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Islamic Banking in Iran
Following the revolution in 1979, the Iranian authorities took steps to transform the banking system of the country in a way that it fully corresponds to Islamic Shariah. In February 1981, Bank Markazi (the central bank) took some administrative steps to eliminate interest from banking operations. As a result, interest on all asset-side transactions was replaced by a 4 per cent maximum service charge and by 4 per cent to 8 per cent minimum “profit” rate, depending on the type of economic activity. Interest on the deposits was also converted into a “guaranteed minimum profit”. In the mean time, preparations got underway for enacting comprehensive legislation to bring the operations of the entire banking system in compliance with the Shariah. The legislation, prepared by a high-level commission (comprising bankers, academicians, businessmen, and religious scholars), was passed by the Parliament in August 1983 as the Law for Usury-Free Banking, henceforth to be referred to as “the Law”. The Law required the banks to convert their deposits in line with the Shariah within one year, and their total operations within three years, from the date of the passage of the Law, and specified the types of transactions that must constitute the basis for asset and liability acquisition by banks (Iqbal & Mirakhore 1985).
Bank Liabilities under the New Law
According to the new Law, liabilities acquired by the banks were required to be based on two kinds of transaction:
Qard Hasan deposits: According to the Law, Qard Hasan constitutes current and savings deposits as in the conventional banking system except that they earn no returns. Of course, the banks can offer different kinds of incentives like non -fixed prizes and bonuses in cash or in kind; an exemption from, or a discount in, the payment of commission or fees; and priority in use of banking facilities.
If seen from customers’ perspective, the purpose of these accounts would be to serve as a means of transaction, payment, and liquidity. Banks are to consider the money received in the form of current and savings deposits as “their own resources” and accordingly they can use it but no profits are to be given to the depositors. However, the full nominal value of the depositors is required to be guaranteed by the banks.
Term investment deposits: Banks are authorized to receive two types of investment deposits, short-term and long-term. The deposits differ with respect to the required minimum time limits, three months for short-term and one year for long-term deposits, and with respect to the minimum amount required, Rls. 2,000 for short-term and Rls. 50,000 for long-term accounts.
Banks have to give priority on investment deposits, i.e., depositors’ resources over their own resources, that is, their capital plus Qard Hasan. Banks are also allowed to use a combination of their own and depositors’ resources in an investment project, in which case the bank and the depositor share the resulting profits. A third possibility is for the bank to replace the depositor’s bank in an investment project to serve as a trustee. In this case the profits as well as any capital gains are returned to the depositors and the bank charges only a commission to cover the expenses of administering the accounts. The bank can guarantee and insure the principal amount of depositor’s resources.
In the cases where combined resources of the bank and the depositors are invested, the return to depositors is calculated in proportion to the amount of invested deposits after subtracting the required reserve portion from the base amount. The banks are required to announce their profits at the end of each six months of their operation and transfer the shares of the depositors’ profits to each of their accounts. Deposits withdrawn earn no profits before the minimum time required or reduced below the required minimum.
Modes of Financing and Credit Operations
The Law provides a number of modes of operation upon which financing and credit operations are to be based. The following are in brief the discussions on each mode of operation:
Musharaka (Partnership): The Law recognizes two different forms of partnership: civil and legal. The first is a project-specific partnership of short duration in commercial production, and service activities in which each partner provides a share of the necessary capital, and the assets and properties acquired are held as community property until the end of the life of the partnership. In these cases, the bank’s share in the capital cannot exceed the share of the manager-entrepreneur initiating or directing the project.
The second form of partnership is a firm-specific venture of longer duration in which the bank provides a portion of total equity of a newly established firm or buys into an existing corporation. The banks can participate in the equity of such partnership only after the technical, economic, and financial viability of the firm (or the project) has been appraised and minimum expected rate of profit from the investment appears to be high enough to warrant the undertaking of the venture by the bank. The Bank Markazi determines the maximum amount of equity participation by the bank, and the minimum amount of participation by other partners. The banks are allowed to sell and purchase shares whenever they deem it appropriate.
