NOTE 1: ??? …. ??? marks beginning and end of my comments

NOTE 2: extensive re-write of paragraph 1 … each point to be stated once only.

NOTE 3: use ‘commercial banking’ instead of ‘banking’ (the investment banking sector is non-existent in many countries)

NOTE 4: don’t forget Muslims like me who find banking repugnant because banks create money out of nothing, at no or little cost, and make society repay that money plus a ton of interest. This method of money creation is cheating … not riba. But the banks would not find it profitable to cheat in this way unless they could charge riba. OK, so the theory might be wrong, but at least give it a mention. Remember how many others argued in this way (Franklin, Jefferson, Jackson, Lincoln …to name four US presidents for example)


NOTE 5: What if inflation is negative. Is money taken away from depositors, and if so to whom is it given? What is the Islamic contract type that allows indexation to take place. What is the measure of inflation … retail inflation, house price inflation, food inflation? Something should be said on this, if only briefly.


NOTE 6: a man who had borrowed money from Abu Hanifa had a tree which provided shade. Abu Hanifa refused to stand under this tree for fear that the benefit of the shade would be riba on the loan that he had given. If lenders of money ultimately benefit in any way from the lending of their money, then this is riba, and on that we agree. Now I understand that the bank is not the lender in this scenario. But the bank staff are paid salaries from the borrowers’ fees, am I correct? These fees are paid by borrowers because they borrowed money. This is dangerous territory. I therefore think that there should be at least one reference to a scholar who allows borrowers to pay fees in order that they may borrow money, even if those fees are not paid to the lender.


Riba-free Commercial Banking

(Transparent, inflation-protected, and operating under conventional banking laws) ·



A.L.M. Abdul Gafoor

Groningen, the Netherlands




Conventional Commercial Banking 1

The needs and concerns of Muslims 2

Inflation 2

The riba limitation 2

Some dissection and analysis 2

Investment and finance 3

Charitable loans 3

The Riba-free Commercial Bank 3

The smaller-size and its implications 4

Compatibility with conventional banking 4

Transparency 5

Misconceptions about loss and gain when a bank is riba-free 5

Operations of the bank 6

Deposit accounts 6

Loans 6

Bills of exchange 7

Government bonds 7

Other services 7

Bank’s services to the depositors: is it riba? 7

Discussion and conclusion 7

References 8



Commercial banking has become an essential sector of the modern economy.  Whilst in some countries the commercial banking sector it may be smaller than in others, rarely can a country can do without its services completely. In the advanced economies, bBanking has become an essential necessity sector of the economyof modern-day life practically every gGovernment departments, business organisationes, institution s and private individuals all needs the services of a bank.  True, it is an absolute necessity in some countries and not so essential in others, but rarely any country can do without it.  Practically every individual in an advanced country needs, and has, a bank account.  In the developing countries too t, and the trend is in thisat direction in every country, including the developing countries.   Muslims, who follow the religion of Islam, and who form nearly one fifth of the world’s population and live in all parts of the world, are no exception to this trend.  However the Muslim community has a problem with the banking system as it exists today and this essay aims to address their concerns.  But before we come to address their special concerndo so, let us briefly examine the services banks provide and how they do it, so that we can determine exactly where the problems lie.  Then we can devisce solutions to address the specific issues that concern Muslims.

Conventional Commercial Banking

The main functions of modern conventional commercial banks as they exist today include providing what is called current account facilities, money transfer services, accepting funds into savings accounts, granting loans and advances, facilitating import-export transactions, and buying and selling foreign currency. 

Current account facilities include accepting cash deposits into your account and allowing you to withdraw from it as when you require the whole of it or a portion.  You can also use a cheque to instruct the bank to pay another person or entity a stated amount of money and debit the same from your deposit in the bank.  Similarly, you can receive payments made by others into your account.  This ability to pay and receive without having to personally carry notes and coins is a great boon to transacting business — personal and institutional.  Private individuals use the current account to receive their salaries and wages and to pay their bills.  Businesses and institutions use the current account to make payments for the goods and services received and to receive payments for the goods and services provided.   It saves time, and is safe and less expensive.  The transactions through cheques can be made whether the payer and the receiver use the same bank or different banks, and whether the concerned banks are miles away in the same country or continents away in different countries. 

Money can also be transferred from one person to another, even without having a current account with a bank, through the banks’ money transfer arrangements — money orders, pay orders, bank drafts, mail and telegraphic transfers, electronic transfers, etc. — both within and outside the country.  There are also other bank guaranteed payment facilities, especially the letters of credit and bills of exchange, which greatly facilitate import-export trade.  In fact such trade is practically impossible without this facility.

Banks also accept funds from the public and institutions into savings accounts, keep them safe, and pay interest on such funds.  In turn, they use these funds to grant loans and advances to borrowers, to whom the bank charges an interest.  This service provides the savers with a known income, while their capital remains intact.  On the other side, it provides the borrowers access to funds, which they would otherwise not have.  The borrowed funds may be used for setting up a new business, to expand existing business, to provide working capital for a running business, or for consumption purposes including buying consumer durables, to rtide over through a difficult period and to meet an unexpected expenditure. 

They also provide many other services including agency services, business introduc­tions and , credit reports, etc.  Another important service is in the foreign currency field — buying and selling foreign currency, issuing travellers cheques and credit cards. 

Some of the above are paid services, others are not.; Ssome involve paying or receiving interest, others not.  But the commercial banks (henceforth the ‘banks’) and banking their services have become an integral part of the present-day world.

