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The Foundations of Islamic Finance

Author: By: Prof. M.N. Siddiqi

During the short span of a quarter century, the Islamic finance spread far and wide reaching Malaysia
and Indonesia in the east and the Americas in the west, and a number of Muslim countries adopted the
new system at the state level.

It is interesting to ask why it emerged, how it works, what sustains it and what are its potentialities for
you and me and the humanity at large. The query is timely as all is not well with our conventional
system of money, banking and finance. It has become increasingly unstable, facing recurrent crises. It
has failed to help in reducing the increasing gap between the rich and the poor, within nations and
between nations. Many think it is partly responsible for increasing inequality.

I will cover the foundations of banking and finance in Islam: its concepts, precepts and laws with some
reference to its roots in early Islamic history. I will also take-up the story of its recent emergence and
spread. In the third and the last section we will have a closer look at the contemporary scene and the
challenges facing Islamic finance today.

The Foundations

Islam looks at wealth as life sustaining, to be used efficiently. God says:

“Give not unto the foolish your wealth which Allah has made a means of support for you”. (Quran, 4:4).

Private ownership is affirmed but viewed as a trust:

“Believe in Allah and His messenger, and spend of that whereof He hath made you trustees.” (Quran,

Islam encourages enterprise, efforts to create wealth, which has been characterized as God’s bounty:

“And when prayer is ended, then disperse in the land and seek Allah’s Bounty”. (Quran, 62:10).

Muslims are obligated to fulfill contracts and keep their promises:

“O you who believe fulfill your undertakings”. (Quran, 5:1)

“…And be true to every promise, for, verily, (on judgment day) you will be called to account for every 12/30/2008
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promise you made”. (Quran, 17:34)

All exchange should be with willing consent of the parties concerned:

“O you who believe squander not your wealth among yourself in vanity Except it be a trade by mutual
consent”. (Quran, 4:29)

Use of wealth and exercise of freedom of enterprise is constrained by the obligation not to harm others.
The Prophet ruled:

“No injury, and no inflicting of injury”. (Ibn Maja, Sunan: chapter on Ahkam)

This has to 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 of paying Zakat or poor tax. But that is
not all, the important thing is the spirit of a cooperative, helpful behavior as mandated by the
Islamic view on life being a test:

“Who hath created life and death that He may try you, which of you is best in conduct”. (Quran, 67:2).

These clear texts provide a sound basis for a positive attitude towards wealth creation and economic
activity. Clear and secure individual ownership rights, one’s right to the fruits of one’s efforts and
contracts enforceable through a social authority, strengthen that attitude and provide a wide arena for

Limits of Freedom

Having put production and exchange of wealth on a firm basis, Islam proceeds to
define a framework for these activities so that justice and fairness is ensured for all
concerned. This comprises do’s as well as don’ts. I focus on the don’ts, as they are more
relevant to our discussion. The following are prohibited:

1 Riba,

i.e. interest on loans and exchange of unequal quantities of similar fungibles. Gold or
silver or a particular paper currency must be exchanged in equal quantities. When gold
or silver or different paper currencies are exchanged with one another, the quantities
can be unequal but the exchange must be simultaneous. Prohibition of interest on loans
is clearly implied by the text of the Quran:

“And if you repent you have your principal, wrong not and you shall not be wronged”. 12/30/2008
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(Quran, 2:279)

As we shall note later on, this and the prohibition of gambling which is next on the list,
target justice in distribution. Islamic law does not distinguish between high rates of
interest characterized as usury and lower rates characterized as interest. Any excess
over and above the sum lent is disallowed. There have been some modern scholars
taking a different view but classical jurists as well as overwhelming majority of
modern scholars take the stand reported above. It is this view which is reflected in
Islamic banking and finance.

2. Maysir,

i.e. gambling, bets and wager. The essence of gambling is taking a risk deliberately
created or invited, which is not necessary in economic activity, to gain thereby. This is
unlike the risks taken by other economic agents, entrepreneurs, speculators, insurers,
which are there as an inalienable aspect of reality.

3. Ghabn,

i.e. fraud and deception.

4. Ikrah,

i.e. coercion, e.g. imposing a contract, or a condition therein, on an unwilling party.

5. Bay’ al -mudtarr,

i.e. exploitation of need, e.g. by charging an exorbitantly high price.

6. Ihtikar,

i.e. withholding supplies of essential goods and services with a view to raising prices.

7. Najsh,

i.e. raising prices by manipulating false bids.

