This site is solely dedicated to publish my writing, mostly on the topic of Islamic finance. Some of the articles were written as partial fulfillment for completing the Chartered Islamic Finance Professional (CIFP) certifications and for the Ph.D in Islamic Finance that I am currently undertake. Interested parties, including reporter/press or students, may reproduce or quote materials published provided that the credit has to be given to my blog (arzim.blogspot.com). Comments must be accompanied by names or pseudonyms. Anonymous postings and those containing profanities and obscenities will be rejected.

Saturday, February 27, 2010

The supply of savings in an Islamic finance is free from the influence of external intervention such as the interest rate. If this is true, how this will motivate people to put their money in Islamic bank deposits?

The reason for the prohibition of riba (interest or usury) is because it is unjust to the borrower. However, in some case, it might also unjust to the lender and the lenders to the banks are the depositors. Banks collect the saving of all small savers and give loans to the entrepreneurs who required capital for business. 

In hyper-inflationary economy, the borrowers might be charged interests up to 15% or more which may not even compensate the rate of inflation. Based on this rate of interest and minus the administrative expenses of the banks and their own margin, they pass this on as the different between the borrowing rate and the lending rate. In many countries, banks are legally prohibited from paying a rate of interest higher than the one specified by law (e.g. United States, the Regulation ‘Q’ places ceiling on the interest rate to be paid by banks to the depositors). Therefore, a contract which is based on interest cannot adjust itself (and banks are only allowed to pay rate of return or interest up the specified limit). Therefore, the rate of return cannot adjust to the rate of inflation and lenders are, at a disadvantage. In addition, when the rate of inflation is high, the real rate of return can becomes negative.

This implies that saving depositors under Islamic banking would be receiving the nominal amount of the deposit regardless of inflation. As mentioned above, in an inflationary situation, the value of the savings deposit may be eroded in a short period of time if there is no corresponding compensation in the form of a return on the deposit. However, from the point of view of Islamic banking proponents, the answer to the above problem lies with the depositor, not with the Islamic bank. In Islam, risk-taking is commended and if the depositor is interested in getting any return, he should take the risk and put his money in investment deposit accounts. If the depositor is interested in a return, there is no guarantee of the protection of the deposit since earning a return could only be achieved by putting the deposit at risk on a Profit and Loss Sharing (PLS) basis. Investment depositors place their funds in investment accounts and are supposed to share in the profit and loss of the investment operations of the bank under the doctrine of mudarabah (profit sharing). Under the arrangement, the bank will use the deposits for investment purposes. The profit will be shared between the bank and the customers. At the same time, the investment account holders bear part of the losses if the project fails. 

With PLS, since prices increase and the rate of return of the project also increases along with the rate of inflation, the real rate of return does not end in a loss. The real rate of return is positive. The banks also interested to maximise their profit and will share in an equitable manner with the depositors. There will be, in a small number of cases, whereby a few enterprises which end in a loss, but by and large in a growing economy, the rate of return is positive, and enterprises will normally achieve, a positive real rate of return. In some cases, the banks which practice mudarabah is able to give return up to 15% or more. This is definitely higher compare to average of 3.5% - 4.0% rate of return from conventional fixed deposits.

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