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Banks and Banking

By:
Rodney Wilson
Source:
The Oxford Encyclopedia of the Islamic World What is This? Provides comprehensive scholarly coverage of the full geographical and historical extent of Islam

Banks and Banking

Modern banking was first established in the Islamic world in the mid-nineteenth century. Financial intermediaries were not, of course, new to the region, as the sophisticated Muslim trading economies had long used specie as a means of exchange, and money changers and money lenders carried out their business in most urban centers. Money changers were especially active in the cities of the Hejaz, such as Mecca and Medina, catering to the needs of the pilgrims, demonstrating that there was no Islamic objection to currency dealings and the exchange of precious metals. The prohibition of ribā (interest) in the Qurʿān, however, meant that there was much suspicion of conventional commercial banking in the form in which it had developed in Europe.

The Penetration of Colonial Banking.

Early commercial banks in the Muslim world were all European-owned: the Imperial Ottoman Bank was an Anglo-French venture and the Imperial Bank of Persia was British-owned and managed. Much financial intermediation in the Ottoman territories was in the hands of Jews or Greek Christians rather than Muslims. The latter were keen traders, and indeed the Prophet Muḥammad had been a trader, but there was reluctance on religious grounds to get involved in the collection and lending of money in particular. Muslim traders granted credit in kind on a deferred-payment basis rather than charging interest. Advances were covered from personal and family equity rather than from savings attracted from strangers by the promise of interest.

The Imperial banks served the government and the trade of the European empires, rather than local Muslim business communities or the wealthy landlord class. The management of Ottoman debt was a major undertaking, and the Imperial Ottoman Bank acted on behalf of the sultan in arranging bonds issued in London and Paris. The Imperial Bank of Persia was closely involved with the Anglo-Iranian oil company, later to become British Petroleum. The National Bank of Egypt, a wholly British-owned institution, was involved mainly in the finance of cotton exports, on which the Lancashire textile industry depended. This trade was controlled by Greek and Levantine merchants rather than Egyptian Muslims. In Malaya, the Hong Kong and Shanghai Bank was active in the finance of the rubber trade, but even the plantation workers were immigrants rather than indigenous Muslims.

Muslim-Owned Commercial Banks.

It was not until the 1920s that groups of Muslim businessmen began to realize that traditional financial intermediation was of limited value in modern economies. For large-scale transactions, especially with foreigners, letters of credit, guarantees, and acceptance of bills were indispensable. Such facilities significantly reduced transaction costs and could mean the difference between concluding business deals and missing opportunities. Yet lenders and money changers were unable to provide such facilities. At the same time, potential Muslim clients often experienced difficulties in obtaining credit from the European-owned banks. The only answer was for Muslim businessmen to establish banks themselves. It was these pressures that resulted in the establishment of Bank Misr (in Egypt), the Arab Bank (a Palestinian institution), the Habib Bank (in British India), and other commercial banks in Muslim countries and communities.

Banks had been kept out of Saudi Arabia by King ʿAbd al-ʿAzīz, who believed that only infidels patronized Western banks, whose practices could never be Islamically acceptable. With the kingdomʾs development and the discovery of oil, there were strong pressures to admit foreign banks, and even Bank Misr applied for a banking license, as its directors thought that their Muslim credentials might impress the king. Permission to establish a branch was refused, but when two well-respected local money changers, the Bin Maḥfūẓ and Kakī families, applied for a banking license, the king agreed, after consultations with some prominent Jiddah merchants.

The license was conditional on the bank operating in a way that was Islamically acceptable—this meant avoiding interest payments or receipts. The institution established, the National Commercial Bank, charged fees for its services and provided current accounts for its customers on which no interest was paid. Lines of credit had to be agreed in advance, and contracts between the bank and its clients were set out clearly, according to the prescribed Qurʿānic rules on just trading practice. Sharīʿah (religious law), which governed all commercial practice, was thus applied to banking in Saudi Arabia.

Nationalization and Muslim Nationalism.

