A recent FE report on the workshop on 'Islamic Banking Operation of Banks' organised by the Bangladesh Institute of Bank Management (BIBM) has highlighted a significant aspect of Islamic banking in Bangladesh. The Review paper of the workshop quoted two sentences of Mr. M. Azizul Huq, widely recognised as an authority on the subject. He said: "One problem with the Islamic Banking system in Bangladesh is that we have gone directly into practice while not giving much attention to concept. To ensure true benefit from Islamic Banking practices, we need to concentrate more on the concept."
The Islami Bank Bangladesh Limited (IBBL) introduced Islami banking in the country in 1983. No team of practitioners in Islamic banking was available in the country at that time. But the positive drive of that period has now established Islamic banking on a firm footing. Islamic banking operations have now attained the coverage of about 20 per cent of the banking sector balance-sheet of the economy.
At the initial stage, many issues regarding the concept of Islamic banking were viewed leniently on the plea that we should allow 'Islamic banking baby' to survive against the current first, and then we would look for perfection and true practice.
Some conceptual obligations were overlooked or ignored referring to a common excuse of 'for the time being' as an urgent/instant solution. In practice, fundamental aspects were also sometimes ignored. This has practically resulted in departing from the basic concept of Islamic banking. Often we talk about mere expanding the volume of Islamic banking business; but least we care for the concept.
Again, in support of the prevailing practice, reference is often made to the precedence established by the pioneers or most of the Islamic banks in the economy. But we hardly think whether their practice was right or wrong, nor do we compare the same with the relevant concept. Consequently such practice now invites misinterpretations. We forget that mere precedence can never be the evidence of rightness or perfection in principle.
Not to talk of the general mass, even some Islamic banking practitioners fail to or deliberately do not distinguish Islamic banking from the conventional one. The reason is very simple. Continuous and indiscriminate violation of the theory or concept has equated them in their mind. Some bankers may claim to have experience in working in both the systems and finding no basic difference between the two. In fact, they do not at all believe in the concept of Islamic banking. May be they were not interested in the concept of Islamic banking. Or they may be excused as they had never been professionally required or compelled to be acquainted with the concept.
But an ideology-based practice must not forget the root. Naturally the question of ethics and ideology is highly relevant in the case of Islamic banking. Prevailing practice sans concentration on the concept has put the very idea of Islamic banking into question. The mentality of constantly compromising with the ideology and prevalence of practice over the theorem should therefore stop. No more temporary or 'for the time being' solution (or overlooking) be allowed to run.
Time has come for the practitioners to follow the concept of Islamic banking truly and faithfully so that an ordinary person can easily differentiate between Islamic Banking and its conventional counterpart.
To elaborate, a particular Mudaraba (profit sharing) module was adopted at the beginning of Islamic banking in the country in 1983. It was identified about 10 years ago that the principle was a serious violation of the concept of Islamic banking and a conceptually valid module was discovered. But till date that violation of Mudaraba module has been taking place through the Weightage system of profit distribution to the depositors.
Now, before going into the details of the Weightage system, let us have a look at the basic factors which are the 'lending rates' and 'borrowing rates' of a conventional bank and then we would talk on those of an Islamic bank.
Conventionally a bank's lending rates are mainly influenced (determined) by the cost of deposit. Other factors like administrative cost (including fund management cost), bank's profit margin and cost of bad or non-performing loans etc, are intentionally kept beyond the purview of this article. These factors vary little for conventional or Islamic banking.
For the sake of simplicity let us confine a bank's income and expenditure only to two items. Income would mean as income from deployment of fund (more simply, as interest received on loan). Expenditure would mean cost of deposit (interest paid on deposit). In conventional banking cost of deposit or interest on deposit is/can be determined unilaterally without waiting for any future data. As such this cost element itself can determine or can be used as a dominating factor to arrive at the interest rate to earn from loan i. e. the lending rate.
Alternatively, it is also possible to predetermine both the interest rates (on deposit and loan) independently. In that case the bank would only ensure a safe margin between the two interest rates to cover its own cost and expected profit. There is even no harm, if the bank determines the lending rate first, and then decides on the borrowing rate, depending upon the former.
There remains no conceptual bar in conventional banking to fix the interest rates in any of the above ways. Predetermined in any way, it is not only norms but also obligatory for a traditional bank to declare the interest rates both on loans and deposit earlier.
Theoretically, under conventional banking, interest expense on deposit is a fixed obligation. Bank is to pay this without any reference to its revenue or business result. Interest amount to pay to depositors is fixed. It does not matter whether the bank earns less or more. This is because, contract of interest to pay is, in no way connected with the volume of revenue of the bank.
Under conventional system, the bank's income and expenditure statement may simultaneously get posting of interest earning items as revenue and interest payment items as cost (since both are predetermined and already known to the bank) to directly arrive at profit of the Bank.
But in Islamic banking, the relationship is totally different. Here cost of deposit cannot be determined unilaterally/independently. As such it is not possible to prefix the rate of return on Mudaraba (most of the deposit of Islamic banking belongs to this type) deposit at the time of collecting the deposit by an Islamic bank.
In Islamic banking the rate of profit on deposit is to be worked out later, at the end of a period to close or conclude accounts. Here cost of deposit or return on deposit (conventional interest on deposit) depends on the future actual income (conventional interest on loan) to earn from the deployment of the bank's fund.
Under Mudaraba (profit sharing) system, all the revenue or income of the bank has to be accumulated first. This accumulation must be accomplished before charging any cost against deposit (as the bank still does not know how much it has to pay to the depositor). This accumulated amount of revenue will then determine the cost of deposit.
Finally, to arrive at the bank's profit, the bank will charge deposit-cost (at the declared ratio or proportion) against that revenue. Thus cost of deposit (profit on deposit for the depositor) is to be worked out from the consolidated revenue of the bank. Such cost will not have simultaneous charge while posting the revenue items. Here revenue is considered first and then cost of deposit. That is, 'cost of deposit calculation process under Islamic Banking starts at the point where its revenue calculation or accumulation process ends.'
The Islamic bank is only to give the depositors a declared ratio (called income sharing ratio) of its earning. Bank will keep the rest for coverage of its own cost and profit margin. Thus, if a client is offered a sharing ratio of 60:40 (Bank: Depositor), he will deserve Tk. 40 if the bank earns Tk. 100 by deployment of that client's deposit. So under this system calculation of earning of Tk. 100 is to be determined first, to work out that Tk. 40 is the cost of deposit.
Thus if earning or revenue of the Islamic bank is Tk. 50 (instead of Tk. 100) it would indicate the depositor will get Tk. 20 (instead of Tk. 40) as profit on deposit (cost of deposit for the bank). Until it is known whether the bank earns Tk. 100 or Tk.50 or so on, it cannot find its cost of deposit. Obviously it is very unlike the conventional banking.
This is the true concept on which the module of distribution of profit to the depositors of the Islamic bank should be based on. As a term, such a method may be called income-sharing method. The proportion to declare with the depositor while the bank collects the deposit may be termed as income-sharing ratio (ISR) or the like.
But most of the Islamic banking operators in the country practise Weightage method, a formula the common stakeholders find difficult to understand. They clearly violate the basic concept of Islamic banking which is based on income sharing.
Afzalul Haq is the former head of Islamic banking of Bank Asia Ltd.