8. Gharar,

i.e. hazard or uncertainty surrounding a commodity, its price, time of payment, time of
delivery, quantity,.. etc. makes the deal invalid. But some little gharar can be ignored
as it may be humanly impossible to eliminate it. 12/30/2008
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9. Jahl mufdi ila al-niza’,

i.e. such lack of information about a commodity, its quantity, price, etc. as may lead to

This list is by no means all inclusive, rather it serves the purpose of highlighting what
the Shariah (Islamic Law) cares about in order to guide men and women towards an
efficient and just economy.

I would also underline the fact that other than prohibition of interest, regulators all
over the world, especially in the United States of America, have been doing their best to
rid the markets from the bad practices noted above. In other words most of the
concerns of Shariah and modern commercial law are common.

As I noted earlier, these do-nots are to be seen in the perspective of the numerous do’s
Islam has mandated, those that enshrine the spirit of caring for other human beings
and, as need be, sharing with them one’s hard earned income and wealth. Economic
agents, be they individuals, groups or institutions, are also under the obligation of
regarding public interest and social purpose in their decisions. However, a detailed
discussion of this point is not warranted in this lecture.

Early Islamic History

True to its view on life, Islamic society witnessed vigorous economic activity since the
day the Prophet came to Madinah. To the agrarian community of the city state was
added a group of experienced traders from Makkah, a great center of inter- regional
trade. The first four to six centuries recorded continued expansion and increasing
prosperity. Monetization came early, and the ban on unequal exchange of similar
fungibles seems to have expedited the process. Muslims started with gold dinars from
the Byzantine and silver dirhams from Persia, but very soon they took to minting their
own coins. The state had the monopoly of coinage and any tampering with their weight
or purity was severely punished.

It is not surprising that trade and commerce over the vast expanse of the world of
Islam, including northern parts of Africa, Spain in Europe and a large part of Asia,
soon produced certain elementary financial instruments.

Chief among these was suftaja (bill of exchange) and sakk (check).

Muslims used customary contracts known in the Arabian peninsula and other parts of
the land of Islam. But some were found violating one or more of the limits noted above 12/30/2008
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and, therefore, rejected. Some were modified to meet the standards of fairness. Thus the
Prophet forbade traders from selling what they did not yet own. He also forbade selling
pieces of cloth spread on the ground by inviting the customer to throw pebbles in their
direction, getting the piece actually hit. Muawiya, the first Umayyid khalifa (661-680)
banned trade in securities based on grain entitlements of recipients.

It is time now to focus on those contracts, other than simple sale and purchase, which
have a closer relationship with investment, finance and business organization. It is
these which were recently adapted to modern conditions to form the basis of Islamic

Profile of Early Islamic Financial Contracts


i.e. profit-sharing. Supplier of money capital contracts with a working partner on the
basis of sharing the resulting profits. Losses, if any, are considered loss of capital and
borne by the owner of capital. The working partner, in that case, goes unrewarded for
its efforts. This is the ‘loss’ borne by the working partner, a feature of mudaraba which
has made some to characterize it as profit and loss sharing or PLS.

The sharing contract when applied to farming, is called muzara’ah or share-cropping.

Shirka, also called musharaka

i.e. partnership. In partnership two or more parties supply capital as well as

work/effort. They share the resulting profits according to agreed proportions, but
losses are to be borne in proportion to respective capitals.


i.e. agency. Business is managed by an agent appointed by the principal-owner. Agent’s

compensation may take different forms.


i.e. reward which is given on successful completion of a specified job. There is no

compensation in case of failure.


i.e. leasing. 12/30/2008
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i.e. payment now for agricultural products to be delivered at a specified time in furure,
with the price being agreed now.


i.e. salam applied to manufactured goods, with the possibility of payment in

installments as the goods are delivered.


i.e. depositing a small fraction of price in a deal to be concluded in future. It binds the
seller to wait but allows the buyer to back out of the deal, with the seller keeping the


i.e. a sale agreement under which the seller purchases goods desired by a buyer and
sells it to him/her at an agreed marked up price, payment being deferred. It is also
referred to as bay’ mu’ajjal or bay’ bi thaman aajil. It is a modern adaptation of an
earlier contract in which deferment was not necessarily involved. The higher price paid
would leave a margin for the seller in order to reward him/her for expertise in
bargaining, better knowledge of market conditions, etc.

It may be noted that Islamic law allows a seller to sell on credit at a price higher than
he/she was charging for payment on the spot. In fact it is regarded to be an aspect of
freedom of enterprise, the seller’s freedom to ask for a price he/she thinks fit to cover
his/her costs and leave a decent profit. It is not like asking for an excess over cash lent
in view of time, the time that passes between borrowing and repayment. No price is
involved in a lending transaction. The object of the transaction in murabaha is a
commodity with its perceived utility to the buyer, whereas the object of transaction in a
loan is money which gives its services through being converted into commodities.
Unlike commodities whose services are known and not necessarily time related, the
services of money involve time and are surrounded with uncertainty.

