LITERATURE ON INTEREST FREE AND CONVENTIONAL FINANCING

Islam is a system of belief that encompasses not only man's relationship with God, but also provides Muslims with a code that regulates their complete way of life. The Quran sets out its notions of equity, justice, fairness, morality and many other values that underpin the entire Islamic system.

The main root of emergence of Islamic financing system is the prohibition of Interest (Riba). So this chapter reviews first the prohibition of interest in Islamic point of view with reference to Quran and Hadith of Prophet (pbuh).

For the review of literature secondary data from various sources were extracted in relation to the objective and Hypothesis of the research. The review of literature is organized in a systematic manner, to ensure the dimensions of the study.  This section has been divided in the following manner.

Section 1:        This section first of all discusses Riba and its prohibition in Islam giving verses of Hoy Quran and Hadith of Holy Prophet Muhammad (pbuh) as well as some verses has been included form other Religions’. This Section also discusses some views of Muslim scholars comparing Islamic and conventional financial systems.

Section 2:        This section discusses the Islamic Banking and Islamic mode of financing including history and emergence of Islamic mode of financing in the world as well as in Pakistan. This chapter also discusses the mode of financing, their characteristics etc.

Section 3:        This section lightly defines conventional Banking and the emergence of interest in the history of the world. Emergence of modern banking and Conventional mode of financing instruments their characteristics.

Section 4:        This section discusses the SME financing in Pakistan. Role of private and other banks in SME financing, the problems faced by SMEs and the, the government steps to develop SMEs in Pakistan.

Section 5:        This section distinguishes between the Islamic mode of financing and conventional mode of financing.

Section-1   

 

1.1       Riba or Interest in Islamic Point of view

The word "Riba" means excess, increase or addition, which correctly interpreted according to Sharia terminology, implies any excess compensation without due consideration (consideration does not include time value of money).[1]This definition of Riba come from the Quran and almost accepted by all Islamic scholars, but scholars identified two types of Riba  'Riba An Nasiyah' and 'Riba Al Fadl'.'Riba An Nasiyah' is defined as excess, which results from predetermined interest which a lender receives over and above the principle (Ras ul Maal) 'Riba Al Fadl' is defined as excess compensation without any consideration resulting from a sale of goods.[2] During the dark ages, only the first form (Riba an Nasiyah) was considered to be Riba. However the Holy Prophet also classified the second form (Riba Al Fadl) as Riba.[3]

The meaning of Riba has been clarified in the following verses of Quran:

"O those who believe fear Allah and give up what still remains of the Riba if you are believers. But if you do not do so, then be warned of war from Allah and His Messenger. If you repent even now, you have the right of the return of your capital; neither will you do wrong nor will you be wronged."[4]

These verses clearly indicate that the term Riba means any excess compensation over and above the principle which is without due consideration. However, the Quran has not altogether forbidden all types of excess; as it is present in trade as well, which is permissible. The excess that has been rendered haram in Quran is a special type termed as Riba. In the dark ages, the Arabs used to accept Riba as a type of sale, which unfortunately is also being understood at the present times. Islam has categorically made a clear distinction between the excess in capital resulting from sale and excess resulting from interest. The first type of excess is permissible but the second type is forbidden and rendered Haram.[5]

There are some Hadiths of Prophet Muhammad (peace be Upon Him) about Riba

Ø                  From Jabir: The Prophet may cursed the receiver and the payer of interest, the one who records it and the two witnesses to the transaction and said: "They are all alike [in guilt]." (Muslim, Kitab al-Musaqat, Bab la'ni akili al-riba wa mu'kilihi; also in Tirmidhi and Musnad Ahmad)[6]

Ø                  Jabir ibn 'Abdallah , giving a report on the Prophet's Farewell Pilgrimage, said: The Prophet, , addressed the people and said "All of the riba of Jahiliyyah is annulled. The first riba that I annul is our riba, that accruing to 'Abbas ibn 'Abd al-Muttalib [the Prophet's uncle]; it is being cancelled completely." (Muslim, Kitab al-Hajj, Bab Hajjati al-Nabi, ; may also in Musnad Ahmad) [7]

