfmed to services performed against a fee or a commission.They would lend depositors' money for short periods recoveringonly service charges just sufficient to cover administrative costs.This would hardly make his banks a profitable business, allowingthem to pass back some of the profi ts to the depositors.

    Thejuridical issues involved inthe above model, and questionedby Muslehuddin,avealreadybeenthoroughlyexamined Ourwriters have established the validity of the two-tier mu4iirabainvolved inthe model outlined above. It isalso valid for a workingparty in mu4iiraba to invest its own capital inthe same enterprise,and for the financier to advance capital to a businessman who hasalready invested hisown capital. Some ofthe other issues relating

    to the feasibility ofthe above mode~ the supplyof short term loansand the possibility of cheating, etc., raised by Muslehuddin, havealready been discussed above.

    Monetary Policy

    Monetarypolicyisdirectedat regulatingthequantityofmoney,its availabilityand its cost The usual objectivesof monetarypolicy are price stability, balance of payments, growth of theeconomyanddistributiveustice- objectivesinwhoserealisationfiscal policyalso partakes.The Central Bank,functioningunder

    supervisionofthe Government(the MinistryofFinance),pursuesthese ends usinga numberof instrumentsat its disposal.

    Policygoalshavebeen discussedbyIslamiceconomistsunderthe generalstudyof theeconomicfunctionsofthe Islamicstate.It

    I ibid.. Chapter s XVII. XVIII .2Several writers have discussed these issues (See the Bibliography entitled: Contemporary

    Literature on Islamic Economics. Leicester, 1978). Reference may be made here toSiddiqi,MN.: Shi rkat aur mu4 ii raba t k i sha r' iu~~ Delhi, Lahore, 1969, especially pp.84-100.


    is presumed that the goals listed in the preceding paragraph aredesirable with comparatively more emphasis on stabil ity anddistributive justice.

    Not many writers have paid special attention to Centralbanking, the immediate interest being focused on evolvinga viablemodel of commercial banking. Some tended to assign the relevant

    functions to the Bait al-Miil, a view that could hardly standfurther scrutiny. As a result, Siddiqi's preliminary discussion ofCentral banking' has yet to be followed up by a more detail edtreatment 2 He notes the absenceof BankRate as an instrumentof policy. Butchangingthe reserve ratio and direct controlsonsupply of credit are two of the conventional weapons stillavailable.In the absenceof interest-bearingsecurities,sale andpurchase of certain kindof shares and 'loan certificates' couldprovide the means of' open market operations'. 3 As an alternativeto the Bank Rate a number of other policy instruments aresuggested The 'Re-finance Ratio'4 refers to the offer of the

    Central Bank to provide additional cash to the commercial banksto the extent of a certain percentage of the interest-free loansgranted by them. Raising or lowering this ratio will have theeffect of expanding or contracting the supply by the commercialbanks of short term credit Prescribing different ratios inrespect ofcredit extended to different sectors ofthe economy can be a meansof channelling credit intodesired directions. Another instrument isthe Lending RatioS which refers to the percentage of demanddeposits which the commercial banks willbe obligedto lendout asinterest-free loans. This instrument too can be manipulated toaffect the supply of short term credit The Central Bank may also

    consider the advisabi lity of control ling the 'ratios of prof itsharing' - the percentage of profits accruing to the entrepreneur(working with capital advanced by the commercial banks) which




    ;; .




    IMuhammad Nejatullah Siddiqi: Banking Without Int eres t, Chapter VI.2More on thi s i ssue in the pos tscr ip t below.3ibid., pp.123-129 and 158-169 .4Siddiqi, M.N.: S om e As pe ct s of t he I sl ami c E co nom y, p .l05 . Delhi , Lahore, 1970.

    Thi s rat io has been ear li er named the 'Borrowing Rat io ', s ee Banking Without Int eres t. op.cit. pp.lI6-122.




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    would flowback to the bank. This issue is also taken upagain inthe postscript below.

    Moral persuasion inpolicy decisions arrived at through mutualconsultat ion has played a significant role in recent t imes. I t ishoped it willhave a still greater role toplay inthe Islamic bankingsystem.

