Islamic Banking: The Challenge Of The Twenty-First Century

ISLAMIC BANKING: THE CHALLENGE OF THE TWENTY-FIRST CENTURY

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Prof. Khurshid Ahmad

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ISLAMIC BANKING: THE CHALLENGE OF THE TWENTY-FIRST CENTURY

By Prof. Khurshid Ahmad*

Notwithstanding some initial hesitation and apprehension, Islamic Banking is now a reality. Here we find a dear illustration of the Islamic ideals taking a practical shape; albeit, in the context of modern institutions and practices.

Nineteen seventy-five can rightly be described as the watershed for the emergence of Islamic Banking Movement at the global stage. Although a lot of intellectual effort was consummated in the earlier decades and some pioneering spade work done in the 1960s and early 1970s, it was the establishment of the Dubai Islamic Bank at the national level and of the Islamic Development Bank, Jeddah at the international level, both in 1975 that the vision began to be translated into concrete, vibrant and dynamic institutions. Ever since. Islamic banking and financial institutions have been established in different parts of the world and a number of Muslim countries have initiated a process to re-model their entire banking system on interest-free Shariah- consistent lines.

In Pakistan, Iran and Sudan, there has been afoot an effort to completely switch over from traditional banking to Islamic banking, while other Muslim countries (e.g. Malaysia, U.A.E., Kuwait, Turkey, Egypt. Algeria. Tunis. Kazakhstan, etc.) Have been experimenting with private sector Islamic banks and other financial institutions; and there have been some such banks and projects even in a number of non-Muslim countries (e.g. U.S.A, U.K., Switzerland, Denmark and Luxembourg). Some two hundred banks with a deposit base of over US$8() billion are presently operating in thirty countries of the world. According to a recent study interest-free banks and financial institutions manage over ten percent of the financial sector in Kuwait and the Gulf region and at the present rate of growth are expected to more than double this business by the early years of the twenty-first century. In view of the market potential an increasing number of the interest-based banks and financial institutions, including some of the leading Western institutions, have opened up interest-free banking counters and are offering interest-free investment portfolios.

The phenomenon of Islamic banking is one of the major innovations introduced in the last quarter of the twentieth century it is worthwhile to briefly examine why this innovation has taken place and what may be the future role of financial institutions based on the Islamic principles of riba- elimination and equity-based financing.

Muslims constitute over one-fifth of the mankind, with fifty-four independent states, occupying some of the most strategic areas of the’ world. There is a universal realization amongst the Muslim people to order their socio-economic life under the inspiration and guidance of their faith, its moral values and principles, and seek the consolidation and integration of the Islamic Ummah.

*Senator Professor Khurshid Ahmad, a former Federal Minister for Planning and Economic Development. Government of Pakistan is presently Chairman, institute of Policy Studies, Islamabad, Pakistan and Chairman Standing Committee of the Senate on Finance and Economy. He is also Chairman, The Islamic Foundation Leicester, U.K. He has authored or edited over three dozen books and was the recipient of (he King Faisal International Prize for Service lo Islam (1990) and Islamic Development Bank Award on Islamic Economics (1988).

That provides the raison d’etre of the Islamization movement. Islamic banking movement being a part of this world-wide Islamic resurgence. However, religious enthusiasm is not die sole explanation for the widespread acceptance of Islamic banking practices even though such considerations have been die prime movers for this very original and innovative financial experiment. Indeed, a lot of hard-handedness has been shown even by the Muslim bankers in adapting the Islamic financial principles to the real-world profit-maximizing behavior. A large part of the acceptability of the Islamic Banking principles can be attributed to the realization that equity capital may indeed be superior to debt capital. Thus, that for instance, it has been suggested that the debt crisis of the decade of the eighties (a by-product of the recycling of the petro-dollars surplus in the preceding decade) could have been avoided if the developing countries had preferred equity capital to debt capital – because while the payment due to the former can be turned on iii good years and off in bad years; the same is not the case for the latter, in which case fixed charges must be paid at all times, good and bad.

The emergence of Islamic bailing is a creative response on the part of the Muslim economists and bankers to squarely face some of the challenges produced by the economic ideologies and experiences of the twentieth century.

