A series of three lectures delivered at UCLA in a Fall 2001 seminar for the business community.
Mohammad Nejatullah Siddiqi
During the short span of a quarter-century, a new way of financial intermediation and investment management emerged and gained a sizeable share of the market—between one-fourth and one-third—in its home base, the Persian Gulf countries. At the same time it spread to Malaysia, Indonesia and the Americas, and a number of Muslim countries adopted the new system at the state level.
Why did it emerge, how does it work, what sustains it and what is its potential for you and me and humanity at large? These are timely questions, given the increasing instability of our conventional system of money, banking and finance which now faces recurrent crises, and which has failed to help reduce the growing gap between rich and poor, between nations and within nations. Many think the conventional system is partly responsible for the growing inequality.
I propose to examine the foundations of banking and finance in Islam, its concepts, precepts and laws, with some reference to its roots in early Islamic history. Then I will describe its recent emergence and spread. Lastly, I will take a closer look at the contemporary scene and the challenges facing Islamic finance today.
Islam looks at wealth as a life-sustaining resource to be used efficiently. God says:
To those of weak understanding make not over your property, which God hath made a means of support for you.… (Qur’an, 4:5)
Private ownership is affirmed but also viewed as a trust:
Believe in God and His Apostle, and spend (in charity) out of the substance whereof He has made you Heirs.… (57:7)
Islam encourages enterprise or efforts to create wealth which is characterized as God’s bounty:
And when the Prayer is finished, then may ye disperse through the land and seek the Bounty of God.… (62:10)
Muslims are obligated to fulfill contracts and keep their promises:
O ye who believe! Fulfill all obligations.... (5:1)
…And fulfill (every) engagement, for (every) engagement will be enquired into (on the Day of Reckoning).… (17:34)
All exchange should be made with the willing consent of the parties concerned:
O ye who believe! Eat up not your property among yourselves in vanities: but let there be amongst you traffic and trade by mutual good-will.… (4:29)
The use of wealth and the exercise of the freedom of enterprise are constrained by the obligation not to harm others, but this must also be seen in the perspective of the positive obligation to care for others and share with them. This is symbolized by the well-known duty to pay the zakat or poor tax. But that is not all: the important thing is the spirit of cooperative, helpful behavior as mandated by the Islamic view of life as a test:
He Who created Death and Life, that He may try which of you is best in deed. (67:2)
These texts provide a sound basis for a positive attitude toward wealth-creation and economic activity. Clear and secure individual ownership rights, the right to the fruits of one’s efforts, and contracts enforceable through a social authority give direction to that attitude and provide a wide arena for its exercise.
Having provided a firm basis for production and the exchange of wealth, Islam proceeds to define a framework within which these activities should take place so that justice and fairness are ensured for all concerned. This framework comprises both recommendations and prohibitions. For this part of our discussion, the prohibitions are more relevant:
• Riba, interest on loans; also the exchange of unequal quantities of similar fungibles. Gold or silver or a particular paper currency must be exchanged in equal quantities. When gold, silver or different paper currencies are exchanged, the quantities may be unequal but the exchange must be simultaneous.
The prohibition of interest on loans is clearly implied in the text of the Qur’an:
But if ye turn back, ye shall have your capital sums: deal not unjustly, and ye shall not be dealt with unjustly.… (2:279)
As we shall note later on, the prohibitions against interest and gambling (which is next on the list) aim to promote justice in distribution. Islamic law does not distinguish between high rates of interest (characterized as usury) and lower rates. Any excess over and above the sum lent is disallowed. Some modern scholars take a different view, but classical jurists and the overwhelming majority of modern scholars take the stand described above. This view is reflected in Islamic banking and finance.
• Maysir, gambling, betting and wagering. The essence of gambling is taking a risk that is deliberately created or invited, and which is not necessary in economic activity, to gain thereby. This is differentiated from risks taken by other economic agents such as entrepreneurs, speculators, insurers, etc., which are an inalienable aspect of reality.
• Ghabn, fraud and deception.
• Ikrah, coercion, e.g., the imposition of a contract, or a condition therein, on an unwilling party.
• Bay’ al-mudtarr, the exploitation of need, e.g., by charging an exorbitantly high price.
• Ihtikar, hoarding, withholding supplies of essential goods and services with a view to raising prices.
• Najsh, raising prices by manipulating false bids.
• Gharar, hazard or uncertainty surrounding a commodity, its price, time of payment, time of delivery, quantity, etc., making a deal invalid. But some small amount of gharar can be overlooked as it may be humanly impossible to eliminate it.
