By: Dr Abdul Ghafar Ismail, Recipient of the AmBank Group Resident Fellowship at Perdana Leadership Foundation

As the financial services provided by Islamic banks are free from interest, the financial contracts created between clients and Islamic banks should also be free from interest. Specifically, the financial contracts should be designed in accordance with shari‘ah principles. By abiding with Islamic principles, banks would be deemed shari‘ah-compliant.

However, authors like Arif (1988), Chapra (l982) and Ismail (2010a,b), claim that other features also matter, such as the contribution of Islamic banking towards a more equitable distribution of income and wealth, and increased equity participation by Islamic banks in the economy. Therefore, the establishment of Islamic banking is not only an effort to comply with the shari‘ah, but also to achieve the Maqasid al-Shari‘ah (the objectives of the Shari’ah).

The point that there is more to Islamic banking than the mere abolition of interest was strongly driven home by M. Umer Chapra in his book “Towards a Just Monetary System”. He envisaged Islamic banks whose nature, outlook, and operations could be distinctly different from those of conventional banks. Besides the outlawing of riba (interest), he considered it essential that Islamic banks should, since they handle public funds, serve the public interest rather than individual or group interests. In other words, they should play a social welfare-oriented rather than a profit-maximising role.

Chapra conceived Islamic banks as a crossbreed of commercial and merchant banks, investment trusts, and investment-management institutions that would offer a wide spectrum of services to their customers. Unlike conventional banks which depend heavily on the ‘crutches of collateral and of non-participation in risk’, Islamic banks would have to rely heavily on project evaluation, especially for equity-oriented financing. Thanks to the profit-and-loss sharing nature of the operations, bank-customer relations would be much closer and more cordial than is possible under conventional banking.

Finally, the problems of liquidity shortage or surplus would have to be handled differently in Islamic banking, since the ban on interest rules out the money market and the central bank. Chapra suggested alternatives such as reciprocal accommodation among banks without interest payments and the creation of a common fund at the central bank into which surpluses would flow and from which shortages could be met without any interest charges.

From the above discussion, Islamic banking has three distinguishing features:
(a) it is interest-free,
(b) it is multi-purpose and not purely commercial, and
(c) it is strongly equity-oriented.

The literature contains hardly any serious criticism of the interest-free character of the operation, since this is taken for granted, although concerns have been expressed about the lack of adequate interest-free instruments. There is a near-consensus that Islamic banks can function well without interest.

A study by Zamir Iqbal and Abbas Mirakhor for the International Monetary Fund in 1987 found Islamic banking to be a viable proposition that can result in efficient resource allocation. The study also suggested that banks in an Islamic system would face fewer solvency and liquidity risks than their conventional counterparts.”

The above is excerpted from “The Future of Islamic Banking in the Global Market” by Dr Abdul Ghafar Ismail who conducted the research under the AmBank Group Resident Fellowship at Perdana Leadership Foundation. The book will be published in 2018. This excerpt was first published in Perdana Magazine 2017.

Dr Abdul Ghafar Ismail is Professor of Islamic Financial Economics, Faculty of Islamic Economics and Finance, Universiti Islam Sultan Sharif Ali, Brunei Darussalam. He got his Ph.D. from the University of Southampton, UK. He is also Principal Research Fellow, Institut Islam Hadhari; AmBank Group Resident Fellow for Perdana Leadership Foundation; and Chairman of the Shariah Committee of Citibank Malaysia. He was previously attached to the Islamic Development Bank (IDB) and Universiti Kebangsaan Malaysia (UKM).