    Thus the Central Bank in an interest-free 'system willhave anumber of instruments which itcould use to regulate the supply ofcredit and the terms on which it is available to the entrepreneur.Abolition of interest, absence of interest-bearing securities and,hence, ofthe speculation in the bonds market, will greatly reduceits problems. The marriage of capital and enterprise effected bythe replacement of interest by profi t-sharing will contributetowards growth and development The ends of distributive justicewill be served by the abolition of interest coupled' with theprinciple of Zakiit applied to most forms of wealth.

    These considerations provide a sound enough basis for con-

    cludingthat interest-free banking is viablein both commercial andCentral banking. As the practice grows,the Monetary Authority aswell as the banking community are sure to discover and devisenewer means of realising the desired objectives.

    At present, the chiefpractical concern of Monetary Authoritiesin the Muslim countries is controlling inflation - a subjectbeingcovered separately in this Seminar. With the creation of highpowered money entirely vested in the Central banks, and theautomatic curtailment of credit with the abolition of interest andcurbs on speculation, inflation can be more easily controlled intheframework of Islamic policies and interest-free institutions.



    !III'I Ii


    Internat ional Banking

    Most of the discussion on interest-free banking assumed aclosed system, in the first instance. In an interest-free internationaleconomy the same model can be extended without difficulty. A'special problem is, however, posed by the realistic assumption



    that interest-free national banking systems will have to interactwith the interest-based system dominating the world. This issuewas taken up by early writers onthe subject and a simple solutionbased on 'permission due to necessity' was suggested Whi letransactions with interest-based insti tutions would involvepayment as well as receipt of interest, these transactions can be

    channelled through the Central Bank which could, as far aspossible, insulate the indigenous economy from the effect ofthesetransactions. If and when a number of countries are wil ling tooperate on an interest-free basis they can form a group of theirown. Interest can be abolished from all international transactionswithin this group. The group can negotiate alternatives to interestwith the outside world wherever feasible.

    The establishment ofthe Islamic Development Bank at Jeddahfol lowed by the formation of Islamic banks at Dubai, Cairo,Khartoum and Jordan* have prepared the ground forinternationalmonetary cooperation free of interest The recently founded

    International Association of Islamic Banks is a step in thatdirection. One of i ts declared aims is to advise i ts members oninvestment and to attend to their l iquidity problems, besideseffectingcoordination in their working and standardisation intheirpractice. One of the prime concerns of International I slamicRanking should be the mounting foreign exchange reserves of theoil-rich countries which are exercising inflationary pressures athome and have, surprisingly enough, increased their vulnerabilityto the manoeuvrings of international high finance. Speedyutilis-ation of these surpluses for human capital formation in, andtransfer oftechnology to, the Islamic peoples in particular and the

    Third World in general , is hardly possible in the framework ofinterest-bearing loans and investments. Interest-free loans on aliberal scale and long term profit-sharing arrangements, possiblywith an initial period ofgrace, could usher in an era of rapid all-round development to the advantage ofthe entire regionsof North

    *M or e r ece nt a dd it ion s ar e t he I sl am ic B ank s i n B ah ra in , K uw ai t an d Lu xem bo ur g.Similar insti tutions are appearing in Bangladesh, Malaysia. Guinea and some other countries.The recen tly estab li shed Dar a l- Mal a l- I s lami i s p romoting these ins ti tu tions and creat inginterest-free investment facilit ies in western countries also.


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    Africa and South and South East Asia of which the creditorcountries would be the major beneficiaries.


    Abolition of interest has become the hallmark of Islamiceconomics in modern times. Here lies the greatest challenge forthe Islamic economists: tojustify it by a fresh analysis of moneyand its role in the economy and present an operat ional model ofinterest-free banking which may convince the modern ~an thatIslam's economic system based largely on the twin principles ofZakat and abolition of Riba is morejust and more efficient thanany other alternative. They have been quite aware of thischallenge and their response has been vigorous. The idea ofinterest-free banking has already entered the stage of experiment-ation after a quarter century devoted to model building. It is nowreceiving attention not only fromtrained economists but also from

    professional bankers and governments. It is advisable that theexisting interest-free institutions provide relevant data and reporttheir problems for analysis and careful consideration by econo-mists. More than in any other area in economics, practice leadstheory in ~oney and banking.

