Interest Free Banking

Having looked at banking systems both in Pakistan and overseas, my first impression is that in today’s world, interest-free banking in Pakistan would be unworkable.

The three common modes of interest free financing currently being used are Musharika, Mark-up and Morabaha. Let us analyze the impact of using each one of these forms.

Musharika: Under this form of financing the bank becomes a shareholder of the business it finances and hence shares in the profit or loss of this business. If this were to be preferred route to be followed, the major issue would be of policing the profitability of the various concerns. Considering the amount of tax evasion in our country, even the Board of Revenue has not been very successful in estimating the profitability of various businesses.

Imagine how hard would it be for a bank to figure out exact profit and loss of a concern. The banks would need to hire dozens of people to work in each business that it finances just to monitor the operations and the profit and loss, which in turn would be impractical to do. Hence, it would be safe to assume that most of the businesses would end up showing a loss and as a consequence of this the banks in turn would also show losses and the depositors would end up losing all or part of their capital.

Consider the case of individual borrowers or consumers. The question here would be that would the bank then end up being partner in a house or a car purchased by the individual. How would one then measure the profit and loss of a depreciating asset?

Mark-up: Under this mode of financing, a bank buys goods from a vendor and sells these to the borrower at a marked-up price. The borrower then pays the bank this amount in installments over a fixed period of time. In essence there is no difference between a mark-up agreement and an interest-bearing loan agreement. The only minor difference being in re-pricing i.e. the mark-up is fixed at the start of the loan, whereas a normal loan agreement will include a re-pricing clause to take care of changes in cost of funds to banks.

Morabaha: Under this mode of financing, the bank purchases goods from the borrower and sells these back to the borrower at a higher price. The borrower may use the amount paid for the purchase of the goods for a pre-defined purpose, while the borrower pays the repurchase price to the bank in installments over a fixed period of time.

Now consider for example the case where a person wants to set up a factory worth millions of rupees. In order to create a Morabaha transaction, the borrower must sell goods that he owns to the bank equal to the amount being borrowed. First of all the borrower usually would not have goods worth that much, so in order to create a Morabaha, one of two things need to be done. Either create a fictitious transaction over goods that do not exist or take existing goods and price them manifold over their real value. In both cases the transaction is fictitious and is just being used to offer an interest-bearing loan.

Looking at the three modes of interest-free financing described above; I find it hard to believe that any one of these would be successful.