Throughout the media, the legal establishment of interest-free banking (IFB) systems is being announced, in reference to Proclamation Number 592/2008 and the progress made by the National Bank of Ethiopia (NBE) through its IFB directives.

Indeed, it is an important, full step ahead for sustainable socioeconomic development and growth for Ethiopia.

In most parts of the world, this system is modelled under an umbrella of Islamic economics.

Islamic economics operate in accordance with Sharia’h Law. It can refer to the application of Sharia’h on economic activity, either where Islamic rule is in force or not.

This paradigm, particularly as developed by modern scholars of Islam, seeks not only to enforce Islamic regulations, but also to implement broader economic goals and policies.

The paradigm is, out of necessity, more limited, revolving around a few main tenants of Islam. These include charitable giving (zakat), borrowing and lending without payment of fixed interest (riba), insurance, inheritance, and socially responsible investing.

The key difference from other financial perspectives is the noninterest rule, since most other religions likewise favour charitable giving and socially responsible investing.

This banking system is widespread and accepted in 50 to 75 countries.

As far back as 1981, Citibank, a giant institution of conventional banking, set up a dedicated Islamic finance unit in London, offering investment services and products aimed at Islamic investors.

The German owned Dresdner Klienwort Benson has also been substantially involved in trade and commodity based investment with or on behalf of Muslim clients since 1990. Other Western institutions with substantial Islamic portfolios include Australia and New Zealand owned ANZ Group Ltd and Dutch owned ABN Amro.

In short, the essential feature of such banking is that it is interest-free. There is more to IFB, such as contributions towards more equitable distributions of income and wealth and increased equity participation in the economy, it is often claimed. It nevertheless derives its specific rationale from the fact that there is no place for the institution of interest in Islamic society.

Islam prohibits Muslims from taking or giving interest, regardless of the purpose for which such loans are made and regardless of the rates at which interest is charged.

To be sure, there have been attempts to distinguish between usury and interest and between loans for consumption and for production.

Riba refers to usury practiced by petty moneylenders and not to interest charged by modern banks, it has been argued, and no riba is involved when interest is imposed on productive loans.

Yet, these arguments have not won acceptance.

Apart from a few dissenting opinions, there is no difference between riba and interest, the consensus among Muslim scholars holds. These two terms are used interchangeably.

The Islamic ban on interest, however, does not claim that capital is costless in an Islamic system. Islam recognises capital as a factor of production, but it does not allow a prior or predetermined claim on the productive surplus in the form of interest.

This obviously poses the question as to what then replaces the interest rate mechanism in Islamic framework. Profit sharing can be a viable alternative, some have suggested. In Islam, the owner of capital can legitimately share the profits made by the entrepreneur.

What makes profit sharing but not interest permissible in Islam is that, in the case of the former, it is only the profit-sharing ratio, not the rate of return itself that is predetermined. Profit sharing can help allocate resources efficiently, as market forces can influence the profit-sharing ratio, so that capital will flow into those sectors, which offer the highest profit-sharing ratios to the investor, other things being equal.

Capital, as a factor of production, deserves to be rewarded, Islam does not deny, as mentioned earlier. Islam allows the owners of the capital a share in any surplus, which is uncertain.

To put it differently, investors in the Islamic order have no right to demand a fixed rate of return. No one is entitled to any addition to the principal sum if he does not share in the risks involved.

The owner of the capital may invest by allowing an entrepreneur with ideas and expertise to use the capital for productive purposes, and he may share the profits, if any, with the entrepreneur-borrower. Losses, if any, however, will be borne wholly by the owner of the capital.

One of the main selling points of IFB is that it is concerned about the viability of the project and the profitability of the operations but not the size of the collateral. Good projects that might be turned down due to a lack of collateral are sometimes financed by IFBs on a profit-sharing basis.

It is especially in this sense that IFBs can play a catalytic role in stimulating economic development. In many developing countries like Ethiopia, development banks are supposed to perform this function.