Trade credit has always played a major role, and it was no different in early Islamic

This list should also include qard, i.e. loan’ which has to be interest free. Since lending
does not bring any material benefit to the lender it is classified with charity and called 12/30/2008
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‘qard hasan’—good loan or beneficial loan. It 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.

As noted above, for centuries Muslims were able to carry on international trade as well
as domestic economic activities---agriculture, industry and trade--on the basis of the
above mentioned practices without resorting to interest based contracts on any large
scale. As Professor S.D. Goitein has recorded 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 twelfth and
thirteenth centuries (sixth and seventh in Islamic calendar) in the Mediterranean

(S D Goitein, A Mediterranean Society, vol. 2, Berkley and Los Angeles, University of

California Press, 1971)

A Realistic Approach.

Prohibition of interest on the one hand and permission to charge a higher than spot
price in credit sales on the other hand makes the Islamic model of finance unique. In
order to realize its significance one should consider the many financial needs, which
are not easily amenable to profit sharing. These are the cases in which there is nothing
to share as the project involved is not a for profit activity. Also relevant are cases of
business enterprise, which 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 at this stage is that both kinds of contracts are rooted
in early Islamic practice.

Recent History Of Islamic Banking And Finance

During the eighteenth, nineteenth and the first half of the twentieth centuries almost
all of the world of Islam was colonized by the European countries. They managed the
economies and finances of these countries in their own interests and in their own ways.
Other than the native elites who had to get involved, the Muslim masses stayed away
from interest-based financial institutions. As the national consciousness grew and
freedom movements promised to bear fruits during the second half of the last century,
the urge to manage their affairs in accordance with their own values and traditions
also emerged in these countries. Indonesia gained independence in 1945 and Algeria in
1963. In between these two dates, all Muslim majority countries became independent. 12/30/2008
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The discussion on the management of their respective economies in order to promote

their own interests had, as an offshoot, brought the Islamic financial movement into
being. While nationalism made them focus on rapid economic development, religion,
the other motivating force in freedom struggle, made many turn to Islam for guidance.

Theoretical Literature

Early theoretical work on the subject appeared during 1940s through 1960s, in Urdu,
Arabic and English. The focus was not banking and finance in the narrow sense but the
economic system as a whole. The writer would, generally speaking, criticize capitalism
and socialism and proceed to outline a system based on Islamic injunctions relating to
moderation in consumption, helping the poor, encouragement of economic enterprise,
avoidance of waste, justice and fairness, etc. The poor tax, zakat, and prohibition of
interest would be emphasized in this context. It would be argued that Muslims should
not adopt the conventional system of money, banking and finance blindly. They must
purge it of prohibited interest and modify it to suit the just and poor-friendly economic
system of Islam. Some of these writers went beyond generalities and suggested that the
early Islamic contracts provided sound bases for restructuring banking so that it was
free of interest and served the goals of Islam. The youngest of Islamic countries,
Pakistan, made the commitment to abolish Riba a part of its constitution.

Professional Muslim economists as well as Shariah scholars made significant

contributions to the subject so that by the end of 1960s some kind of a blueprint of
Islamic banking was available. Bankers and businessmen had also joined the task of
evolving a workable model since efforts were on in several Muslim countries to put the
idea into practice. The political conditions in Arab countries were not favorable for any
initiative at the state level. But private practical initiatives had a greater chance of
mobilizing the monies needed for such a venture in these countries, as we shall see
when tracing the history of the practice of Islamic banking.

The earliest theoretical model was based on two-tier mudaraba, profit sharing
replacing interest in bank-depositor as well as bank-borrower relationship. Islamic
banks would be financial intermediaries, like conventional commercial banks, only
they would purge interest from all their operations, relying on partnership and profit-
sharing instead. They could operate demand deposits like their conventional
counterparts and offer other services against fees, like other banks. Banks directly
doing business and entering the real estate market in order to make profits for their
depositors and shareholders (partners) was not a part of this model.

But practitioners in the Arab world did not see much scope in this model. Accepting 12/30/2008
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deposits into investment accounts on profit-sharing basis was all right, but their
profitable employment needed direct involvement in business. Merchant banking was
also nearer to the milieu with which Shariah scholars were familiar. They felt more at
home with a model in which savings were mobilized on profit sharing basis but their
profitable use was based on familiar Islamic contracts of sale and purchase and
leasing, etc.


i.e, cost plus or mark up financing entered into the model of Islamic banking in the
second half of the nineteen-seventies. By this time practice had revealed the difficulties
of applying the mudaraba (profit-sharing) contract in dealing with businessmen in a
legal environment that failed to provide any protection to the financier in this case,
unlike the protection it 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.
Shariah scholars, many of them formally advising Islamic financial institutions, made
significant contributions in developing the model.