Despite the decline of colonialism and emergence of over one hundred and forty independent states (over fifty of them being Muslim states) during the last half a century, the political and economic hegemony of the West remains a gruesome reality. Whereas the British and the Mughal India had roughly similar per capita levels of industrialization and income at the beginning of the nineteenth century ¹ and Turkey was more affluent and technologically ahead of most of Europe and America at that moment of world history, the picture is very different as the twentieth century is drawing to its end; The present world economic system is controlled and manipulated by a group of twenty-three countries belonging mostly to the Western hemisphere. “The richest one-sixth of the earth’s population…enjoys a disproportionate five-sixths of its wealth” ². In the words of a former Secretary’ General of the World Federation of United Nations Association: “Twenty percent of the Northern minority controls 82.7% of world Gross National Product; 81.2% of world trade; 80.5% of domestic investment: and 94% of research and development” ³. According to the UN Development Studies, the developing countries are losing over $500 billion a year income that they could have earned because of protectionist and restrictive barriers that exist in the North against their products, as also because of the multifarious pressures of interest rates on their borrowings and other structural inequities between North and South. Add to this the role of multi-national companies, around 500 of which control some 50% of the total world trade. The politico-economic crisis of the South has been further aggravated by the grafting of the Western model of centrist nation-state into almost every society in the Third and the Muslim world, resulting in regional divides, ethnic conflagrations and social tensions. The neglect of the small producer and trade who go to make up the backbone of the economies in most of the Third World countries, bas further dampened the economic scene.

1. See P. Bairoch. “International Industrialization Level-s from 1750 to 1980”, Journal of European Economic History. 11 (1982) and Paul Kennedy, Preparing for the Twenty-First Century, Random House, New York, 1993. p. II.
2. Paul Kennedy, op.cit. p.46.
3. Erskine Childers, “Amnesia and Antagonism”, JUST, Malaysia. See Impact International London. September 1996.
   

This has produced a lop-sided world. As Paul Kennedy puts it:

“Developed Northern regions place much greater stress per capita upon the earth’ 5 resources than do developing countries, simply because the former consumes so much more. Thus, the consumption of oil in the United States – with only 4 percent of the world’s population – equals one-quarter of total world annual production; in 1989, the United States consumed 6.3 billion barrels of oil, ten times the consumption of Britain or Canada and hundreds of times that of most Third World countries, which makes do on very little. The same imbalance is true of a range of other items from paper to beef According to one calculation, the average American baby represents twice the environmental damage of a Swedish child,; three times that of an Italian, thirteen times that of a Brazilian, thirty-five times that of an Indian and 280 (!) times that of a Chadian or Haitian because its level of consumption throughout its life will be so much greater. That is not a comfortable statistic for anyone with a conscience” ⁴

And the prospects for the future are grimmer Paul Kennedy concludes:

“The gap between rich and poor will steadily widen as we enter the twenty-first; century, leading riot only to social unrest within developed countries but also to growing North-South tension, mass migration and environmental damage from which even the ‘winners’ might not emerge unscathed.” ⁵

Although this state or affairs is the result of a complex array of factors – moral, ideological, social and cultural – there is a large grain of truth in the claim that unbridled capitalism and the interest-based banking system have played an important role in the making of this crisis.

Banking is no longer a mere exercise in taking deposits and ex-tending loans. Whatever be the beginning, the fact is that the banking system today constitutes the very nerve-system 6f the world economy. Finance is the life-blood and banks control and mange this life-line. With the disintegration of the socialist politico-economic system, the opening up of the Third World countries, and greater integration of the global economy, the role of financial institutions in setting the pace of economy has increased manifold. Here we are faced with a fundamental problem: the institution of banking has grown over the centuries in the context of a particular ethico-economic culture. Although riba (usury-interest) was forbidden by almost all great religions and ethical systems, and different cultures and civilizations had given rise to their own distinct financial institutions, including the medieval Christian and Islamic civilizations, modem banking grew in the lap of capitalism and around the pivot of riba (interest), While banks perform a number of services, financial intermediation has become their major function, Modern banking system has successfully!

