A.L.M. Abdul Gafoor
Appropriate Technology Foundation
Groningen, The Netherlands
Today, a fixed deposit in a bank is considered an investment because it earns a return, and a loan is considered an asset by the bank for the same reason. But they are both interest-earning loans. Whatever the purpose, money is available only as a loan at interest. The lenders (both the depositors and the bank) are not really concerned about whether the money was invested in a productive activity or consumed; neither is their return related to the result of any productive activity in which their capital was used. Even when the loan was intended for consumption, or the investment resulted in loss, the pre-determined interest must be paid. In contrast to this, in the Islamic tradition, the distinction between investment and lending had been clearly recognised and provided for, but unfortunately, in modern times, its importance does not seem to have been fully appreciated and acted upon.
The Qur’an recognises two different sets of purposes for which money is needed, and notes the two techniques used by capital-owners to cater for these needs. But the techniques must match the purposes. The need of entrepreneurs for capital is recognised, and in order to cater to this need investment of capital in productive employment is encouraged, but it must be done on a profit and loss sharing basis. Borrowing and lending (for productive or non-productive purposes) are also recognised as legitimate need and technique, but they should be done on the basis of mutual help — without loss or profit to either party. The need of entrepreneurs for short-term (couple of weeks to couple of months) advances and loans (to overcome cash flow difficulties, for unspecified purchases, miscellaneous expenses, bridging loans, import/export credit, letters of credit, etc, etc.) fall within the latter category. This is a very important type of financing need for all running enterprises, but especially critical for small businesses, which are the backbone of all developing economies, to which category most of the populous Muslim countries belong. Conventional banking deals with it very effectively by advancing short-term loans, at interest. But Islamic banking and finance as practised today has great difficulty in dealing with this need; in fact, it is one of its major shortcomings.
The Qur’an also recognises a set of circumstances in which one may find himself/herself — circumstances which warranted leniency or pure charity. A borrower, who borrowed with the intention of repaying the loan, hoping on better future circumstances, may find that hope remaining unrealised within the expected timeframe. He needs leniency until better times return. Others may find themselves in circumstances where they could not even promise to repay. They deserve charity. The Qur’an encourages leniency on the part of lenders, and recommends voluntary charity to those who posses the means.
By recognising the different types of needs and circumstances which naturally occur in any human society and dealing with them using suitably different techniques, the Qur’an seeks to prevent unpleasant consequences, rather than seeking to find solutions after the damage is done. In this essay we propose to explore the specifics of this comprehensive approach in the context of the present-day world.
The circumstances in which man lives changes in time and space. But there seem to be also some inherent characteristics that remain constant. It is necessary to distinguish the latter from the former, and to devise new methods and institutions that address the needs of these inherent characteristics when circumstances change. The inherent characteristics that remain constant are: 1) the need of capital-holders to earn an income using their capital; the need of traders, merchants and entrepreneurs for such capital; the latter’s ability to use that capital to earn a profit doing their business; and hence their ability to reward the capital-providers for their contribution, 2) the need for loans (for business and personal use), and 3) the need for charity.
How do we address the above needs and characteristics in the circumstances of our day? Many of the verses of the Qur’an were revealed to address specific questions or situations that arose during the lifetime of the Prophet (peace be upon him) but the general guidance contained therein is independent of time and place. The messages should be understood in the context in which they were revealed but the resulting guidance is for all time and place. The Qur’an is no cookery book; it leaves the details to the humans, giving them enough latitude to devise their own solutions according the circumstances in which they happen to live in time and location. In our present-day circumstances, we need to realise that there are subdivisions within these major categories and that these need be dealt with appropriately.
This falls under the first category. To illustrate the position of the Qur’an in this case, let us take an example. Suppose a person at the time of the Prophet (peace be upon him) in Mecca had some capital. He could earn an income from it in one of two ways: by engaging in trade (buying and selling) or by lending at interest. The Qur’an said: do the former and avoid the latter, for they are not the same though some do argue so.
At this point, it is necessary to note that trade was the main occupation of the Meccans at the time. But the principles involved are applicable to all enterprises. Trade was practised either individually or in partnership. Partnership was on the basis of either musharaka or mudaraba. Musharaka is where both partners invested capital in a business (trade) and jointly ran the business, and shared the resulting profit or loss. A capital-holder who did not wish to engage himself directly in the business opted for mudaraba, where he teamed up with an entrepreneur (trader), provided him with all the necessary capital, and shared in the profit of the enterprise at a pre-agreed ratio (or absorbed the full loss if and when that occurred). In effect, a sleeping partnership. So a capital-owner who wished to earn an income using his capital but without directly engaging himself in an enterprise was given only one option: go into partnership with an entrepreneur on the basis of mudaraba (profit sharing and loss absorbing).