The needs and concerns of Muslims

The nearly 1.2 billion Muslims in the world are scattered all over the planet.  There are 56 member-countries in the Organisation of Islamic Conference, and there are Muslim minorities, large and small, in practically almost all countries.  There are over 100 million Muslims in India, more than an amount similar to that of all the Middle-eastern countries put together, though they are a minority in that country of over one billion people.  The countries and people are also at various different stages of development and advancement.  A major characteristic of the Muslim population distribution is that the majority are in the developing countries, with all the associated infrastructure deficiencies, including low levels of literacy.  But they all Many of them need modern banking facilities, and most of them they all have one a common concern — avoiding riba (interest) in their dealings.  A banking system designed to address their concerns has to take into account this main concern as well as the other factors.


In common with most developing countries, the Muslim countries also face extreme levels of inflation.  Conventional banking deals with the inflation problem tacitly – by incorporating it into the interest rate.  Since that is not possible in a riba-free system, we have to address the problem explicitly.[1]

The riba limitation

The main concern of the Muslim community is its desire to avoid dealing in riba, because riba is strictly prohibited in their religion — Islam.[2] As far as money is concerned, Rriba is loosely translated as interest.  Whether this translation is accurate or not — whether the Arabic word riba and the English word interest mean the same thing — is the subject of a long-standing debate.  This question needs to be satisfactorily resolved in order to find a proper solution to the problem.  In the meantime, onea comprehensive and commonly accepted definition formdefinition of riba ??? the ribawi items include more than just money … perhaps mention riba al-fadl/riba al-nasia, or just keep my amendment as inserted ??? (in matters of money) is that: when one lends some money is lentto another, if the lender demands more than his principal to be returned, the excess amount so demanded is riba.  Islam strictly prohibits demanding and/or receiving riba, paying riba, and witnessing or writing such a transaction. 

In the context of modern banking, the depositors receive interest, borrowers pay interest, and the bank both pays and receives interest, witnesses writes and perhaps also witnesses ??? perhaps also witnesses because maybe the bank cannot act as a witness to its own transaction?? the transaction and as well as keepings account of it.  It is on this account basis that modern banking is repugnant to the Muslims..  Their dilemma is that it is difficult to be part of today’s world without the medium of modern banking.  Hence the search for a riba-free alternative. 

We can begin by asking whether all the operations of a commercial bank are unacceptable to the Muslims on account of the riba prohibition.  Can they make use of some and seek alternatives for others?  To do that, we need to first look first at the working of a conventional bank in some detail.  

A bit of Some disssection and analysis

The sources of funds available in a bank can be categorised by the type of deposit account in which it is held as well as by the purpose for which it is held.  Similarly, the use of funds too can be categorised by type and purpose.  A schematic representation is given in the table below. 


Table: Sources and use of funds and their uses, by purpose


Source of funds

Purpose of deposit

Use of funds

Purpose of the use

Current account deposits

Safety and ready availability; transaction convenience

Money transfers, short-term advances

To facilitate receipts, payments and transactions; to accommodate short-term financial needs

Ordinary savings account deposits

Safety, easy availability; temporary holding and possible compensation for inflation

Short- and medium-term loans

To accommodate small / medium size financial needs at small / medium terms.

Time (Fixed) savings account deposits

Safety, fixed and known return, compensation for inflation

Long- and medium-term loans

Financing large-scale / long-term investments



The first source is the current account deposits.  They are held in the bank for the purposes of safety and ready availability and for the transaction convenience, which has become almost a necessity in modern life.  We have already seen the working of a current account.

The second source is the ordinary savings deposits.  Banks pay an interest on savings deposits in order to attract more funds, but the primary concern of the depositor in an ordinary savings account is the safety of his/her savings and its easy availability when needed.  It is usually a temporary holding and the paid interest is expected to covers the value loss due to inflation.  ??? not always … there are many times in history, recent and not so recent, when interest paid does not cover for inflation … UK 1970’s, Germany 1920’s … ??? In less developed countries, many people have no need or access to current accounts, for various reasons, and therefore they resort to ordinary savings accounts.  Whatever the intentions of the depositors the banks use the funds to grant loans and advances to clients and borrowers.

The third source of funds is the fixed deposits.  Here the main consideration of the depositor is the fixed and assured interest (or return) he receives from the bank.  Safety and compensation for inflation are also considerations but they are part of the package.  The bank uses the funds from this source to grant long-term and large-size loans.

Investment and finance

The fixed deposits are investments from the point of view of the depositors, and the loans granted using  this source of funds are finance from the point of view of the entrepreneur-borrowers.  Since the fixed return paid to the depositor will fall under the category of riba, Muslims depositors cannot accept the paid return.  The loans are also given on fixed-return basis.  This too is riba and therefore Muslim entrepreneurs cannot make use of such finance.  Hence a riba-free bank cannot provide such an account.  Islamic bankers came up with the idea of converting this account into an investment account and using the funds to finance borrowers’ projects under a profit-and-loss-sharing scheme whereby the investment account holders too will receive a share, which will not be a pre-fixed amount and may well be a loss.  But this scheme has not proved unviable and has in fact created more difficulties.[3] 

In order to deal with these difficulties, which are peculiar to Muslims and therefore have not been taken into consideration by the conventional banking system, Muslims will have to develop their own institutions.  A suitable proposal has been made elsewhere.[4]  It is suggested that the funds from the third source be handled by an entirely separate institution operating under the rules of mudaraba.  Therefore this essay will deal with only the first two sources of funds and their commercial use. 

Charitable loans

The Islamic banking movement has introduced another category to the use of funds.  This is called by various names such as qard hassan, (sometimes transliterated as gharz-al-hasaneh and qard-e-hasana).  The important requirement here is that if the borrower is unable to repay the loan at the agreed time, further time should be allowed for repayment or the loan  it should be written off and regarded as charity.   But it begs a reasonable question: does an entity that holds other peoples’ money in trust have any right to give charity out of it?  Furthermore, it will undermine the promise to return the full amount to the depositors.  How is the shortfall to be made up?  Besides, imagine the branch manager of a chain of banks being given the authority to determine who of his borrowers is under dire circumstances and the power to write off his loan.  It is an open invitation to corruption and fraud.  Therefore we will leave the charitable loans to private individuals and charity organisations.