Ø                  From 'Abdallah ibn Hanzalah: The Prophet, said: "A dirham of riba which a man receives knowingly is worse than committing adultery thirty-six times" (Mishkat al-Masabih, Kitab al-Buyu', Bab al-riba, on the authority of Ahmad and Daraqutni). Bayhaqi has also reported the above hadith in Shu'ab al-iman with the addition that "Hell befits him whose flesh has been nourished by the unlawful."

Ø                  From Abu Hurayrah: The Prophet, said: "On the night of Ascension I came upon people whose stomachs were like houses with snakes visible from the outside. I asked Gabriel who they were. He replied that they were people who had received interest." (Ibn Majah, Kitab al-Tijarat, Bab al-taghlizi fi al-riba; also in Musnad Ahmad) [8]

1.2       Restriction of Interest in other religions

The ancient religion of Near East, and the secular codes arising from them, did not forbid interest. If you lend food money or monetary tokens of any kind, it was legitimate to charge interest. Early C.5000 BC Food money in the shape of olive, dates seeds or animals was lent out. The interest was considered legal among the Mesopotamians, Hittites, Phoenicians and Egyptians. Some times it was fixed by the state.[9]

But the view of Jewish Religion was different. The Torah and later sections of the Hebrew Bible criticize interest-taking, but interpretations of the Biblical prohibition vary. One common understanding is that Jews are forbidden to charge interest upon loans made to other Jews, but allowed to charge interest on transactions with non-Jews, or Gentiles. However, the Hebrew Bible itself gives numerous examples where this provision was evaded.

In the Old testaments From the American King James Version

[Exodus 22:25] "If you lend money to any of my people that is poor by you, you shall not be to him as a usurer, neither shall you lay on him usury."

And following quotations are from the Hebrew Bible, 1917 Jewish Publication Society translation:

If thou lend money to any of My people, even to the poor with thee, thou shalt not be to him as a creditor; neither shall ye lay upon him interest. (Exodus, 22:25)[10]

1.3       Opinions on Islamic and Conventional Financing

Rodney (2003)discusses on Islamic and conventional system of Banking in “Banking and Finance to SMEs in Sudan” Published in 2003 that a major advantage that Islamic financial institutions enjoy over their conventional competitors, as moral suasion can be used to ensure repayment and full disclosure of all information relevant to the financing. Given these more favorable conditions for Islamic financing, funding of smaller, and even micro, businesses becomes viable.

Large numbers of relatively poor people can benefit from Islamic finance, including recipients of micro-finance. One major advantage of Islamic finance is that risks are shared between the financing institution and the beneficiary, which means entrepreneurs are better placed to concentrate on what they do best. Islamic banks, with a portfolio of funded projects, are better placed to take on greater responsibilities for risk.

The author provides a lucid explanation of those Islamic methods of finance most appropriate for small and micro-enterprises, namely Musharaka partnership finance, Murabaha mark-up trade financing and Mudarabah profit sharing financing.

The author admits his early doubts about the effectiveness of Islamic financing for SME businesses. He discovered its much greater suitability for SME support than conventional financing methods, largely because of its participatory nature that benefits the recipient and encourages client loyalty. Where there is an ongoing dialogue between the financier and the entrepreneur, business decision-making is improved, as two parties working together produce a superior outcome than each working in isolation.[11]

Professor Ibrahim says about SMEs in his publication “Poverty Alleviation via Islamic Banking Finance to Micro-Enterprises (MEs) in Sudan”that these businesses have nevertheless played a major role in generating employment opportunities and increasing the family income of people of modest means. He evaluates the contribution of the informal sector, craft workshops and productive families, all of which have benefited from Islamic financing, especially since the 1990s. This has helped significantly with poverty alleviation, and there is much potential for this type of small and micro business support to be extended in the Sudan as well as elsewhere in Africa and the developing world more widely.[12]