It is remarkable that the same choices exist even today: a) put your money in a partnership company (with you as the sleeping partner) or buy shares in a shareholder company; b) deposit in a bank or buy bonds and securities. In the former you share in the profit and loss, and in the latter you receive an interest income.
In the circumstances of the present-day world, investment and finance can be dealt with efficiently by recognising the subcategories within this main head and adopting appropriate techniques.
The first need is easily addressed in the form of sleeping partners and shareholders in modern companies. Unfortunately, this type of modern company is rather rare in the Muslim world, though it is actually the modern version of the ancient practice of mudaraba. On the contrary, they play a major role in the economies of the developed countries. Large-scale industries and trading concerns, contributing to the real economy, were established using such investment and finance. What exist in the Muslim world are the one-person-owned-and-operated businesses and enterprises. These are, of course, necessary but they have their limitations. To advance, Muslims will have to follow the example of others. The idea of sleeping partner and shareholder companies should be promoted among Muslim financiers and entrepreneurs and such enterprises should be set up and professionally run in all sectors of the real economy. There is no choice, even though, in doing so, they will be only regaining their lost heritage of 1400 years ago.
Another complementary form of investment option, also based on the mudaraba principle, which caters to small capital-holders who would otherwise resort to bank deposits and/or bonds, is presented in Gafoor (1996). This can be operated by investment companies and investment banks, and provides the investors with a unit-trust/unit-share type of investment and will finance enterprises that are currently financed by bank loans. This is a new concept and a comprehensive project proposal is available at the author’s website. This was developed as a riba-free alternative to fixed deposit accounts and medium- and long-term loans in order to address the concerns of Muslims. But the resulting product does not require the participants to be Muslims. It is simply a responsible form of financing, operating under conventional business laws. Hence it can be practised by anyone in any country. This should go a long way in preventing businesses and enterprises going bankrupt due to their inability to service bank loans. And thereby provide stability to all economies.
Pure mudaraba partnerships between known parties at the local level also should be promoted and popularised. This will help both the small capital-holders and budding entrepreneurs, and will contribute to the development of the local economy. This is another lost heritage that Muslims should revive at the earliest opportunity. It requires trust, honesty, integrity and professionalism. But advice and intermediation by independent accounting professionals and bookkeepers should be used to substantiate such trust by verifiable documentation.
This falls under category of lending and borrowing. Here too, by recognising the subcategories within this head and adopting appropriate techniques, we can deal with the needs very efficiently.
The first thing that comes to mind when one thinks of a bank is bank loans. But the bulk of the work that goes on within a commercial bank (retail bank, deposit bank) is transfer of funds, from one account to another — within the same branch, between branches of the same bank, between different banks, between different countries, etc. Individuals use their demand deposit (current) accounts to pay their bills and receive their salaries/wages/pensions; businesses use current accounts to make and receive payments for the goods and services supplied; government and other entities use them to pay and receive their dues. This has become a basic necessity in practically all countries, a backbone of all modern economies and societies — the more advanced a country the more essential this service. It saves tremendous amounts of time and effort for individuals and organisations in travelling and carrying the necessary cash to and from each of their creditors and debtors. Thus its contribution to the national economy and its efficient running is immeasurable.
Yet, this important service is provided by the banks, in large measure, free of charge. Why free, and how is the operational costs of this services met by the bank? For, on the one hand, this transfer of funds from account to account without actual movement of funds makes possible what is called bank credit creation (that is, the act of lending more money than that available in the vaults of the bank). Therefore, the bank encourages the public to use its services to transfer funds by providing the service free. On the other hand, the costs of the operation is recovered from the borrowers as part of the interest. Thus, in conventional banking this essential service has become intertwined with riba, in the form of interest charged on bank loans and interest paid on bank deposits (which is the major source of funds for the loans). This is unacceptable to the Muslims, yet they too need the banking services (transfer of funds as well as loans) just like everyone else.
Islamic banking theory sought to resolve the problem by offering the loans completely free of interest (or grudgingly with some service charge) and meeting the costs of the services from earnings made elsewhere (profits made from buying and selling, and other forms of trade) using funds in the investment accounts. This has led to several complications. A major problem is that this form of banking is not workable under conventional banking laws and therefore cannot be implemented, except in a few Muslim countries where special laws have been enacted. In all other countries, banking services and loans have been left to the conventional banks and Islamic banking has limited itself to financing, tacitly calling itself Islamic Finance. Thus a riba-free (retail) banking system is still to be designed and implemented.