Then we will have a bank that is free of the encumbrances of the charitable loans, but it will also be without the benefit of a large source of funds — the fixed deposits.  Yet this bank will be able to provide all the services generally required of a commercial bank.  We will call the resulting bank the riba-free commercial bank.

The Riba-free Commercial Bank

The bank under consideration is a commercial entity that provides services for a payment.  It accepts deposits, guarantees their safety and full return, and provides all current account facilities — such as cash receipts, cheque collection and payment, electronic and other types of fund transfers, etc. — currently provided by conventional commercial banks.  Depositors explicitly or implicitly agree to their funds being used to grant loans to borrowers, but the bank guarantees the full return of their deposits as and when required or as agreed.  The depositors do not demand nor are they paid any financial returns on their deposits.  As such the depositors deal in no riba.  

The borrowers are granted loans on condition that the capital, which belongs to the depositors, is returned in full, whatever their financial circumstances, and they pay the bank a fee for making the funds available to them.  The fee includes all the costs incurred by the bank and a remuneration (or profit) for providing the service.  This service can be likened to the services provided by a courier who carries the money from the depositor (the real owner-lender of the money) to the borrower.  At the end of term, the courier carries the money back to the owner.  The courier is also responsible for the security of the money while in his possession.  Since the owner-lender did not demand any extra amount (which would be riba), the borrower does not pay any extra amount (to the owner-lender) beyond the principal.  Since no riba was demanded or paid, the courier does not carry, witness or keep account of any riba.  Therefore the bank’s “lending” operation is free of riba.  The bank makes sure that the borrower has the ability to repay the capital and the fees. 

At this point it is worthwhile to point out and emphasize the two basic assumptions in the concept  of this riba-free bank.  One, riba is what is demanded and/or received by the capital-owner (who is the real lender) over and above the capital he lends; and two, the payment made by the borrower to the courier for his services is not riba.  It is necessary that these two crucial points are fully understood and accepted as correct under Islamic law before we proceed with further discussions.

There is also another important aspect.  The perception of a bank as a moneylender.  True, banks originated from the moneylender who lent his own money on interest.  But the modern banks no longer do that (even though some of the shareholders money may also be used).  It is mainly the depositors’ money that they lend to the borrowers.  In this sense they are couriers of money as described above.  They are also couriers of money when they carry payers’ money to the receivers (which is the main current account operation).  Therefore we have to take account of present-day  realities and change our traditional perception of banks as moneylenders to one of couriers of money.  This changed perception will free Muslims of many difficulties, which arise as a consequence of equating banking with money lending, and the banks with moneylenders.  In any case, our riba-free commercial bank is designed strictly as a courier of money — it is a service provider in the field of banking and finance.  Seen in this light, this bank’s operations are all riba-free and the fees it charges for its services have nothing to do with riba.[5]

Requiring the bank to write off the loans of persons who are unable to repay it, and to consider them as charity, is also a consequence of equating a bank to a moneylender who lends his own money.  One is free to do what he wants with his own money but a courier who carries someone else’s money has no right to give it away in charity.  As such, our bank, being a courier of other people’s money,

This bank does not get involved in charitable loans.  Consequently, there is no “leakage” to its funds.   

CompatibilityCompatibility with conventional banking is one of the desired goals in devising this riba-free bank.  As mentioned above, we have also eliminated the possibility of a leakage and that should find favour with the banking authorities.  But the riba-free limitation has made it a smaller bank.  Let us now examine the positive aspects of these features.

The smaller-size and its implications

The commercial bank envisaged here is a much smaller one than a standard conventional bank.  This is a consequence of accommodating the riba-prohibition rule of Islam and hence a built-in feature.  Therefore we need to examine the implications of this necessarily smaller size. 

It came about because we spilt the deposit base of the conventional bank into two parts: demand deposits and ordinary savings deposits on the one hand and the fixed deposits on the other.  The latter is generally much larger in size, and therefore what is leftover is at most only one-half of the standard size of a conventional bank. 

On account of the smaller size and its composition, this bank cannot grant long-term and large-size loans; it is limited mostly to advancing short-term and small-size loans, although while some medium-term and medium-size loans may be accommodated. 

However, oOn account of theise term and size limitations, this bank is much less exposed to business-failure risks.  That gives more stability to this bank and to the banking system as a whole. 

The smaller deposit-base and the larger reserve requirement on these deposits also result in much reduced bank-created credit.  It does not negate the bank’s credit-creating ability, and thus deny the economy of the benefits of this facility, but it limits its size. Thus it reduces the risk of bank failures and adds to the stability of the banking system.  Furthermore, it restrains money supply expansion and hence helps to hold down inflation.

If the equity capital required to set up a bank is based on the size of the bank, this smaller-size bank, with much reduced failure-risk, will entail a smaller equity capital.  This will enable the establishment of more commercial banks, resulting in increased competition, which, in turn, should result in better service and efficiency. 

The reduced capital requirement will also help to take the banking facilities to remoter areas as well.  People residing in areas away from the main cities hold their monetary capital in the form of cash (notes and coins) for want of a bank in the neighbourhood.  This is the case in many developing countries and hence a considerable portion of the available monetary capital remains outside the banking system.  If this cash, both idle and active, could be brought into the banking system and the credit creating ability of the commercial banks is used, more funds from domestic sources will become available for business purposes.[6] ??? If this is a problem, why doesn’t the government just manufacture and issue more notes and coins into circulation. Why let the banks create the money and charge people courier fees in respect of transferring it, when the state could do it all free of charge? ???

