Issues in Islamic Banking

Issues in Islamic Banking
The Islamic foundation, Leicester, London, U.K., 1983/1403H, pp.152.
ISBN 0860371174 PbK.
Reviewed: M.N. Mannan
International Centre for Research in Islamic Economics
King Abdul Aziz University, Jeddah, Saudi Arabia
The book contains six papers both published and unpublished and begins with a
survey article on money, banking and monetary policy in which the author has claimed
that he examined critically issues such as demand for money, credit creation, 100%
reserves, discounting, indexation and so on. Then the author provides an "exposition" of
the “mudaraba” and answers the question “why” Islamic economists advocate a change
from interest to profit-sharing which will contribute to allocative efficiency, justice and
stability. On the economics of profit-sharing, the author argues that forces of demand
and supply should determine the ratio of profit-sharing between users and suppliers of
capital. The last chapter offers brief comments on the Report of the Pakistan Council of
Islamic Ideology, 1980. (p. 133).
This collection is an interesting addition to the growing literature on the subject.
The first paper on "Islamic Approaches to Money, Banking and Monetary Policy"
surveys the recent contribution in the field. Its main strength lies in the fact that it is
informative. In most cases, the paper has described, not analyzed the implications of
various viewpoints on some major issues such as creation of credit, discounting future
values, indexation, etc. Thus, contrary to the author's claim, most of the issues have not,
in my view, been critically examined or unfolded. In many cases, it is not at all clear as
to what is the viewpoint of the author who appears to have taken simplistic views on the
highly complex monetary process.
Let me give a few examples. The author appears to assume that value of money will
remain stable once interest rate is abolished and zakah is imposed. Money will then
perform its primary and derivative functions smoothly. (p. 16, para 2, p. 17, para 2).
58 Reviewed: M.N. Mannan
Although abolition of interest and imposition of zakah is expected to contribute to
stability, yet sound economic analysis calls for an examination of the economists'
distinction between two concepts of money (i.e., defined narrowly as either M1 or widely
as M2 or M3). This is needed to understand the changing views on what is money. The fact
is that what is an acceptable medium of exchange has changed and will continue to
change over time. It is to be clearly recognized that stability of money depends not merely
on interest but also on endogenous factors such as level of business activity, level of
expected profit, commercial banks' ability to respond to economic incentives, as well as
exogenous factors such as the control of the central bank.
Despite this inadequate treatment, the author appears to accept the role of money as a
medium of exchange in an Islamic economy. But surprisingly in his treatment of
indexation (p. 44, para 3), the author has relegated the role of money as a medium of
exchange and wants to place currency transaction and commodity transaction on the same
footing. This confusing and contradictory position becomes further complicated when he
tells us that in an inflationary situation indexation of loans gives "a privilege to the
lender" and "this amounts to a gain without risk which runs counter to the basic Islamic
principle in the realm of finance" (p. 44, para 3). Here also the author could not identify
the difference between real value of money and its monetary value. This will remain a
standing puzzle to me. At this stage, it is to be clearly understood that the outcome of
indexation of loans is inherently uncertain; while the indexation of loan can be positive,
negative or equal to principal in money term, not in real term, a pre-determined rate of
interest on loan tends to be always positive in money term.1 Thus interest on loan is a
“gain without risk”. This is what is prohibited in Islam.
Again, on the question of discounting future values, the author appears to have taken
a simplistic view by leaning solely on Dr. Zarqa's paper (p. 41, para 3). Though Dr.
Zarqa's paper helps to understand the role that the rate of return can play in Islamic
economics, a number of questions are still unresolved. The author did not provide an
objective analysis. It is to be noted, however, that while discounting future values to
present value (PV) involves a clear choice between present and future consumption
involving the welfare of the future generation, it is not only an economic choice, but also
a moral and ethical choice rooted in the Shari’ah. Thus expected rate of financial return
may not always be the true guide to appropriate use of discount rate. Even the secular
economists advocate the use of zero interest rate for discounting the future flows of costs
and benefits in respect of government projects. Besides, at an operational level, the proper
discount rate (i.e., (i) in the equation of PV method) is not some form of interest but the
marginal rate of return. Using the market rate of interest as discount rate is indeed a very
special case, as it is based on the assumption of perfect capital market. Seen in this light
the author's exposition of this issue is considered to be inadequate. So is the case with his
treatment of other issues such as 100% reserves (p. 46, para 3), Murabaha (p. 137, para 2),
Bai Mu'ajjal (p. 139) and investment Auctioning (p. 149, para 2).
(1) See reviewer's article: “Indexation in an Islamic Economy: Problems and Prospects” in the Journal of
Development Studies, vol. iv, 1981, Institute of Development Studies, NWFP Agricultural University,