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Islamic Finance
Islamic finance — shorthand for “banking transactions in compliance with Islamic principles” — is a form of modern banking that has evolved in the context of modern-day global financial markets. Claiming to abide by the prescriptions of Islamic law, Islamic finance is arguably the most important area where Muslim economic doctrines are tested and put into practice. In 2007, an aggregate of USD 500 billion were reported to be under management according to Islamic principles and, with annual growth rates of 15 to 20 percent, Islamic finance is generally hailed as a success story. Whether Islamic finance also is faithful to its overarching goals, namely, to establish an alternative financial system that is compliant with Muslim business ethics, and whether such a system is superior to the conventional financial system, continues to be a subject of debate.
Islamic Finance And Islamic Law
The rich and diverse tradition of Islamic jurisprudence did not regulate banking transactions in any detail, nor did it develop a general theory of obligations. This means that the legal principles underpinning Islamic financial transactions are essentially a product of contemporary Islamic scholarship, formulated and legitimized in accordance with the canonical texts of Islamic law. Although many details continue to be disputed, certain core principles have emerged:
- Interest on loans is prohibited. This prohibition Is derived from the Qurʾanic ban of ribā, that is, “illicit gains” in commercial transactions (2:275). The prohibition of ribā is held to proscribe any excess or gain in consideration for the deferral of a debt;
- Speculation is unlawful. This principle is derived from the prohibition of gharar, that is, (excessive) uncertainty in bilateral transactions. In principle, the object of a contract must be determined and ready for delivery when the contract is concluded; and,
- Profit is only permissible if it is based on an (entrepreneurial) risk. This means that all financing parties should participate in the fate of the financed venture or asset. This renders a fixed return on a certain investment impermissible.
The Emergence Of The Islamic Finance Industry
The first Islamic financial institution was set up in 1963 in the town of Mit Ghamr, in the Egyptian Nile Delta. It was structured as a credit cooperative and its founder, Dr. Aḥmad al-Najjār, who was influenced by the German concept of savings banks (Sparkassen), promoted compliance with Islamic principles as a prerequisite in order to reach the conservative rural population.
The Iraqi scholar Muḥammad Bāqir al-Ṣadr (d. 1980), one of the foremost (Shīʿī) jurists of the twentieth century, is credited with masterminding the concept of the Islamic bank based on the application of Islamic legal principles and a reinterpretation of traditional contractual structures of Islamic law. In his seminal book “The Interest-Free Bank in Islam” (al-Bank al-lā ribāwī fi l-Islām, 1969), he proposed that an Islamic financial system be based on Shari’a principles and that the most important principle was the ban of interest on loans.
Since the Village Bank in Mit Ghamr, the Islamic finance industry has changed considerably, due to a combination of the doctrine of Islamic economics and the oil wealth of the Arab Gulf countries. The first commercially oriented Islamic bank was the Dubai Islamic Bank, established in 1975, and by the end of the decade there were many others throughout the Middle East. In 1981 a major transnational company, the Dār al-Māl al-Islāmī, was set up, based in Geneva. These institutions engaged in corporate finance and retail transactions targeting wealthy Muslim investors, pursuing a commercial agenda with a business model that was predicated, however, on the claim to abide by religious prescriptions. With their promotion of “interest-free” banking, the prohibition of interest became the key concept of Islamic banking.
In 1974 the Organization of the Islamic Conference (OIC) summit in Lahore created the Islamic Development Bank (IDB). In addition to acting as a development bank for the Muslim world, this intergovernmental organization was entrusted with providing training and advice to Islamic financial institutions. Although the IDB did gain a certain role in development finance in the Muslim world, its influence on the Islamic finance industry at large remained limited.
Since the 1990s, Islamic finance has witnessed a considerable internationalization. The rapid growth of the economies in the Arab Gulf and Southeast Asia, along with the emergence of new financial hubs in Bahrain, Qatar, and Dubai, have globalized Islamic financial practices. In 2011, most international banks are active in Islamic finance — some through a wholly Islamic subsidiary (such as CIIB, the Islamic Bank of Citi Group), others as part of their normal product range (e.g., Deutsche Bank) — and Islamic banking has matured into one aspect of global finance.
Islamic Financial Transactions
Islamic banks have developed contractual structures that cover the full range of (conventional) banking services.