Compatibility with conventional banking

Our bank satisfies the basic requirements of a deposit-taking bank.  One, it guarantees the depositor’s capital; two, the bank contracts to pay a non-negative return; three, its assets are assessable,; and four, its the return on themincome are is  also assessable and sufficient to maintain the bank; and three, the interest paid to the depositors is non-negative.  Our the bank contracts to pays a non-negative return. zero interest, but that is no problem for the The banking authorities, so who are more concerned with the maintenance of long as it is not negativecapital certainty than with the rate  at which interest is paid, should to this extent be satisfied.[7]  There are also no built-in leakages due to charitable loans.  Other formal legal requirements are easily met.  Thus our bank qualifies to be registered as a deposit-taking bank with the central bank under conventional banking laws.  This authorisation to set up and operate as a commercial bank under conventional laws has several advantages.

One, itthis will ensure proper auditing and monitoring, which will in turn inspire public confidence in the bank.  This is vital. 

Two, it will enable riba-free commercial banks to be set up in allALL countries of the world, Muslim and non-Muslim.  This will greatly facilitate international export-import trade without the fear of being involved in any riba dealings. 

Three, since this bank can be set up in non-Muslim countries as well, and will offer all conventional commercial banking services, its clientele need not be limited to the Muslims.  Therefore it has as a good a chance of survival as any other bank. 

Four, the considerable number of Muslims living in non-Muslim countries will have the possibility to bank with a riba-free bank which is competitive and offers all the generally generally-used facilities of a conventional bank. 

Five, since all religions do prohibit interest earnings, and even where it is not explicitly prohibited people do look down upon those who lend on interest, some people will appreciate the chance to bank without interest provided the value erosion of their capital due to inflation is compensated and all other banking facilities are offered.  There are also people who eschew interest for reasons other than religious belief.  They too will appreciate the opportunity given by this bank.

Six, this bank can hire officers who have already had training and experience in conventional banking, and they can get to work practically straightaway without having to undergo further training in an entirely new system.  This is a very big advantage, and is cost-wise and time-wise efficient.  It will minimise the any gestation period and reduce teething troubles.

Seven, the compatibility with conventional banking makes the conversion of a conventional bank into a riba-free one easy and quick.

Eight, from the customers’ point of view too, it is easier to understand and follow the procedures since they are not very different from the ones the customers are already used to in dealing with the conventional banks.

Finally, these banks, being compatible with the conventional system, will be able to easily communicate and deal with other banks, within and outside their own country.

TPractically none of the advantages listed above are currently available to the Islamic banks as they operate today do not maintainoffer these advantages, even within the few Muslim countries where they are permitted to operate on their own terms.  As such it is worth giving some serious thought to the proposed riba-free bank.


Transparency is absent in both the conventional and the Islamic forms of banking.  But it is the foundation of the proposed riba-free commercial banking.  In the first place, transparency tells both the bank itself and the supervising authorities what the real costs are, how they are distributed, and what the profits are.  Secondly, in dealing with inflation, it enables one to know exactly what the loss of value of capital due to inflation was and how it was compensated.  Both the depositors and the borrowers too know what they are being charged or paid, and for what reason. 

This transparency comes about on account of the model we are using in computing the fees charged by the bank.  In conventional banking this fee is a single item, called interest, and it is calculated as a percentage of the principal and depends on the duration of the deposit or loan.  In Islamic banking as practised today, in most cases, it is also a single item called profit (or mark up) though it may or may not depend on the size and duration of the “loan”.  In the model used here this single item is considered as consisting of six components: interest paid to the depositor (which is identified with riba), the cost of specific services provided to the borrower on account of the current loan, cost of overheads of the bank (which includes the costs of general services provided to the depositors and borrowers), bank’s profit, a premium to the loan default insurance,[8] and compensation for the loss of value of capital due to inflation. 

From the borrower’s point of view “interest” charged by the bank is the cost of borrowing, and it has now been shown to consist of six components, only one of which is real interest (identified with riba).  The first component (interest) is present in conventional banking and absent in riba-free banking; the next three components cover the fee charged by the bank; the insurance premium goes to a separate fund; and, if inflation is taken into consideration, the last component (compensation for inflation) is recovered from the borrower and passed onto the depositor.  Unlike in the computation of the conventional interest, each one of these components is computed in a different way[9] and posted to its own separate account.  This may seem much additional work, but in this computer age it is not.  The result, however, is a positive gain.  Let us take a closer look.

Compensation for inflation is the same for all loans in all the banks because it is computed using the same data and formula.[10]  The loan default insurance is expected to be run by a single body (or several bodies operating under the same rules) and therefore the premium should be the same for any given borrower in any bank. 

Within the fees charged by the bank, the first component is the cost of services procured in the course of processing the loan application.  This is specific to the particular loan under consideration, and often consists of charges paid to outside agencies (such as to a lawyer for title checking of the collateral, stamp duties to the government, etc.) and is a one-time cost.  The second is the cost of overheads cost.  This is a generalised cost estimated using total annual average net overheadss costs of the bank (consisting of staff salaries, buildings, supplies, maintenance, etc. less income from paid services using the same facilities) divided by the total annual average loans granted by the bank during the same period.  Thus it is the bank’s cost in obtaining and sustaining loanable funds.  This is a per-dollar-per-day cost, equally applicable to all loans and advances.[11]  This cost, being expenses minus incomes of the bank, will depend on the efficiency of the bank.  Hence it is subject to market forces.  It is continuously monitored, and may vary from year to year, but is kept fixed during the year.  The third component, bank’s profit, is a percentage of the first two components.  This percentage may vary from bank to bank, but since this system is transparent, under normal circumstances market competition will determine its size. 