Dr Vijay Kumar (2004) in his study “some aspects of liquidity crises in Islamic Banks” stats The sources of funds of Islamic banks introduce depositors as a third party, in profit and loss contractual agreements. He highlights the change in the structure of equity and liability, Islamic banks mainly use low cost demand deposits (interest free with some fixed administrative costs) to finance investment and hence tend to be more profitable. Demand deposits have high rate of turnover and if the banks deploy these funds on long duration projects /activities, the possibility of liquidity crisis cannot be ruled out. He tries to find out reason of liquidity cries, he want to know are Islamic banks in a position to mobilize resources irrespective of the economic conditions prevailing in these countries, in comparison with traditional banks? Is there a way out to overcome the liquidity crisis through restructuring of liquidity?

He says Islamic banks follow policies, which are not according to the prudent banking practices. The macroeconomic environment and other bank regulatory conditions and policies prevailing in the country influence mobilization of deposits.[13]

Tariqullah dictates in his paper “Principles of Islamic Financing.”  published in 1992. That, Islamic principle of financing is been considered to be based on the variable rate of return (i.e. profit sharing). Therefore, Mudarabah has been treated by these scholars as a synonym for Islamic finance. This is perhaps the reason for neglecting the financing potentials of the sale based principle of finance and for the difference in this regard between interest and sale. As a result Islamic economists tend to describe the Islamic economy as debt free.

He further says that the emergence of Islamic financial institutions has highlighted the immense financing potential of the sale based principle where financing results in debt creation. This clarifies the point that there is a difference between the fixed nature of return on capital invested in real transaction (sale) and on capital invested in pure finance (interest) it is therefore clear that profit sharing is the only Islamic principle of earning a return on capital invested in pure finance (where ownership is separated from management) however , as sale on a deferred basis serves the financial needs of the buyer and seller, it is no wonder that mark-up and renting principles become the dominant practice of contemporary Islamic financial institutions.[14]

Harper, Malcolm (1997) says in “Partnership financing for small enterprises: some lessons of Islamic credit system.” that it is generally acceptable that if finance to SMEs is to be sustainable, this should be at the market rates of interest not confessional rates of interest. Successful innovative financial schemes to SMEs are those which meet the sustainability, profitability and non-charity criteria, through charging a rate of interest which justifies the transaction cost of lending...[15]

Taylor, T and Evans, J, (1987) In his work ‘Islamic banking and the prohibition of usury in western economic thought’ Taylor and T an Evans says that,  “some evidence of common origin as well as some calls for the application of Islamic formulae to conventional banks. When comparing the Western medieval economy and the Islamic system of banking, Taylor and Evans concluded that both systems prohibit usury and permit any return from partnership, provided that the partner making the investment genuinely shares the risk. They wrote “the closeness of the two systems [Western medieval economy and the Islamic system] is great and there is some evidence of common origins. Contemporary Western thought, however, has apparently removed itself far from its own tradition — hence the gap between Western and Islamic banking systems” [16]

1.4       Defining SMEs

To be classed as an SME or a micro-enterprise, an enterprise has to satisfy the criteria for the number of employees and one of the two financial criteria, i.e. either the turnover total or the balance sheet total. In addition, it must be independent, which means less than 25% owned by one enterprise (or jointly by several enterprises) falling outside the definition of an SME or a micro-enterprise, whichever may apply. The thresholds for the turnover and the balance sheet total will be adjusted regularly, to take account of changing economic circumstances in Europe (normally every four years).[17]

a.         UK

In the UK, sections 247 and 249 of the Companies Act 1985 define a SME for the purpose of accounting requirements. These sections have been amended a number of times, most recently by Statutory Instrument 2004/16 - The Companies Act 1985 (Accounts of Small and Medium-sized Enterprises and Audit Exemption) (Amendment) Regulations 2004. According to this a small company is one that has a turnover of not more than £5.6 million, a balance sheet total of not more than £2.8 million and not more than 50 employees. A medium-sized company has a turnover of not more than £22.8 million, a balance sheet total of not more than £11.4 million and not more than 250 employees. It is worth noting that even within the UK this definition is not universally applied.[18]