• Paul Kennedy, op.cit. Pp.32-33.
• Ibid. P.334.

created a vast pool of assets which otherwise would have been in different places and forms, converted them into a huge force for financing private and public projects and in this historic process these financial agents were not only able to mobilize tills vast financial pool but also develop the power to create credit on its basis, and as such wield enormous power and leverage, much in excess of the real asset base. This power; has increased exponentially- with the advent of a set of new financial instruments known as derivatives, which have overtaken the financial markets of the world during the last decade. Derivatives are contracts whose value is based on the value of other underlying contracts; and derivative dealers are commercial and investment banks that create, price, well, and trade financial derivatives. These contracts give one party a claim on an underlying asset, at some point in future, and bind a counter-party to meet a corresponding liability. The contract may describe an amount of currency or a security, or a physical commodity, or a stream of payments, or a market index. It might bind both parties equally or offer one party an option to exercise it or not. It might provide for assets or obligations to be swapped.

The growth of derivatives has been spectacular. According to a BIS survey, the total value of OTC and exchange derivatives in April, 1995 was US$47.5 trillion. In addition to OTC derivatives, there was a further $16.6 trillion in notional principal of exchange trade derivatives. As such the derivatives volume was somewhere over $64 trillion. By contrast, the estima.ted Gross Domestic Product of all countries in the world was $28,954 trillion at end of 1995 ⁶. U.S.A. excels in the derivative markets as well. It had approximately $18 trillion in 1994 – as against total U.S. corporate financing of around $1 Trillion in that year. It is estimated that the present daily turnover of derivatives in the world markets is over $1 trillion -approximately’ annual turnover being over $300 trillion, 12 times the total GDP of the world.

The Quarterly Banking Profile of the U.S. Federal Deposit Insurance Corporation shows that the derivatives portfolios of the U.S. Commercial Bank have been increasing at the rate of 30-35% per year. Moreover, the derivatives are concentrated among the largest institutions. The five top banks (Citicorp, Chemical Bank. Bankers Trust. J.P. Morgan and Chase Manhattan) held 75.5% in derivatives, compared to 19.5% by the next 10 banks, and 5% by the remaining 653 hanks. By comparison, assets of U.S. Commercial banks rose 9% and loans rose 8% during the year ending June 1994. Thus, the “off-balance sheet derivatives were almost four times die banks total assets.

While the twentieth century has a number of achievements to its credit, it is also bequeathing a legion of problems and contradictions to the twenty-first century. The most important challenge relates to the failure of the world economy towards eliminating poverty, deprivation and gross inequities of income, wealth and opportunity adversely affecting around one third of the mankind. Economic expansion has taken a novel form in which the link between the monetary and the physical economies has been loosened, if not almost severed. This lies at die root of the contemporary economic malaise. And as this has also been a century, characterized by globalization, the instability generated by those developments has also assumed global proportions.

• World Economic Outlook, IMF, October 1996, p.67

The nature and structure of a modem capitalist economy can best be described as a debt-based economic. Whether we look into the consumption sector of the individual and the household or the production sector, private or public, economic activity revolves round the pivot of credit based on interest. The strategy for growth pursued over the last two centuries has used credit as an instrument not only for physical growth but also for fiduciary expansion. That is why the financial expansion via credit creation has become the premium mobile tor economy also the major headache for the system as far as stability is concerned. External indebtedness of the developing countries stands at $1,956 trillion in 1996. The situation in respect of the developed countries is no different. America is not only the richest country of the world; it is also the most indebted country on the globe. In 1960, the federal deficit stood at $5.9.6 billion and the national debt at. $914.3 billion. (In the year 1900 the national debt was $1 billion). In 1991 the deficit was pushed up to well, over $300 billion, while the national debt approached $4 trillion). Paul Kennedy, in his thought-provoking study. Preparing for the Twenty-First Century, observer:

“It was not only the national debt which soared during the 1980s, but every other form of debt…Consumer debt, fuelled by ‘easy money’ incentives reached $4 trillion, while repayments diminished personal income Corporate debt was even worse: ‘as the 1990s began, about 90 percent of the total after-tax income of U.S. corporations went to pay interest on their debt’…Public and private debt equated roughly 180 percent of GNP…Deficits in the balance of payments and current accounts represent a further change…As a result, the United States now pays its was by borrowing from foreigners roughly $100 billion each year. Once the world’s largest creditor, “the United States has by some measures become the world’s largest; debtor nation within less than a decade”.⁷

This is a global context in which we want to underpin the real relevance of the principles on which Islamic banking is based and the promise they bear for the future. Islamic approach to economics is rooted in a different vision of the economy: one that is equity based as against a credit-based one. Not that there would not be a possibility for loan transactions Oard Hasan exists at a certain level to meet genuine individual or business needs. But the structure of the economy would be or a very different nature capital and entrepreneurship would be co-participants, sharing the risks as well as the rewards of the enterprise.