The fact that all of thisese information are is routinely available to the borrowers gives them the necessary information to shop around for to their advantage, creating competitive market conditions.  This management information is also very useful to the bank supervising authorities, who will then have a good overview of general trends in the whole sector. 

This detailed transparency, which is not available under the current practices, is a major characteristic of the proposed system.  On account of the fact thatFurthermore, since all the components (of the cost of borrowingbank charges $$$ wouldn’t it be safer to use something like the term ‘courier cost’ or ‘administration cost’ $$$) are subject to market forces, and none to arbitrary fixation, and the results are transparent, it is a truly free-market system.  Consequently it reaps the benefits of that system — efficiency and lower costs.

Misconceptions about loss and gain when a bank is riba-free

Frankly speaking, when one talks of Islamic banking there seems to be two expectations — expressed and unexpressed — in the minds of people.  Those who expect to borrow seem to feel that they would get loans on which they need not pay any interest — they need to repay only the capital.   On the other side, those who have capital seem to feel that they would get a return on their capital that would be higher than if they used a fixed-deposit account in a conventional bank.  And, the bankers are afraid that no one will deposit in a no-interest account, and that a no-interest loan is simply impossible.  These are valid concerns and expectations.  But, it should be pointed out and emphasised that, they relate to the savings accounts, especially the fixed deposit accounts; and our scaled-down commercial bank does not deal in this type of deposit, neither in the medium- and long-term loans granted using such funds.  As such they are beyond our scope here.  Our bank deals only in current accounts and ordinary savings account deposits, and in loans and advances granted using funds from these accountsdeposits.  Yet it is would be good useful to see and record how examine the validity of these expecta­tions and reservations are in the case of our bank, vis-à-vis the conventional banks.


First the current (or demand deposit) accounts.  Conventional banks do not pay any interest on current account deposits.[12]  Our bank also does not.  So there is no difference between the two banks in this area.  This leaves us with only the ordinary savings accounts and the short- and medium-term loans.

An ordinary savings account in a conventional bank stands somewhere between a current account and a fixed-deposit (or time-fixed) savings account, both in terms of interest received and facilities provided.  An ordinary savings account holder has the advantage of withdrawing his deposit (fully or partially) practically at any time (or at very short notice).  In this he is nearly akin to one having a demand deposit account, but without the other facilities of the latter (mainly transactions using cheques).  A depositor holds his funds in such an account because he is not sure when he may need his funds back or how much at any given time.  Here he has the advantage of taking out what he needs when he needs, but what is not withdrawn earns interest, albeit at a reduced rate compared to a fixed deposit but better than the zero interest of a current account deposit.  The main concern of such a depositor is the safety of his funds.  In developing countries, for various reasons, some people are unable to have a current account and therefore they use a savings account instead.  These latter are not concerned about the interest.  Some others use this account to build up a certain amount for future use (such as to buy property, durable goods, or invest in a business) by depositing their extra earnings as and when they receive it.  These and such others consider any interest received as compensation for loss of value suffered by their capital due to inflation.  But the interest on these deposits are computed on the minimum balance held during a calendar period, such as a quarter or month.

When there is high inflation the lower rate paid on ordinary savings accounts hardly covers the capital loss due to inflation.  Further, when the minimum balance and calendar period criteria are taken together, many depositors miss out on their interest.  For example, if one deposited 5000 on 5 January and withdrew it on 27 June, given a minimum period of three months, he would have missed the first quarter by four days and the second quarter by  three days and would receive no interest whatsoever, even though his money was available to the bank for a full five months and more.[13]  As another example, suppose a person deposits 5000 on 15 December, withdraws 4000 for an emergency on 20 March and deposits it back five days later on 25 March, and finally withdraws the whole amount on 15 April.  He will receive interest only on the 1000 minimum balance held during the first quarter, on account of that withdrawal for five days. This happens all too often in practice, and therefore the perceived loss to ordinary savings depositors is in reality minimal.[14]  If compensation for inflation loss can be arranged, as is proposed in this system, then such fears will have no basis. 

The expectation of cost-free loans from a bank is simply wishful thinking.  It is both unrealistic and impractical.  Unfortunately it is the result of a narrow, out of context, interpretation of a Qur’anic verse.  The verse is addressed to a lender who lends his own money to a known person, in a person-to-person context.  The lender is asked not to demand anything more than his capital from the borrower.  The additional amount is called riba and prohibited, but the capital is his due.  Even here, if the borrower had to incur expenses in travelling to meet the lender, the lender is not expected to pay the travel expenses of the borrower, and the travel expense is obviously not riba.  If he sent a courier instead and the courier asked for the same travel expenses, and his wages in addition, these will have to be paid by the borrower and not by the lender, and this expense is not riba.  Obviously it is ridiculous to expect the courier, who provides a tangible service to the borrower spending his own time and effort, to do it free and also to incur the travel expenses, without any benefit to himself.  Yet this is exactly what some seem to expect when they demand interest-free loans from a bank.  That a modern bank incurs a lot of expenses — in collecting funds from depositors, keeping them safe, scrutinising the loan applications of the borrowers, disbursing the loans, re-collecting them and repaying the depositors, and in keeping accounts and records of all these — is for all to see.  Riba-free loans are possible, when the capital owners do not demand it, but cost-free loans are a fantasy, except when it is a person-to-person transaction in the same locality. 

What the proposed riba-free bank promises is exactly what it says — banking facilities[15] without involving in riba.  The small reduction in the charges the borrower pays this bank (as compared withto those paid toat to a conventional bank), because it does not include the riba component, is incidental.[16]  So is the minimal loss an ordinary savings account depositor may suffer.  The yardstick of success is whether the bank operates riba-free or not — not whether the loss or gain is more or less when compared withto a conventional bank.