    Meanwhile the entire area ofnon-bank financial intermediaries,of near money, oftransactions inforeign currencies and the vitalsubject ofinternational monetary organisation awaits the attentionofIslamic economists. It is hoped expert attention will be focusedon these areas in individual researches as well as in seminardiscussions.

    Postscript:Review of Contributions during 1977 - 1981

    The two seminars on the Monetary and Fiscal Economics of.Islam in 1978 and 1981, held atMakka andIslamabad respectively,have contributed to further progress in the subject under review.Many ofthe points made earlier and noted above received furtherelaboration and clarity. Of great interest, however, are the newissues that received attention. These are noted below:


    Demand for Money

    Demand for money and its determinants have always engagedthe attention of economists. Writers on an interest-free economyowed the subject a fresh look. This is the more necessary as theyhave successfully demonstrated that the mode of supply ofmoneyin an interest -free economy based on profit -sharing will beentirely different from what it is at present Creation ofmoney inan interest-free system will be investment oriented, not based onlending. Seen in thisperspective thetransactions and precautionarydemand for money remain intact, with perhaps some variation intheir magnitude depending on the redistributive effects of Zakat,its impact on marginal propensity to consume, and the extent towhich the social security arrangements in Islamic society lessenthe need for precautionary holdingof money. The factor requiringa closer scrutiny is the 'speculative' demand for money.

    Hardly anyone agrees with Metawally's assertion I that in anIslamic economy 'No money would be demanded for speculativepurposes since. . . no speculation is allowed in Islam.' As SultanAbou Ali pointed out2all three motives for the demand for moneywillexist inan Islamic economy. There has been a general feeling,however, that the speculative motive for holding money will bemuch weaker in an Islamic economy as compared to the interest-based economy. This viewpoint, already reported above, ha~beenrecently reaffirmed by Chapra3 who thinks that the demand formoney will be 'basical ly ' determined by transactions and pre-cautionary motives which are largely a function of the level ofincome. .

    A closer look at the demand for money has been attempted by

    Ma'bid Ali al-J arhi in his comprehensive discussion on 'AMonetary and Financial Structure for an Interest-Free Economy:

    ] MM Metawally: 'Fiscal PolicyinIslamicEconomy'. Paper presented attheFollow-upSeminar on Monetary and Fisca l Economics of I s lam, I sl amabad , 1981.

    2ibid.. Comments.

    3MU. Chapra: 'Monet ary Policy in an Islamic Economy'. Paper presented at theFol low-up Seminar on Monetary and Fisca l Economics of I sl am, I sl amabad , 1981.


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    ."Institutions,MechanismandPolicy'. I An average rate ofprofit oninvestment replaces the rate ofinterest as the opportunity cost ofmoney, in the context of investment behaviour in an interest-freesystem. In Jarhi's model the closest approximation tothis rate willbe therate ofreturn onCentral Deposit Certificates ofthe shortestmaturity. 'The Central bank can open investment accounts in its

    member banks, in which itdeposits whatever money it creates andfrom wJ1ichit withdraws whatever money it requires. Memberbanks. . . willinvest these deposits inthe real sector inaccordancewith the jnvestment policy ofeach. . . Such deposits willbe termedCentral Deposits or CD's . . . The Central bank can create aninstrument which could be termed Central Deposit Certificate.CDC's can besold to the public and their proceeds be invested inCD's through the banking system. Obviously the CDC's provide alower degree of financial risk since each carries with it a title to amore diversified investment portfolio than any member bank canitself prov ide. The rate of retu rn on CDC's will approach the

    average rate of profit on investment for the whole economy.'2Once Jarhi is able to replace the rate of interest with a clearlydefined rate of return he can call the conventional analysis ofdemand for money to his service. 'Whenever this rate of returnrisespeople willfindit preferable to economisein holdingmoney fortransactions and to divert some ofit to investment Whenever thisrate ofreturn falls, it becomes less costly to hold cash, encouragingpeople to increase their current deposits or add to their holdings ofloan deposit s in the Central bank. Briefly, we can say that the