Islamic Loans
The most important Islamic financing transaction is the murābaha (“mark-up”) loan. Under a murābaha, a bank acquires an asset and sells it on deferred terms with a mark-up. Thus, instead of extending a loan, the bank engages in the purchase (and sale) of an asset, and instead of charging interest, the bank achieves a trading profit. Most contractual structures envisage that the risk of loss in transit is exclusively borne by the customer, who also waives any and all rights with regard to defects of the asset. As a result, the risk structure of a standard murābaha loan is similar to a conventional loan. This is even more obvious with a tawarruq (“commodity murābaha”), by way of which the bank sells certain traded commodities to the customer (which the customer, in turn, can convert into cash through the commodity exchange). This structure, in particular, has been criticized by more conservative Islamic scholars for merely mimicking a conventional credit transaction.
Asset Finance
Leasing transactions (ijāra) are widely used in Islamic finance. Since Islamic principles require the lender to participate in the ownership risk, Islamic banks assume the risk of the commodity and pass it on to a third party on the basis of a maintenance agreement. Another structure, also used in project financing transactions, is the contract of manufacture (istisnāʾ). As with a murābaha, the bank undertakes the construction of a certain project on behalf of the customer (and sells it to the latter on deferred terms). Again, instead of lending money, the bank engages in “real” economic activity.
Capital Market Instruments
Islamic banks have developed a number of capital market instruments, most importantly the sukūk (Islamic bond). Under a sukūk transaction, the issuer sells and transfers a certain asset (e.g., a real-estate portfolio) to a special purpose vehicle (SPV) and rents it back for a specific time period. The SPV funds the acquisition by issuing sukūk certificates to investors, which provide for their participation in the rental income of the underlying transaction (equivalent to a coupon in a conventional transaction). At the end of the contractual term, the issuer repurchases the asset, which allows the SPV to redeem the sukūk certificates (economically speaking, to repay the bond). It is a source of debate among Islamic scholars whether it is permissible to determine the redemption price in advance (with the effect that the sukūk effectively is turned into a fixed-income instrument).
Fund Structures And Private Equity
There are various Islamic structures under which the lender participates as silent partner (mudāraba) or in the equity (mushāraka) of a business. These profit- and loss-sharing structures implement the Islamic principle of “no profit without risk sharing” most faithfully. In practice, however, they only play a marginal role, as they are cumbersome to manage and raise regulatory issues (no guarantee of the deposits). On the investment side, banks have set up Islamic investment funds (investing normally in real estate or equities) that are based on these structures. All permissible investments must comply with an Islamic screening. As far as equities are concerned, certain industries are excluded (such as alcohol, pork, and pornography), as are target companies that have a high debt ratio or receive considerable income from interest payments.
Islamic Insurance Schemes
Commercial insurance, whereby the insurer undertakes against a premium to indemnify the insured (or to pay a certain sum of money) in case a certain event occurs, is not permissible from an Islamic perspective, as it is deemed unlawful speculation. Islamic insurance schemes (takāful) thus are based on the concept of cooperative insurance, whereby all participants exposed to the same risk contribute to an indemnity fund. Often a commercial insurance company will serve as the takāful fund’s manager and the conditions are comparable to those offered by commercial insurers.
Scholars, Fatwas, And Shari’a Boards
Normally, Islamic financing transactions are reviewed and certified by a board of Islamic scholars (the Shari’a board), which renders an opinion (fatwa) as to their compliance with Islamic principles. The scrutiny and approval of complex financial transactions is a challenging task, however, which requires a thorough knowledge of Islamic jurisprudence and a sound understanding of modern banking practices; although some Islamic scholars have begun to specialize in it, the circle of internationally recognized scholars remains small (estimates range from twenty to fifty), so that Islamic legitimacy is a scarce resource. There are conflicts of interest, due to the combined advisory and auditing function of many scholars, and the certification process itself has often been criticized for being slow and non-transparent. Also at odds with the requirement of standardization in the global banking industry are the discursive tradition of Islamic jurisprudence and the plurality of opinion. In response, industry organizations such as the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI, Bahrain) and the Islamic Financial Services Board (IFSB, Kuala Lumpur) were established to, inter alia, define Shari’a standards for the Islamic finance industry, which will replace the ad hoc certification by individual scholars, at least to the extent financial innovations are concerned.