However, the transparency we discussed earlier will bring about reductions to the cost of borrowing, compared to a non-transparent conventional bank so long as it remains non-transparent.[17]  Additionally, the compensation for inflation provided for in this system will safeguard the depositor from real loss to his capital without recourse to riba.

Operations of the bank

The compatibility of this bank with that of a conventional banking procedures one makes facilitates the its integration operation of this bank into an existing banking systemvery easy.  For all the tried-and-proved trusted methods of the conventional banks can be readily used by this bank.  Only , except that that the cost of borrowing as explained above will replace bank interest in all calculations, and the deposit interest rate will be set equal to zero.  Where relevant, compensation for inflation will be computed as explained in Gafoor (1999) and will be collected from the borrowers and paid to the depositors, as appropriate.  Now let us very briefly sketch the main operations of the bank.[18]

Deposit accounts

This bank will have two kinds of deposit accounts: demand and savings.  Demand deposits will earn neither riba nor any compensation for inflation.  Savings deposits too will not earn any riba but they will be paid compensation for inflation on minimum balances held, say, for a minimum of three calendar months. 


It will provide short-term advances, and short-term and medium-term loans, which can be for durations of less than a month, less than a year and less than three years, respectively.  Borrowers will pay the cost of borrowing on all loans and advances.  However, one or more components of the cost of borrowing may become zero, depending on the type of loan.  For example, compensation for inflation will be collected from all loans of three months or more duration but this component will be zero in shorter-term loans; short-term advances will not have the service cost component; and inter-bank loans will entail only anthe overheadss charge, all others being zero.  Islamic banks as they operate today find it difficult to provide needed services in many important areas.  These include short-term advances to tie oversee through liquidity problems, medium-term loans to set up small businesses, short-term loans (or working capital) to running businesses, and consumer credit, on a viable commercial basis.  But these are among the most important banking services required in any economy.  Inter-bank credit is also another important necessity in a conventional banking system, but Islamic banks are unable to provide it.[19]  Under the proposed riba-free bank these loans and advances can be provided very easily. 

Bills of exchange

Other important areas include treasury bills, bills of exchange, and any financing connected with letters of credit.  These too present no problems, since they can be treated as short-term loans (of generally less than three months) and charged accordingly. $$$ the letter of credit confirms the conditions under which payment is to be made … it is not a form of loan $$$

Government bonds

Another important area is government bonds.  The suggested solution to this is to denominate these bonds in units of gold.[20]  Then they will be sold at the current price of gold and will be bought back at the price current at the time of maturity.  Thus the government will not pay any riba and the bond-holders will not demand or receive any riba, but the real loss of value of their capital due to inflation will be automati­cally and very transparently compensated.  $$$ we’ve been over this one before … it definitely doesn’t apply in the rich countries if you take the last 20 years of data on gold price versus consumer prices/house prices/equity indices etc.$$$ This, however, will require new govern­ment legislation.  Governments of high inflation countries should consider this course of action seriously.  $$$why not cure the problem at its root .. the inflation is often being caused because too much money is being created … by the state and/or the commercial banks$$$ Banks come into the picture only after government action.

Other services

All other normal commercial banking operations will take place as in a conventional bank.

Bank’s services to the depositors: is it riba?

Depositors, both current and savings account holders, receive several types of services from the bank.  These include, safekeeping of their moneyservices, accepting deposits whenever they bring are them brought in, keeping them safe, returning them fully or in part when requested, keeping account of all these, accepting cheques drawn in favour of an account-holder and presenting it to the drawer’s bank and collecting the proceeds and crediting it to the payee, paying cheques drawn by an account-holder, honouring standing orders for regular payments, electronic transfer of funds, cash dispensing from automatic teller machines, , etc., etcand so on.  Most of these are offered free of charge though the bank incurs a lot of expense in providing them.  They are offered to the depositors free only because their money, while held in the bank, is used by it to lend to borrowers and thereby earn an income.  These services are needed by the depositors, and they should pay for them in cash if obtained from any other source.  But the bank provides them free in order to induce them to keep their money with the bank.  This service in kind is offered and received only because the depositor has given (or lent) some money to the bank; otherwise it would require payment in cash.  Seen in this light, is it riba? $$$ payment for the service of safekeeping (wadia) is widely accepted $$$


The Islamic banking literature seems to be largely silent on this question.[21]  But it is necessary to raise the question, even though we do not propose to answer it.  It is for the Shari’a experts to enlighten us on this.  All that we can say here is that the bank as proposed above can accommodate both yes and no answers.  If the answer is no, then nothing in the present state of affairs need to change.  If yes, then the depositors will have to pay a fee for the services they receive and it will become an income to the bank, ; consequently it will reducinge the its net overheads cost.  and hence Consequently the cost of borrowing will become cheaper. 

Discussion and conclusion

In the foregoing paragraphs we have taken a conventional bank and divided it into two sectors, one that provides a banking service and the other that caters to investment and finance.  Our essay here was concerned with the former and the latter has been dealt with in a companion article.[22]  The sector that is under consideration here plays an important and essential role in conducting the businesses of individuals, organisations, businesses and the government, and touches the lives of practically everyone.  Most of the daily activities in a bank, including almost all the transactions, take place in this sector.  Comparatively speaking, the number of people involved and the number of transactions taking place in the other sector are much smaller, even though each transaction may involve huge sums of money. 