    II, .1 L.

    i Iii! 1Ii

    IPaper presented at the Follow-up Seminar on Monetary and Fiscal Economics ofIslam,held a t I sl amabad , January 6-11, 1981. We have before us the rev ised version of th is papersubmi tt ed in February, 1980 for inc lusion in the seminar volume under pub li ca tion . But thea ut ho r h as m ad e s ub st an ti al c ha ng es i n t hi s p ape r si nce t hen an d a n A ra bi c v er si on d at edJune 1981 i sbeing pub li shed by the Interna tional Cen tre for Resea rch in I sl amic Economics . .

    King Abdulaz iz Unive rs ity, Jeddah. We have quo ted the Eng li sh ver sion where nochangeswere involved, reference being made to the Arabic version only when itdoes involve changes.It isinteresting to note that section VI-C, ofthe English version entitled' Speculative Demandfor Money ' i scomple te ly rewri tt en for the Arabic ver sion , appearing as chapter f ivesect ionI V un de r t he t it le ' Dem and f or Mo ne y i n t h e In te re st -Fr ee S yst em '.

    2al-Jarhi, op. cit., Eng li sh ver sion , sec tion I II , A , 4 .


    demand for money is an inverse function of this rate of return.' IJarhi then proceeds, with a demand for money curve slopingdownward from left to right , with the Y axis showing the rate ofreturn on CDC's, to study the equilibrium inthe financial marketNo fresh insights are offered as far as the demand for money isconcerned Attent ion is focused instead on how the supply of

    money can be managed in an interest-free system. The only pointhemakes about changes inthe rate ofreturn onCDC's isthat theywould reflect real factors relating to production. Then he hastensto conclude that his' demand for money function rel ies on realfactors .~hich are stablein the long run. It is not an unstablefunction like the speculative demand for money function.'2

    Jarhi fails to discuss the relationship between changes in theprice of CDC' s and other marketable investment instruments andthe demand for money. Thus he leaves out the whole subject ofexpectations so crucial to any analysis ofdemand for money. Hefailsto distinguish explicitly between the expost rate ofreturn and

    the expected rate of return on investments. He makes the demandfor investment instruments a direct function of the rate of return,people buying more CDC's and other investment instruments asthe rate ofreturn rises. What happens to the price ofCDC's andother investment instruments in such a situation? Presumably theywould rise with every rise in the rate of return, implying largerquantities being demanded at higherprices, and vice versa! Peoplewho want to use their money for making profits through buyingand selling 'investment instruments' generally 'speculate' aboutthe direction in whichthe prices ofthese instruments are expectedto change. Once Jarhi introduces marketable instruments l ike

    CDC's in the system he is obliged to deal with this type ofspeculation at some length, which, unfortunately, he failsto do. Agreater attention to the market for CDC's and other investmentinstruments and the extent to which 'speculation' may interactwith'real factors' in determining theit prices, and hence their rate

    Ial Jarh~ op. ciL, Arabic ver sion , chapter f ive, sec tion IV.

    2ibid. I tmay a lso beno ted tha t anea rl ie r a tt empt insec tion IV, C of the Eng li sh ver sion torel at e d em and fo r m on ey t o ch an ges i n t he m ar ke t pr ic e o f C DC' s a nd o th er i nve st me ntins truments i s abandoned in the Arabic ver sion .


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    of return, is called for before one can g~t a clear idea ofdetennination of demand for money in an interest-free economy.