Islam is not opposed to a return on capital. It proposes that banking Systems that operate on the basis of ex ante fixed rate of interest be replaced by profit-sharing systems in which the rate of return to the financial resources is not blown in advance and is not fixed prior to the undertaking of transactions. It is to be an ex post facto phenomenon.

Islam encourages trade and commerce. Profit is not only permissible; it is encouraged as a positive value Instead of fixed rate of return geared to an assumed rate of profit, Islam provides for a variable rate of return-

• Paul Kennedy, Preparing for the Twenty-First Century, Random House, New York, 1993. Pp.286-288.

-based on actual profits. This is the basis on which Islam wants capital and entrepreneurship to co-operate and co-participate in the production process. Islamic societies were able to develop a number of financial instruments and institutions during the first millennium of Islamic history and although the economic system is much more complex today. Islamic banking movement is an effort to develop an alternate system in the context of the contemporary economy.

However, it deserves to be noted that the abolition of interest is only one aspect of Islamic economics. Islam aims at establishing a just economic order, based on clearly spelled out-economic rights and concepts of property, contracts, work and distribution of income and wealth. It stipulates a framework of values and disvalues, desirables and undesirables and hedges the market mechanism with a moral filter so as to ensure efficiency and equity in the process of allocation of resources.

The role of state has also been clearly defined, neither being a neutral police state of the Laissez-faire type nor a totalitarian state of the socialist order. There is limited scope for intervention for specific objectivities. Islam also emphasizes the need for stabilization of prices and protection of the value of money, which is a measure of value and a standard for deferred payments. In such an economy, banks are not mere financial intermediaries but also play an active role in developing and maintaining a certain pattern of economy, serving certain socio-moral objectives as well. Of course, banks are not expected to act as charities, philanthropic organizations or mere “welfare institutions”, but the welfare, equity and stability dimensions are as relevant to the banking ethos in an Islamic scheme as are considerations of efficiency, optimality and profitability. Definitely there would be trade-offs. As such the objective is to achieve a balance between efficiency and equity, between profitability and welfare, and between expansion and stability. Traditional banking is also trying to discover the moral dimension in a limited sense. The whole movement towards ethical banking is an instance in point ⁸. But that is something on the periphery – and not even the whole periphery. Ethics and social objectives are central to Islamic banking – and that is why Islamic banking is not mere interest-free banking. It is much more than that. It represents a new and vastly different vision of the whole economy.

The basic idea of Islamic banking is to devise an efficient and equitable system of the profit-and-loss some say only profit-sharing (PLS). The efficiency property derives from its insistence on the linkage between the financial and the real, sectors of the economy, while the equity property is based on maximizing the rate of return on deposits, depending on the length of the period for which they are held.

But to make Islamic banking efficient and equitable its profitability -that is, the difference between the rate of return on advances and the rate of return on the deposits (Which is also referred to in the literature, as the spread’) – should be maximized. Yet another requirement is that the risk element inherent in the bank’s operations is minimized, and scrupulously managed.

• See James J. Lynch, Ethical Banking: Surviving in an Age of Default, Macmillan, London, 1996

The connection between the efficiency and the profitability properties is provided by the fact that, as established by many empirical studies, the level of economic activity is the most significant determinant of the growth of deposits and advances, and of the ‘spread’. In other words, to maximize the profitability of the banking system, economic policy must aim at enhancing the growth rate bf output. Whence follows that the Islamic banking, by strengthening the link between the financial and real sectors of the economy, also raises the potential social profitability of the Islamic banks over the traditional banks.