In the history of banking, the origins of the first sector goes back to the goldsmiths and their receipts confirming the deposit of gold by a client and its availability to the bearer, and the second sector goes back to the moneylender who lent his own money on interest.  Later on these two were combined to form the progenitors of the modern bank.  The activities in the first sector provides the modern bank with the ability to create bank credit, and the second the bulk of the monetary basis for this creation (using depositors’ money).  Thus this combination enables the modern bank to lend huge sums of money.  In turn, this enables the debt-based financing of enterprises, large and small.  This contributes to greatly accelerated economic activity, development and prosperity $$$ no! the Prophet s.a.w. said that although usury may be much it always leads to utter poverty so lending money at interest on a huge scale will lead to utter poverty, not to prosperity $$$, using a relatively small monetary base; but it also has its negative side.  Business cycles are traced back to speculation and excessive bank credit.  Beyond a certain limit, unstable banks, bank failures, and the consequent economic chaos are the results. 

By separating the two sectors, this chain of events can be eliminated at source without losing the benefits of either.  The commercial bank can still create credit and help cash flow and provide financing, but on a smaller scale and on shorter terms, using the funds in current and savings accounts.  This would practically eliminate risks of bank failures.  And, the funds that would otherwise go into time-deposits will be used by investment companies and investment banks to equity-finance enterprises, giving stability to the economy.  But both will have to go together to create a comprehensive banking and finance system.

Unfortunately, Islamic banking has come to be associated with the investment and finance sector, and has practically ignored the other sector, except in a few countries such as Pakistan, Iran and Pakistan the Sudan where it has been compelled to accommodate the other tooit.  It is also hHere too that it has dismally failed.  Besides the fundamental flaws in the model used, tThere is are historical  background for this situationis also a historical reason for this. 

In the Middle-east, Most The Islamic banks of the century that has past came into being consequent to the oil price hike of 1973 and the resultant flow of huge amounts of money into the oil producing countries of the Middle East.  When the new money The flowed in the only income-earning investment options available were those offered by the conventional banks, based on interest.    This pricked the Muslim religious conscience, and they searched for interest-free alternatives.   Dubai Islamic Bank, the DMI (Darul Maal Islami) group with banking subsidiaries such as Faisal Islamic Bank, the Dallah Al-Barakah group and the Kuwait Finance House, these are some of the first fruits of this search.  They came into being beginning 1975.

What was required here was an agent to find opportunities for the direct employment of new money.  The ancient concept of mudaraba  suited this situation best, and the investment accounts of these banks and the mark-up trade financing model served the purpose well.  Large chunksSome of the new inflow of money $$$ if I’ve understood you right, then no!almost all of the oil money went into the Western commercial banks … during the first oil boom many of those above mentioned banks didn’t even exist $$$began to be  were deposited in the investment accounts of these banks, and the banksy used it to finance the huge imports required for public and private development projects and consumption needs.  The size of both the deposits and the transactions were large, and the profits were good.  There was also enough new money to support several such new banks, $$$ over the last 20 years, DMI (and probably Al-Barakah) have from time to time survived only because of cash injections made in the form of new equity from the majority owner$$$ and more was left over in private hands providing sufficient liquidity in the economy.  The conventional banks too continued to operate in these countries side by side with the new banks.  Large Western banks provided all the conventional facilities, both nationally and internationally, and dominated the field.  They satisfied the commercial banking needs of the country and, bSinceecause the current account operations of the conventional banks were considered riba-free, the need for a fully riba-free system was not acutely felt. 


When it was sought to establish Islamic banks in Western countries, based on this model, their conventional central bank regulatory authorities refused permission.  $$$ … but Dallah Al-Barakah for example established a world-wide group of commercial banks that still exists in many countries$$$ Therefore financial institutions, which are governed by a different set of rules, were set up in these countries, and they targeted high net net-worth individuals and large ticket trade items.  They concentrated on short-term  trade financing and generally avoided long-term commitments.  Reputed Western banks joined in the bonanza, and Islamic banking came to be identified with this model.  $$$ yes$$$


In Iran and Pakistan, Islamic banks were established (beginning 1981) for a different reason — religion and politics.  It was by government initiative and the aim was to completely rid the economy of riba, and they began with the banking system.  But tThe needs and circumstances of these other countries mentioned above areare  different.  Unlike in the oil producing countries of the Middle- Eeast, there is no (or very little) inflow of new (oil-bonanza) money here.  Most of the money comes from normal economic activities, except for any outside loans and aid.  There are few high net net-worth individuals.  The deposits come mainly from a large number of small depositors.  There are also few large ticket items of import.  The economies of these countries are dominated by a large number of small and medium size businesses which need temporary advances to tide over short-term liquidity problems, and loans to set up new enterprises and to expand existing ones.  Inflation and liquidity are also acute problems.  The situation is similar in most of the other Muslim countries too.  The existing Islamic banking models does not suit this situation.  Therefore their search for a riba-free alternative continues. 

The profit-and loss-sharing (PLS) concept of the Islamic banks seems to work when it comes to financing one-time trade contracts (even though they give such activity gives raise to questions of economic morality), but it is very has proven itself difficult to implement it when in the financing of enterprises on a medium or long-term basis.[23]  We have dealt with this aspect and provided a viable solution in the companion article mentioned earlier. 

The PLS scheme is also unsuited able to catering forto the short-term liquidity needs of businesses, individuals and the government,; nor to can it provide short- and medium-term loans to set up new small enterprises and working capital to for running existing businesses.[24]    Neither is iFurthermore, it is unsuitable for providing consumer loans on a commercially viable basis.  Inter-bank credit is another difficult area. 

In this article we have tried to rectify this lacuna by establishing a riba-free commercial bank that uses conventional banking methods and operates under conventional banking laws.  This bank provides all current account services, and makes use of the riba-free demand and savings deposits to provide riba-free — but not cost-free — loans and advances.  It can also create bank credit to meet the credit needs of its clients, and provide inter-bank loans.