b.         European Commission

The Commission has a third category called Micro Enterprises. A micro enterprise has a headcount of less than 10, and a turnover or balance sheet total of not more than €2 million. A small enterprise has a headcount of less than 50, and a turnover or balance sheet total of not more than €10 million. A medium-sized enterprise has a headcount of less than 250 and a turnover of not more than €50 million or a balance sheet total of not more than €43 million.[19]

Criteria	Micro enterprises	Small-size enterprises	Medium-size enterprises
Max. number of employees	< 10	< 50	< 250
Max. turnover in million ECUs	-	7	40
Max. balance sheet total in million ECUs	-	5	27

 

c.         USA[20]

In the USA, a government department called the Small Business Administration (SBA) Size Standards Office sets the definition of small business. The SBA uses the term “size standards” to indicate the largest a concern can be in order to still be considered a small business, and therefore able to benefit from small business targeted funding. The concern cannot be dominant in its field, on a national basis. It must also be independently owned and operated. Unlike the UK and the European Union which have simple definitions applied to all industries, the US has chosen to set size standards for each individual NAICS coded industry. This variation is intended to better reflect industry differences. The most common size standards are.

500 employees for most manufacturing and mining industries

100 employees for wholesale trade industries

$6 million of annual receipts for most retail and service industries

$28.5 million of annual receipts for most general & heavy construction industries

$12 million of receipts for all special trade contractors

$0.75 million of receipts for most agricultural industries

d.         Pakistan

In Pakistan, SMEDA has defined the SMEs in terms of employment generated as well as investment in productive assets. SMEDA's definition of SMEs is primarily based on the number of personnel employed in the enterprise. The secondary criteria for classification of the SMEs, is the value of productive assets employed in the enterprise.

SMEDA SME Definition

Small & Medium Enterprises are defined as follows, as approved in SME Policy 2007

Enterprise Category	Employment Size (a)	Paid Up Capital (b)	Annual Sales (c)
Small & Medium Enterprise (SME)	Up to 250	Up to Rs. 25 Million	Up to Rs. 250 Million

The Federal Government, in line with the economic development of Pakistan may, from time to time modify the eligibility criteria as it sees fit. All providers of services receiving funding from the Government may define more narrow scopes for specific targeting purposes. (smepolicy, 2007)

SME Definition (proposed under SME act)

Tax ordnance 2005 defines Small business with equity of up to Rs 25 million and turnover of Rs 200 million.

An SME entity is defined as a business with an investment in productive assets
(not including land and building) ranging between Rs. 2-40 million and employing between 10-99 workers.

Small: between 10-35 employees and productive assets range of Rs. 2-20 million.
Medium: between 36-99 employees and productive assets range to Rs. 20-40 million.[21]

SME Definitions used by various institutions in Pakistan

Table 1

Institution	Small	Medium
SME Bank	Total Assets of Rs. 20 million	Total Assets of Rs. 100 million
Federal Bureau of Statistics	Less than 10 employees	N/A
Punjab Small Industries Corporation	Fixed investment. up to Rs. 20 million excluding land and building	N/A
Punjab Industries Department	Fixed assets with Rs. 10 million excluding cost of land
Sindh Industries Department	Entity engaged in handicrafts or manufacturing of consumer or producer goods with fixed capital investment up to Rs.10 million including land & building
State Bank of Pakistan (SME Prudential Regulations)	An entity, ideally not being a public limited company, which does not employee more than 250 persons (manufacturing) and 50 persons (trade / services)   and also fulfills one of the following criteria: (i) A trade / services concern with total assets at cost excluding land and buildings up to Rs 50 million. (ii) A manufacturing concern with total assets at cost excluding land and building up to Rs 100 million. (iii) Any concern (trade, services or manufacturing) with net sales not exceeding Rs 300 million as per latest financial statements.

