Banks without interest: is it conceivable?

The previous two papers addressed the questions of whether Islam has really prohibited interest and whether there is a strong socio-economic rationale behind this prohibition. This leaves unanswered the third question of whether it is possible to establish an efficient financial system in modern times without the intermediation of interest. A number of people, including some Muslims, may give a negative reply. They may feel that even though there are a number of ills associated with interest, these have to be tolerated because they do not find it possible to organize a financial system without interest. Their key argument is that the rate of interest is a price and, like all other prices, it plays a crucial role in the supply of, and demand for, financial resources in any economy. It interest is abolished, how will financial resources get mobilized and allocated?

There can be no difference in opinion on the need for a realistic market price to mobilize the surplus savings form savers and to allocate them among users. There can, however, be a difference of opinion on which price is most suitable if the objective is to actualize the humanitarian goals of need-fulfillment, full employment, equitable distribution of income and wealth, and economic stability.

As argued in the previous paper, financial intermediation on the basis of interest frustrates the optimum realization of these humanitarian goals. The relatively easy availability of credit promotes living beyond means and does not thereby accentuate only macroeconomic imbalances and financial instability but also squeezes the resources available for need-fulfillment and productive investment. Lower growth in savings joins hands with structural rigidities and other socio-economic factors to contribute to slower growth in investment, output and employment.

Islam therefore prohibit interest like other major religions. This should help promoted greater reliance on equity. However while Islam encourages equity financing, it allows credit, but for only real goods and services, and not for speculation, through its sales-based modes of financing (to be discussed later). Thus, while financial intermediation in an Islamic economy would be largely on the basis of profit-and-loss sharing (PLS) modes, credit would also play a role.