• Jahl mufdi ila al-niza’, such lack of information about a commodity, its quantity, price, etc., as may lead to dispute.
This list—which is by no means complete—highlights important aspects of Shari`a (Islamic law) that guide men and women toward a just and efficient economy.
I would also point out that regulators all over the world, and especially in the US, have been doing their best to rid the markets of these detrimental practices (with the exception of interest). In other words, Shari`a and modern commercial law share many common concerns.
These prohibitions should be seen in the perspective of the numerous positive injunctions that enshrine the spirit of caring for other human beings and sharing with them, as need be, one’s hard-earned income and wealth. Economic agents, be they individuals, groups or institutions, are also under the obligation to consider public interest and social purpose in their decisions.
True to its views on life, Islamic society has witnessed vigorous economic activity since the Prophet first came to Medina. To this agrarian community was added a group of experienced traders from Mecca, a great center of inter-regional trade. The next four to six centuries saw continuous expansion and increasing prosperity. Monetization came early, and the ban on unequal exchange of similar fungibles seems to have facilitated the process. Muslims started with Byzantine gold dinars and Persian silver dirhams, but early on they began to mint their own coins. The state had a monopoly on coinage, and any tampering with their weight or purity was severely punished.
Trade and commerce over the vast expanse of the world of Islam, which included North Africa, Spain and a large part of Asia, soon produced certain elementary financial instruments such as the suftaja (bill of exchange) and the shekk (check).
Muslims used customary contracts known in the Arabian peninsula and other parts of the Islamic world. While some of these were found to violate one or more of the prohibitions noted above and were therefore rejected, others were modified to meet the standards of fairness. Thus the Prophet forbade traders from selling what they did not yet own. For example, Mu`awiya, the first Umayyad caliph (661-680), banned trade in securities based on the grain entitlements of recipients.
We now turn to those contracts, other than simple sale and purchase, which have a closer relationship with investment, finance and business organization, and which have recently been adapted to modern conditions to form the basis of Islamic banking.
• Mudaraba, profit-sharing. A supplier of money capital contracts with a working partner on the basis of sharing the resulting profits. If there are losses, these are considered loss of capital and are borne by the owner of the capital, while the working partner goes unrewarded for his efforts. The “loss” borne by the working partner is a feature of mudaraba that has prompted some to characterize it as profit and loss sharing or PLS. The sharing contract, when applied to farming, is called muzara’a or sharecropping.
• Shirka, also called musharaka, partnership, wherein two or more parties supply capital and participate in management. They share the resulting profits according to agreed proportions, but losses are borne in proportion to respective capitals.
• Wakala, agency. Business is managed by an agent appointed by the principal/owner. The agent’s compensation may take various forms.
• Juala, reward that is given upon the successful completion of a specified job. There is no compensation in the case of failure.
• Ijara, leasing.
• Salam, payment in advance for agricultural products to be delivered at a specified time in the future, with the price being agreed at the time of payment. This is similar to a commodity forward.
• Istisna’ is salam applied to manufactured goods, with the possibility of payment in installments as the goods are delivered.
• `Urboon, the deposit of a small fraction of the price in a deal to be concluded in the future. It binds the seller to await completion but allows the buyer to back out of the deal, with the seller keeping the deposit.
• Murabaha, a sale agreement under which the seller purchases goods desired by a buyer and sells them to the buyer at an agreed marked-up price, with payment being deferred. It is a modern adaptation of an earlier contract in which deferment was not necessarily involved. The higher price paid would allow a margin to reward the seller for his expertise in bargaining, better knowledge of market conditions, etc.
It should be noted that Islamic law allows a seller to sell on credit at a price higher than he would charge for payment on the spot. This is regarded as an aspect of the freedom of enterprise, i.e., the seller’s freedom to ask for a price that he thinks fit to cover his costs and leave a decent profit. This is different from asking for an excess over cash lent in view of time, i.e., the time that passes between borrowing and repayment, since there is no price involved in a loan transaction. Whereas the object of a loan transaction is money that provides its services through being converted into commodities, in murabaha the object of the transaction is a commodity with its perceived utility to the buyer. The services of money involve time and are surrounded by uncertainty, unlike commodities whose services are known and not necessarily time-related.
This list should also include qard, i.e., an interest-free loan. Because such lending does not bring any material benefit to the lender, it is classified as charity and called qard hasan—a good or beneficial loan. It has played a significant role in financing consumption of the poor and needy, but its role in business enterprise has been marginal except in the form of trade credit which changes its nature.