Direct investment: Banks can invest directly to any economic activities they choose so long as the following requirements are met: (i) banks cannot invest directly in projects in collaboration with the private sector, or in projects that lead to the production of luxury and unnecessary commodities; (ii) the ratio of the initial capital of these ventures to total funds needed must not be less than 40 per cent; (iii) the total fixed capital necessary for undertaking these projects must be provided for by long-term financial resources; (iv) undertakings of direct investment by banks must be based on well-documented evaluation and appraisal of the project, and use of bank resources and investment deposits in direct investment projects is allowed if, and only if the expected return from these projects is sufficient to meet the minimum required rate designated by Bank Markazi; (v) banks must report to Bank Markazi the amount of their own, as well as depositors’ resources allocated to direct investment projects; (vi) once the projects in which the banks have directly invested have begun their productive activity, banks can sell shares to the public; and (vii) Bank Markazi is authorized to investigate and audit direct investment projects in which banks have invested.
Mudaraba: This is a short-term commercial, contractual partnership between a bank and an agent entrepreneur according to which financial capital is provided by the bank and managerial effort by the entrepreneur in order to undertake a specific commercial project. Banks are required to give priority in their Mudaraba activities to co-operatives. Moreover, banks are not allowed to engage in Mudaraba financing of imports with private sectors.
Salaf transactions: To provide firms with the needed working capital, banks can pre-purchase their future output so long as the product characteristics and specifications are determined at the time of the purchase and the agreed price does not exceed the market price of the product at the time of the transaction. Banks, however, cannot sell the product until they have taken physical possession of the same. The delivery date of the product, which is to be fixed at the time of the transaction, cannot exceed one production cycle or one year, whichever is shorter.
Installment purchases: Banks are authorized to purchase raw materials, machinery and equipment for firms and resale the same to them on installment. The volume of raw materials cannot exceed that necessary for one production cycle and the repayment period for the same cannot exceed one year. The price of the product is to be determined on a cost-plus basis. The repayment period for machinery and equipment cannot exceed their useful life, which is considered to begin on the date of their utilization in the production process and the duration of which will be determined by the central bank. Residential housing can also be built and sold by banks on installment.
Lease-purchase transactions: Banks can purchase the needed machinery and equipment, or other moveable or immovable property, and lease the same to firms. While signing contract agreement the firm has to provide guarantee to take possession of the property at the end of the contract period, if the conditions of the contract are fulfilled. The time period involved in this transaction cannot exceed the useful life of the property (to be determined by the Bank Markazi). Banks, however, cannot engage in transactions in which the useful life of the property is less than two years.
Ju’alah (transaction based on commission): Banks may provide or receive services on requirement and charge or pay commissions or fees for such services. The service to be performed and the fee to be charged must be determined at the time of the transaction.
Muzara’ah: Banks may provide agricultural lands that they own or are otherwise in their possession (e.g., as a trust) to farmers for cultivation for a specific period and a predetermined share of the harvest. Banks may also provide seed and fertilizer along with the land if they so require on the same basis.
Musaqat : Banks may also provide orchards or trees that they own or that are otherwise in their possession (e.g., as a trust) to farmers for a specific period of time and a predetermined share of the harvest.
Qard Hasan loans: Banks are required to set aside a portion of their own resources for extending interest-free loans to (i) small producers, entrepreneurs, and farmers who would otherwise be unable to find alternative sources of financing investment and working capital and (ii) needy consumers. Banks are permitted to charge a minimum service fee to cover the administrative cost.
General Regulations Governing Asset Acquisition by Banks
The Law of Usury-Free Banking, along with the promulgation of regulations concerning modes of transactions, specifies additional regulations that govern asset acquisition by banks (Ibid, p.108).
Banks can only extend credits when they are reasonably assured that the principal sum granted and resulting profits are returned within a specific period of time. Banks are responsible for the control and supervision of the activity to which their own resources and/or the resources of their depositors are contractually committed.
Credit can be extended, conditional upon observance of proper procedures that ensure the security of the financial resources extended by the banks. Banks must ensure that the value of physical assets obtained through the use of their resources by their clients and the value of collateral is, at all times, equal to the remainder of the outstanding principal. To this end, banks may take steps to ensure the value of such assets or collateral during the lifetime of the project.
While banks may engage in joint venture projects with other banks, one specific bank must assume the responsibility of supervision and control of the project undertaken. Banks must take necessary steps to ensure that their clients understand that contracts mutually consented to are binding legal documents and will be treated as such by the courts.