During the political revolutions in Egypt, Syria, and Iraq in the 1950s, the colonial banks and the private Muslim banks were taken into state ownership. In Pakistan, the banking system was nationalized a decade later, and in most Muslim countries, states played significant roles in the financial system. The intervention by the state was not due to Islamic ideology; indeed sharīʿah is concerned with inheritance matters in the context of the private ownership of property. Rather, the nationalization measures reflected the adoption of a planned approach to economic development and an attempt to introduce heavy industry following a Soviet type of model.

The nationalized banks mainly advanced funds to the new state-run industries, the allocation being determined by the priorities set out in the development plans. Quotas were set for each industrial sector and even individual plants, which meant that there was scarcely any flexibility to allow for changing circumstances or new opportunities. In practice, the funding available was often less than had been anticipated, which meant across-the-board reductions in lending ceilings rather than selective cutbacks on which it might have proved difficult to get agreement.

One problem was that the nationalized banks failed to attract new depositors. Ordinary citizens appeared unimpressed by the fact that their deposits were more secure, as government-owned banks were unlikely to go out of business. Interest was paid on savings deposits, but the rates were low and scarcely compensated for inflation. Financial repression prevailed in the sense that savings were not harnessed by the formal banking system. Instead there continued to be much hoarding of gold and, to a lesser extent, silver. Money changers and money lenders continued in business, catering to needs that the nationalized banks did not cover.

Evidence of the failure of the nationalized banks is easy to find. Bank deposits were worth less in Syria and Iraq, for example, than they were in Jordan, a much smaller country, where there had been no nationalization measures. The ratio of bank assets to gross domestic product was static in Egypt and fell in Pakistan, indicating financial shallowing rather than the deepening that might be expected with development. The bureaucratic nature of the nationalized banking business put off many potential clients. There was a reluctance to widen the range of financial services on offer, and there were no competitive pressures to innovate through the introduction of modern technology.

In some Muslim countries, notably the Gulf States, Malaysia, and Indonesia, governments have favored privately-owned banks in the form of publicly quoted joint-stock companies. There has nevertheless been a desire to see a majority-ownership stake in the hands of local Muslims. Following independence in Kuwait, the branches of the British Bank of the Middle East were sold to indigenous investors, and the bank became the Bank of Kuwait and the Middle East. In Saudi Arabia, 60 percent of Citibankʾs operation was offered to the public, and a new institution created, the Saudi American Bank. The injection of Saudi Arabian capital into the hitherto foreign-owned banks enabled them to expand, creating a more competitive financial environment.

An Islamic Financial Alternative.

There was considerable dissatisfaction with conventional commercial banking in most Islamic countries, both on the part of Muslim scholars and intellectuals and among the general public, who were aware of the Qurʿānic position on ribā. Merely having fees and service charges instead of interest was not seen by many as a satisfactory solution, and in many Muslim countries ribā was quite open. Some thought that only usury was ribā, and in any case charging interest to business borrowers could not be a problem on religious grounds, if the aim of the prohibition on ribā was to protect the poor private borrower from hardship. In the United Arab Emirates, a court ruling outlawed compound interest but permitted simple interest.

In Turkey, where inflation was an ongoing problem, nominal interest to compensate for rising prices was justified, as long as there was not a real interest burden on borrowers. Such arguments, however, did not impress fundamentalist thinkers whose concern was not merely with the prohibition of interest, but with the introduction of participatory finance as a real Islamic alternative. Earning a predetermined return for merely hoarding could not be justified. On the other hand, profit as a result of risk-sharing was not only legitimate, but highly desirable.

Profit Sharing.

The principle of profit sharing, which was well established in Islam, was known as muḍārabah. Depositors could earn a share in either the bankʾs pro-fits or the profits from a specified investment. Usually profit-sharing deposits are described as investment accounts, with the depositor required to give a minimum period of notice for withdrawals, usually from one month up to a year. The rate of profit is declared by the bank at the end of the financial year after the accounts are audited, and the depositor's profit share is greatest for the longer-notice accounts.

If the bank is making a loss, no profit-share may be offered, although profit pay-outs to depositors generally take precedence over dividend payments to shareholders. The value of deposits is usually guaranteed, unlike bank equity, the price of which depends on stock-market conditions. There is therefore less risk for holders of investment accounts than for equity investors, but the latter have voting rights at annual general meetings of the bank, whereas depositors do not.

