02 January, 2015

Socio-economic impact of Islamic banking

Bank, the most powerful instrument to shape the economy of a society, works as the intermediary between the savers and the actual users of money capital. Small savings can not individually form viable capital but when those are brought in a pool, form a sizeable money capital which plays a very important role in economic development of a country. Banks pool the savings and lends out of the same for promoting productive activities of the society.

Historically banks have performed their functions on the basis of a fixed return i.e., interest. Interest forms the basis of relationship of the bank with the depositors as well as the user of money capital. The purpose of this Short Essay is to demonstrate that the basis i.e., interest works to the detriment of social interest affecting the allocation of resources, level of economic activities and value of money in undesirable ways (1). And also to demonstrate as to how profit and loss  sharing banking (Islamic banking) results in desirable effects on the allocation of resources, level of economic activities and value of money. Adoption of Islamic banking will not only save the humanity from evil consequences of interest, it will also contribute to socio-economic justice and equitable distribution of income and wealth (2), favour weaker sections of the society (3) and help establishing harmonious relationship among different groups  of the people contributing towards greater stability and peace.

On allocation of resources
Conventional banks are profit oriented and their resources are allocated in such a manner so as to ensure profit earning for the institution. On the other, Islamic bank is welfare oriented and interested in maximizing social benefit.

In most of the free societies the people belong to mainly 3 (three)  classes (i) the upper class, (ii) the middle class and (iii) the lower class. The upper class is economically solvent and commercially viable. A bank can earn a lot by investing with the people belonging to this class. The middle class having scarce balance income maintain their lives mostly at subsistence level. They are instantly not viable commercially but there is the bright possibility of their becoming so if financial assistance is extended in case of necessity. The other class is said to be the class of have nots. They are neither instantly viable nor have the possibility of their becoming so. They require charity services from the society.

In developing countries like Bangladesh approximately 90% people remain untouched by banks. They have no balance income to maintain an account with bank. Banking is monopolised by remaining 10% people. Out of this ten percent 9 are depositors and one belonging to the upper class is actual user of fund. In other words capital accumulated by nine is consumed by one. As the conventional banks are mostly concerned with earning interest, they continue this process of transferring resources from the poorer sections of the people to the richer. They do not bother for the nonviable groups of the people.

Islami bank in sprit has the concern for all the three classes of people. It has three heads of allocation of resources for three classes of people. (a) Investment fund for earning profit, it goes mainly to the upper class. (b) Qard for making the prospective one viable, it goes mainly to the middle class. (c) The Zakat and Sadaqa fund for sustaining and establishing the have nots in life, it goes to the lower class. By allocating resources in this manner Islami bank tries to bring harmony among different groups of the people and works as an automatic instrument for balancing the society.

On economic activities:
Conventional Bank is by nature less productive and discouraging to the new entrepreneurs. In interest based system the income of the bank is fixed and in no way related with actual outcome of business. Safe return of principal amount along with fixed interest is sufficient for them. So, they do not require to bother for better performance or more production in the projects financed by the Bank. On the contrary Islami bank is not owner of any predetermined fixed income from its investment. It is directly related with the business and have to share the actual return from business either profit or loss. So, by virtue of its nature Islami bank is concerned with better performance and more production by its clients. If clients earn profit bank will be benefited and in case of loss bank have to share the loss with the client. Massive loss by the projects financed by the bank shall threat the very existence of the bank. So, for the very survival, Islami bank has to extend its helping hands to the clients. It will help the clients with necessary Counsel and Co-operation for making the venture a success. Joint efforts by both the bank and the client will lead the project to sure success. In this process Islami bank will boost up production and bring prosperity to the society.