The link between the superior equity and efficiency of Islamic banking drives from the requirement that the profits (and the losses) made by such banks are shared in accord with moral (and binding) principles of justice and beneficence (“adl wa ihsan). Thus, given the normal operating expenses incurred by Islamic banks and the rate of return on their advances, the potential rate of return on deposits must be generally higher than that offered by the traditional banks.

The linkage between the riskiness, the efficiency, the equity, and the profitability of Islamic banking rests on its ability (which it must demonstrate in practice) to devise an investment portfolio which, on the one hand. Satisfies the preferences of the risk-averse investors and those of the risk takers (i.e. those who take risk and those who can afford a lot of risk); while, on the other hand, it should reflect the state of economic activity in the society.

Apart from any considerations for efficiency, equity and profitability, there is the case for the PLS instruments because they seem to reflect most faithfully the principles of Shariah Such instruments also set Islamic banking (based on equity-finance) apart from traditional banking (based (in debt finance). In other words, the PLS instruments make the Islamic nature of banking most visible. The revolutionary potential this type of banking bears for the future is beginning to be realized by an increasing number of Western economists and bankers.

A study by the Development Centre of the OECD on Arab and Islamic Banks touches upon this aspect. The author, Ms. Traute Wohler-Scharf, says:

“If the South proposes now, with Islamic banking principles, a new concept of socio-economic interaction (profit-sharing systems, focus on small and medium- sized innovative entrepreneurs, with the major objective of economic asset creation, etc.), it would be a contribution to co-operation concepts so far mainly propounded by the countries of the industrialized world.

Islamic banking is trying to change die relationship between finance on one hand and industry and commerce on the other. This new relationship is the basis of the Islamic economic system being set up. Though Islamic principles have yet to be put to the test in the competitive environment of international finance, die two systems are similar in that they both strive for closer ties between financial intermediation and economic asset creation.

Islamic banks could make a useful contribution to economic growth and development, particularly in a situation of recession, stagflation and low growth levels, because the core of their operations is oriented towards productive investments. All countries, both in the North and in the South, need more venture capital. Loan capital is available, particularly in industrialized economies, but at the high interest rates. However, even medium-scale entrepreneurs there find it difficult to raise sufficient risk capital for expansion and innovation. This has acted as a brake on productivity and economic growth in the North.

Thus, practical and intermediate co-operation possibilities exist between Islamic banks and enterprises all over the world. The intermediate’ process remains to be fully developed” ⁹.

Professor John R. Presley and J.G. Sessions of Loughborough University (UK) have in the May 1994 issue of the journal of the Royal Economic Society of Britain, The Economic Journal, tried to examine this central contribution of Islamic principles of finance {Islamic Economics: The Emergence of a New Paradigm). The authors, after regretfully noting that the:

“Western economists have been somewhat remiss in the last decade in failing to recognize what has the appearance of a new paradigm in economics – that of Islamic economics.”

They conclude:

“A riba contract creates an explicit mapping between the compensation and the input of capital… The prevalent method of Mudarabah-financing tries compensation on the outcome of the project. Mudarabah therefore allows the contract to control the managers’ incentive to exert effort directly, since this effort affects the relationship between capital investment and the outcome of the project. Under a Mi contract the manager is let free to choose the individually optimal of investment in each state contingent on his contractually specified level of effort. Such a contract permits a mean-variance improvement m capital investment – average investment is increased whilst inefficiently large fluctuation around this level is reduced… We have shown that the use of the prevalent alternative method of financier remuneration (i.e. Mudarabah) will, under certain conditions, lead to an enhanced level of capital investment on account of the ability of Mudarabah to act as an efficient revelation device. “¹⁰

I may also add a succinct observation by the leading German economist. Professor Hans Alba’ah who says:

“They (the Islamic banks) supply equity in the form of venture capital to investors whose share is their basic ingenuity and their labour.

• Traute Wohlers-Scharf, Arab and Islamic Banks, new business partners for developing countries; OECD. Pairs .1983 p.95
• J.R. Presley and J.G. Sessions, ‘Islamic Economics: The Emergence of a New Paradigm”, the Economic Journal. Vol. I04.No.424. May 1994, p.595.