Islamic banks also offer current-account facilities for transaction balances, which can be instantly withdrawn by check or automatic teller machine. No return is offered to current account holders, but in some cases international charge cards such as Visa are offered to depositors, though these are managed on a direct-debit basis rather than as credit cards. Usually only current account holders can apply for credit.

Credit Facilities.

The use of bank funds reflects the demands of their clients and the environment in which the institutions operate. Much of the finance required in Muslim countries is to fund trading activity, so Islamic banks are, not surprisingly, most active in this field. Islamic trade financing is offered on a murābaḥah basis whereby the bank purchases goods on behalf of the client and later resells them to the client at a markup. The bank charges the markup to cover its costs and to allow a return for the risk it takes on during the period it owns the goods being traded. The Islamic bank usually does not take delivery of the goods but has the responsibility of ownership, unlike a conventional commercial bank.

Islamic banks also offer longer-term credit facilities through leasing or ījārah, especially for items of capital equipment. In some cases this may involve hire-purchase or installment sale, where the customer eventually acquires ownership of the equipment. Longer-term participatory finance is also provided by Islamic banks that become the partners in the business, according to the principle of muḍārabah. The bank may provide all of the funding, acting as ṣāḥib al-māl (the financier), and the muḍārib (the active manager) provides the entrepreneurial skills and management.

Under a mushārakah (equity sharing) arrangement, funding may be provided to an existing company. Alternatively a new company can be established as a financing vehicle that may be concluded after an agreed period.

The Spread of Islamic Banking.

The first modern Islamic banking institutions were farmer credit unions in Pakistan in the 1950s and the Mit Ghamr Savings Bank, a small rural institution founded in Egypt in 1963. The latter was modeled on the German local savings banks, which had impressed Aḥmad al-Najjār, the bank's founder. Influential elements in Nasserʾs political party, the Arab Social Union, and some of the senior managers in the countryʾs nationalized banks disliked al-Najjār's initiative and the Islamic nature of the institution. In 1971, it was incorporated into a new government-controlled institution, the Nasser Social Bank, which had responsibility for the collection of zakāt, the Islamic wealth-tax. Many saw this new institution as a state agency rather than a bank.

The major expansion in Islamic banking came in the 1970s with the establishment of the Dubai Islamic Bank in 1975, the Faysal Islamic Banks in Egypt and Sudan in 1977, the Kuwait Finance House the same year, the Jordan Islamic Bank in 1978, and the Bahrain Islamic Bank in 1979. The impetus came in part from the oil-revenue boom in the Persian Gulf and the growing economic muscle of the more conservative Muslim Gulf states at the expense of the more secular Arab nationalist movement. There was, in any case, a growing dissatisfaction with Arab socialism, especially among the young, and a feeling that there should be a greater emphasis on Islamic values in all spheres, including the economic and financial.

Gulf business interests strongly supported the new Islamic banking movement. Prince Muḥammad ibn Fayṣal of Saudi Arabia was the founder of the Faysal Islamic Banks. Shaykh Ṣāliḥ Kāmilʾs Dallah al-Barakah Group, based in Jiddah, aided the Jordan Islamic Bank and funded the al-Barakah Islamic Banks, which spread from Turkey to Tunisia, and even to London. The al-Rājiʿī money changing group applied for an Islamic banking license in Saudi Arabia and offered Islamic financial services internationally through their London based investment company. Prince Muḥammad founded Dār al-Māl al-Islāmī (the House of Islamic Funds), as an international financing body in Geneva.

While new Islamic banks had to compete with the conventional ribā-based banks in most Muslim countries, they appear to have been particularly successful in attracting deposits. The Kuwait Finance House accounts for one-fifth of total deposits in its home country, and the Jordan Islamic Bank has succeeded in attracting deposits from poorer people who had not previously used banks. Financial deepening has improved with the presence of the new banks, which often complement, rather than substitute for, existing banks. Islamic banking has now spread to Malaysia and Indonesia, and Bank Islam Malaysia has funded many promising industrial ventures, including those run by Chinese-speaking non-Muslims. Bank Muamalat Indonesia would appear to have enormous potential in a rapidly industrializing country with 160 million Muslims.

