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Islamic Banking and Finance: Concept and Reality

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 Islamic Banking and Finance:
Concept and Reality
By
Ruslan Sabirzyanov* and MohamadHaidirHashim*

Abstract
The aim and focus of the foundations and principles of the modern Islamic
finance is to revive the justice and equity in the society, and that formulates
the core objective of the Islamic system. However, in the current situation,
Islamic banking and finance (IBF) is apparently mixing up the concept of
social welfare and the conventional ideology of wealth maximisation
altogether due to the unavoidable need to compete with the conventional
financial system and the force of convergence between those two. There are
many Islamic finance scholars who now argue that ‘banks are not for poor’,
which clearly shows that the need for the new institution is necessary.
Therefore, establishment of new institutions and reformation and
improvement of present ones will bring complete and solid Islamic financial
system, which then will contribute to enhancement of the distributive and
social justice in the society, which will be one step closer to the completion of
the true Islamic economic system. This paper studies the emergence of IBF,
its relationship with maqasid al-Shari’ah, meaning, proper comprehension
and appropriate application of Shari’ah objectives, as well as challenges
facing in realising these divine objectives. The paper analyses current
practices of IBF showing examples of social failure and deviations of IBF
from the concept of maqasid al-Shari’ah and provides some practical
solutions, implementation of which should bring IBF back on its course to
achieve maqasid al-Shari’ah.
Keywords:IBF; Islamic Finance; Islamic Economics;Maqasid al-Shari’ah;
Social Failure; Maslahah

1. Introduction
Islamic Banking Finance or commonly abbreviated as IBF, is a movement that has
become an industry over time, a banking solution designed to help Muslims around the

*
MSc in Islamic Banking and Finance, IIUM Institute of Islamic Banking and Finance
(IIiBF), International Islamic University Malaysia (IIUM)
*
Master of Economics, Kulliyyah of Economics and Management Sciences (KENMS),
International Islamic University Malaysia (IIUM)

88 Journal of Islamic Banking and Finance July– Sept. 2015

world for their daily financial transactions and to prevent the consumption of riba
(interest) in their life. Despite complex problems in different financial markets and the
global uncertainties it has grown substantially, it has emerged in the markets of Muslim-
majority as well as Muslim-minority countries.
Compliance with the principles of Shari’ah is a distinguishing feature of IBF that
sets it apart from its conventional counterpart. It comprises of not only the ways and the
details of financial transactions, but primarily, the values, which drive IBF
operations(Dusuki & Abozaid, 2007). These principles and values have extensive roles in
realising maqasid al-Shari’ah (objectives of Shari’ah). Fundamentally, objectives of
Shari’ah disclose the holistic view of Islam, as Islam is a complete and integrated pattern
of life incorporating everything personal and public in this world and the Hereafter.
Therefore, objectives of Shari’ah intend that each person and organisation realise justice,
brotherhood and social welfare. Hence, the realisation of society, in which everyone
collaborates with each other, and even competes constructively to achieve the ultimate
success (falah), is sought.
Consequently, ordinary maximisation of profits and increase of wealth cannot be
the only driving goal of a Muslim society. Maximisation of profits and increase of wealth
should go along with efforts to ensure consciousness and spiritual health, fair play and
justice at all levels of individual interaction. Thus, IBF in particular and Islamic
economics in general are assumed to be based on the maslahah prescribed by maqasid al-
Shari‘ah. Only aforementioned development would be in accordance and harmony with
the maqasid al-Shari’ah (Siddiqi, 2006).
Unfortunately, the movement that was initiated by all good intentions, has over
time diverted from its true purpose due to the competitive pressure from conventional
financial institutions. For that reason, the narrow view of recognising the ‘Shari’ah
compliance’ by only focusing on the legal forms of contracts should change. Moreover,
in order to fulfil the aspirations, which are stated by maqasid al-Shari‘ah, other financial
and even non-financial institutions should be introduced.
The remaining of this paper is organized as follows: the second part provides an
overview of emergence of IBF and its underlying ideas and principles. The third part
deliberates objectives of IBF in line with maqasid al-Shari’ah, theory and practice. The
fourth part provides evidences of IBF becoming quasi-Islamic. This is followed by
practical recommendations, which can help IBF institutions to fulfil all their objectives. A
brief conclusion is offered in the final section.
2. Emergence of IBF
Islamic economics rose together with Islamic renaissance during 60-70s of the XX
century, and many efforts have been put forward to study, elaborate and further develop
Islamic economics, unfortunately Muslims don’t have significant political power and will
to implement their values. Making changes to a system or implementing a totally
different system without a doubt requires significant political and economic powers. That
said, since of recent centuries, Muslims were and are out of significant powers or controls
over the world, Islamic economics remains as an ideal and unreachable utopia, which
exists only in the researches, books and articles of scholars and economists and the minds
of many Muslims.
It is understandable that IBF even though having all aspirations of Islamic
economics, had to be developed not within the ‘ideal’ Islamic framework but rather
within the conventional or neo-classical framework. However, the first group Islamic

