Besme'lah'e Rahman'e Rahim Ladies and Gentlemen,

1. Proposed Revision of the Iranian Non-Usury Banking Act(Proposed for consideration to: the Monetary & Credit Council and the Central Bank of I.R. of Iran)

2. Besme'lah'e Rahman'e Rahim Ladies and Gentlemen, You might already know that shortly after the 1979 Revolution in Iran, the banking system was nationalized. A bit later an Islamic banking bill was drafted which was later approved by the parliament. This new law called Non-Usury Banking Law has been in use since March 20th, 1983 and all banks operating in Iran are required to comply with it. This differentiates Iran from many Islamic countries which alongside their so called "Islamic banks“, they have "Conventional banks“ operating there. In the early nineties, many Iranian technocrats at various official positions and particularly those at the Central Bank, had concluded that state-owned banking could not support a higher rate of GDP growth deemed necessary to provide for the ever increasing number of youngsters entering into the work force. Their efforts resulted in the passing of the law allowing for the establishment of privately-owned banks. In the early days of this decade a number of private- banking licenses were issued. Karafarin Bank is one of such banks which is privately owned and was established in 2001. These banks were, of course, required to operate under the same Non-Usury Banking Law. Upon closer examination of Non-Usury Banking Law of Iran by myself, as Managing Director of Karafain bank, and delving into my background in conventional finance and banking, I detected some possible weaknesses in the above- mentioned Law, which are presented below.

3. The gist of the argument is that if we do not somehow use "fixed and pre-determined rate" in our banking system, whether it is called interest or profit, we would be depriving many potential investors (depositors) from safe and secure investment. Such investments would be “yielding a fixed return” somewhat higher than the inflation rate; and, without the fixed rate, we would be increasing the “cost of capital” to the users of funds (loan/investment recipients). The argument presents itself in the following theories: • Risk Aversion: Not all those who are in possession of surplus funds, i.e. "investors", are risk-takers. Therefore, our system should allow the option to risk-averse depositors too that if they so wish, they could place their surplus funds in the banking system and receive a "pre-determined profit" on their invested funds. • Capital Market Line: The basic theory of finance, i.e., risk–return relationship or capital market line (CML) states that rational investors behave sensibly and the amount of risk they will take-on is positively correlated to expected return. In other words, they move along the CML line, based on their own personal indifference or utility curves.

4. Considering that CML is the line obtained from connecting the return received from zero-risk-asset and is drawn tangent to a curve representing efficient portfolios of risky assets, it becomes obvious that there is only one point where a portfolio of risky assets offers a return for the given risk which is unbeatable; ie, "given the return" no portfolio with lower risk can be found, or "given the risk" no portfolio with higher return may be found. Therefore, without the risk-free-return, except for the one point on the curve representing the efficient portfolio of risky assets, all other points even those on this curve will result in investors being either deprived of higher returns or are forced to assume unnecessary additional risk. Return CML x x x x x x x x x x x x x Risk Free Return Risk

5. Cost of Capital: Return on investment from the view points of investors of funds is the same as cost of funds from the view points of the recipient of funds (or borrowers). We know that there are five basic modes of financing available to any individual or firm: a- Short-term bank loans/overdrafts, b- Creditors/payables, or notes payable, c- Long-term loans or bonds, d- Preferred shares, shareholders loan, or various types of mezzanine finance, and e- Equity, common stock, or capital. As we move from (a) towards (e), risk increases and accordingly return (cost) must increase to compensate (penalize) the investors (recipient of funds) for the higher risk assumed (created). If categories (a) and (c) of the above five financing modes are not available in an economy and banks are not allowed to offer short and long-terms fixed and pre-determined credit facilities, weighted average cost of capital in such an environment increases, making users of funds (borrowers) less competitive compared to their international competitors. • In addition to the above theoretical problems, the present Iranian Usury-Free-Banking Act has the following practical problems: • Problems with the Existing (Iranian) Non-Usury Banking Law: • 1) Multiplicity/Variety of Contracts (o’quood), • 2) Inadequate Training of the Users, • 3) Inappropriate Selection of Contracts by Users and Inability to Counsel the Clients, • 4) Inapplicability of certain Contracts to the Operation of some Banks, • 5) Absence of Proper Supervision over the Use of Various Contracts, • 6) High Cost of Proper Implementation of Contracts, • 7) Divergence of Contracts from the Requirements/Wishes of some Clients. • Upon presentation of these arguments to the Minister of Finance of the time (some four years ago), a committee consisting of bankers, economists and Shari'a experts were gathered and the above problems were thoroughly considered. • What is being presented below is the output of this committee's work for a country without a "conventional banking system," in which all banks must operate in an "Usury-Free-Banking Environment."