One of the specific needs to meet was financing house purchase on terms acceptable
Islamically. 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
possessing it in full as he/she purchased the government owned part bit by bit. The
second was a cooperative in which members pooled resources and got funded in turn,
the pooled resources being profitably invested while waiting. The third method is based
on murabaha, the customer paying the higher deferred price in installments.

In practice small variation were introduced to ensure Shariah compatibility as well as

financial viability.

During 1980s the subject of Islamic banking and finance received broad based
academic and professional attention. A number of Muslim countries began considering
implementation of the idea officially and appointed expert bodies to work out the
details. Several universities started teaching the subject and encouraged research
resulting into hundreds of PhD dissertations, some of them in the universities in Europe
and America. Numerous seminars and conferences drew attention to the subject in
places as wide apart as Kuala Lumpur, Dhaka, Islamabad, Bahrain, Jeddah, Cairo,
Khartoum, Sokoto (Nigeria), Tunis, Geneva, London and New York. A number of
research centers made Islamic economics their field, paying special attention to money 12/30/2008
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and banking. Some of these launched academic journals providing forums for exchange
of views and dissemination of information on a world-wide 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). The special
techniques for launching Shariah compatible mutual funds were also developed in this
period. This involved selecting companies whose shares could be traded as they did not
violate any Shariah norms. This selection was made by screening out the undesirables.
The first norm was that the products in which the company dealt should not be
prohibited ones like alcohol or pork. The other was that its finances should be free of
interest bearing loans and its revenue free of interest income. Since the condition about
debt finance would eliminate almost all shares traded on the stock exchange, some
scholars allowed a leverage of 30% or less. There could be other criteria also but these
two are the main, 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 Shariah scholars, owes
itself to the initiative of professional players in the field.

As the launching of the Dow Jones Islamic Indexes evidenced, Islamic finance too
needed the modern tools designed to handle the complex web of financial transactions.
The Indexes track Shariah compliant stocks from around the world.

Advantages of Islamic Banking and Finance

Before we turn to Islamic banking in practice, let us note some of its features
emphasized in the literature.

Justice and fairness to all concerned was the main feature of a model of financial
intermediation whose core was profit sharing. Interest was 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 would contribute
to a more equitable distribution of income and wealth.

Islamic finance will foster greater stability as it synchronizes payment obligations of

the entrepreneur with his or her revenues. This is possible only when the obligation to
pay back the funds acquired from the financier and pay a profit is related to realization
of profits in the project in which the funds are invested, as it is in the profit-sharing 12/30/2008
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model. Contrary to this, in the debt-financing model the payment obligations of the
entrepreneur are dated as well as fixed in amount. The same is the case with the
financial intermediaries, their commitment to the depositors in time and saving
accounts is to pay back the sum deposited with interest added. When a project fails and
businessman defaults, the financial intermediary must also default with ripple effects
destabilizing the whole system. The debt based financial system of capitalism is
inherently prone to recurrent crises. This malaise of the capitalist financial system is
well discussed by Hyman P. Minskey in his book, Stabilizing an Unstable Economy
(New Haven and London, Yale University Press, 1986.)

The linking of depositors’ entitlements to the actual profitability of the projects in

which their monies are invested through the services of the financial intermediary, the
bank, would almost eliminate the risk of runs on the bank insofar as the investment
accounts are concerned. A report or rumor that the bank investments are not doing
well will not prompt a rush of withdrawals from investment accounts as depositors
could get only what is actually salvageable. Waiting till the situation improves would
be a more rational option.

Islamic finance is more efficient as it allocates investable fund on the basis of expected
value productivity of projects rather than on the criterion of creditworthiness of those
who own the projects, as is the case in debt based finance. There is no guaranty that the
most promising projects seeking finance will come from the most wealthy. As
Schumpeter has shown the most innovative may be empty handed. But debt finance
would not serve these. It would prefer those who, on the basis of other assets owned by
them, would be able to pay back the sum borrowed, interest added, even when the
project being financed failed to create additional wealth.

Last but not the least, Islamic finance will be less prone to inflation and less vulnerable
to gambling-like speculation, both of these being currently 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-like speculation than the conventional debt based
arrangements. Murabaha is firmly linked with 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 production or exchange of real goods and services. An
Islamic system of finance in which profit-sharing and mark up financing both exist side 12/30/2008
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by side would still retain the advantages noted above.