The question of providing loans and all other banking services without involving in riba is addressed in Gafoor (1995). This uses a general model of the cost of borrowing and a courier-bank concept. A detailed discussion of this is available as an article at the author’s website. A comprehensive project proposal is also available at the author’s website.
The proposed banks will provide all banking services and are designed to operate under the conventional banking laws and regulations. They will accept demand deposits and ordinary savings deposits, and will use the funds in these deposits to provide short-term and (some) medium-term loans and advances. To be sure, this is only “half” of a modern bank, the other “half”— consisting of the fixed deposits and the long- and medium-term loans — being given over to the participatory financing companies and banks mentioned earlier. The need for and the advantages of such a division and separation are given in the project proposal referred to above.
Again, though the system was developed in order to address the riba concern of Muslims, the resulting product does not require the clientele to be Muslims. It has been shown that when the bank is constituted as envisaged here, the riba involvement becomes insignificant and its removal will be hardly noticed by the clients. It becomes simply a transparent form of banking that can be implemented in any country, without any changes to the present banking laws. This should be of special interest to Muslim communities living in non-Muslim countries.
Historically, all banks have generally served governments, businesses, and the well-to do. For good collateral and guaranteed revenue to service the loan are essential considerations in granting a loan. As time passed on, the banking business expanded into the newly developing middle class that had gradually acquired savings, properties and stable incomes. Their savings made them welcome, and their properties and stable (mainly wage) income made some of them eligible for small loans. Legislation has been passed to safeguard the interests of both parties, though by now the banks have emerged as the stronger of the two. This is the case in the developed countries. In the developing countries, with their low levels of literacy and economic development, participation of the majority in the banking sector is very limited. They have a long way to go. Yet, they too have need for credit, albeit in small measure. But the conventional banks are not designed to cater to them. Neither will the riba-free commercial bank we have presented above be able to act differently. One little appreciated reason is that the modern banks are not like their forerunners, the moneylenders of old who lent their own funds. The modern banks handle, borrow and lend other peoples’ money and are managed by professional executives who are governed and constrained by legally binding rules and regulations. They have very little personal discretion.
That leaves a large section of the population in the developing countries, and many small communities in the developed countries, outside the banking system. This is where the private moneylenders come in. They are still alive and well, and ready to pounce. They usually know their clients, live in the same locality, are very reasonable as to collateral, and are quite accommodating — no lengthy approval procedures either — provided the “risk premium” is set suitably high. It is difficult to beat them — they have survived many attempts — but a try is still worth it. Massive efforts at education and economic development at grassroots level are still necessary to keep the unfortunate out of their clutches.
In the meantime and beyond, there is a need for institutions between the type of commercial banks described above and the others to be described below. It is possible to set up savings and loans societies at the local community level to serve the needs of those not served by the commercial banks. They can be organised and run along the lines of the non-profit community lending discussed in the article, “Interest, Usury, Riba and the Operational Costs of a Bank”, mentioned earlier. Community leaders can play a major role in this project, and religious leaders should promote and support it, because, being an alternative to private riba-based money lending, it is an effective preventive strategy.
There is still another section of the population — the un-bankable, who are either fully avoided by the moneylenders or mercilessly exploited. These are the ones living on the fringes of the society; their concern is daily subsistence. They are not beggars, neither are they unwilling or unable to work. They often have a useful locally marketable skill. They simply lack that very small capital which can enable them to own the tools and the small stock of raw materials necessary for their trade. In dollar terms, the capital they need is often less than the cost of a meal in New York or London.
The Grameen bank movement in Bangladesh has proved that such people are bankable, and that with very little help they can be put on their own two feet and enabled to regain their place in society with dignity. It has a twenty-five year successful history, and its methodology has been adopted in many countries around the world. So the tools are already there. What is necessary in any community is to examine whether the concerned community needs such a bank, and then to set about it. It needs dedicated workers, but the results can be very satisfying. See Gibbons and Sukor (1994) for its theory and practice.
