Riba-free Commercial Finance Alternatives by Al- Mawrid School

In his book ‘Meezan (2014a)’¹, Javed Ahmad Ghamidi writes that as per his understanding of Chapter Al-Baqarah, verse 283, it is undesirable to ask for collateral in credit transactions. This understanding is quite limiting in contemporary banking and finance where the problem of moral hazard and adverse selection is quite serious.

If the collateral remains in the ownership of the borrower and no benefit is obtained by the financier from it, then it does not seem to be problematic. On the upside, the presence of collateral mitigates the problem of moral hazard in credit transactions. Javed Ahmad Ghamidi has himself recommended that situations of Gharar (uncertainty) and Zarar (harm) shall be avoided. The presence of collateral avoids the potential harm to the lender in case the borrower reneges on loan repayment.

In his book ‘Maqamat (2014b)’², Javed Ahmad Ghamidi argues that since bank only receives interest from the benefits generated in the borrower’s productive enterprise; thus, this institution could be accommodated if:

The bank stops asking for markup when the borrower suffers loss or ends business. The bank takes ownership of assets which are provided in lease finance. The bank asks only inflation adjusted principal amount in non-commercial loans

In his other works, the author has suggested that profit-only equity participation could also be employed as an alternate to interest-based lending whereby, the financier will obtain return on investment only when the business enterprise – to which the financing is provided – earns positive profits. In essence, it will be a principal secured financing.

First, we take the first point. Banks deal in debts. They mobilize deposits on the basis of debt and they also provide funds to the borrowers as debts. They do not provide funds on the basis of equity financing. When banks provide debt-based financing, they expect to receive repayment of principal amount of debt with stipulated pre-determined interest. Banks loan out money on expectation of getting their principal amount of loan paid along with stipulated interest. It does not matter whether the loan is provided for personal use or commercial use and whether it is provided for the purchase of assets, property or to retire other payment obligations.

As per Islamic principles, if the nature of finance provided by banks creates debt, then they cannot demand a stipulated increase over and above the principal amount of debt. However, banks demand a stipulated pre-determined increase over the principal amount of debt. This is substantiated and reflected in marketing, contract documentation, financial reporting and banking laws. For the author to assume and unintentionally advocate anything different when banks themselves and the regulators do not make claim to the contrary is not understandable to say the least.

Let us illustrate this point with a simple example. A borrower receives a loan of Rs 1,000,000 for three years at a rate of 15%. He earns profit of Rs 100,000 in the first year, profit of Rs 200,000 in the second year and incurs a loss of Rs 50,000 in the third year. Then the amount payable to the bank in the form of interest is Rs 150,000 in each of the three years. The proposal to not charge interest in the period when there is loss does not alter the nature of contract, which is based on debt.

There is no justification for the stipulated Rs 150,000 demanded by the lender from the borrower irrespective of what is the outcome of productive enterprise. The profit to the lender in interest based banking remains Rs 150,000 in all three years no matter whether the borrower earns profit or loss.

The suggestion of not charging any mark-up or not asking for profit share in the case of closure of business pertains to managing liquidation and bankruptcy rather than providing an alternate way of finance.

The other suggestion of fixed mark-up based on average expected profitability ignores the fact that accounting of revenues and expenses is possible in a standardized way and involves a third-party audit. The author conceives such matters of financial transactions and credit in an individualistic sense. Commercial clients obtaining credit from banks are by and large corporations, who are duty-bound to publish financial statements regularly and get their accounts audited. Furthermore, such profit distribution based on average or expected profit rate has to be adjusted at maturity upon knowing the final outcome of the productive enterprise.

Ibn Qudamah in Al-Mughni (2013, 8th edition) wrote:

Javed Ahmad Ghamidi argues that bank also participates in the business through assessing the business potential of the client and by monitoring it. However, such credit assessment is meant for checking creditworthiness only. It does not imply that the bank is assessing business potential to take part in business as a partner bearing risk of the enterprise. The monitoring exercise is only meant to check that a defaulter is not wilfully reneging on credit commitments. This by no way means that the bank is participating in the business as equity investor.