Secondly, they supply equity in the form of equity capital as participants in the type of project which in general has majority shareholders. They may be ideally suited to meet the needs for equity capital in developing countries where the business risk is particularly, high as well as in the industrialized countries where the development of new process and new projects involve high risk and requires large amount of Venture capital.”¹¹

Islamic banking, if properly developed on the fundamental principles expounded by Islam, is destined to play a crucial role in reconstructing the economy in the 21st century on very sound foundations. But let me say in all honesty that Islamic banking, despite a promising beginning, is only in its larval stage. The real concept in its all comprehensiveness is yet to be fully translated into reality. The movement has a long way to go to become truly’ representative of the original concept. The efforts that are being made with seriousness and dexterity to eliminate riba from financial dealings, however welcome, have a long mileage to achieve. It is a fact that these experiments are being made in a climate – both domestic and external – which is anything but congenial. The moral fibre of the society is weak. The legal framework is antagonistic. The tax system is partial towards the interest system and almost inimical to a profit-sharing system. The state of competition between the Islamic and traditional banking systems is such that most of the odds are against the Islamic system, hi this context whatever progress has been made is path-breaking. Yet it deserves to be acknowledged that these efforts represent only first steps towards the direction of Islamic banking. Present day interest free banks have relied rather too heavily on those permissible instruments of financing which are closest to the traditional system like  Murabah (mark-up) and Ijarah (leasing) – Almost 80 to 90 percent lending has been done through these instruments. The real alternate instruments of Mudarabah (trustee-financing) and Musharika (profit-sharing) have been resorted to only to a very limited extent. Other ethico-social objective has also not received the importance they deserved. Greater success has been achieved in the field of deposit- mobilization particularly many untapped sources have been drawn upon. But the socially beneficial and development and welfare oriented utilization of these resources has left much to be desired. Employment generation and flow of resources towards the lower and middle classes of the society, particularly in the rural sector, where great potential as well as the greatest challenges exists, has not taken place. So is the question of efficient utilization of funds. That is why it would be unfair to judge die success or otherwise of die Islamic banking scheme mainly on the basis of the limited and partial experiment that is presently being made. The experiment is not even halfway through. The mileage yet to be covered is’ crucial. The distinctive character of the system is yet to unfold. Then and then alone the scope and extent of the experiment could be fully and realistically appreciated.

However, looking at the actual experience, at least in some countries, the rate of return offered by die Islamic banks has been generally lower than that offered by the traditional hanks before the Islamic banking was introduced.

The investment portfolio held by the Islamic banks has generally favored trade-related over production- related activities, short-term profitability over long-term profitability, and private-

1. Hans Alba’ah in Islamic Banking, Proceedings of Baden-Baden Seminar, London

-profitability over social profitability. The heavy concentration in few assets of short-term duration has typically lowered the stability of the Islamic bank’s portfolios and has increased die degree of their risk.

In practice, there has been an overwhelming preference by die users of loan able funds for the mark-up instruments over the PLS instruments, which have been overshadowed in. the bank’s portfolios.

The real rate of return (adjusted for the inflation rate) has been generally lower, if not negative, while that on the bank loan it is strictly positive. In view of these challenges from within and the major difficulties and bottlenecks from without, the Islamic banks have to undertake the Herculean task of implementing Islamic financial norms in such a manner that efficiency, profitability and equity are achieved simultaneously.

It is therefore submitted that the system of auditing of bank accounts must be upgraded to determine their legitimate operating Expenses and the monitoring, of the cases of bank default or other derivations from the norm This should be an integral part of Islamic banking (indeed, of any responsible banking). In other Words the information basis of Islamic bank must be widened and made readily available with the help of modern computer-based technologies – which allow the storage, the processing and the dissemination of relevant information in a very short time and at least cost. This is basic, because the information cost typical 1\’ rises when Islamic banking is introduced. For instance, the depositors will have to evaluate the relative performance of competing banks to reach a decision about where to invest their funds. On the other hand, the bank will have to seek greater and timely information about the use of the funds it makes available to the entrepreneurs.

The cases of loan default must be dealt with severely m Islamic banks as they amount to khiyanat which is a great sin in Islam. In general, any misappropriation of bank funds should be declared a social crime.