Supervision of the Banking System
The Law placed the responsibility of supervision of the entire banking system of the country with Bank Markazi. Bank Markazi can exercise the following means for exercising its authority. It determines:
(a) Legal reserve requirements for various types of bank deposits of the banks;
(b) Bank-by-bank credit ceilings on aggregate and sectoral credit;
(c) Minimum and maximum expected rates of return from various facilities to the banks;
(d) Minimum and maximum profit shares for banks in their Mudaraba and Musharaka activities
(e) Maximum rates of commission the banks are to charge for investment accounts for which they serve as trustees;
(g) The maximum amount of credit facility granted by banks to each applicant;
(h) The ratio of credit facilities granted by each bank to various deposits; and
(j) The maximum amount of commitment made by each bank emanating from open letters of credit, endorsements, issuing guarantees, as well as the type and amount of collateral for such commitments (Ibid, p.109).
Moreover, Bank Markazi is authorized to audit and inspect banks’ accounts and documents and is further empowered to devise additional regulations to enhance its supervisory authority as the need arises to ensure and safeguard against threats of banks’ insolvency. Bank Markazi has developed procedures based on these guidelines for commercial banks to follow their transactions.
The New Monetary Policy
The new Law and its by-laws and regulations have maintained the powers and rights of the monetary policy so far as they are not in contradiction with Islamic principles. In Iran, monetary policy is implemented independently of fiscal policy and follows the same objectives as those followed by classical monetary policy (Mahdavi 1986). To implement monetary policy, except the rate of interest, all monetary policy instruments, such as legal deposits, the global and sectoral ceilings of credit facilities, discount rates, and so on are still applicable in Iran (Mahdavi 1995, p.226).
Along with the elimination of interest rate certain other completely new monetary instruments have been created by the Law and put at the disposal of the monetary authorities. A number of these new instruments included in the Law to perform functions similar to those of the interest rate in implementing monetary policy may be described as below:
Minimum Anticipated Rate of Return (MARR): Anticipated return is future net income arising from certain banking operations. MARR is a yardstick by which to judge the acceptability of credit applications submitted to the bank. In fact, MARR, which reflects the opportunity cost or hurdle rate to finance the opportunities, is one of the new instruments incorporated in the Islamic banking regulations in Iran. The rate may play a major role in implementing monetary policy. Banks are authorized to finance if, and only if, the anticipated calculated rate of return on such financing is at least equal to MARR. In other words, projects whose anticipated calculated rate of return is below MARR are rejected (Ibid, p.227). That means, an increase or decrease in MARR will lead to contraction or expansion of the credit volume granted by banks.
Maximum Rate of Profit (MRP): Another new monetary instrument embodied in the Law is MRP. The monetary policy authorities determine the rate. MRP is used by Islamic banks in Iran as a “mark-up” or “cost-plus” on the price of the assets and/or commodities sold to customers on credit. The MRP has the similar kind of impact as that of the MARR so far as its use as monetary tool.
Unique Features of Islamic Banking in Iran
The unique features of Islamic banking in Iran may be identified in the following contexts (Ibid, p.227).
a) Banks’ Credit Portfolio
One of the main features of an Islamic bank in Iran is the content of its portfolio. Each bank’s portfolio is composed of a vast number of investments in a variety of economic activities e.g., agricultural, industrial, mining, housing, etc. Certainly, such a portfolio is well diversified. The risk and return on such a portfolio would seem to be very close to those of a market portfolio. A portfolio with this feature signifies minimum risk and maximum return. This finally leads to an assured and stable return to the bank’s depositors.
Efficiency is another feature of the said portfolio. Each investment project and/or subject accepted by the bank complies with the standards set up by the monetary authorities. One of the standards is MARR. Thus, the projects with highest rate of return, i.e. the highest efficiency, have priority in credit facilities. Such procedures will eventually force the economic units concerned, and the economy as a whole, towards efficiency.
b) Probability of Losses on Capital
A stable return with low risk on an Islamic bank’s portfolio makes the profit-and -loss account of such a bank in Iran less vulnerable. Hence, the risk on equity capital of these banks will be minimized. Moreover, one should bear in mind that the depositors in an Islamic bank will receive, proportionately, the bank earns. This, in turn, can help banks in avoiding even more losses.
