Current practices

Generally speaking, all interest-free banks agree on the basic principles. However, individual banks differ in their application. These differences are due to several reasons including the laws of the country, objectives of the different banks, individual bank’s circumstances and experiences, the need to interact with other interest-based banks, etc. In the following paragraphs, we will describe the salient features common to all banks.

Deposit accounts

All the Islamic banks have three kinds of deposit accounts: current, savings and investment.

Current accounts:

Current or demand deposit accounts are virtually the same as in all conventional banks. Deposit is guaranteed.

Savings accounts:

Savings deposit accounts operate in different ways. In some banks, the depositors allow the banks to use their money but they obtain a guarantee of getting the full amount back from the bank. Banks adopt several methods of inducing their clients to deposit with them, but no profit is promised. In others, savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals and minimum balance. Capital is not guaranteed but the banks take care to invest money from such accounts in relatively risk-free short-term projects. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands.

Investment account:

Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit (or loss) in a given proportion with the bank. Capital is not guaranteed.

Modes of financing

Banks adopt several modes of acquiring assets or financing projects. But they can be broadly categorised into three areas: investment, trade and lending.

Investment financing

This is done in three main ways: a) Musharaka where a bank may join another entity to set up a joint venture, both parties participating in the various aspects of the project in varying degrees. Profit and loss are shared in a pre-arranged fashion. This is not very different from the joint venture concept. The venture is an independent legal entity and the bank may withdraw gradually after an initial period. b) Mudarabha where the bank contributes the finance and the client provides the expertise, management and labour. Profits are shared by both the partners in a pre-arranged proportion, but when a loss occurs the total loss is borne by the bank. c) Financing on the basis of an estimated rate of return. Under this scheme, the bank estimates the expected rate of return on the specific project it is asked to finance and provides financing on the understanding that at least that rate is payable to the bank. (Perhaps this rate is negotiable.) If the project ends up in a profit more than the estimated rate the excess goes to the client. If the profit is less than the estimate the bank will accept the lower rate. In case a loss is suffered the bank will take a share in it.

Trade financing

This is also done in several ways. The main ones are: a) Mark-up where the bank buys an item for a client and the client agrees to repay the bank the price and an agreed profit later on. b) Leasing where the bank buys an item for a client and leases it to him for an agreed period and at the end of that period the lessee pays the balance on the price agreed at the beginning an becomes the owner of the item. c) Hire-purchase where the bank buys an item for the client and hires it to him for an agreed rent and period, and at the end of that period the client automatically becomes the owner of the item. d) Sell-and-buy-back where a client sells one of his properties to the bank for an agreed price payable now on condition that he will buy the property back after certain time for an agreed price. e) Letters of credit where the bank guarantees the import of an item using its own funds for a client, on the basis of sharing the profit from the sale of this item or on a mark-up basis.

Lending

Main forms of Lending are: a) Loans with a service charge where the bank lends money without interest but they cover their expenses by levying a service charge. This charge may be subject to a maximum set by the authorities. b) No-cost loans where each bank is expected to set aside a part of their funds to grant no-cost loans to needy persons such as small farmers, entrepreneurs, producers, etc. and to needy consumers. c) Overdrafts also are to be provided, subject to a certain maximum, free of charge.

Services

Other banking services such as money transfers, bill collections, trade in foreign currencies at spot rate etc. where the bank’s own money is not involved are provided on a commission or charges basis.

Shortcomings in current practices

In the previous section we listed the current practices under three categories: deposits, modes of financing (or acquiring assets) and services. There seems to be no problems as far as banking services are concerned. Islamic banks are able to provide nearly all the services that are available in the conventional banks. The only exception seems to be in the case of letters of credit where there is a possibility for interest involvement. However some solutions have been found for this problem -- mainly by having excess liquidity with the foreign bank. On the deposit side, judging by the volume of deposits both in the countries where both systems are available and in countries where law prohibits any dealing in interest, the non-payment of interest on deposit accounts seems to be no serious problem. Customers still seem to deposit their money with interest-free banks.

The main problem, both for the banks and for the customers, seem to be in the area of financing. Bank lending is still practised but that is limited to either no-cost loans (mainly consumer loans) including overdrafts, or loans with service charges only. Both these types of loans bring no income to the banks and therefore naturally they are not that keen to engage in this activity much. That leaves us with investment financing and trade financing. Islamic banks are expected to engage in these activities only on a profit and loss sharing (PLS) basis. This is where the banks’ main income is to come from and this is also from where the investment account holders are expected to derive their profits from. And the latter is supposed to be the incentive for people to deposit their money with the Islamic banks. And it is precisely in this PLS scheme that the main problems of the Islamic banks lie. Therefore we will look at this system more carefully in the following section.