Islamic and conventional banks: The issue of excess liquidity and price spill over.

Byline: Ahsan Nisar

Doing business in Islamic way requires Muslims to undertake transactions free of Riba (interest), Gharar (uncertainty), Maisir (gambling) and non-Halal (prohibited) activities. Islamic banks are, therefore, forbidden from taking or offering interest or usury. Unlike in conventional banking, a lender in Islamic finance should shares the risk of the project with the borrower, as neither the borrower nor lender controls the outcome of the venture. This risk sharing in financial contracting by replacing ex-ante fixed return, with an ex-post uncertain return based on a profit-sharing principle, differentiates Islamic from conventional banking. Under this profit and loss sharing (PLS) paradigm, only the profit-sharing ratio between the financer and borrower is determined ex-ante.

In practice, however, Islamic finance institutions offers both PLS and non-PLS products. A financier could opt for direct equity stake, based on participatory financing (or PLS), or non-participatory financing (or non-PLS) with no take on equity. The important participatory forms are Mudaraba, and Musharaka. In former contract, a 'sleeping' partner contributes capital while active partner contributes expertise/knowledge. In latter contract, a financier also participates into the activities of the venture. Important non- participatory financing form includes Murabaha ('markup' or cost-plus sale), Ijara (lease), Bay' salam/Istisna (deferred delivery), Bai muajjal (deferred payment), Jo'alah (service fee), and Qard al hasana (charity/beneficence loan).

A large number of institutions offer interest free banking based on Islamic products in predominantly Muslim, as well as, in non- Muslim countries. Only Iran, Pakistan, and Sudan are referred to as countries with full Islamic banking. Despite PLS banking introduced in Pakistan in 1980s, banks never shared losses with the depositors neither their depositors received any share in the windfall profits, which the banks in Pakistan are making. Moreover, the contract these banks are making with their client are based on ex-ante fixed rate and are benchmarked with the interbank market or policy rate, which makes them conventional instead of PLS based Islamic banks.

Only designated Islamic banks established following the recommendation of Commission for Transformation of Financial System (CTFS) and Pakistan's Supreme Court ruling in June 2002. Since 2002, State Bank of Pakistan (SBP) issued licenses for Shariah...