c) Distribution of Income
An Islamic bank’s portfolio in Iran contains a huge volume of investments in the activities of society. The income of those activities is shared, firstly, between the banks and the customers and, secondly, between investment depositors, i.e., a large number of the population in the society.
d) Uses of Banks’ Resources
The mechanism of Islamic banking is such that the resources are used for the purpose of granting credit facilities. The credit facilities are supplied indirectly in the form of assets and/or commodities. Based on these procedures, the financial needs of any sector of the economy are supplied by the banks in exactly the volume dictated by the monetary authorities. As a result, the method of financing of the type as in Iran is of great assistance to the achievement of monetary policy objectives.
e) Supervision and Control
The Islamic banking system in Iran has its built-in supervision and control in both use and repayment of credit facilities. The following phased out procedure automatically facilitates supervision and control. In the phase of study and examination of the application, confirmation of the feasibility of projects and conformity of the application with the rules and regulations ensure the necessary control. During the stage of use of funds, banks act as buyers and sellers, which also gives them control. During the last period of financing, however, supervision is rather difficult. During this stage, the resources if not controlled, may be diverted to other uses. Hence the supervision at this stage needs to be tighter.
Implementation of the Law
Much of the trend in Islamic banking in Iran has been influenced by factors, which have their roots in the pre-Revolutionary economic structure, as well as post-revolutionary external and internal political developments. The post revolution economy had inherited a host of difficult economic problems. Before the revolution, the Iranian economy had become highly dependent on oil revenues as well as on the imports of raw materials, intermediate goods and food. The industrial sector was organized without due attention paid to efficiency or comparative advantage and with very weak forward and backward linkages to the rest of the economy. The agriculture sector, which was producing surplus commodities until late 1960s, began to contract and there was a massive migration of farmers into the cities (Khan & Mirakhore 1989, p.8).
The revolution brought with it a host of economic problems including, inter alia, massive capital flight, which almost led to the collapse of the banking and financial system (Bank Markazi). The problems began to multiply for the economy at a rapid pace as the revolution took place. The economy, already vulnerable to internal and external shocks, faced the freezing of foreign assets, economic sanctions, interruption in production, the influx of nearly two million Afghan refugees, and the war with Iraq, drastic reduction in oil revenues (Behdad 1988, p.p.3-4). Concurrently, the constitution of the Islamic Republic of Iran specified objectives for the economy to be pursued—such as income redistribution, self-sufficiency in production, strengthening the economy, and reduced reliance on oil revenues—all of which required fundamental restructuring of the society’s economic behavior and institutions. The fall in oil revenues, plus the political objective of non-reliance on external financial resources, inevitably meant that the banking system would have to be relied upon to play a role far broader than that of pure intermediation (Khan & Mirakhore 1989, p.8).
The banking system has been used as an instrument of restructuring the economy—away from services and consumption toward production—in four ways. First, credit to the service sector, which constituted 55 percent of the GDP (1984-85), has been drastically reduced to halt its expansion in the short-run and curtailed its size in the medium-term. The policy went into effect during the second phase and continued in the later phase. Second, using all available modes of Islamic financing to help farmers improve and expand production has used bank credit to encourage the growth of the agriculture sector. Coupled with substantial government subsidies for seed, fertilizer, machinery, and crop insurance, the credit policy of the banking system is aimed at reviving the agriculture sector. This policy was initiated during the first phase and strengthened in the later phases. Third, Islamic banking has been used to create incentives for the development of a cooperative sector spanning agriculture, industry, and trade (Ibid, p.9). Cooperatives are given priority in credit allocation and in direct investment as well as in Musharaka financing by the banking sector.
The banking system also has been used as an instrument of income redistribution through the provision of Qard Hasan loans for the needy, financing for the building of low-income housing, and financing for small scale agro-business and industrial cooperatives often without stringent collateral requirements. Additionally, the banking system has financed government deficits, which obviously has distribution impacts. It is clear that with reduction of oil revenues from 27 percent of GDP in 1977/78 to only 4 percent in 1986/87, the banking system has been a major source of finance for achieving many of the social and economic goals of the Islamic revolution.
Given the extraordinary circumstances in which the Iranian economy has found itself since revolution, the performance of Islamic banking since its implementation in 1984 has been remarkably smooth (Ibid, p.9).