Trade credit has played a major role in Islamic history. For centuries Muslims were able to carry out international trade and domestic economic activities on the basis of the practices described above, without resorting to interest-based contracts on a large scale. As Professor S.D. Goitein showed in his monumental work, A Mediterranean Society, partnership and profit-sharing, and not interest-based borrowing and lending, formed the basis of commerce and industry in the Mediterranean region in the twelfth and thirteenth centuries.
Prohibition of interest on the one hand and permission to charge a higher than spot price in credit
sales on the other hand, make the Islamic model of finance unique. In order to realize its significance, one should consider the many financial needs which are not amenable to profit-sharing. These include cases in which there is nothing to share, as when the project involved is not a for-profit activity. Also relevant are cases of business enterprise that are difficult to monitor. The inclusion of trade-based modes of financing like murabaha salam and leasing along with sharing-based modes makes the package of Islamic contracts capable of accommodating all kinds of financing needs. What is important to note is that both kinds of contracts are rooted in early Islamic practice.
During the eighteenth, nineteenth and the first half of the twentieth centuries, nearly the entire Islamic world was colonized by European nations who managed the economies and finances of Muslim countries in their own interests and in their own ways. Aside from the native elites, the Muslim populations had no involvement in interest-based financial institutions. As their national consciousness grew and movements for independence promised to bear fruit following World War II, a desire to manage their affairs in accordance with their own values and traditions emerged. Indonesia gained independence in 1945 and Algeria in 1962. Between these years, all other Muslim-majority countries became independent. The Islamic financial movement came into being as an offshoot of the discussion of the management of these new national economies with a view to promoting the national interest. While nationalism tended to focus attention on rapid economic development, religion, the other motivating force in the struggle for freedom, made many turn to Islam for guidance.
Early theoretical work on the subject appeared in Urdu, Arabic and English during the 1940s, 50s and 60s. The focus was not banking and finance in the narrow sense but rather the economic system as a whole. Writers generally began by criticizing both capitalism and socialism and then proceeded to outline a system based on Islamic injunctions concerning moderation in consumption, helping the poor, encouraging economic enterprise, avoidance of waste, promotion of justice and fairness, etc. In this context, writers often emphasized the poor tax (zakat) and the prohibition against interest. It was argued that Muslims should not blindly adopt the conventional system of money, banking and finance, but rather should purge it of prohibited interest and modify it to suit the just and poor-friendly economic system of Islam. Some writers went beyond generalities to suggest that early Islamic contracts provided sound bases for the restructuring of banking so that it would be free of interest and would serve the goals of Islam. Pakistan incorporated the commitment to abolish riba into its constitution.
Professional Muslim economists and Shari`a scholars made significant contributions to the discussion, so that by the end of the 1960s a kind of blueprint for Islamic banking was available. Bankers and business people also joined in the task of developing a workable model while efforts were made to put the idea into practice in several Muslim countries. Political conditions in the Arab countries were unfavorable for state-level initiatives, but private initiatives had a better chance of mobilizing the monies needed for such a venture, as we shall see.
The earliest theoretical model was based on two-tier mudaraba, with profit-sharing replacing interest in bank-depositor and bank-borrower relationships. Islamic banks would serve as financial intermediaries, like conventional commercial banks, except that they would purge interest from their operations and rely instead on partnership and profit-sharing. They could operate demand deposits like their conventional counterparts and, like other banks, they could offer other services against fees. Banks directly doing business and entering the real estate market in order to make profits for their depositors and shareholders (partners) were not a part of this model.
But practitioners in the Arab world did not see much scope in this model. Accepting deposits in investment accounts on a profit-sharing basis was alright, but their profitable employment required direct involvement in business. Merchant banking was closer to the milieu with which Shari`a scholars were familiar. They felt more at home with a model in which savings were mobilized on a profit-sharing basis while their profitable use was based on familiar Islamic contracts of sale, purchase, leasing, etc.
Murabaha (cost-plus or mark-up financing) entered into the model of Islamic banking in the late 1970s. By this time, practice had revealed the difficulties of applying the mudaraba (profit-sharing) contract in dealing with business people in a legal environment that failed to provide any protection to the financier in such cases, unlike the protection provided to interest-based finance. Adverse selection in an environment dominated by interest-based institutions was another serious problem. Other Islamic contracts like salam, istisna’ and wakala were also being explored. Shari`a scholars, many of whom were formal advisors to Islamic financial institutions, made significant contributions in developing the model.