Private person-to-person lending at interest is, and has always been, the primary focus of all religious and social prohibitions. But the need for such personal lending has always been there and will continue to be there for all times. Often it is mutual (borrower today, lender tomorrow, etc.) between known persons — friends, family, colleagues, etc. Sometimes, one may need to go outside this small circle, to wealthier persons who are in no need of the supplicant’s help in money matters. It is in these cases that the lender tries to derive some benefit from the borrower’s need, by charging interest. The ill effects of interest in this transaction can be removed only by personal refrain by the lender. This can be attained only by personal enlightenment or the fear of accounting on the Day of Judgement. The revulsion of society to such an act is also an effective restrainer. The work is cut out in this area for the religious leaders and teachers of morality.
The leniency and charity recommended in the Qur’an, when the borrower is in straitened circumstances, can be practised only in the case of private lending. For a person can exercise such personal judgement and authority only on his/her own possessions. All other cases considered above relate to people handling other people’s property.
The fact that private money lenders were the forerunners of conventional banks, and that no banking institutions comparable to the modern ones existed in Muslim history, seem to have led today’s Muslims to apply the Shari’a rules relating to private lending to bank lending as well. However, not recognising the difference between a private lender lending his own funds and a bank lending other peoples’ money, has created much confusion, false expectations and some misuse by borrowers. Islamic scholars and banking institutions could spare a lot of trouble by recognising this difference, declaring it and advising the borrowers and the general public beforehand that no leniency or charity of this kind is to be expected from banking institutions.
The money-related needs discussed in the previous section (Banking and loans) concern a section of the population that is able and expects to repay their debts, as well as any expenses incurred in the process. But there is always, in any society, another section of the population which simply cannot even expect to pay their debts. They are poor, unemployed or unemployable and have no or small and uncertain income; most often they will not be given any loans and therefore will not even dare to ask for one, small as it may be. They are the ones the society as a whole, and the able in particular, are obliged to look after by means of charity. But this is the area of private individuals and not of banking institutions. Conventional banking wisely kept out of it; but Islamic banking, in its enthusiasm to solve all problems with one tool, tried to deal with it too and got itself into trouble. Like personal lending, charity too should be left to individuals. They only have full authority over their own funds to use it as they see fit.
Charity is the third category of needs, and here too we find subcategories that need be dealt with using different techniques.
The third need is recognised and charity is recommended in several places in the Qur’an. (Here we are not talking of the obligatory alms-giving called zakaat but of optional charity, which is called sadaqa.) This is a personal affair. Those who have extra funds may give any amount they wish to whomever they wish. This does exist and will continue to exist, but people must be continuously reminded of its necessity and merit. Personal charity should be encouraged at all levels. This is a task especially of social and religious workers at the personal and community levels.
However, in the present crowded world where fewer and fewer people know others at a personal level, there is also a need for organised charity. Therefore, charity organisations catering to specific needs, purposes, places or communities should be set up and run, perhaps on the lines of modern Western ones.
The Qur’an talks of two types among the poor, the needy and the beggar — miskin and fakir. The needy are generally not known to the others because they do not ask, but they may be in more straightened circumstances than the beggar. This is one area where an organised charity may be of great relevance on account of the (donor and receiver) anonymity it can provide. Social and religious workers along with like-minded professionals should give some thought to this.
In the above paragraphs, we saw the Qur’an guiding us to recognise the existence of three different needs in any society — investment and finance, banking and loans, and charity — and pointing to the proper techniques for dealing with each of them. The guidance is applicable to our present-day world too and the techniques are already available. We need not re-invent the wheel. We need to only recognise them and make use of them. It is hoped that our small exercise in the foregoing pages has enabled us to identify the necessary components of a comprehensive financial system for an Islamic economy in today’s context, and has placed them in perspective.
© A.L.M. Abdul Gafoor, April 2003.
(An edited version with the title, “Set the wheels on motion”, was published in “Islamic Banking & Finance” Magazine, Issue #3, 2004.)
 “And if the debtor is in straitened circumstances, then (let there be) postponement to (the time of) ease; and that you remit the debt as almsgiving would be better for you if you did but know.” Qur’an (2:280). All Qur’anic quotations are from M. Pickthall’s translation.
 “… they say: Trade is like usury; whereas Allah pemitteth trade and forbiddeth usury.” Qur’an (2:275).
 There were also reciprocal obligations on the part of the entrepreneur, the recipient of the capital. All his transactions needed to be transparent and the accounting accurate and verifiable. To be fair, the environment of the day and the society as well as the open nature of caravan trade made complying with these obligations both necessary and inevitable. Compliance was rewarded with respect and further prospects while failure to comply extracted the heavy price of social ostracism. The entrepreneur was not required to provide collateral but the goods remained the property of the financier.