Islamic Banking Practice: Early Initiatives

A number of interest free saving and loan societies are reported to have been
established in the Indian subcontinent during 1940s. But efforts to arrange finance for
business enterprises seem to have started later. One pioneering but short lived
experiment was that in Mit Ghamr in the Nile valley in Egypt in 1963. Same year saw
the establishment of Tabung Haji in Malaysia. Money being saved for meeting the cost
of the pilgrimage to Makkah is profitably invested by this organization which is still

The Phillipine Amanah Bank was also established during the same period to enable
Muslims to meet some of their financial needs without involving interest. An interest
free bank in Karachi, Pakistan was established by some individuals around the same
time but it did not survive for long.

Islamic Banking Practice In The Private Corporate Sector

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, which
were guaranteed, as well as into investment accounts which were to receive a share in
the profit accruing due to their use in business by the bank. Within the next ten years,
i.e. by 1985, 27 more banks were established in the same manner in the Gulf countries,
Egypt, Sudan, etc. Many more were to follow all over the Muslim world. Also by 1985,
over 50 conventional banks, some of them located at money centers like London, were
offering Islamic financial products. This was followed by up by some of the major
conventional banks establishing Islamic branches dealing exclusively in Islamic
products. Citi-Islamic in Bahrain and Grindlays in Karachi were followed by the
National Commercial Bank in Saudi Arabia establishing over 50 Islamic branches by

Islamic investment companies and Islamic insurance companies also appeared in the
late 1970s and grew in number. Later, in 1990s, a number of Islamic mutual funds
appeared, many of them being managed by reputed western firms.

By the year 2000, there were 200 Islamic financial institutions with over US$ 8 billions
in capital, over $100 billions in deposits, managing assets worth more than $ 160
billions. About 40% of these are in the Persian Gulf and the Middle East, another 40% in
south and Southeast Asia, the remaining equally divided between Africa on the one
hand and Europe and the Americas on the other hand. Two thirds of these institutions 12/30/2008
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are very small, with assets less than 100 million US dollars.

Two Islamic banks operated in Europe for some years. Islamic Bank of Denmark was
converted into an investment company and Al Barakah London had to stop deposit
taking. As the Bank of England explained, a deposit taking institution had to guarantee
its repayment in full in order to qualify for a banking license. As of now, western
societies are served either by Islamic mutual funds or by grass roots initiatives at the
community level financing the purchase of houses and other consumer durables.

Islamic Banking at the State Level

Pakistan ‘Islamized’ banking between 1979 and 1985 through a series of Ordinances
issued by the Federal government and a number of circulars issued by the State Bank of
Pakistan, the country’s central bank. Even though profit sharing replaced interest as
the basis of time deposits and saving accounts, the actual rates paid are not market
determined as all major banks were nationalized during the 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 is minimal.
Government finances remain conventional, burdened with huge interest based foreign
and domestic debts.

Private initiative played little role in the Islamization process and the market hardly
got a chance to throw up Shariah compatible financial instruments. The whole 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 was not heeded.

Iran passed its usury free banking laws in 1983. All banks are nationalized. In
accordance with the school of Islamic law followed in Iran, depositors may get
‘rewards’ on their savings provided they are not committed in advance. Financing of
domestic and external trade is done on mark up basis. But sharing modes do play a
significant role in financing agriculture and industry. Interest free loans are available
for the poor to meet such needs as housing, their source being the state.

Sudan launched Islamic banking in 1984 whose coverage was later extended to the
entire financial sector in 1989. Sharing based modes of finance are used in agriculture
and industry and the government is considering sharing based investment certificates
to be sold to public, the funds so mobilized to be used in developmental projects. The
poor state of the economy stands in the way of the market playing any significant role
in the process. But the recent phenomenon of oil as an increasing source of public
revenue is likely to make a difference. 12/30/2008
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Malaysia had its first officially sponsored Islamic bank in 1983. All other banks also
offer Islamic financial products. Overall supervision vests in the country’s central
bank, Bank Negara Malaysia, which has a board of Shariah scholars to advise it.
Malaysian Islamic financial system allows sale of debt instruments based on
receivables from sale of real goods and services and those based on leasing. The
government issues bonds (Malaysian Government Investment Certificates, 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 1994 under state patronage, has about 400
branches all over the country. Its financial operations follow the Malaysian model.
There are other smaller Islamic banks too, e.g. the Shariah Bank.

Turkey does not practice Islamic banking at the state level, but several Islamic banks
were launched under special licenses in late eighties-early nineties. They are still
functioning, along with other non-bank Islamic financial institutions.