Islami bank by its activities encourages more and more investment and develops new entrepreneurs. Conventional banks make the people inactive. If any body can save Tk. 100,000/= he can easily earn a definite return of Tk. 12,000/= at the end of the year simply by depositing the amount to the bank without making any effort for productive investment of his money, when the rate of bank interest is 12% per annum. Where there is the opportunity of riskless definite income people do not dare to take risk of investment for uncertain return. The result is obvious-new entrepreneurs do not emerge and old one becomes poured with unmanageably large capital. But when the entire banking system will be Islamised then there will remain no room for unearned income. In an Islamic banking system the owners of money will have two alternatives to invest; they either deposit their money with a bank or may invest by themselves for further generation of cash. In both the cases they have to solder the risk of loss. Naturally in such a situation they will prefer the last one which will ultimately result into emergence of more and more new entrepreneurs. In conventional banking system the risk of business solely rests with the entrepreneur. Bank does not take the risk of loss. In case of loss also the entrepreneur has to pay both principal and interest alike. But in Islamic system bank acts as the automatic insurer for the entrepreneur by sharing the loss of the venture. So business undertaking in collaboration with Islami bank is less risky and much encouraging for the entrepreneurs. Result is obviously development of entrepreneurial skill and creation of a congenial climate for investment which is the prime concern for economic development of a country.

On value of money:
In Islam, money is a measuring scale and a unit of account. It stresses unequivocally on keeping money value stable. Erosion in the value of money i.e., inflation is denounced in Islam. Inflation implies that money is unable to serve as a just and honest unit of account. It makes money an inequitable standard of deferred payment and an untrust worthy store of value (4). Interest in the main cause of inflation which is a curse of modern economy. Interest on borrowed funds used in production raises the cost of goods and services. Similarly, interest earned by the depositors adds to the money supply. Thus both these interest rates i.e., the lending rate and the borrowing rate of an interest based bank work as two edges of a double edged sword-one inflates the cost of goods and services and the other inflates money supply in the market. Economists are unanimous that cost push and inflated money income are amongst the major causes of inflation (5). Interest contributes positively to both these causes. Islami bank closes both the doors of inflation. It neither realizes any definite amount from the client nor pays predetermined excess to the depositors. Islami bank shares the actual return of the business either positive or negative; distributes a portion of the positive return as profit among the depositors and writes off the negative return from its books of account. So, no question of raising cost of production arises and the barometer of money supply in the market moves with ups and downs in supply of goods and services.

The Modern world is tired of fighting inflation; Western economists are busy with controlling inflation by using age old principle of changing rates of interest. Rise in rates of interest begets further inflation instead of arresting the same. But profit and loss sharing banking may respond positively and act as automatic controller of inflation which is the crying need of the time.

The world has been experiencing a number of economic ills. Interest sustains most of them. To get rid of the ills Kynes suggested zero rate of interest. That is not also the just answer. The correct answer is PLS banking i.e., Islamic banking. Mr. Sanat Mehta a former Finance Minister, State of Gujrat, India quoting IMF staff papers commented that ‘Interest free banking system based on Islamic tenants may adjust more easily to financial shocks and thus prove to be more stable than its western counterparts (6). One thing deserves mention here that banking is the most important element for ensuring harmonious growth of economy but not the only element. So to achieve optimum result other agencies – political, social, economic, monetary and fiscal must also play a complementary role. The impacts discussed here may be expected from a total Islamic banking system and not from one or two micro Islamic banks (7).

(1) Rationale of Islamic banking – Dr. M. Najatullah Siddiqui.
(2) Money and Banking in Islam – Dr. M. Umar Chapra
(3) Al Quran, Sura Wuasas Ayat No. 5-6.
(4) Money and banking in an Islamic framework-Dr. M. Umar chapra.
(5) Islamic banking and some common misgivings- Clarifications from socio-economic
points of view-M. Azizul Huq, Executive President, Islami bank Bangladesh Limited.
(6) Quoted from a letter of Mr. Sanat Mehta enclosed with a letter dated 22.10.1986 addressed to Islami Bank Bangladesh Limited by Mr. Hunaid Khorakiwala for an sponsor of Profit Sharing Bank in India.
(7) Islamic Banking System –A Road to Social Justice
                - M. Azizul Hqu. Executive President
                  Islami Bank Bangladesh Limited

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