Islamic Banking or non-interest banking as it may be called could be simply understood to be a banking process where interests are not charged. Earnings on money lent can only be realized from a definite value creating process. Thus, non-interest banking legalises only profits. All other forms of interests charging are prohibited.
2. DISCUSSION/ COMPARISM
To discus this topic reasonably in this brief paper, it may be wise; to make an assessment by way of comparison and so compare non-interest banking as against the conventional form of banking that is predominant today. Thus, comparing profit and loss sharing against interest charging.
1 - Savings and Investments
These are the 2 most important determinants of economic growth and development in any economy. Contrary to the general apprehension, which purports that prohibition of interests may reduce the level of savings and may thus retard economic growth and development. A rise in interest rates, reduces the income of the borrower. It consequently reduces his propensity to save/invest. This happens because of the cost (interest) of funds he borrows.
2 - Unemployment and Inflation
When interests rates are high, cost of capital are high and eventually cost of production are also high. This causes a fall in the volume of enterprise thereby leading to the closure of production units, retrenchment of workers to cut down costs or because their services are no longer required, and producers may decide to increase prices of their goods and services to balance their 'cost/income' trend. Thus, inflation is triggered.
3 - Profitability and Productivity
Profit sharing promises leverage benefits to firms free of risk and a return higher than the rate of interest to the financier. Fluctuations in the rate of profit on equity under profit and loss sharing finance are likely to be smaller than the rate of profit on equity under interest finance, and profit and loss operations may have a small destabilising potential for the economy as a whole compared to financing on interest. For the financiers and the firms that borrow funds from them, the profit and loss sharing system is the best and most suitable.
3. RISK SPREAD
With the prohibition of interests; preference shares, debentures, commercial papers, treasury bills, bankers' acceptance will no longer exist (at least in their interest earning forms). This does not in any way narrow the investment opportunities/portfolios available to banks. This is because other assets representing profit sharing arrangements will also exist automatically. Thus, the names of preference shares, commercial papers etc may not change, but their interest characteristics will be abolished.
In an Islamic financial system, the availability of assets with a variety of risk characteristics is a distinct possibility and there is no reason to assume that there is a limit to the diversity of assets in such a system.
In light of the above justifications, it is quite obvious that non-interest banking is here to stay. I am of the least doubt that from the inferences, which can be drawn from the comparisons above, non-interest banking, will succeed. This is because 'profit sharing' is superior as compared to other tools of macro-economic policy (that is, 'interest charging'). Profit sharing has a quality, which most other macro-economic tools usually lack. This quality is stability.