The Islamic Development Bank

The Organization of Islamic Conference (OIC) took several steps culminating in the
establishment of a bank of Islamic countries which would serve the entire Muslim
ummah (community of the faithful). Share capital, initially fixed at US dollars two
billion was supplied by member countries the largest coming from Saudi Arabia,
Kuwait, Libya, United Arab Emirates and Iran. It started operations in 1975 with head
quarters at Jeddah, Saudi Arabia. Clause one of its charter states that it was “to foster
economic development and social progress of member countries and Muslim
communities individually as well as jointly in accordance with the principles of
shariah.” In compliance, the IDB does not deal with interest.

By the year 2000 the Islamic Development Bank (IDB) had financed inter-Islamic trade
to the tune of over 8 billion US dollars mostly using the mark up technique. It also gives
loans, taking only service charges according to actual administrative expenditures. But
it does try to promote sharing based modes of financing. It is also managing an
investment portfolio in which individual Islamic banks place their surplus liquidity.
Even though it cannot, and does not aspire to, serve as a lender of last resort for all
Islamic banks, it is trying 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. The Islamic Chamber of Commerce and the
Islamic Foundation for Science, Technology and Development are two of these. It is also
distributing scholarships for higher learning and technical education to Muslim 12/30/2008
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students in countries in which Muslims are in a minority.

In order to fulfill its mission, the IDB has established the Islamic Research and Training
Institute (IRTI). It conducts in house research, sponsors external research, publishes a
research journal, conducts training courses, organizes seminars and conferences and
maintains a database on Islamic countries’ economies, etc.

The Islamic Development Bank interacts with all regional and international financial
institutions like the International Monetary Fund (IMF), the World Bank, the Asian
Development Bank, etc.

Islamic Banking and Finance as Part of the International Community

The IMF issued its first study on Islamic banking in 1987. Since then more than a dozen
research papers have come from that forum on important aspects of Islamic finance.
IMF has reported no problems in dealing with member countries committed to Islamic
banking. On the other hand Islamic financial institutions too never faced any problems
dealing with regional and international financial institutions. The Accounting and
Auditing Organization for Islamic Financial Institutions (AAOIFI) is in contact with the
standards committee of the Bank of International Settlements based at Basel,

All Islamic financial institutions operate within the system supervised by their
respective central banks and other relevant authorities. They are neither working in
isolation nor engaged in creating a separate space of their own. They are inspired by a
vision of financial arrangements more conducive to justice and development for all,
especially the poor and the weak. This is a goal hopefully cherished by all.

Problems and Prospects of Islamic Banking and Finance

During the last few decades of the twentieth century, the period in which Islamic
banking and financial institutions were evolving, great changes were taking place in
the financial environment. In this lecture I will examine the problems and prospects of
Islamic banking in the perspective of these changes. Two changes are most significant,
decline in intermediation and resort to more active, rather aggressive management of
investment, and world-wide integration of financial markets in the wake of

The first trend, symbolized by the repeal of Glass-Steagal in the United States, should
be advantageous to Islamic finance insofar as financial intermediation was based on
interest. Greater involvement of banks/financial institutions in investment 12/30/2008
Finance In Islam Page 16 of 22

management afforded wider scope for using the Islamic financial techniques of profit-
sharing, mark up financing, etc.

The problem is, investment management in modern conditions boils down to risk
management which is very underdeveloped in Islamic financial theory and practice.
Add to this the fact that, in Islamic perception, this is one of the areas of conventional
finance in need of drastic reforms. This need was recently underlined by the story of
Long Term Capital Management (LTCM ), (told by Roger Lowenstein in his book, When
Genius Failed, Random House, 2000 ). So we face a double challenge, to develop
Islamic techniques of risk management and to see that these new techniques are free
from the ills with which conventional methods are suffering. This is different from the
challenge faced in the middle of twentieth century, to develop a method of financial
intermediation free of interest.