To satisfy the equity requirement, the difference between die rate of return on bank deposits and that on bank advances should be as small as possible— making due allowance for the bank’s operating expenses as determined by authorized auditors.

To be preferred over the traditional banks, the Islamic banks should be made to offer a real rate of return, ranging from zero to a reasonable positive value, depending on the length of time for which the deposits arc held. The reason is that in times of inflation the rate of return on bank advances typically raises by more than the inflation rate. This should enable the Islamic banks to do inflation adjustment on the rate of return offered on their deposits as well.

The Islamic banks should evolve innovative portfolios to suit the risk preferences of different classes of savers. It would be morally indefensible to make all classes of savers to bear the same degree of risk – irrespective of their capacity to take risk (which depends on the size of their respective incomes, savings, etc.). The Islamic banks should also show enterprising spirit by funding projects of a longer-term nature and where the social profitability of investment is higher than their private profitability – which typically covers all areas where external economies are large (health, education, infra-structure investment, etc.).

To lower the incidence of risk and uncertainty, a system of deposit insurance may have to be instituted. On the, side of bank advances, the legal structure governing private property rights should be clarified and strengthened. The evolution of effective supervisory mechanisms at different levels, horizontal and vertical, also poses a critical challenge that must be met unequivocally.

While the present writer firmly believes that the Islamic banking can come of age only in an economy and society that is committed to total Islamization and where real transformation is produced as a result of comprehensive movement, consisting of Islamically oriented behavior of the individual and socio-economic reform based on Islamic values, he belongs to that group of economists who regard the contemporary- Islamic- banking movement, despite all its weaknesses, as a positive development which bears great promise for the future. I also believe that despite fundamental differences with the traditional banking there is a vast area of co-operation between the two streams. After all venture capital has played a very important role in the development of the world economy. Investment banking has been an integral part of banking more prominently in the German and French traditions of banking.

Unit trusts and investment houses are operating as major financial institutions in the world today. IFC as against IMF and World Bank has gone into equity financing as part of international developmental effort. 1 does not think Western bankers would be averse to the idea of developing new modes of co-operation with the Islamic banks and financial institutions if they are presented with economically viable projects. If Bosphores Bridge – a billion dollar project – could be financed through venture capital, why not thousands of other projects. Once this new commonality of interest, based not on traditional ‘interest’ but some form of equity – sharing – is built, I am sure new avenues of co-operation can be explored. Huge untapped resources exist in the Muslim world and one of the reasons why they remain untapped is Muslim reluctance to go for interest- based financial institutions. Recent surveys have shown that even in Saudi Arabia, between 40-60 percent of the households that have a relatively high per capita income do not have a bank account. A large number of those who keep deposits have refused to take interest”.¹²

The situation is not different in other Muslim countries and even with the Muslim communities in many Western countries. This potential is yet to be tapped fully. Moreover, Islamic banking principles and instruments are not relevant to the Muslims only. They have universal applicability. Some recent trends in world capital movements show clear shift towards equity investment and venture capital. Net private capital flows (direct investment, net portfolio investment and other longer and short-term net investment flow s to developing countries were $10.1 billion on average during 1973-77, which increased to $27.4 billion during 1978-82, and to $117.8 billion during 1989-95. The actual figure for 1995 being $166.5 billion.

1. See R. Wilson. Banking and Finance in the Arab Middle East, Macmillan, London, 1983; N.A Sherbiny. OH and the internationalization of Arab banks, Oxford, Institute of Energy Studies, 1985.

As against this, net official flows, mainly debts, were $11.1 billion during 1973-77, $23.4 billion during 1978-82 declined to $16.4 billion, average during 1989-95. The amount of venture capital in funding in Asia has risen by 27% during recent years. ¹³ If these trends provide some clue to the future, they suggest greater scope for equity-investment in the coming decades. This, among others, sets the ground for greater co-operation as well as healthy competition between Islamic and traditional banks in the next century. Let the Islamic and traditional banking not look upon each other necessarily as rivals, despite their differing perspectives and idealisms. They can still be partners in building a brighter future for mankind-both in the Muslim and the Western worlds.

1. International Capital Markets: Developments, Prospects and Key Policy Issues by Takatoshi Ilu and David Folkerts-Landau. IMF, Washington, September 1996, pp.5-6.