One of the specific needs was financing for home purchase on Islamically acceptable terms. Three models of interest-free finance were developed. The first, which formed the basis of the House Building Finance Corporation of Pakistan (1980), was based on joint ownership and rent-sharing, eventually leading to the home dweller owning the home in full as he gradually purchased the government-owned part. The second model was a cooperative in which members pooled resources and were funded in turn, while the pooled resources were profitably invested in the meantime. The third model was based on murabaha, with the customer paying the higher deferred price in installments. In practice, small variations were introduced to ensure Shari`a compatibility as well as financial viability.
During the 1980s the subject of Islamic banking and finance received widespread academic and professional attention. A number of Muslim countries considering implementation of the idea appointed expert bodies to work out the details. Several universities began to offer courses on the subject and encourage research which resulted in hundreds of PhD dissertations. Seminars and conferences drew attention to Islamic banking and finance in places as far-flung as Kuala Lumpur, Dhaka, Islamabad, Bahrain, Jeddah, Cairo, Khartoum, Sokoto (Nigeria), Tunis, Geneva, London and New York. A number of research centers began to specialize in Islamic economics and some launched academic journals to provide forums for the exchange of views and the dissemination of information on a worldwide scale.
During the 1990s the model was further developed and refined. The liabilities side saw frameworks put in place for handling trust funds, venture capitals and financial papers based on ijara (leasing), salam (forwards) and murabaha (mark up). Special techniques for launching Shari`a-compatible mutual funds were also developed. This involved selecting companies that did not violate any Shari`a norms and whose shares could therefore be traded. The first norm was that the products in which a company dealt should not be prohibited items like alcohol or pork. The second was that its finances should be free of interest-bearing loans and its revenue free of interest income. Since the condition concerning debt finance would eliminate almost all shares traded on the stock exchange, some scholars allowed a leverage of 30% or less. There can be additional criteria, but these two norms are common to all existing Islamic funds. Once the filtering process was complete, managing a portfolio became a professional job. This is why the phenomenon of Islamic mutual funds, even though endorsed by a group of Shari`a scholars, owes its existence to the initiative of professional players in the field. As the launching of the Dow Jones Islamic Index demonstrated, Islamic finance also required modern tools designed to handle the complex web of financial transactions.
Before turning to the actual practice of Islamic banking, let us note some of its features emphasized in the literature.
Justice and fairness to all concerned is the main feature of a model of financial intermediation whose core is profit-sharing. Interest is essentially unfair because our environment does not guarantee positive returns to business enterprise financed with borrowed money capital. Current practice penalizes entrepreneurship by obliging it to return the principal even when part of it is lost due to circumstances beyond the entrepreneur’s control. Justice requires that money capital seeking profit share the risk attached to profit-making. A just system of financial intermediation will contribute to a more equitable distribution of income and wealth.
Islamic finance will foster greater stability as it synchronizes the payment obligations of the entrepreneur with his revenues. This is possible only when the obligation to pay back the funds acquired from the financier and also pay a profit is related to the realization of profits in the project in which the funds are invested, as is the case in the profit-sharing model.
In contradistinction to this, in the debt-financing model the payment obligations of the entrepreneur are dated and fixed in amount. The same is true for financial intermediaries, whose commitment to the depositors in time and savings accounts is to pay back the sum deposited with interest added. When a project fails and a business person defaults, the financial intermediary must also default, and the ripple effects destabilize the whole system. The debt-based financial system of capitalism is inherently prone to recurrent crises. Hyman P. Minsky discusses this malaise of the capitalist financial system in Stabilizing an Unstable Economy (1986).
By linking the depositors’ entitlements to the actual profitability of the projects in which their monies are invested through the services of the financial intermediary, a bank would almost eliminate the risk of runs on the bank insofar as the investment accounts are concerned. A report or a rumor that the bank’s investments were not doing well would not prompt a rash of withdrawals from investment accounts, since depositors would only be able to get what was actually salvageable. A more rational option would be to wait until the situation improved.
Islamic finance is more efficient in that it allocates investable funds on the basis of the expected value productivity of projects rather than on the criterion of the creditworthiness of those who own the projects, which is the case in debt-based finance. There is no guarantee that the most promising projects seeking finance will come from the most wealthy. Indeed, the most innovative may be empty-handed, but debt finance does not serve them. It prefers those who, on the basis of other assets they own, are able to pay back the sum borrowed with interest added, even when the project being financed fails to create additional wealth.
Finally, Islamic finance is less prone to inflation and less vulnerable to speculation, which are currently being fueled by the presence of huge quantities of debt instruments in the market. Debt instruments function as money substitutes, while equity-based financial instruments do not. And speculators find it much easier to manipulate debt instruments than those based on profit-sharing.