There is a need for riba-free banks in all countries where Muslims live.  But most countries operate under conventional banking laws, and it is futile to expect the situation to change.  Need not either need it change.  Given also the generally tight monetary situation in countries other than the oil producing ones, we have to look for a solution within the conventional model.  The model presented above is designed to work within the conventional laws.  Under this model converting an existing bank into a riba-free one, as well as setting up a new onesbank, are is relatively easy. 

Now it is up to the Muslim bankers and others to take steps to establish such riba-free commercial banks in all countries of the world, and pave the way for riba-free economies in Muslim countries.





1.       Ahmad, Shaik Mahmud, Towards Interest-free Banking.  New Delhi: International Islamic Publishers, 1992.

2.       Ainley, Michael, A Central Bank’s View of Islamic Banking.  In: European Perceptions of Islamic Banking.  London: Institute of Islamic Banking and Insurance, 1996.

3.       Diwany, Tarek El, The Problem with Interest.  London: Ta-Ha Publishers, 1997.

4.       Gafoor, A.L.M. Abdul, Interest-free Commercial Banking.  Groningen, the Netherlands: Apptec Publications, 1995.

5.       ¾¾ , Participatory Financing through Investment Banks and Commercial Banks. Groningen, the Netherlands: Apptec Publications, 1996.

6.       ¾¾ , Commercial Banking in the presence of Inflation.  Groningen, the Netherlands: Apptec Publications, 1999.

7.       ¾¾ , Islamic Banking and Finance: Another Approach.  Groningen, the Netherlands: Apptec Publications, 2000.

8.       George, Eddie, Islamic Banking.  In: European Perceptions of Islamic Banking.  London: Institute of Islamic Banking and Insurance, 1996.

9.       Institute of Policy Studies, Elimination of Riba from the Economy.  Islamabad: Institute of Policy Studies, 1994.

10.   Rad, Tourani A., Theoretical and Practical Aspects of the Interest-free Banking System.  Amsterdam: Nederlands Institut voor het Bank- en Effectenbedrijf, 1991.

11.   Usmani, Muhammad Taqi, An Introduction to Islamic Finance.  Karachi: Idaratul Ma’arif, 1999.

12.   Yassseri, Ali, “Islamic Banking Contracts as Enforced in Iran: Implications for the Iranian Banking Practice”.  Paper presented at the 4th International Conference on Islamic Economics and Banking, August 13-15, 2000, Loughborough University, UK.




© A.L.M. Abdul Gafoor 2001

May 2001.


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Yassseri, Ali, “Islamic Banking Contracts as Enforced in Iran: Implications for the Iranian Banking Practice”.  Paper presented at the 4th International Conference on Islamic Economics and Banking, August 13-15, 2000, Loughborough University, UK.






·  Based on a talk given to The City Circle, at The Toynbee Hall, London, 26 May 2000.


  The author is thankful to Dr. Saad Al-Harran, Tarek El Diwany and Wobbe Langeveld for their comments and suggestions on an earlier version.  The author alone is responsible for all errors.

Author’s contact details: Phone+Fax: 00-31-50-5775136; e-mail:

[1]  See Gafoor (1999) for a comprehensive treatment.

[2]  Neither the Qur’an, the Holy Book of Islam, nor the traditions of the Prophet of Islam explain the reason for this prohibition.  But rational and experience-based explanations have been offered by many.  For some recent expositions, see Ahmad (1992) and El Diwany (1997).  In the present study we take the prohibition as given.

[3]  See Gafoor (1995) Chapter 4 for details.  This chapter is available online as an article, Islamic Banking, at the author’s websites: and

[4]  See ‘Mudaraba–based Investment and Finance’ at the author’s websites:,; and Gafoor (1996).

[5]  It is relevant to note here that all three most referred to Islamic banking models (viz. Iranian, Pakistani and Siddiqi) provide for such service charges.  See Gafoor (1995) Chapter 4 for details.

[6]  If compensation for inflation is also granted, as proposed in this model, more money will be brought into the savings accounts.

[7]  See quotations from Pemberton and Schotta in Rad (1991).  Also Eddie George (1996).

[8]  A special collective insurance scheme proposed in this system.  See Gafoor (1995, 2000) for details.  The latter is also available online at the author’s websites.

[9]  Details are given in Gafoor (1995 and 1999).

[10]  The rationale and the method of computing the realised capital loss due to inflation is given in Gafoor (1999).

[11]  Some may object to this cost being related to the size and duration of the loan.  For a rational explanation with illustrative example, please see Gafoor (1995).

[12]  There is now a new tendency in advanced countries to pay some interest on these too.  But that need not distract us here.

[13]  Of course the effect will be less severe if the minimum period is one calendar month, but the argument still holds.  The trend now is to reduce the minimum period and this is being helped by the widespread availability use of computers.

[14]  Empirical studies testing the truth of this claim will be very useful.

[15] Regrettably, the day-to-day banking facility needs of ordinary individuals, businesses, organisations and the government are not given sufficient attention in the Islamic banking literature.  The number and size of the transactions effected daily are very large, and they affect many aspects of life forof a large number of people.

[16] Contrary to popular perception, the pure interest component in the cost of borrowing (CoB) is much smaller than (only a fraction of) the interest paid to the depositor.  This comes about on account of the bank’s credit creation.  See Gafoor (1996) Appendix B for a concise explanation of the process of credit creation.  For a mathematical explanation of its role in reducing CoB, see Gafoor (1999) Appendix A.

[17]  Empirical studies using the general model given in Gafoor (1999) Appendix A and data from conventional banks will be very useful in testing this claim.

[18]  See Gafoor (1995) for details.

[19]  See Ainley (1996), Usmani (1999).

[20]  See Gafoor (1999) for details.

[21]  Please correct me if I am wrong.

[22]  Please see footnote 3 4 above.

[23]  See Gafoor (1995), Chapter 4.

[24]  Ibid.