IFBs are expected to be more enterprising than their conventional counterparts are. In practice, however, most of the IFBs have been concentrating on short-term trade finance, which is the least risky, particularly at the early phases of newly established IFBs.

Long-term financing requires expertise, which is not always available, some explain. There are no backup institutional structures, such as secondary capital markets for Islamic financial instruments, others reason.

The tendency to concentrate on short-term financing reflects being in the early years of operation. After all, short-term financing is easier to administer, less risky, and the returns are quicker.

The banks may learn to pay more attention to equity financing, as they grow older.

Historically, all banks have generally served governments, businesses, and the well-to-do. Good collateral and guaranteed revenues for servicing loans are essential considerations in granting loans.

As time passed on, the banking business expanded into the newly developing middle class that has gradually acquired savings, property, and stable income. Their savings made them welcome, and their property and stable (mainly wage) income made some of them eligible for small loans.

Legislation was passed to safeguard the interests of both parties, although, by now, the banks have emerged as the stronger of the two.

This is the case in developed countries.

In developing countries, like Ethiopia, with their low levels of literacy and underdeveloped financial sector at the grass-roots level, participation of the majority of the population in the banking sector is very limited.

There is a long way to go. Yet, they, too, have a need for credit, albeit in small measures.

However, the conventional banks are not designed to cater to them. The modern banks are not like their forerunners, the moneylenders of old who lent their own funds.

Modern banks handle, borrow, and lend other people's money and are managed by professional executives who are governed and constrained by legally binding rules and regulations. They have very little personal discretion.

That leaves a large section of the population in Ethiopia and other developing countries as well as many small communities in developed countries outside of the banking system.

This is where the private moneylenders come in. They are still alive and well, and ready to pounce.

They usually know their clients, live in the same locality, are very reasonable as to collateral, and are quite accommodating. They have no lengthy approval procedures either, if the “risk premium” is set suitably high.

It is difficult to beat them. They have survived many attempts, but it is worth a try. Massive efforts at educational and economic development at the grass-roots level are still necessary to keep the unfortunate out of their clutches.

In the meantime, there is a need for special financial institutions with development motives to establish IFB and interest-free micro financial institutions that will mobilise the savings and loans at the local community level to serve the needs of those overlooked by interest-bearing commercial banks.

They can also be organised and run along the lines of the commercial banks by operating in interest-free windows and non-profit community lending schemes. Community leaders can play a major role in this respect, and religious leaders should promote and support it because, being an alternative to private interest or riba-based money lending, it is an effective preventive strategy.

There are still the un-bankable, who are either completely avoided by moneylenders or mercilessly exploited by them. These are the ones living on the fringes of the society, and their concern is daily subsistence.

They are not beggars; neither are they unwilling or unable to work. They often have a useful locally marketable skill. They simply lack the very small capital, which can enable them to own the tools and the small stocks of raw materials necessary for their trades.

In dollar terms, the capital they need is often less than the cost of a meal in New York City or London.

Such people are bankable, the Grameen Bank Movement in Bangladesh has proved, and, with very little help, they can stand on their own two feet and regain their place in society with dignity. Grameen has a 25-year history of success, and its methodology has been adopted in many countries around the world.

The tools are already here. What is necessary is for the community to examine whether it needs such a bank, and then to set about providing one. It needs dedicated workers, but the results can be very satisfying.

Given the infancy of the financial industry in Ethiopia and the presence of communities not served by existing financial institutions, the introduction of an interest-free, pro-poor financial system is not just an alternative. If there is a need for speedy economic growth and reduction of poverty, it is a necessity.

Recently, there have been new banking businesses coming on board with IFB based features, like ZamZam (under formation).

Along with existing public and private banks, a difference in the country’s socioeconomic growth and development will soon be affected.

The success of these banks, particularly IFBs, like ZamZam, as well as existing banks interested in opening up branches using similar modes of financing, depends on government support through the creation of an enabling legal and regulatory environment.