A.L.M. Abdul Gafoor, Participatory Financing through Investment Banks and Commercial Banks, Apptec Publications, Groningen, 1996. pp.97.
Interest plays a central role in the Western monetary system. This role is firmly embedded in classical economic theory (Fisher, 1930).[I. fisher, The Theory of Interest, New York, Macmillan, 1930.] But what are the consequences for a monetary system, if interest in the classical sense (that is, the compensation for individuals who are willing to exchange current consumption for future consumption) is prohibited by religion, as in the case of Islam? This is the subject matter of the two books reviewed here. The first volume shows, using a general model of the commercial bank lending process, that interest can be eliminated from modern commercial banking (assuming that the clientele wishes to avoid dealing in interest, which is a sin as far as Muslims are concerned). In the resulting banking system depositors entrust their money to the bank for safe-keeping and permit the bank to use their funds to grant loans. Capital is guaranteed but no interest is paid. Borrowers obtain their loans through the bank and they pay a fee for the services provided the bank. The bank is an agent of the borrower (it finds counterparts for the borrower who are willing to advance to the borrower funds) and not a lender. Banks in this system are service providers, whose main income is the fees they charge for the service they provide.
In the above mentioned system there is no mechanism by which income is generated for the depositors. But Islam has nothing against profit (the Koran assumes a system based on individual enterprises and individual reward), and the second volume discusses the possibilities Islamic banks have to use depositors' funds to earn an income for themselves as well as for depositors. To this end, Islamic banks have invented the concept of participatory financing. In this concept, the bank, using the money entrusted to it by depositors, participates in an enterprise. It is a partnership between entrepreneur, bank and depositor, in which all risks are shared. The bank is the intermediary entrepreneur and depositor. The funds used to finance these participations come from so-called 'investment accounts.' These are time deposits which bear no interest, and the deposited capital is not guaranteed (nor is there any profit guarantee). This system of participatory financing has features that are attractive, at least in theory. For one thing, it gives the provider of money a strong incentive to be sure that he is doing something sensible with it. Moreover, the system stresses the sharing responsibility by all users of funds, and this accountability helps to make the system more open. But, as the author extensively discusses, the system of participatory financing also has its drawbacks. The intermediary role played by the banks implies that these institutions need to have considerable expertise and experience in project selection and evaluation and assumes that the bank knows as much about the business in question as the entrepreneur does. If not, there is asymmetry in information which could make the banks averse to such participations. Moreover, participatory financing seems applicable only to certain types of projects, i.e. entrepreneurs investing in new enterprises. The failure to recognise the later drawback is, according to the author, the main reason for the problems currently faced by the Islamic banks. The latter applied the concept of participatory financing to projects for which conventional financing through lending from their deposit accounts would be appropriate. Also, they used funds from other accounts than the investment account for financing the participations. This caused problems as the guarantee of capital is (in the absence of interest) the sole reason for holding these other accounts (i.e. time and savings deposits), and capital is not guaranteed under participatory financing.
All in all, these two volumes present an interesting analysis of a banking system without interest. Knowledge of such a system is useful, because a large part of the world population adheres to a religion which prohibits interest but still is in need of the economic functions performed by a "Western-style," interest-bearing, banking system. Moreover, rethinking a banking system without interest requires one to understand the precise role interest plays in the conventional interest-bearing system. This understanding is useful by itself.