It is true that these advantages belong to a system whose core is profit-sharing. But even murabaha (cost-plus or mark-up) financing keeps the system far less vulnerable to inflation and gambling (e.g., speculation) than do conventional debt-based arrangements. Murabaha is firmly linked with the exchange of real goods and services. It is a price, to be paid later. It is essentially different from money given as a loan which may or may not be linked to the production or exchange of real goods and services. An Islamic system of finance in which profit-sharing and mark-up financing exist side by side will still retain the advantages noted above.
A number of interest-free savings and loan societies are reported to have been established in the Indian subcontinent during the 1940s, but efforts to arrange finance for business enterprises seem to have started later. There was one pioneering but short-lived experiment in Mit Ghamr in Egypt in 1963. The same year saw the establishment of Tabung Haji in Malaysia which is still in business, profitably investing money being saved to meet the cost of the pilgrimage to Mecca. During the same period the Philippine Amanah Bank was also established to enable Muslims to meet some of their financial needs without involving interest. An interest-free bank in Karachi, Pakistan, was established around the same time but did not survive.
The Dubai Islamic Bank was established in 1975 under a special law allowing it to engage in business enterprise while accepting deposits into checking accounts that were guaranteed, as well as into investment accounts that were to receive a share in the profit accruing due to their use in business by the bank. Within the next ten years, 27 more banks were established in the same manner in the Gulf states, Egypt, Sudan and elsewhere. Indeed, many more were to follow all over the Muslim world. By 1985, over 50 conventional banks, some of them located in money centers like London, were offering Islamic financial products. Some of the major conventional banks subsequently established Islamic branches dealing exclusively in Islamic products. Citi-Islamic in Bahrain, Grindlays in Karachi, and the National Commercial Bank in Saudi Arabia established over 50 Islamic branches by the 1990s.
Islamic investment companies and Islamic insurance companies also appeared in the late 1970s and their numbers have increased. A number of Islamic mutual funds appeared in the 1990s, many of which are managed by reputable Western firms.
By the year 2000, there were 200 Islamic financial institutions with over US $8 billion in capital and over $100 billion in deposits, managing assets worth more than $160 billion. About 40% of these institutions are in the Middle East, another 40% in South and Southeast Asia, and the remaining 20% equally divided between Africa on the one hand and Europe and the Americas on the other. Two-thirds of these institutions are very small, with assets of less than $100 million.
Pakistan “Islamized” banking between 1979 and 1985, and even though profit-sharing replaced interest as the basis of time deposits and savings accounts, the actual rates paid were not market-determined, as all major banks had been nationalized during a previous regime. On the assets side, mark up became the main basis of bank finance for business. Some financial products based on profit sharing were launched, but their role in the market has been minimal. Government finances remain conventional, burdened with huge interest-based foreign and domestic debts.
Private initiative had a minimal role in the Islamization process, and the market hardly had a chance to create Shari`a-compatible financial instruments. The entire process was conducted with some speed by the bureaucracy under orders from the top. Even the recommendation of the Islamic Ideology Council to make a start from the assets side went unheeded.
Iran passed usury-free banking laws in 1983, and all banks were nationalized. In accordance with the school of Islamic law followed in Iran, depositors may get “rewards” on their savings provided these are not committed in advance. The financing of domestic and external trade is done on a mark-up basis. But sharing modes do play a significant role in financing agriculture and industry, and interest-free state loans are available to the poor to meet such needs as housing.
Sudan launched Islamic banking in 1984; its coverage was extended to the entire financial sector in 1989. Sharing-based modes of finance are used in agriculture and industry. The government is considering sharing-based investment certificates to be sold to the public, with the funds thus mobilized to be used in development projects. Unfortunately, the poor state of the economy stands in the way of the market playing any significant role in the process. However, the recent phenomenon of oil as an increasing source of public revenue is likely to make a difference.
Malaysia got its first officially-sponsored Islamic bank in 1983. All other Malaysian banks also offer Islamic financial products. Overall supervision vests in the country’s central bank, Bank Negara Malaysia, which is advised by a board of Shari`a scholars. The Malaysian Islamic financial system allows the sale of debt instruments based on receivables from leasing and from the sale of real goods and services. The government issues bonds (Malaysian Government Investment Certificates, or MGICs) to be redeemed at par but carrying coupons conferring financial benefits that vary. Malaysia has an active Islamic money market trading in assets-based securities.
Indonesia’s Bank Muamalat, established in 1994 under state patronage, has about 400 branches throughout the country. Its financial operations follow the Malaysian model. There are other smaller Islamic banks as well, e.g., the Sharia Bank.