    Jarh i r ight ly started by st ressing the point that abo lition ofinterest would forge a direct linkbetween demand for money andreal investment via the average rate of profit on investment Thehigher the profit you expect the more investment you make, and

    the less money you hold But this simple world is shattered topieces by twofacts to which closer attention has to be paid inorderto salvage that world One is the availability of marketableinvestment instruments which can be regarded as the next bestalternatives to money. The other fact is that the price of theseinvestment instruments will be subject to forces of demand andsupply. Hence, one has to reckon with the self-justifying nature ofspeculation on future trend ofprices and rates ofreturn, despite thereal factors to which J arhi refers. We need greater detailsregarding the nature ofhis CDC's andother marketable investmentinstruments, and the tenns and conditions attached to them, in

    order to examine his contention that they would be immune tosuch speculation.

    What Jarhi does instead is to rely on diagramatic analysis toargue how the Monetary Authority should manage the supply ofmoney to keep the rate ofreturn on investments at the equilibriumlevel . Changes in the rate of return ar ise in his analysis in theinvestment sector, leading to changes in the demand for money.The Monetary Authority moves into make compensatory changesin the supply of money which can eventually bring the rate ofreturn back to its fonner level (figures 1-3 to 1-5 and 2-3 to 2-5 inthe Arabic version). Alternatively, the propensity to consume

    may increase leading to a decline insaving.This too will raise therate of return, increasing the demand for money. Compensatorychanges inthe supply ofmoney may fail,however,to bringtherateofreturn to its fonner level, inthis case(figures 1-6 and 2-6 intheArabic version).

    The diagramatic analysis remains unconvincing inthe absenceof an analysis of expectations andprices ofinvestment instruments,as noted above. Profit expectations in an investment-centred,rather than lending-centred, system call for a much closer analysis




    than Jarhi could afford His model leans too heavily onthe supplysidefor the obvious reason that itcanbe managed The factthat wedonot know how tomanage the demand for money to hold makesan insight into the determinants of this demand still moreimportant The economics ofan interest-free economy must awaitgreater efforts in that direction.

    Discounting Future Values

    Another contribution of some significance has been the affinn-ation that there is nothing un-Islamic about discounting futurevalues e.g. future yields of capital goods, to their present values,and that the expected rate ofreturn on equity and not the rate ofinterest is the proper factor to discount with. This has been donerecently by Anas Zarqa. I It is not a positive time preference thatnecessitates discounting of future values but the fact that invest-ment often has a positive net marginal product Hence, discounting

    is required in order to ensure efficiency. Furthennore, it isdesirable to do this 'to achieve the Islamic objective of avoidingisrlif'. Zarqa finds the alleged dependence of discounting oninterest to be rather illusory. Zarqa's paper should put a stop tothetendency of some of our writers to turn to a 'shadow' rate ofinterest because of the need for discounting future values.


    Another issue that attracted great attention during the periodunder review is that of indexation. Price stability is an accepted

    goal of monetary policy in an Islamic economy, but inflation isrampant all over the world and it cannot be claimed withcertainty that abolition of interest alone will eradicate this eviLSince loans donot carry interest inan Islamic economy, the lenderwill be deprived of whatever compensation interest could offeragainst the depreciation of the sum lent due to inflation. This led

    I Muhammad Anas Zarqa: .An Is lamic Pe rs pe ctive on the Economics of Disc ounting inProject Evaluation'. Revised paper for inclusion in the volume on Islamabad Seminar(January, 1981).


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    Rafiq al-Misrito observe that 'indexation of loans solvesa bigeconomic,legaland financialproblemand is also useful in thecontextofIslamicbanking.It willencouragesavingsanddeposits(loans)withoutinterest It willonlyprotecttherealvalueofloans,whichis agreatadvantageforthepeopleofourtimewhooftenfindtherateof inflationto be higherthan therate ofinterest Lastly,indexationofloans realisestheobjectiveofstabilityinthe valueofmoney whichhas alwaysbeen so dear to the Muslimsas statedabove'. I Al-Misricitessomejuristicopinionsto buttresshis case,but he does not discuss the economic implications of indexatioILIndexation has, however, beenrecommendedon economic groundsbyNaqvi.2 According to him, 'a positive rate ofinterest performs,though imperfectly, the functions of safeguarding the real value ofprivate saving'; when interest is abolished, 'a system of linkingprivate savingwith an appropriate cost ofliving index mayprovide