Journal of Islamic Banking and Finance July– Sept. 2015 89

banks were founded in 60-70s with the objectives of economic development of human
well-being and social justice. After that, during the 80s, IBF with the significant help of
petro-dollar became internationally known, then, during the 90s it witnessed rapid growth
in terms of number of institutions and their assets bases. Later, more and more new types
of ‘Shari’ah compliant’ transactions were invented.
Nonetheless, during all these periods, since IBF had to operate within the neo-
classical economic system, IBF had to develop its working framework to suit the present
economic system. It is obvious that Islamic financial institutions (IFIs) have chosen the
way of conventional banking and finance institutions operation with some addition of
Islamic activities. In other words, the main goal of IBF has become more profit-oriented
and inclined towards increasing the wealth and this has been evidently shown by the fact
that the debt-based financing overtook and dominated over equity based and profit-and-
loss (PLS) sharing financing. Consequently, the social responsibility part has reduced to
merely zakah and sadaqah-like activities. In principle, Islamic economics prioritise and
promotes equity or PLS sharing financing over debt financing. Thus, having IFIs
preferring debt financing indicates that IFIs has moved away from the aspirations of
Islamic economics (Asutay, 2007). Performance-wise, currently, the true objectives of
IBF that are set by Islamic economics could not be implemented to the full extent. It is
worthy to mention that the objectives of IBF are very much different from its
conventional counterparts. In the next section we are going to further elaborate the
objectives of IBF.

3. Objectives of IBF
As Islamic economics uses Qur’an and Sunnah as a primary sources from which
the rules and values are derived, likewise the objectives or goals of IBF in principle are
based on the same sources by using the approach of objectives of Shari’ah and maslahah.
To better understand objectives of IBF we need to understand the meanings of maqasid
al-Shari’ah and maslahah. Indeed, these two categories are very close to each other,
however there are differences between them.
Maqasid al-Shari’ah is an Arabic term, which means aims and objectives of the
Shari’ah, its rationale. “Maqasid al-Shari’ah is the goals and objectives of Islam as a
system of life that constitutes standards and criteria, values and guidance based on divine
revelation (wahy) to be applied in practical life to solve human problems and guide the
direction of human life”(Laldin & Furqani, 2013).In other words, it is the reasons upon
which the Shari’ah is established. Maqasid al-Shari’ah targets the realization of benefits,
advantage, welfare, etc., and avoiding off vice, loss, injury, etc., for all beings in every
aspect and segment of life. Therefore, this can be stated in Arabic as maslahah. It is clear
that all Shari’ah rulings come with purpose to benefit the creatures and protect them
anytime and anywhere, therefore, “maqasid al-Shari’ah allows flexibility, dynamism and
creativity in social policy” (Dusuki & Abozaid, 2007). Shari’ah recognises three areas,
which constitute wellbeing, namely, educating individual (tahdhib al-fard), establishing
justice (iqamah al-‘adl) and endorsing benefits (maslahah) to people (Vejzagic & Smolo,
2011).
It is worthy to mention that maqasid and maslahah principles must not and cannot
contradict Shari’ah texts, because Qur’an and Sunnah are the core from which other
principles and rules are derived. Unfortunately, in current situation there are some
misconceptions when priority over Shari’ah texts is given to maslahah, which at the

90 Journal of Islamic Banking and Finance July– Sept. 2015

same time is derived not from Shari’ah texts, rather it has been taken from the practical
approach and reasoning only. In this scenario, it is clear that the interpretation of
maslahah and maqasid has been somewhat abused to justify the actions and norms by
some IFIs that are currently and continuously happening.
Therefore, we need to shed light on objectives of IBF through the maqasid
approach. In short, “the general objectives of IBF are to promote virtues and avoid vices”
(Mohammed, 2009). In addition, they are multidimensional, which appear in addressing
both material and, most importantly, spiritual needs of human being. Thus, they have
effects on the conducts of man in the Hereafter. Since the list of virtues and vices is
almost infinite, we would like to emphasise on the main and the most important
objectives of IBF. Namely, IFIs as a good corporate citizen shall:
• contribute in various educational and training programs that develop not
only knowledge and skills, but more importantly proper moral values;
• support educational institutions along with scholars and students;
• provide scholarships, research grants, finance da’wa activities, Qur’an
memorisation programs, educational conferences and workshops, and
publications;
• ensure fairness in contract terms and conditions, pricing of products and
services, and in all their business activities;
• ensure that all their business ventures are free from negative elements that
may create injustices, such as riba, fraud, corruption, etc.;
• use funds wisely and direct them to those vital areas that can help reduce
income and wealth inequalities, for example, investments in real sectors
that have large spheres of public goods;
• promote welfare, which includes not only profitability, proper risk
management and efficiency, but public interest as well;
• ensure that their policies and programs on public interest have taken into
consideration the preservation of the five aforementioned essential
elements.
Thereby, it is clear those IFIs, which pursue these objectives, are ‘really’ Islamic,
while others, who do not pursue them are quasi-Islamic.
Moreover, IBF development and structure must go in line with dimensions of
maqasidic approach, which are as follows.
• The Shari’ah compliance should not mean only fulfilment of minimum
requirements of Islamic jurisprudence (fiqh) but it should encompass system
of Islamic values and goals that are to be embedded into the structure of
Islamic finance. “The Islamic in Islamic finance should relate to the social
and economic ends of financial transactions, rather than the contract
mechanics through which financial ends are achieved” (El-Gamal, 2006).
• The global Islamic vision should set a course in the development of a
healthy comprehensive IBF system, which includes goals and policies.

Journal of Islamic Banking and Finance July– Sept. 2015 91

 • In order to set the right direction for the development of Islamic finance
and regulate its operational framework the process of ijtihad (deriving and
setting new rules in Islamic jurisprudence) should start with
comprehension of maqasid and their further implementation in the
structuring of financial contracts(Laldin & Furqani, 2013).
The question boils down to whether ‘IFIs follow all these aforementioned
objectives and perspectives in their day-to-day transactions, in their products and services
development etc.?’ With this in background, the next section discusses the real state of
being of IBF by assessing the performance of IFIs.

4. Performance of IBF Institutions

In the previous parts of this paper, it is stated that contribution to the development
of the society through ethical investment is one of the means using which IBF aims to
fulfil the aspirations of Islamic economics. Nevertheless, critical analysis of performance
of IFIs shows the overwhelming convergence with conventional financial institutions in
terms of products, services and operations at the expense of the objectives of Islamic
economics. IFIs’objectives and outcomes over the years fell along the lines of
neoclassical economics, unfortunately not in line with moral Islamic economic aims.
Islamic economics being the framework and foundation for IBF emphasises on ‘equity’
giving higher priority to economic and social optimality. Notwithstanding the
aforementioned IFIs prioritise ‘efficiency’ over ‘equity’ (Asutay, 2012).
Surprisingly, despite all the hopes placed on IBF as main force of development,
considering that debt financing is short-term oriented and thereby contributing less to
economic development than equity financing, which is generally longer term, preference
of debt financing in present Islamic finance clearly shows that most of IFIs are not
specifically interested in social welfare and economic development (Asutay, 2007).
A critical study on the performance of IFIs shows that there is an increasing
discrepancy between the realities of IFIs and the objectives of Islamic economics. With
the evidences of a growing body of empirical literature showing that the deviation
generally demonstrates itself in ethical and social anticipation related spheres, it is
possible to claim the ‘social failure’ of IFIs particularly and IBF as a whole. It is clear
that IBF became just an ‘industry’, which makes very good money and is growing day by
day, although not according to the aims that Islamic economics have put for IBF initially.
Consequently, in recent years there is a debate that “has been around ‘form vs.
substance’ or ‘Shari’ah compliant finance vs. the Islamic based finance,’ which indeed
brings the entire legitimacy of the current practice of IBF into question”(Asutay, 2012).
What factors of IBF are becoming just a mere ‘industry’ and why the failure of
initial idea of IBF as a part of a ‘movement’, which supposedly was to bring economic
development, social distributive justice.?
4.1. Present Economic and Monetary System and Interest Rate
Benchmark
Although IFIs perform their work using ‘Shari’ah compliant contracts and
products’, they are still inescapably affected by the business cycles of the economy as
well as by the existing economic and monetary system.

92 Journal of Islamic Banking and Finance July– Sept. 2015

 Surprisingly, despite the very first aim of IFIs, elimination of riba, interest,
however, returns into the IFIs operations through different mechanisms. As an evidence,
the table below illustrates a strong correlation between Islamic financing rates and
conventional interest rate in Malaysian market. As can be observed, the saving deposit
rate between both banking systems correlates at 68.93% whilst the figure is at 69.92% for
average financing rate.
Table 1.Comparison between Islamic Financing Rate and Conventional
Interest Rate.

Islamic Banking Institutions: Financing Rate Conventional Banking Institutions: Interest

and Rate of Return to Depositors Rates
Average rates Savings Base Average Average Savings Base Average
during the deposit Financing Financing rates during deposit Financing Financing
period Rate Rate the period Rate Rate
2012 1 0.97 6.62 6.19 2012 1 1.05 6.53 4.87
2 1.09 6.62 6.26 2 1.05 6.53 4.88
3 1.05 6.62 6.12 3 1.05 6.53 4.74
4 0.91 6.62 6.08 4 1.04 6.53 4.88
5 0.99 6.62 5.98 5 1.04 6.53 4.80
6 0.93 6.62 5.94 6 1.04 6.53 4.88
7 0.93 6.62 5.96 7 1.04 6.53 4.71
8 0.94 6.62 5.98 8 1.03 6.53 4.72
9 0.95 6.62 5.98 9 1.03 6.53 4.76
10 0.94 6.62 5.87 10 1.03 6.53 4.76
11 0.93 6.62 5.85 11 1.03 6.53 4.71
12 0.93 6.62 5.90 12 1.03 6.53 4.70
2013 1 0.92 6.62 5.88 2013 1 1.00 6.53 4.69
2 0.91 6.62 5.90 2 1.01 6.53 4.72
3 0.86 6.62 5.81 3 1.01 6.53 4.70
Source: Bank Negara Malaysia (BNM)
Correlations: 1) Saving deposit – 68.93% 2) Average financing rate – 69.92%
To reiterate, because IFIs find themselves in a neo-classical economic framework
and present monetary system they have to compete with conventional banks to stay in the
market, therefore IBF industry unwillingly or willingly still uses interest as a benchmark
to measure the mark-up value or the time value of money in the project evaluation.
Consequently, there is an obvious correlation between returns of IFIs and the changes in
the interest rates. This is evidenced by a number of recent studies such as Chong and Liu
(2009) and Ganand Kwek (2010). The absence of a developed benchmark for IFIs’
operations should be regarded as a serious issue, which then reflects in a concurrence
between conventional and Islamic banking and finance.
What is more, there are some scholars, Meera and Larbani (2004; 2006a; 2006b)
among them, who argue that since the monetary system based on interest, fiat money,

Journal of Islamic Banking and Finance July– Sept. 2015 93

fractional reserve banking and money creation and “default is for sure by the mere design
of the system”(Meera & Larbani, 2006a), the whole system with its parts, including IBF,
contradict the objectives of Shari’ah and, hence, objectives of Islamic economics.
Consequently, Shari’ah compliance of the whole system has been put under a big
question.
4.2. Controversial Products and Focus on Financial Sector
Furthermore, as mentioned above, IBF as an Islamic economics operational tool
suggests the removal of speculation as well as it is considered as embedded financing
towards the real sector of economy. However, in recent years, to meet the complicated
needs of financial sector including corporate vast number of sophisticated new Islamic
financial instruments were introduced to the market by means of Islamic financial
engineering. These new products, such as sukuk, Islamic derivatives and other Islamic
structured products, based on the concepts of organised tawarruq, bai' al-dayn,bai' al-
inah, are created by compromising the value system of IBF. As a result, contribution to
the real sector financing and development became negligibly small. Moreover, as these
new products are merely copies of conventional models, they bring all shortcomings
related to them and put IBF industry under the same dangerous position as conventional
industry, which recently has faced consecutive crises.
In addition, there is a direct correspondence in the performances of Islamic and
conventional financial sectors indicated by a recent study (Asutay & Aksak, 2011). It is
implied by the Islamic economics that IBF should be a moral compass for capitalism, and
should bring more stability to the financial system. Nevertheless, the study shows that the
reality of practice is opposite to the ideal theory.
4.3. Prevailing of Debt Financing over Equity Financing
As stated before, since equity financing is long term by norms, it contributes more
to the development of the economy than debt financing. Nevertheless, IFIs opt for debt
financing because it is short term and, therefore, less risky. Again, this a clear deviation
from Islamic economics, which assumes that IBF should be based on asset-based
financing, i.e. equity financing with the risk and profit and loss sharing products.
However, critical analysis of IFIs performances shows that the dominant mode of
financing is debt financing. Most of the Islamic banks all over the world, if not all, prefer
murabahah instrument financing or other types of debt financing over equity financing
like mudarabah and musharakah which constitutes either nil or insignificantly small
portions of the total financing portfolio of IFIs.
The fact is IFIs are not interested in equity or PLS modes of financing, because
they carry high risk and some other issues in their implementation like agency problem
for example. For that reason, IFIs have chosen to be inconsistent with Islamic economics
principles and values by adopting solutions mirroring that of, conventional like “Islamic
debt financing”, which are much less risky and brings a much higher (fixed) return.
4.4. Shortage in Development Financing, Contribution to the Growth of
the ‘Bubble’
As in Islamic economics, IBF is a development-driving sector, through which
economic and social development are achieved. IBF supposedly should provide financing
to the real sector of the economy especially agriculture and industry, which indeed need

94 Journal of Islamic Banking and Finance July– Sept. 2015

long-term financing in order to develop and prosper. Nonetheless, although IBF has been
present for more than 35 years and undoubtedly contributes to the economic growth, its
contribution to the social and economic development is not as much as it is meant to be.
Economic development is not growth of just pure financial products, rather it is creating
new values, real products, making real outcome. IBF, since it opted for debt financing
and financial products that are based on fractional reserve system over equity financing,
contributed to the growth of not real economy, but to the growth of so called ‘bubble’
which has its sequences.
As deposits and loans are considered in banking system as assets, and thus, loans
‘create’ asset to the banks, which are indeed pure debts and are not backed by any real
asset since through the fractional reserve banking system, multiple credit creation banks
give birth to most money. Most money in the banking system is just accounting figures,
not actual hard money. Despite the fact that this money is created out of thin air, it carries
with it purchasing power. This is the seigniorage of fiat money.
Islamic banks like conventional banks contributes to the money creation process,
which introduces more money supply to the economy that eventually leads to inflation in
the system. Since the price influences the GDP, artificial increase in price would also
increase the GDP, but in actuality the economy does not grow because the amount of the
real production in the economy might still be the same.
4.5. Failure in Social Responsibility
Despite the fact that for conventional financial institutions corporate social
responsibility (CSR) is merely voluntary activity, it however should be included in the
basic activities of IFIs as stated by Islamic economics. Since maqasid approach straight
forward refers to economic and social development as well as environmental concerns,
IBF must be not only Shari’ah compliant, but also CSR compliant.
Nonetheless, as shown by Sairally (2005), Dusuki and Abdullah (2007), Farook
(2007), Abuznaid(2009), Hassan and Harahap (2010) and Dusuki(2011) CSR activities of
IFIs are poor. Most of the time, CSR activities are limited to zakah and sadaqah
distribution as well as some other unsystematic charitable activities.
4.6. Underdeveloped Corporate Governance
Corporate governance (CG) is one of the most important features in the success of
the company in the present day. Nevertheless, recent financial crises show that
inappropriate CG practices were among the reasons. Most businesses endeavour to follow
best practices and have a high level of corporate governance. Nowadays, merely being
profitable is not enough. It is essential for each company, especially corporations,
together with profitability to testify to good corporate citizenship by means of thorough
corporate governance exercise, ethical behaviour and environmental awareness.
However, IBF again just adopts conventional model and has not developed its own
CG model based on the values and principles of Islamic economics. Islamic economics
aims to develop comprehensive CG model based on tawhid and shura approach, which
constitutes under itself the vertical dimension of the Islamic ethical system in which all
are equal in front of God, and all are responsible according to their position and the trust
they are entrusted with. Unfortunately, asAsutay (2012) states that none of the IFIs has
developed an understanding of Islamic CG model. Moreover, the initiatives by IFSB
(Islamic Financial Services Board) and AAOIFI (Accounting and Auditing Organisation
for Islamic Financial Institutions) remain weak and are not commonly accepted.

Journal of Islamic Banking and Finance July– Sept. 2015 95

5. Practical Recommendations
As seen from the previous chapters, IBF has deviated from the aspirations of
Islamic economics and became a mere industry. In other words, IBF fails to represent a
real Islamic model of finance; therefore there is a need to introduce other types of Islamic
financial and non-financial institutions in order to fulfil the aspirations of Islamic
economics and take another step to approach the ideal Islamic economic model.
5.1. IBF Supporting Institutions
First of all, since IFIs are already in existence, it is necessary to improve their
performance by introducing or creating some institutions that will help IFIs to “minimise
the risks associated with anonymity, moral hazard, principal/agent conflict of interest,
and late settlement of financial obligations” (Chapra, 2007). Some of these institutions
are stated below.
• Credit-rating agencies, trade associations and chambers of commerce.
They will rate Islamic banks and other financial institutions as well as
private, all public and private issuers of credit instruments with respect to
their financial strength, creditworthiness and fiduciary risk. Not only that,
these institutions will evaluate Shari’ah compliance of financial
instruments. As a result, information asymmetry should decrease
substantially. The International Islamic Rating Agency (IIRA) is an
example of such institution. Together with IFSB and AAOIFI they should
set standards for adequate disclosure.
• Centralised Shari’ah board, which will standardise Islamic financing
modes to the possible extent. Today each Islamic bank has its own
Shari’ah board and Shari’ah standards tend to differ from country to
country, from region to region, which of course is one of the obstacles in
establishment of solid and harmonic financial system. It is proposed, that
Central Shari’ah Board (CSB) should be set under OIC (Organisation of
the Islamic Conference) or its subsidiary IDB (Islamic Development
Bank). In each country or region, CSB will have its branch. IFIs will be
examined by the members of Shari’ah board in order to be certified as
Shari’ah compliant. Since Shari’ah board will be independent from IFIs
and members will be paid not by IFIs, but by the board, there will be no
ground for issue of “fatwa shopping”. IFIs however will pay some fee to
the CSB in order to sustain its work.
• Another important point is Shari’ah clearance and audit. Obtaining
certificate of Shari’ah compliance is not enough, Shari’ah compliance of
all transactions must be maintained in order to create confidence among
the customers that IFIs’ transactions do not violate Shari’ah. It can be done
by CSB, but there must be another group of auditors, so each group will
focus on their targets and will be independent in order to bring more
confidence to the customers about conformity of performance of IFIs with
Shari’ah. Second option is to give auditing and supervising task to the
independent auditing companies with expertise in IBF.
• Shari’ah courts that would help to solve legal issues like unlawful
procrastination of payment of loan and etc. It should provide guidance and

96 Journal of Islamic Banking and Finance July– Sept. 2015

 assistance to the banks and customers for verdicts when disputes arise
between them. However, application of this facility in Muslim minority
countries is very hard and even impossible in some cases.
• Islamic financial market, which will bring liquidity for Islamic financial
instruments, which then will ensure competitiveness of IFIs with
conventional ones. The establishment of IFSB, Liquidity Management
Centre (LMC) and International Islamic Financial Market (IIFM) will
provide the institutional infrastructure needed for an Islamic financial
market. While IFSB sets international standards “that promote and enhance
the soundness and stability of the Islamic financial services industry by
issuing global prudential standards and guiding principles for the industry”
(definition of IFSB), IIFM will ensure “active and well regulated trading
and capital flows across the full spectrum of Shari'ah compliant and
financial instruments internationally” (vision of IIFM). LMC is meanwhile
needed “for the purpose of facilitating the investment of the surplus funds
of Islamic banks and financial institutions into quality short and medium
term financial instruments structured in accordance with the Shari’ah
principles” (definition of LMC).
These “should help the Islamic financial system to expand at a faster rate in the
future and create for itself a larger niche in the financial markets of Muslim countries”
(Chapra, 2007).
5.2. Islamic Social Banks
Nonetheless, there are proponents of other ideas, such as Islamic social banks.
According to Asutay (2007) the second best solution for the Islamic banking is to form
new institutions that can help poor and perform the actual duties of Islamic banks, the
example given is MitGhamr bank of Egypt i.e. the first Islamic bank that was formed in
order to provide credit facilities to those people who were cast aside by the financial
institutions of the country i.e. lower and middle level income group. For that purpose, the
formation of new legislation and legal structure along with the new institutions (Islamic
social banks) is proposed. However, these new Islamic social banks should not be
involved in the current Islamic banking practices and should only focus on small scale
credit facilitations and all other large scale projects should be referred to the ‘traditional
Islamic banks’.
The idea of Islamic social banks is put forward so that Islamic banks can do their
actual job in the society and could help alleviating poverty, which is one of the main
objectives of Islamic finance. The concept of depositors is removed from the proposed
Islamic social banks and donations from the rich and the government funding are the way
forward by the banks to run their operations. Otherwise, the concept and involvement of
depositors in Islamic social banks will certainly require returns in the equation for the risk
involved and depositors will expect high returns, which as previously mentioned, not the
objective of the Islamic social bank.
Social banking is a provision to the banking and financial services that if
consequently pursued, as one of the objectives, would positively contribute to the
development of human beings today and in the future. On the other hand, Islamic bank is
supposed to be the social bank in the very first place but as has been argued the legal

Journal of Islamic Banking and Finance July– Sept. 2015 97

frameworks of different countries tend to force the Islamic banks to compete with the
conventional banks at the expense of the social banking function.
Furthermore, if the current Islamic banks fail to be socially responsible, then how
can the new suggested Islamic social banks work as ‘pure social banks’ in long term and
what are the measures required so that they would not end up as Nasser Bank Egypt?
New or old banks have to work under the same legal structure of the banking act or the
Islamic banking act of the country, by which the social banks will either merge with the
current system or will fail and close down. The immediate new thought suggested is by
introducing of new legislations which could be a lengthy process and in conflict with
constitutional laws especially in non-Muslim majority. However, in Muslim countries the
Islamic banking acts and other legal provisions are already in place for both Islamic
banks and the Islamic non-profit organisations alike.
5.3. Islamic Cooperatives
Ahmad (2003) suggests that “a satisfactory and feasible solution may be found
outside the organised corporate sector by combining the principles of cooperative
movement and Islamic banking”, especially in Muslim minority countries. There are
many benefits and advantages of establishing cooperatives:
• isolation and protection from more competitive corporate sector, which
will allow cooperation to easily develop and prosper;
• less capital requirement than corporate sector, hence less regulation, which
allows to easily establish and manage cooperation;
• cooperative institutions are usually offered many incentives, which can
immensely help them, especially on start-up;
• cooperative institutions are resilient with respect to size, which brings
flexibility to the cooperative system;
• decentralisation, in other words each community can have its own
cooperative;
• different cooperative institutions can be established for different purposes,
for instance: interest free cooperative housing societies interest, free
cooperative credit societies, cooperative investment funds and etc.
5.4. Zakat and Waqf Institutions
Another way to improve present Islamic financial system is to reform zakat and
waqf institutions. It is suggested by many authors like Khan (2010), Kahf (2003) that
zakat and waqf institutions can play a major role for being the ‘social banks’ and some
considered waqf as the third sector for the Islamic banking and finance, although all have
put emphasis on improving the efficiency of these institutions. Zakat and waqf
frameworks are already available in the Muslim communities around the world and the
only question is the efficiency and effectiveness of these institutions and these institutions
can be the best social banks if they are managed properly.
The zakat and waqf institutions can be one of the best tools for poverty alleviation
along with micro financing, although micro financing recently has been infected with the
same interest based conventional system that has reduced the efficiency of micro finance

98 Journal of Islamic Banking and Finance July– Sept. 2015

institutions and similar NGOs that give micro credit through which, although arguable,
are responsible for the inflation in the domestic market. Whereas waqf along with zakat
have been indicated in early history providing free education, scholarships, orphanage,
free treatments and inn for the poor and needy.
As mentioned by majority of Islamic scholars around the world that the efficiency
and effectiveness of these institutions is the main problem, but it is less costly both in
monetary and physical labour context, to fix the issues with the waqf and zakat
institutions rather than designing and regulating a new institutions(Dusuki, 2008a;
Elmelki & Ben Arab, 2009; Farook, 2007).
5.5. Community Development Financial Institutions
Taking everything into account, aforementioned proposed institutions can be
established in a different wrapping, namely community development financial institutions
(CDFIs). The Community Development Finance Association defines CDFI as
“sustainable independent financial institution providing capital and support to individuals
or organisations to develop and create wealth in disadvantaged communities or under-
served markets” (Sairally, 2007). There are six basic types of CDFIs, namely:
• community development corporation-based lenders and investors;
• micro-enterprise development loan funds;
• community development venture capital funds;
• community development loan funds;
• community development credit unions;
• community development banks.
CDFI concept has its origins in the history of self-help finance which resulted out
of financial exclusion of some communities by mainstream financial institutions
(Sairally, 2007). This origin of self-help and self-sustainability is similar to Islamic
approach. During Islamic caliphate, entrepreneurs and businessmen who had excess
money were the driving force of the development of the community by providing
financing to the poor and needy (Chapra, 2007). CDFIs however in the present
circumstances are slightly more complicated variance of the original version, thus it is
suggested to further perform precise critical analysis of their performance from Islamic
point of view.

6. Conclusion
The aim and focus of the foundations and principles of the modern Islamic finance
is to revive justice and equity in the society, and that formulates the core objective of the
Islamic system. However, in the current situation, IBF is apparently mixing up the
concept of social welfare and the conventional ideology of wealth maximisation
altogether due to the unavoidable need to compete with the conventional financial system
and the force of convergence between those two. There are many Islamic finance scholars
who now argue that ‘banks are not for poor’, which clearly shows that the need for the
new institution is necessary. Therefore, establishment of aforementioned institutions and
reformation and improvement of present ones will bring complete and solid Islamic
financial system, which then will contribute to enhancement of the distributive and social

Journal of Islamic Banking and Finance July– Sept. 2015 99

justice in the society, which will be one step closer to the completion of the true Islamic
economic system.
The problems of development of new prospects of Islamic finance at the theoretical
and practical levels still exist. There are three main points that should be kept in mind to
develop Islamic finance:

• issues related to structuring or financial engineering of products and

instruments to serve the objectives set by Islamic economics;

• development of human capital as there is still a huge need for professionals

that are well-versed in principals of Islam together with conventional finance;

• fundamental matters of directions, structure, goals, concept and, finally,

paradigm of an Islamic financial system.
In addition, there is a problem of a lack of theoretical or conceptual coherence and
harmony in Islamic finance literature, which emerged due to the lack of attention to the
aforementioned vital points. IBF has to return back to the way of development that is
according to Islamic perspective. This would most probably lead to rethinking and
redefining of financial instruments, goals and framework as a whole.
Regrettably, the way IBF has been developed lays down too much emphasis on the
operational and technical aspects using formalistic legal approach in order to meet, or
more worryingly circumvent, the requirements of Islamic law. Different from
conventional, Islamic financial instruments, products and services that are designed to
serve distinctive Islamic economic objectives are yet to be introduced to the market.
Hence, transformation and development of economy and society as meant by Islamic
economics could not been achieved yet. Unfortunately, contemporary IBF is merely
striving for profitability and efficiency like conventional finance by modifying the
external structure.
We assert that this attitude originates in misconception or misunderstanding of the
bigger picture or bigger agenda of IBF according to Islamic economics that is in line with
the concept of maqasid al-Shari’ah. IBF instruments and products in essence should be
structured in light of vision and goals of Islamic economics. However, the present
practices show that in IBF the existing conventional financial products and services are
adjusted to meet requirements Islamic law whilst upholding the same goals as the
capitalist financial system.
Obviously, substantial works should be employed not only in the foundational area
of IBF but also in the operational area. As a result, IBF will be able to offer indisputable
Islamic alternative to existing financial practice. For this purpose, a strong and
comprehensive philosophical basis, which originates from an Islamic world view, is
required. God-willing, IBF will eventually achieve its objectives as defined by Islamic
economics that are in line with the concept of maqasid al-Shari’ah, of forming moral and
ethical financial system that would ensure just, fair and equitable mobilisation and
allocation of resources; eliminating and preventing exploitation of man by man; fair and
transparent financial practices with ethical triumph.

100 Journal of Islamic Banking and Finance July– Sept. 2015

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