On the second point, if one compares the operations and product structures of Islamic and conventional banks, some distinct features appear. Islamic banks take ownership of the assets and undertake the risks related to the ownership of the assets before selling or leasing the assets to the client. In contrast, conventional banks do not take ownership of the assets and hence do not undertake any risks related to the assets.

Conventional banks begin charging interest right away as soon as the loan is sanctioned. In contrast, Islamic banks only charge rents for the use of asset if they provide lease financing via Ijarah. The rent only starts from the date of transfer of asset in usable condition.

It is strange that the author has shown reservations with Islamic banking while mentioning the conditions for valid banking as per his view which ironically only Islamic banks seem to follow!

Finally, we take up the third point from both economics and Islamic perspective. From the economics perspective, the proposal of benchmarking loans with inflation index is not realistic and practical in commercial financial intermediation. Bank is a financial intermediary between savers and those who require financing. Banks make profits through the difference in interest rates on deposit mobilization and financing operations. They charge higher interest on financing and take it as their interest income and provide lower interest to the depositors, which is a cost to the banks. Indexing loans with inflation will not yield any spread for the bank as financial intermediary in the two-tier debt-based banking. From the Islamic perspective, a debt contract cannot have a stipulated increase over the principal amount. It does not matter whether the increase is computed as a percent of the principal value of loan or benchmarked against price or cost of living index.

In his book ‘Maqamat’ and in the recent public lectures, Ghamidi(2014b) suggests that investment in Government’s national saving schemes for retired employees is permissible since government gives the surplus amount on principal on its own and can change the surplus amount by its own desire. This view is effectively close to the view of Sheikh Muhammad Sayyid Tantawi. Shaikh Tantawi is convinced of the argument that investing funds where profits or returns are specified at the outset is permissible from Islamic viewpoint.

As per Javed Ahmad Ghamidi, the government borrows funds for investment purposes and gives the

All scholars whose opinions were preserved are in consensus that silent partnership (Mudarabah) is invalidated if one or both partners stipulate a known amount of money as profit.

residual returns earned on investment projects to the borrowers. As per his understanding, issuing prize bond is also a source of finance adopted by the governments to finance investment projects. Since governments pay surplus amount or a windfall gain, i.e. ‘prize’ unilaterally, it is not similar to Riba prohibited in Qur’an. An important social benefit of these schemes is that they benefit the needy people who depend a lot on regular income arising as returns on these saving schemes.

This view can be responded to in two ways from the economics perspective. For government requiring funds for investment or development, Sukuk instrument can be used for project-based financing and for financing development infrastructure. As a matter of fact, this instrument has been utilized by the Government of Pakistan both inside Pakistan and outside as well to obtain funds.

For the individuals who are risk averse and who want regular Halal return on savings, Islamic asset management companies offer services to manage investments through income funds, sovereign funds, capital protection funds and index funds. There are at least 39 Islamic income funds, 27 Islamic money market funds, 40 Islamic pension funds and 1 Shari’ah Compliant index tracker fund operating in Pakistan at present. There are 6 full-fledged Islamic banks and at least 18 conventional banks with Islamic banking windows which offer investment schemes with relatively lesser risk for different maturities. The total branch network of Islamic banking has surpassed 4,666 in number by 2023. Thus, there are sizable number and variety of investment options where stable, regular and Halal source of returns can be earned on investments.

Secondly, government does not unilaterally give variable returns ex-post on national saving scheme instruments. It advertises the rates which are pre-announced. It is also a misunderstanding that the sourced funds are used in investment projects. As of now, the government’s expenditure is mainly concentrated in non-development activities. The meagre amount which is budgeted for public sector development program is also usually curtailed mid-year amidst high cost of debt servicing and other non-development expenditures.

If government’s decree of setting predetermined rate on debt is considered allowable, then there is nothing stopping principally to legitimize interest in state-run economies where the banking sector is government-owned in the first place.

Therefore, both looking at the structure of the national saving scheme instrument as well as looking at the other Shariah compliant ways of earning Halal and stable returns in Islamic finance industry, the simplistic leeway to interest-based national saving scheme instruments is neither needed nor warranted in principle.