Recently, some commercial banks have started offering Islamic banking facilities, including the state-owned banks in Egypt and the National Commercial Bank in Saudi Arabia. Even some European banks offer Islamic financial products, including Kleinworth Benson of London and the Swiss Banking Corporation. Islamic financial instruments are increasingly accepted internationally, even in non-Islamic countries, and the basic principles are generally understood.

In Iran and Pakistan, the entire financial system was Islamized in the 1980s, and all banks in those countries operate under the sharīʿah. Not only is ribā prohibited, but all deposits are accepted on a participatory basis, and financing is entirely through Islamic instruments. It is too early to assess the success of these experiments, as Iran's economy was severely damaged by the long war with Iraq, and Pakistan has been subject to political instability and ethnic tensions.

It is clear, however, that Islamic banking is no mere passing phenomenon. Ethical concerns are perfectly consistent with profitability, and the Islamic banks have been able to harness long-term savings on more favorable terms than secular institutions. The substitution of equity for debt finance is advocated by many development agencies. Participatory finance is especially suited to small business, and there is a venture-capital gap in many Muslim countries. Islamic finance can meet these needs and provide a workable alternative to conventional lending. Of course, initial problems have inevitably occurred, but the experience so far is encouraging. The best motivation is moral rather than merely financial, and Islamic financial intermediation has been embraced with considerable enthusiasm by many.

See also ECONOMIC DEVELOPMENT; ECONOMICS, subentry onECONOMIC INSTITUTIONS; and INTEREST.

Bibliography

  • Ashker, Ahmad el-. Islamic Business Enterprise. London, 1987. The Egyptian experience, including the calculation of financial ratios.
  • Beaugé, Gilbert. Capitaux de l’Islam. Paris, 1990. Major French-language source on the subject.
  • Chapra, Muhammed Umer. Towards a Just Monetary System. Leicester, 1985. Discussion of money, banking, and monetary policy in the light of Islamic teaching.
  • Gamal, Mahmoud A. el-.Islamic Finance: Law, Economics, and Practice. Cambridge University Press, 2006.
  • Iqbal, Munawar and Philip Molyneux. Thirty Years of Islamic Banking: History, Performance, and Prospects. Palgrave Macmillan, 2004.
  • Iqbal, Zubair, and Abbas Mirakhor. Islamic Banking. Washing-ton, D.C., 1987. First detailed account of the experiences of Iran and Pakistan.
  • Kazarian, Elias. Finance and Economic Development: Islamic Banking in Egypt. Lund, Sweden, 1991. Well-written treatment from an economic-development perspective.
  • Lewis, Mervyn and Algaoud, Latifa. Islamic Banking. Edward Elgar, 2001.
  • Mallat, Chibli, ed.Islamic Law and Finance. London, 1988. Especially interesting on Malaysia and Turkey.
  • Meyer, Ann Elizabeth. “Islamic Banking and Credit Policies in the Sadat Era: The Social Origins of Islamic Banking in Egypt.”Arab Law Quarterly1 (November 1985): 32–50. Well-researched article based on interviews with participants.
  • Presley, John, ed.Directory of Islamic Financial Institutions. London, 1988. Useful reference volume.
  • Shirazi, Habib. Islamic Banking. London, 1990. Legal aspects of Iran's Islamic financing practices.
  • Siddiqi, Muhammad Nejatullah. Muslim Economic Thinking. Leicester, 1981. Survey of contemporary literature on the subject.
  • Siddiqi, Muhammad Nejatullah. Partnership and Profit Sharing in Islamic Law. Leicester, 1985. Covers contracts and business liability.
  • Vogel, Frank, and Samuel Hayes. Islamic Law and Finance. Boston, 1998.
  • Warde, Ibrahim. Islamic Finance in the Global Economy. Edinburgh, 2000.
  • Wilson, Rodney. Islamic Business: Theory and Practice. London, 1985.
  • Wilson, Rodney. Islamic Financial Markets. London, 1990. Experiences of Islamic banking in Kuwait, Iran, Jordan, Pakistan, and Turkey.
  • Wilson, Rodney. “Islamic Financial Instruments.”Arab Law Quarterly6 (April 1991): 205–214. Considers Islamic bonds, certificates of deposit, and equities.
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