Although Turkey does not practice Islamic banking at the state level, several Islamic banks were launched under special license in the late 1980s and early 90s. These are still functioning, along with other non-bank Islamic financial institutions.
The Organization of Islamic Conference (OIC) took several steps toward the establishment of a bank that would serve the entire Muslim umma (community of the faithful). The Islamic Development Bank (IDB) began operations in 1975 with headquarters in Jeddah, Saudi Arabia. Share capital, initially fixed at US $2 billion, was supplied by member countries, with the largest portion coming from Saudi Arabia, Kuwait, Libya, the United Arab Emirates and Iran. The first clause of its charter states that its purpose is “to foster the economic development and social progress of member countries and Muslim communities individually and jointly in accordance with the principles of Shari`a.” In compliance, the IDB does not deal in interest.
By the year 2000, the IDB had financed inter-Islamic trade to the tune of over US $8 billion, mostly using the mark-up technique. It also makes loans, taking only service charges according to actual administrative expenditures; tries to promote sharing-based modes of financing; and manages an investment portfolio in which individual Islamic banks can place their surplus liquidity. Even though it cannot and does not aspire to serve Islamic banks as a lender of last resort, it tries to help them solve their liquidity problems. It fosters technical cooperation between member countries and has established or sponsored a number of institutions for this purpose, e.g., the Islamic Chamber of Commerce and the Islamic Foundation for Science, Technology and Development. It also distributes scholarships to Muslim students for technical training and higher education in countries where Muslims are in the minority.
In order to fulfill its mission, the IDB has established the Islamic Research and Training Institute (IRTI) which conducts in-house research, sponsors external research, publishes a research journal, conducts training courses, organizes seminars and conferences, and maintains a database on the economies of Islamic countries. The IDB interacts with all regional and international financial institutions, e.g., the International Monetary Fund, the World Bank and the Asian Development Bank.
Islamic Banking and Finance and the International Community
The International Monetary Fund issued its first study on Islamic banking in 1987 and has since produced more than a dozen research papers on important aspects of Islamic finance. It has reported no problems in dealing with member countries committed to Islamic banking. Likewise, Islamic financial institutions have never encountered any problems in dealing with regional and international financial institutions. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) maintains contact with the Standards Committee of the Bank of International Settlements based in Basel.
All Islamic financial institutions operate within the systems supervised by their respective central banks and other relevant authorities. They do not work in isolation, nor do they create a separate space of their own. They are inspired by a vision of financial arrangements more conducive to justice and development for all, especially for the poor and the weak, a goal hopefully cherished by all.
Great changes were taking place in the financial environment during the last few decades of the twentieth century while Islamic banking and financial institutions were evolving. Some of the most significant changes were the decline in intermediation and the resort to more active and aggressive management of investment, and the worldwide integration of financial markets in the wake of globalization.
The first trend, symbolized by the repeal of the Glass-Steagall Act in the US, should be advantageous to Islamic finance insofar as financial intermediation was based on interest. The greater involvement of banks and other financial institutions in investment management afforded wider scope for the use of Islamic financial techniques such as profit sharing and mark-up financing.
The problem is that investment management in modern conditions boils down to risk management, which is very underdeveloped in Islamic financial theory and practice. In Islamic perception, this an area of conventional finance in need of drastic reform. This need was recently underlined by the story of Long-Term Capital Management, told by Roger Lowenstein in his book, When Genius Failed (2000). Thus we face a dual challenge to develop Islamic techniques of risk management and to see that these new techniques are free of the ills associated with conventional methods. This is different from the challenge faced in the mid-twentieth century, which was to develop a method of financial intermediation free of interest.
The mastery of risk is a stupendous challenge. It may be regarded as the distinguishing feature of modern times. Someone has rightly remarked that the elimination of risk has replaced the elimination of scarcity as a major preoccupation.
Risk is an ever-present factor, especially in business, but industrialization brought risks previously unknown in trade and agriculture. Industrial production often involves long periods of time, and the longer the period of production, the greater the uncertainty. The scope of the market has expanded to cover the entire globe, introducing new kinds of risk. When Islamic laws were being written more than a thousand years ago, the nature and scope of risk and uncertainty were different. However, we can still learn something which in combination with the modern experience should enable us to realize the Shari`a objectives of justice, fairness and efficiency.
The Prophet is reported to have prohibited the sale of an unborn calf, i.e., one still in its mother’s womb. He is also reported to have prohibited the sale of fish still in the pond. In both cases, the reason was the uncertainty surrounding the quality and/or the quantity of the commodity being sold.