Risk Management in an Islamic Framework

The task is stupendous. Mastery of risk may be regarded as the unique feature
distinguishing the modern times. Some one has rightly remarked that elimination of
risk has stolen the center stage from the elimination of scarcity as a major

Risk was always there, especially in business. But industrialization brought risks
unknown in trade and agriculture. Industrial production often involves long periods of
time .The longer the period of production the more the uncertainty. The scope of the
market has expanded to cover the whole world, introducing new kinds of risk. More
than a thousand years ago, when Islamic laws were being written, the nature and
scope of risk and uncertainty was different. However, something can still be learnt
which, in combination with the modern experience, should enable us to realize the
Shariah 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 sale of fish still in the pond. In
both cases the reason is the uncertainty surrounding the quality and/or the quantity of
the commodity being sold. Also, note that it was possible to remove the uncertainty
involved to ensure fair dealing without killing the deal itself or causing unbearable

The Prophet is reported to have permitted the sale of fruits still on the trees and yet to
ripe, despite the uncertainty as to quantity and/or quality present. It was not possible
to wait till the fruits were fully ripe and were plucked and weighed or counted. That
would leave no time for marketing. 12/30/2008
Finance In Islam Page 17 of 22

The Prophet is reported to have prohibited the sale of a non- existent commodity. But he
did allow salam, sale of an agricultural produce months ahead of the crop, provided the
price was paid in advance at the time of contract. This was found to be advantageous to
the farmer as well as the grain trader, hence the uncertainty present was tolerated for
a purpose.

The message seems to be clear. Transactions need be based on complete information, as

far as possible, in order to ensure neither party is under any illusion. But, given mutual
consent, some uncertainty can be tolerated in order to secure larger advantages.

As to be expected, the juristic discussion of gharar (hazard, uncertainty) or

transactions in absence of complete information is full of controversies. Some would
care more for fairness and, hence, try to discourage transactions in situations of
incomplete information. Others would give more importance to allow people enter
deals they perceive to be mutually advantageous. I do not propose to enter into the
details in the limited time available. I would rather draw attention to what exactly is
involved in terms of human needs and interests in situations in which contracts must
cover the future in order for life to go on efficiently.

Risk, Speculation and Gambling

It is important, at this stage, to distinguish gambling, which must be avoided, and

other kinds of risk taking. In the words of Irving Fisher, a gambler seeks and makes
risk which it is not necessary to assume. All games of chance are of this nature. But life
is full of risky situations which cannot be avoided. Business specially involves risk
because production of wealth as well as some other transactions involve the future, and
it is not possible to have full and certain information regarding the future. People
arrive at ways to face these uncertainties that are mutually advantageous. We try to
understand this through some examples.

A farmer sells future contracts of grain in order to protect himself from a fall in price,
whereas a food processor buys future grain contracts in order to protect himself from a
rise in prices. Both benefit. Even though each one is taking some risk, total risk is now
less and both can go ahead 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 possible fluctuations in oil prices would make future planning
in both industries almost impossible.

Since direct deals between farmers and food processors or oil companies and airlines
would be cumbersome and costly, it is efficient to have middlemen/intermediaries. 12/30/2008
Finance In Islam Page 18 of 22

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. They do not, like
gamblers, create or invite the risks they are dealing with. These are business risks
which had to fall some where. Speculators take these risks, pool them, repackage them
into parcels 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 decisive impact on spot markets, making them more stable.

Current research in these matters, and on the subject of risk management in Islamic
framework in general, is inconclusive. The position is the same when we consider the
currency markets. Contractors need different currencies at different points of time in
order to fulfill production plans extending far into future and involving inputs from
several currency areas. To make a commitment to do a job like delivering an aircraft or
a shopping complex or an airport at a price denominated in a single currency at the
time of the contract, the firm doing the project has to ensure that requisite amounts of
other currencies are available at the proper time to buy the inputs needed. This
involves buying foreign currencies in advance, something not permitted in Islamic law
as interpreted at the present. Some scholars do, however, find a way through binding
promises doing the job of actual contracts.

Current methods of dealing with uncertainties in the financial markets involve dealing
in derivatives. These are innovations with little by way of precedents in the past. Some
Islamic scholars find the old practice of urboon, i.e. depositing a small fraction of price
in a deal to be concluded in the future, capable of justifying some kind of options which
are the simplest kind of derivatives. This could be the first step towards a broad range
of derivatives, some of them based on futures.

Financial Markets

It is time to wind up this discussion of financial markets in Islamic framework with a

synoptic view of the situation. If we classify financial transactions into:

Money for money

Money for equity

Money for debt

Debt for equity 12/30/2008
Finance In Islam Page 19 of 22

Debt for debt

Equity for equity

Prohibition of interest seems to affect all the three markets into which debt figures,
insofar as debt can be traded only at par. Money for equity poses no problems. Nor
does the swapping of equity for equity. I have already noted the problem relating to the
currency market. The overall conclusion is that financial markets under Islam will be
smaller as compared to their size in 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 proportions with the real economy has undesirable consequences for
the distribution of income and wealth. It also makes it amenable to gambling like

But a too restrictive approach on part of Islamic scholars in the name of minimizing
gharar (hazard, uncertainty) and blocking the road to riba (sadd zariah) runs the
greater risk of stifling genuine economic activity by reducing the amount of liquidity
available on the one hand and increasing the total amount of risk on the other hand.
The overall result could be Muslim societies run in accordance with these restrictive
interpretations of Shariah lagging behind in economic progress and losing out to
others, eventually, politically and culturally also. Instead of being the heralders of a
more just, more stable and more efficient financial regime they would then serve only
as a warning against a religious and moral approach to money, banking and finance.
That would be a disaster that needs not be. It is hoped the new generation of Islamic
economists will rise to the challenge posed by this situation.