Islamic Finance And The State
Islamic finance developed independently from the state. The driving force behind it was an alliance of petro-dollar banking and Muslim revivalism. Only very few states — among which are Iran, Pakistan, and Sudan — have made attempts to “Islamize” the banking sector by banning interest-bearing loans, and none has been particularly successful in establishing an alternative, Islamic financial system. It appears that Islamic finance hubs fare better in jurisdictions where the official law does not enforce Islamic prescriptions relating to interest and speculation. Nevertheless, the contractual practices of Islamic finance do intersect with state law in certain areas, among them banking regulation and litigation. Here, the relationship between Islamic finance and the state has not always been easy.
Terrorism Financing?
In the aftermath of 9/11, Islamic banks were suspected of providing a financial platform for Muslim terrorism. Although some may have been used to fund terrorist activities, there is no hard evidence that their Islamic orientation in any way promoted this. Moreover, the informal money transfer (ḥawāla), which is an attractive way of transferring illicit funds as it works on a basis of personal trust without leaving a paper trail, takes place outside the formal banking system and is not practiced by Islamic financial institutions. The issues with ḥawāla banking lie mainly in the lack of proper regulation (which, for example, has caused the UAE Central Bank to take action against ḥawāla operators), not the mechanism as such.
Banking Regulations
Another issue for states is the extent to which they should adopt special rules tailored to Islamic banks and their needs. Some countries, such as Malaysia, Kuwait, Bahrain, and Dubai, have enacted a separate regulatory regime for Islamic financial institutions; others, such as the United Kingdom, have exempted Islamic financial institutions from certain regulatory rules that are in conflict with Islamic financing structures. More recently, it seems as if financial regulators have entered into a competition for the best regulatory environment for Islamic banks, with the international financial centers London, Luxembourg, and Geneva (in addition to the new financial centers in the Arab Gulf) vying for the prize. One of the central issues discussed in European jurisdictions is the exemption from the “double stamp duty” that is triggered when title to an asset first transfers to the bank before it is transferred to the customer.
Islamic Finance Litigation
Litigation arising out of Islamic financing agreements can be a particular challenge for state courts. Normally, Islamic financing agreements are governed by the law of a specific legal order (e.g., English law, which is a preferred choice of law in financing transactions). However, at times parties to the litigation also invoke principles of Islamic law, arguing that they have transacted with an Islamic bank. In view of the interpretative pluralism of Islamic law, this can be a considerable challenge for commercial courts. In a series of cases, English courts have judged that an Islamic financing agreement is governed by the agreement of the parties and cannot be challenged on the basis of Islamic principles. According to this approach, adjudication on the Islamic permissibility of the transaction is left to the Shari’a board and cannot be raised in court. This approach must be seen in the context of English commercial law, which provides the parties with wide discretion to determine the content of transactions. It remains to be seen whether courts in a Middle Eastern jurisdiction, which to a certain extent claim to validate provisions of Islamic law, will take the same approach.
Form vs. Substance:
The Discussion of Muslim Business Ethics
From an economic perspective it is often difficult to see the difference between an Islamic and a conventional transaction, in particular with regard to Islamic loan and bond structures; as both transactions are asset-based, one can argue that the transaction is linked to the real economy (the bank trades in precious metals and engages in a sale and lease-back transaction, respectively). This link to the real economy, however, is artificial, and critics of Islamic finance point out that the risk profile of these transactions is very similar to conventional deals. In their view, Islamic finance has failed to establish a true alternative to the conventional financial system and the Islamic scholars have designed complicated and opaque legal devices with the sole aim of circumventing the prescriptions of Islam.
For this reason, critics such as the U.S.-based economist Mahmoud El-Gamal have attacked the formalism of Islamic banking and argued in favor of a renewal of Islamic banking based on an Islamic value system. According to this line of thinking, only a value orientation of Islamic finance, substituting substance for form, would justify its existence. This calls for a debate on how to design an Islamic financial system that is substantially different from conventional finance and how to determine the guiding ethical principles of such a venture. However that may be, the question of whether Islamic finance is a viable alternative to the existing financial system gained greater interest when, during the financial crisis of 2007, mainstream economists noted that Islamic banks were not affected, and their interest in Islamic finance was piqued.
Islamic Finance
410 – 002
https://discerning-Islam,org
Last Update: 02/2021