The Prophet is reported to have permitted the sale of unripened fruit on the tree despite the uncertainty as to its quantity and/or quality. It was not possible to wait until the fruit was fully ripe and plucked and weighed or counted, for that would leave no time for marketing.
The Prophet is reported to have prohibited the sale of a non-existent commodity. But he did allow salam, the sale of agricultural crops months ahead of the harvest, provided the price was paid in advance at the time of contract. This was found to be advantageous to the farmer and to the grain-trader, hence the uncertainty involved was tolerated for a purpose.
The message seems to be clear. As far as possible, transactions must be based on complete information in order to ensure that neither party is under any misapprehension. But given mutual consent, some uncertainty can be tolerated in order to secure greater advantages.
As is to be expected, the juristic discussion of gharar (hazard or uncertainty) or transactions in the absence of complete information is full of controversies. I do not propose to enter into the details, but would rather draw attention to the human needs and interests involved in situations where contracts must cover the future in order for life to go on efficiently.
It is important to distinguish between gambling (which must be avoided) and other kinds of risk-taking. In the words of Irving Fisher, a gambler seeks and takes unnecessary risks. Such is the nature of games of chance. But life is full of risky situations that cannot be avoided. Business especially involves risk because the production of wealth involves the future, and it is impossible to have full and certain information regarding the future. People find mutually advantageous ways to face these uncertainties. We will illustrate this with several examples.
A farmer sells future grain contracts in order to protect himself from a fall in prices, whereas a food processor buys future grain contracts in order to protect himself from a rise in prices. Both parties benefit, for even though each one is taking some risk, the total risk is less, and they can proceed with their production plans on the basis of agreed prices. Another example is oil futures sold by oil companies and purchased by airlines. Without these contracts, the fluctuations in oil prices would expose future planning in both industries to almost impossible risks.
Since direct deals between farmers and food processors or between oil companies and airlines would be costly and cumbersome, it is efficient to have middlemen or intermediaries. Some sort of clearing arrangements soon follow. In short, we have a new market for commodity futures. There is a role in this market for speculators. Unlike gamblers, they do not create or invite the risks they are dealing with. These are business risks which must fall somewhere. Speculators take these risks, pool them and reorganize them into packages that are more acceptable to some in terms of quantity, quality, time involved, etc. Speculators take risks in order to make a profit thereby. They specialize in transferring risks to those willing to take them. They also allocate risk over time. Future markets have a decisive impact on spot markets, making them more stable.
Current research on the subject of risk management within the Islamic framework is inconclusive. The position is the same when we consider the currency markets. Contractors need different currencies at different points in time in order to fulfill production plans extending far into the future and involving inputs from several currency areas. In order to make a commitment to do a job, like delivering an aircraft, an airport, or a shopping complex at an agreed price in a single currency at the time of the contract, a firm has to ensure that the requisite amounts of various other currencies are available at the proper time to buy the inputs needed. This involves buying foreign currencies in advance, which is not permitted under Islamic law as presently interpreted.
Current methods of dealing with uncertainties in the financial markets involve dealing in derivatives. These innovations have little precedent. Some Islamic scholars find that the old practice of urboon (depositing a small fraction of the price in a deal to be concluded in the future) may justify some kind of options which are the simplest kind of derivatives. This could be a first step toward a broad range of derivatives, some of them based on futures.
Let us wind up this discussion of financial markets in the Islamic framework with a synoptic view of the situation. For this purpose, we will classify financial transactions as follows:
The prohibition of interest seems to affect all three markets in which debt figures, insofar as debt can be traded only at par. Money for equity poses no problems. I have already noted the problem relating to the currency market. The overall conclusion is that Islamic financial markets will be smaller compared to an interest-based regime, all other things remaining the same. Islamic economists think it will be good for society. The ballooning of the financial sector out of all proportion with the real economy has undesirable consequences for the distribution of income and wealth. It also makes it vulnerable to gambling, i.e., speculation.
But an overly restrictive approach by Islamic scholars in the name of minimizing gharar (hazard, uncertainty) and blocking the road to riba (interest) runs the greater risk of stifling genuine economic activity by reducing the amount of liquidity available on the one hand while increasing the total amount of risk on the other. The overall result could be that Muslim societies which are run in accordance with these restrictive interpretations of Shari`a will lag behind in economic progress and eventually lose out to others politically and culturally as well. Instead of heralding a more just, stable and efficient financial regime, they would then serve only to discourage a religious and moral approach to money, banking and finance, a disaster that need not be. One hopes that the new generation of Islamic economists will rise to the challenge.