Globalization of Financial Markets

This is the second change I mentioned in the beginning. Financial markets the world
over are integrated as never before. Money moves across national boundaries without
cost and instantaneously. The few remaining exceptions are on the way out. In
principle this change should be favorable to Islam which never cared much for national
boundaries. In practice however it does pose problems for Islamic financial movement,
for two different reasons. Firstly the home base of this new trend is the Middle East and
South and South East Asia where the economies are small and financial system less
sophisticated than in the developed countries. Secondly, Islamic financial institutions
themselves suffer from smallness in size and very few of them operate in more than one
country as the major players in the field do. The situation has changed with the entry of 12/30/2008
Finance In Islam Page 20 of 22

some major conventional financial institutions into the field. But that has made it
harder 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. The redress can only come through international agreements curbing
speculation and regulating the financial markets. The insights of the Islamic financial
movement relating to sharing modes of finance, commodity-linked financing like
murabaha, and reducing the role of debt have great potential in this regard.

Prospects at the State Level

There is a lull in the state sponsored Islamic finance. Pakistan, which took the lead, is
in a flux. With the economy skidding and 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 out of a period of being ostracized by
western countries, sends no signals of being in a better situation. Malaysia was
expected to do better after its emergence from the crisis that visited South East Asia in
1997-98, but the world wide recession looming on the horizon at this moment
(November 2001) makes the prospects uncertain. Little is known about Iran, but at
least there is no setback and no weakening of the political will. In short, no new
initiatives are expected in state sponsored Islamic banking and finance in view of the
difficult economic situations and political uncertainties in the countries pioneering the

Prospects in the Private Corporate Sector

Meanwhile progress has been made 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 to standardize Islamic financial products continue. The standards developed by

the Accounting and Auditing 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 felt as the present lack of uniformity is baffling. There
are moves to coordinate the activities of the various Shariah advisory boards of Islamic
financial institutions as the way they function remains a source of confusion. 12/30/2008
Finance In Islam Page 21 of 22

There is a big information deficit in the Islamic financial industry hampering its
further growth and development. The absence of rating agencies, specially agencies
that would rate products as well as institutions on the ground of their Shariah
compliance, is the biggest example of this deficit.

Despite odds, the industry continues to grow, especially in the Gulf countries. It has
also reached the newly independent Central Asian Islamic Republics and the Balkans.
But the weak economic conditions in those countries are naturally reflected in the state
of their nascent Islamic financial institutions.

Prospects at the Grass Roots and the Community Level

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 in size. They serve their respective
communities in interest free house finance and installment purchase of consumer
durables, as well as in investing their savings on the basis of profit sharing. The
possibilities of expansion are great.

Research and Development

All innovations need a base in research and development, which in turn draw on
fundamental research in universities and laboratories. Islamic finance became a
subject of research in universities in 1980s. The subject is discussed every year at high
profile conferences in Bahrain, Harvard, and other places. Yet the resources devoted
and the facilities available hardly match the challenges facing the industry.

As the Bank of International Settlements has noted, innovations in three directions are
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 hence to move towards greater securitization of assets, is
already recognized as evidenced by the developments in Malaysia. The bottleneck at
the present seems to be risk management.

Another important area awaiting innovative initiatives is a vision that encompasses

Zakat (obligatory charity) Waqf (charitable endowments) and Islamic financial
management. Securitazation can help mobilize the huge wealth locked into awqaf
properties which in their turn can be developed by investment of zakat funds awaiting
distribution. At the present only a small fraction of the liquidity generated by zakat 12/30/2008
Finance In Islam Page 22 of 22

passes through Islamic financial institutions, a situation reflecting the distance

between the poor, non-banking population and these institutions.

The goal of progress with justice and equity inspires the entire humanity and there is
no reason the potential of Islamic financial institutions contributing towards the
realization of this goal remain unexploited. In the age of globalization no system that
serves only the interests of a particular country or group of countries can evoke
universal acceptability. Protection of small countries from speculators chasing
instantaneous profits, reduction of the role of debt in international finance and
financing projects helpful in reducing poverty and inequality deserve every ones

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