    an answer - perhaps the only answer - to this problem' . ButN aqvi conveniently forgets the fact that abolition ofinterest wouldnot deprive savings of a positive return, only that the return wouldbe uncertaiIL Chapra3 has rightly arguedthat indexation isno curefor inflatioILIt may even accelerate it aesides that: 'even thoughit is proposed with the innocent objective of doing justice to theRibii- freelender, it has the potential ofdoinggross injustice to theborrower'.4 As Kahf observes, 'the attempt to compensate oneparty for erosion inthe value ofmoney is unfair and unjust, and itwill be redundant if everybody were to be compensated for thesakeofjustice'. Accordingohimindexationwouldalsoviolate

    the Islamic prohibition ofribii'[-faf/.l.

    Zubair alsofinds indexation

    IRafiq al-Misri: ai-Islam wa'l-Nuqud ( Is lam and Money) p .92. In te rnat iona l Cen tr e forResea rch in I sl amic Economics , K ing Abdulaz iz Unive rs it y, J eddah, 1981.

    2S.N.H. Naqvi: E th ic s and Economics : An Isl amic Syn thes is . The Islamic Foundation,Leicester, 1981, p.121.

    3M.U. Chapra: 'Money and Banking in an I sl amic Economy '. P roceed ings o f the MakkaSeminar, 1978.

    4ibid. T he a rg um en t i s r ep ea te d w it h a dd ed f or ce i n a l at er p ap er ' Mo ne ta ry P ol ic y i n a nI sl am ic E co no my ' p re se nt ed a t t he I sl am ab ad S em in ar i n 1 98 1.

    s Mo nz er K ah f i n d is cu ss io n o n C ha pr a' s p ap er. P ro ce ed in gs o f t he M ak ka S em in ar ,1978.



    to be against Islamic principles and without any basis in Shafi'a. IAs a practicingbanker, Abdul Jabbar regards indexation to beimpracticaL 2

    As a matter offact, an'yschemeofindexationcanhardlycoverallcategoriesofpeopleaffectedby inflation.Insofarasit doesnot,it willbe dis.criminatory. Assumingthat it does,it willaccelerateinflation, defeating its purpose. There is only one remedy toinflationand that ispricestability.This objectivemaybe realisedonly imperfectly,but it is hot advisableto singleout lendersforcompensationas all contractualincomesare affectedby inflation.

    The eagerness to protect depositors in 'loan accounts' ofIslamicbanks (i.e. depositorswhoare not interestedin investingtheir savings but only in safe keeping) which makes al-Misrisuggestindexationis quiteunderstandable.SultanAbou Ali hasalsojoined him by suggestingthat 'the amountof loan could be

    relatedto a physicalunitaccordingtothe lender'spreference.Theborrowerwillborrowonthe sameterms.The principalofthisloanwillbe redeemedindexed,eithermoreor less, to theunit chosenwith no interest'. Notwithstanding the juristic objections ofZubair and Kahf noted above, the idea seems to beimpractical inthe context of Islamic banking. This is evident when we considerthe disposal of these deposits by interest-free banks. They areutilised partly in givinginterest-free loans and partly in profitableinvestment by the bank itself.The interest-free loans are earmarkedfor priority consumer needs, very short term business needs andthe government In most cases these loans are for non-productive

    purposes. I t is hard to fmd justificationfrom the borrower 's

    viewpoint for the compensation against inflat ion he would becalled upon to make atthe time ofrepayment Regarding the partbanks are allowed to invest on a profit-sharing basis, we run intodifficulties if the rate of inflation is higher than the rate of profit



    I M uh am ma d U me r Z ub ai r i n d is cu ss io n o n C ha pr a' s p ap er. P ro ce ed in gs o f t h e M a kk aSeminar, 1978.

    2Abdul Jabbar Khan: 'Commercial Banking Operations in the Interest-Free Framework' ,I sl amabad Seminar, 1981.

    3Su lt an Abou AIi a s con tr ibutor to thed i scussion on Chapra' s paper 'Money and Bankingi n a n I sl am ic E co no my ', P ro ce ed in gs o f t he M ak ka S em in ar , 1 97 8,


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    accruing to the bank as its share of the profits ofthe enterprise towhich the funds are supplied In such a situation the banks maytotal ly refuse to accept deposits into their loan accounts. Oncebanks are deprived of the possibility of making profits by utilisingpart of these deposits , they may legit imately demand 'servicecharges ' from the depositors as well as from those who'secure

    interest from loan. This would be doubly justified in view of theadditional cost of calculating the inflation coefficient This willopen a door which has undesirab le implicat ions, as noted bySultan Abou Ali himself in a subsequent paragraph of the notequoted above.

    There is a signi ficant volume of voluntary pr ivate lendingwi thout interest in an Islamic society. Once the principle ofindexation isintroduced at thebank's level this practice willbe putunder heavy strain. I f a similar pract ice i s allowed in privatedealings, it will open the floodgates to interest If it isnot allowed,the prohibi tion wil l car ry no moral weight and is likely to be

    violated on a large scale. To the extent that such a prohibition isenforced it may lead to a cessation of private lending so causinghardship.

    Lastly, indexation ofloans gives a privilege to the lender whichthe one who decides to hold his money does not enjoy. In theinflationary world in which we are considering this proposition(which is never known to have been made in a deflationarysituation) this amounts to a 'gain without risk' which runs counterto the basic Islamic principle in the realm of finance.


    Creation of Credit and Seigniorage

    In their search for effective cures for inflation some Islamiceconomists have turned once again to creation of credit and thefractional reserve system - issues which have been under discus-sion for quite some time, as reported above. Credit has, ofc;:>urse,to be created to meet the society's growing need for means ofexchangebutKahfl.andJ arhi 2 insistthat it mustnot beleftto the

    IMonzer Kahf I sl amic Economy, op. c it . p.73.

    2Mabid AIi a l- Ja rh i: I sl amabad paper, op. cit .


    commercial banks as it enables them to reap unjustified profits.Creation ofmoney by commercial banks isbound to be inflationaryas these banks are motivated by profi ts and not public interestThe power to create credit should, therefore, belong to the CentralBank which is moved by public interest

    Serious doubts have been expressed, however, regarding the

    efficiency of a system in which only the Central Bank isempowered to create credit Arriff' notes that theadvocates ofthischange have failed to argue that it willbe a more efficient way ofcreating credit, and step further to suggest that theproposed system willbe more inflationary asthe Central Bank willbe under constant pressure to create credit for non-productivepurposes. Chapra3 seeing no advantage in such a change focusesattention on the subsidy or 'seigniorage' (the difference betweenthe return on or purchasing power of created money and the costsincurred in its creation) from society to the commercial banks.'The question is: who should benefit from this subsidy? In the

    existing system, the subsidy goes directly or indirectly to threegroups: (a) the banking public, through the provision of a numberof banking services free of charge; (b) "privileged" borrowersfrom banks through lower rate of interest, the lossto society beingthe difference between the opportunity cost of created money tosociety and the "prime" rate of interest; and (c) the bankstockholder, through increased profits. The poor and the needypeople of the society and the non-banking public get no directbenefit from deposit creation. It can be argued that in the .socialwelfare oriented valuesystem oflslam, the power to create moneyshould be considered a social prerogative and, therefore, the net

    income should be used for general welfare and, particularly, forimproving the lot of the poor people'.Chapra then proceeds to suggest ways and means through

    IMohammad Arr iff ind i scussion on Chapra' s paper 'Money and Banking in an Isl amicEconomy '. P roceed ings of the Seminar onMone ta ry and Fisca l Economics ofI sl am. Mil ia .1978. "

    2Mohammad Saqr inProceedings of the Makka Seminar, d iscuss ion on Chapra' s paper.

    3M U. Chapra 'Money and Banking in anIs lamic Economy '. P roceed ings of the MakkaSeminar. 1978, Sec tion 3-B.



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    whichthiscanbe arranged Oneof thesewaysis to considerthetotal of derivativedepositsas mutf