References

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[1] Noor Ahmed Memon (2007)  “Islamic Banking: Present and Future Challenges “ Journal of Management and Social Sciences Vol. 3, No. 1, (Spring 2007) 01-10  Department of Economics, Institute of Business & Technology (BIZTEK)

http://www.biztek.edu.pk/downloads/research/jmss_v3_n1/1-islamic%20banking.pdf

[2] IslamicBanker.com “Riba interest explained” http://www.islamicbanker.com/riba.html

[3] Noor Ahmad Memon. (2007) “Islamic Banking: Present and Future Chalanges” Journal of Management and Social Sciences. Vol. 3, No. 1,01-10. Department of Economics, Institute of Business & Technology (BIZTEK)

[4] The Holy Quran Al Baqarah 2: Ayath  No 278-9

[5]  Meezan islamic Bank ”Guide to Islamic Banking”   http://www.meezanbank.com/pages.aspx?iPageID=184

[6] Jamia Masjid Nairobi “ Riba interest in Hadith”  http://www.islamkenya.com/html/i_bank3.html

[7] Dr Shariq Nisar  ( 2007)  “Riba in Islam”  Finance in islam learning Islamic finance http://www.financeinislam.com/article/10/1/552

[8] Ashraf, Imran. (2002) “Guide to Islamic Banking”. Meezan Bank. [Online] 2002. [Cited: 4 18, 2009.] www.meezanbank.com/guide-islamicbanking.aspx

[9] Wikipidea. History of Banking. Wikipedia the free incyclopedia. [Online] 2008. [Cited: 4. 15, 2009.] www.wikipedia.org/wiki/history-of-banking 

[10] CHABAD Library The complete jewish bible with Rashi comentry Shemot - Exodus - Chapter 22  http://www.chabad.org/library/bible_cdo/aid/9883

[11] Prof. Wilson Rodney, (2003). “Banking and Finance to Small and Micro-Enterprises in Sudan – Some Lessons from the Islamic Financing system”. University of Durham, Institute of Middle eastern and Islamic Studies,. Uk london : UK Publisher: Institute of Islamic Banking and Insurance, 2003.

[12] Ibrahim, Badr-El-Din A.(2003) “Poverty Alleviation via Islamic Banking Finance to Micro-Enterprises (MEs) in Sudan:Some lessons for poor countries”. Bremen Germany : Institute for World Economics and International Management (IWIM) D-28334 ,

[13] Kumar, Prof. Dr K.C Vijay.(2004) “Some aspects of liquidity crisis in Islamic Banks in MENA Region”. india : Modern college of Business & sciences(MCBS),

[14] Tariqullah, Khan Monzer Kahf .(1992) “Principles of Islamic Financing” Paper No 16 . s.l. : Islamic research and training institute Islamic Development Bank.,

[15] Harper, Malcolm. (1997) “Partnership financing for small enterprises: some lessons of Islamic credit system” sp.64, p. 1 , . s.l. : IT publication.

[16] Taylor, T and Evans.(1987) ‘Islamic banking and the prohibition of usury in western economic thought’. s.l. : National Westminster Bank Quarterly Review, November,, July 1987. pp. p. 26,.

[17] SME UK (2006) Information Europe information society http://ec.europa.eu/information_society/activities/atwork/work_paradigms/smeinfo/index_en.htm

[18] Scottish GOV (2004) The Scottish government Riaghaltas na h-alba. http://www.scotland.gov.uk/Publications/2008/05/29141216/4

[19]European commission (2003) http://ec.europa.eu/old-address-ec.htm

[20] SBA(2008)Small Business Administration US small business Resource http://www.sba.gov/contractingopportunities/officials/size/index.html

[21] SBP smepolicy 2007. SME policy. SMEDA. [Online] 2007. [Cited: 4 20, 2009.] www.smeda.org/projects/SME-policy-department.html.

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