6. The New Proposal for Non-Usury Banking: In view of the above-mentioned shortcomings, a new Non-Usury Banking Model is being proposed based on the following premises: a) There will be three different types of banks: Commercial, Specialized, and Universal; and two sets of contracts: Mobadelei (Transactional) such as installment credit, and Mosharekatie (participatory) such as “mosharkate madani or participation in a certain project”; b) Our proposed “commercial bank”, while restricted to a limited number of “contracts” (only Mobadelei),will be able to offer almost all-above-the-line services offered by a typical commercial bank as defined in the international literature; c) The “specialized bank” will be able to offer what a typical “investment co.” or a “development bank” does; d) Our “universal bank” may offer what a commercial bank and/or a specialized bank do only if it has a sophisticated enough accounting system, capable of splitting various sources and uses of funds/contracts; and e) Below the line activities: “derivative products”, as well as investment banking services are under consideration and development at present.

7. Benefits of the proposed model: a)Fewer contracts (Mobadelei) are designated for Commercial Banks, b) Fewercontracts (Mosharekatie) are assigned for Specialized Banks, and c) Mobadelei and Mosharekatie contracts for Universal Banks. d) Multiplicity of contracts is reduced, lessening the need for training, e) No longer matching of types of deposits and types of contracts (trust funds) would be needed.

8. Definitions and Interpretation: Ghar’zol hasaneh Jari (current a/c): Based on mutual consent, this type of deposit accounts earn no profit as depositors wish to make use of them as current a/c’s. Ghar’zol hasaneh Pass-an-daz (savings a/c): Based on mutual consent, this type of deposit account earns no profit as depositors wish to have their funds used by banks for granting of Ghar’zol hasaneh loans (credit lines granted by banks in spirit of charity, claiming no profit from recipients).

9. Daily investment deposits a/c: Based on an all-purpose power-of-attorney granted to banks, depositors place their surplus funds with banks and wish to earn profit on the daily balances with this type of deposit a/c’s. Term investment deposit a/c: Based on an all-purpose power-of-attorney granted to banks, depositors who wish to earn higher profit on their available funds for investment for specified periods, place such funds with banks for short, medium or long term. Installment Credit: Under this type of credit facility, banks cash-purchase the items (including current or fixed tangible assets )desired by their clients, add their profit to the purchase price and sell the items to their clients on credit, receiving the selling price and profit over time.

10. Hire purchase: Under this type of credit facility, banks cash-purchase “depreciable assets” desired by their clients, and rent these assets to their clients. Upon making the last rental payment, the client will own the asset. Ja’aleh: Under this type of credit facility, banks cash-purchase desired “services” that their clients require under a “cash Ja’aleh contract” and convey the same to their clients under a “credit Ja’aleh contract.” The credit amount including profit may be paid back in one lump sum amount or in installments. Sa’laf (forward contracts): Under this type of credit facility, banks purchase for cash, an amount or all of, the “future finished products” of their clients. Under the same agreement, clients are empowered (authorized) to sell the finished product, to their regular customers and reimburse their bankers out of the proceeds of such sales.

11. Purchase of Future Obligations (discounting receivables): Under this type of credit facility, banks may discount ”account or notes receivables” of their clients with or without recourse to their clients. The difference between face value of the obligations and the discounted price consists of profit and conditions of the transaction. Ghar’zol hasaneh (non-profit bearing loans): Under this type of credit facility, banks offer non-profit-bearing loans for charitable purposes. What each bank may offer for this type of facility amounts to what it has received in form of Ghar’zol hasaneh pass-an-daz (savings a/c), less than what it places with the Central Bank in form of statutory deposits. Banks may charge only a commission for the services rendered. Govahi Sepordeh Aam (universal certificate of deposit): Based on an all-purpose power-of-attorney to specialized banks, for profit-bearing investment at the option of the banks. The term may be froom one to five years.

12. Govahi Sepordeh Khas (special purpose certificate of deposit): Based on a specific-power-of-attorney to specialized banks, for profit-bearing investment in specific projects. The term may be froom one to five years. Government loans and grants (from development budget): The state may allocate a portion of the development budget for this purpose and place it with specialized banks. Grants may be invested and loans may be granted under the terms and conditions specified above for different kinds of credit facilities. Banking facilities: Specialized banks may utilize banking facilities, whether domestic or international, to supplement their local currency resources.

13. Mosharekat Hoqoqi (equity investment in legal entities): Specialized banks may invest in legal entities. Their stake may be as low as a token holding, to a majority stake in the target entity, a new venture or a going-concern. No collateral is envisaged here. Mosharekate Madani (investment/participation in selected projects): Specialized banks may invest in the form of “Mosharekate Madani” in selected projects with legal or real persons. Collateral in form of the project itself, or additional collateral within the legal entity may be obtained. Direct Investment: Specialized banks may invest in and own all shares of another entity.

14. Proposed Model for Commercial Banks:

15. Proposed Model for Specialized Banks:

16. Proposed Model for Universal Banks: