Is Islamic banking Islamic ? – A Rebuttal ! 

Islamic Banking, since its beginning in Pakistan, is facing criticism from all quarters, be it financial sector or general public, and so much so, from some Islamic scholars as well. The criticism may not be an issue in itself, however, it becomes so, when the critics are not aware of even the basic principles of Islamic banking. This criticism is so frequent that not a day goes by, when someone is not commenting negatively on the subject, either in print, electronic or social media. Interestingly, most of these critics firmly agree and believe by heart that the “Interest” is prohibited in Islam, in all the forms whatsoever. Yet, they raise flimsy objections on “islamic banking”, despite knowing that Islamic banking is the only way to eliminate the “Interest” from the economic system. And more interestingly, these critics do not bother to suggest any alternate to the “interest based economy system”, at all. This criticism thus becomes ‘critique for the sake critique’, and nothing else.

For instance, a recent article – “Is Islamic Banking Islamic?” published in a reputed daily English newspaper, tried to portray that “islamic banking” is mere paperwork to pretend it so.  The write, in order to substantiate its stance, quoted the example of “Istisna” (a product of Islamic banking) for a transaction to purchase “cotton”. The author, ex federal finance minister, mentioned that if a company wants a loan for buying cotton, it can obtain the loan directly from a conventional bank, nevertheless, in case of an islamic bank, the islamic bank will instead will buy cotton from the market and will sell it to the company, for the price of the cotton plus profit thereon, for payment due in future. The author observed that an Islamic bank in this transaction will actually buy the cotton or sell it to the company, though there is paperwork to pretend that it has taken place. The writer, a finance guru, has put a lot effort to criticize Islamic banking, through the said example. However, it appears that he didn’t know that “Istisna” cannot be used for buying commodity (ies) in Islamic banking. Istisna is an Islamic mode of financing used for acquisition of assets that are to be manufactured (machinery, etc) or constructed / produced, in future. So, if such an eminent personality of Pakistan is criticizing Islamic banking, based on an incorrect understanding, then what we can expect from the general public – anything indeed. Needless to refer that he also believed in that the “Interest” is forbidden in Islam and he quoted a Quranic Verse also, to establish it so as well.

The purpose of this writing is (not) to highlight the above article. The objective is to submit that there is a great need for creating awareness amongst all sectors of life about Islamic banking. This is also necessary for the reasons that the State of the Islamic Republic of Pakistan is bound to eliminate the Interest from the country’s economy by 31^st December, 2027, as directed by the Federal Shariat Court, vide its Judgement on Riba, of the year 2022.

Criticism on Islamic banking was quite frequent in its early days, i.e. the period from 1980 to 2002. It was a period when Islamic banking was regulated by a very basic framework issued by SBP, i.e. BCD Circular No. 13 of 1984. It was in fact beginning of Islamic banking in Pakistan, with the commonly used Islamic banking product, Murabaha, which was based on mark-up system. This was indeed a paperwork sort of solution. However, in 2002, a full-fledged Islamic bank started its operations with many Islamic banking products, like Diminishing Musharaka, Ijara, Istisna, Bai Muajjal, Salam, etc. Subsequently, SBP issued many guidelines and instructions to strengthen the subject framework. In 2008, SBP issued formal sharia compliance guidelines. Then in 2010, SBP started adopting AAOIFI Standards which strengthened the framework more properly and effectively. This process rebutted the criticism of the early days. At present, the common concerns that are raised by the critics are (i) use of KIBOR as the bench mark rate and (ii) the conventional risk calculation.

The critics raise the concern that since KIBOR is interest based benchmark which is used by conventional banks for calculating the return on the lending, therefore, using KIBOR by Islamic banks leads to interest based model. But the critics fail to appreciate that KIBOR is not an interest based bench mark. It is Karachi Inter-Bank Offer Rate. It becomes interest based rate, when the banks offer the rate for conventional interest bearing loans / placement of funds between them. However, KIBOR will not be an interest bearing benchmark, if all banks would use this benchmark to place their funds, based on Islamic banking products. So, the objection is rebutted, being a misunderstanding.

The other objection is that Islamic banking models does not reflect true risk sharing. The critics argue that Islamic banks heavily rely to fixed-return and debt-like contracts to avoid the market risks, failing to embody true Islamic risk-sharing. This is again a misconception. In reality, Islamic banking products are closely tied to the real economy. They are exposed to distinct forms of market risk, like financial loss due to unfavorable price, currency, or commodity fluctuations hence, this is again an incorrect stance.

Islamic Banking is very simple, if someone is ready to understand it. Banks, worldwide, accept money from their customers on interest at fixed rate(s) and then lend the money to the borrowers on interest. The money is either accepted in savings accounts, for which the Banks agree to pay Interest to the depositors at a fixed rate, or in current accounts, for which the Bank generally do not pay any return to the depositors. In Islamic banking, the banks also accept money from their customers. However, for saving accounts, Islamic banks accepts money on “Mudarabah” basis. Mudarabah means an arrangement in which a person participates with his money and another with his efforts for sharing in profit from investment in an agreed manner. The profit is divided in strict proportion agreed at the time of contract and no party is entitled to a predetermined amount of return or remuneration. Here, Islamic banks work as the party that provides the management and labor for investment of the money.  Nevertheless, Islamic banks in this process don’t fix a rate of profit on the deposit, but the profit is divided in strict proportion agreed at the time of contract and no party shall be entitled to a predetermined amount of return or remuneration.

This accepting of money by banks is the first leg of “banking”, worldwide. The other leg is lending the money to the borrowers. Conventional Banks lend money to the borrowers on Interest, at a fixed rate. Whereas, Islamic banks do not lend money on Interest rather invest the money in sharia permissible modes of investments or products. Islamic banks do not lend money for a guaranteed return. Instead, in assets-backed financing, banks must buy and hold physical assets (such as real estate, machinery, or commodities). If the market value of these assets drops, the bank takes a direct loss. Whereas, under profit-and-loss sharing financing, the returns fluctuate based on actual business performance. If the business does well, profits are shared. If it fails, the bank loses its invested capital. In Murabaha (cost-plus) and Salam (advance payment) financing, banks trade commodities. They face market risk if commodity prices crash before they can sell them on. In Lease / Ijarah financing, banks assume the risk of asset deterioration. The asset’s value dictates the rental return and its eventual sale price, both of which are subject to market shifts. Thus, one can see that the objection related to market risk is also baseless.

We are living in a Muslim country. If we cannot try to adopt Islamic financial / economy system, then we may not claim that Pakistan is an Islamic republic, at all.