This is the second important change I mentioned at the outset. Financial markets the world over are integrated as never before. Money moves across national boundaries costlessly and instantaneously. In principle, this change should be favorable to Islam which never much cared for national boundaries. In practice, however, it does pose problems for the Islamic financial movement, for two different reasons. Firstly, the home base of this new trend is in the Middle East and South and Southeast Asia, where the economies are small and the financial systems less sophisticated than in the developed countries. Secondly, Islamic financial institutions suffer from smallness in size and very few of them operate in more than one country as the major players do. The situation has changed with the entry of some major conventional financial institutions into the field. But this has also made things more difficult for the older Islamic financial institutions, obliging them to consider mergers and consolidation.
Globalization has increased the volatility of almost every financial variable, especially the exchange rates. It has also reduced the efficacy of national economic macro-management. Redress can only come through international agreements curbing speculation and regulating financial markets. In this regard, the insights of the Islamic financial movement concerning sharing modes of finance, commodity-linked financing such as murabaha, and reducing the role of debt have great potential.
At present there is a lull in state-sponsored Islamic finance. Pakistan, which once took the lead, is in a state of flux. With its economy skidding, burdened with huge domestic and foreign debt, it is faltering in its resolve to forge ahead with an innovative approach to money, banking and finance. Sudan, possibly emerging from a period of ostracism by Western countries, shows no sign of being in a better situation. Malaysia was expected to do better after it emerged from the 1997-98 Southeast Asian crisis, but the worldwide recession looming on the horizon makes the prospects uncertain. Little is known about Iran, but at least there has been no setback and no weakening of political will. In view of the difficult economic situations and the political uncertainties in the countries that pioneered the experiment, no new initiatives are expected in state-sponsored Islamic banking and finance.
Meanwhile, there has been progress in the regulation of Islamic financial institutions by their respective national authorities in view of the increasing market share of these institutions. There is better understanding of Islamic finance by the monetary authorities and closer cooperation between them and these institutions, sometimes with the involvement of the Islamic Development Bank.
Efforts continue to standardize Islamic financial products. Standards developed by the Audit and Accounts Organization of Islamic Financial Institutions are being adopted. The need to standardize such basic elements of Islamic finance as mudaraba, murabaha and ijara is widely accepted; the present lack of uniformity is baffling. There are moves to coordinate the activities of the various Shari`a advisory boards of Islamic financial institutions, since the way they function remains a source of confusion.
There is a large information deficit in the Islamic financial industry that hampers its further growth and development. The absence of rating agencies, especially agencies that would rate products and institutions on the basis of their Shari`a compliance, is the best example of this deficit.
Despite the odds, the industry continues to grow, particularly in the Gulf countries. It has also reached the Balkans and the newly independent Central Asian Islamic Republics. But the weak economic conditions in those countries are naturally reflected in the state of their nascent Islamic financial institutions.
The youngest Islamic financial institutions are found outside Muslim-majority areas—in the Americas, Europe and India. Many of them have successfully completed their first decade of operations. All of them are growing. They serve their respective communities with interest-free home finance and installment-purchase of consumer durables, as well as by investing their savings on the basis of profit-sharing. There is great potential for expansion.
All innovations require research and development which in turn draw on basic research in universities and laboratories. Islamic finance became a subject of academic research in the 1980s, and every year it is discussed at high-profile conferences, yet the resources devoted to it hardly match the challenges facing the industry.
As the Bank of International Settlements has noted, innovation in three areas is crucial: liquidity enhancement, risk transfer and revenue generation. In its early days, Islamic finance had to focus on revenue generation, as it had to compete with conventional finance and show comparable returns. Times have changed. The need to enhance liquidity and therefore to move toward greater securitization of assets is already recognized, as evidenced by developments in Malaysia. The bottleneck now seems to be risk management.
Another important area awaiting innovation and initiative is a vision that encompasses zakat (obligatory charity), waqf (pl. awqaf, charitable endowments) and Islamic financial management. Securitization can help mobilize the tremendous wealth locked up in awqaf properties which in turn can be developed by the investment of zakat funds awaiting distribution. At present only a small fraction of the liquidity generated by zakat passes through Islamic financial institutions, a situation reflecting the distance between these institutions and the poor, non-banking population.
The goal of progress with justice and equity inspires all of humanity, and there is no reason why Islamic financial institutions should not be able to help realize this goal. In the age of globalization, no system that serves only the interests of a particular country or group of countries can find universal acceptance. The protection of small countries from speculators chasing instant profits, the reduction of the role of debt in international finance, and the financing of projects that will help reduce poverty and inequality are goals that merit everyone’s attention.
Published: Saturday, December 01, 2001
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