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 Chapter 4: Islamic Finance –
The Basics
LEARNING OUTCOMES
Studying this chapter will enable you to understand:
 Islamic finance and its growth
 Convergences in the Islamic and conventional financial systems
 The nature and significance of the ‘no risk, no gain’ principle of
finance and its validity
 The internationalization of Islamic finance—its reasons and
consequences
 The comparative performance of Islamic banks
 Islamic banks and the financial crisis

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 Islamic finance: why and for
whom?
 Ideas on Islamic finance had always existed in economic writings,
because of the prohibition of interest, gambling and indeterminacy in
contracts.
 Islamic banking theory and practice began to spread rapidly after the
1970s.
 Today, over 600 Islamic finance institutions (IFIs) operate in more than
75 countries around the world.
 The value of the assets they control rose from US$300 billion in 2007 to
more thanUS$1600 billion by the middle of 2013.
 Markets have acquired a measure of sophistication in range and depth,
and the number of retailing and investment products is increasing.
 Both the private and public sectors have contributed to the expansion.

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 Among the factors that have contributed to the rapid progress of
Islamic finance, the following deserve specific mention:
– There are 1.63 billion Muslims in the world. They already constitute
27% of the global population and their numbers are growing much
faster than any other religious group.
– The demand for Islamic finance is expected to rise exponentially as
profit-seeking, proactive investment is now tending to overtake the
negative filtering (or screening for prohibited activities) of yesteryears.
– Spiralling oil prices have tripled in just the five years ending in July
2012. Petro-dollars have flooded into the oil-producing Muslim countries
and the Middle East economies have been booming for decades.  
– There is a visible movement of economic power centres towards the
East.

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 System convergence
 The pioneers of Islamic finance chose to follow the structures of
conventional banking when introducing the Islamic financial system.
 This allowed the mainstream foreign banks to enter the field through
‘windows’, or establishing exclusive subsidiaries.
 This eventually led to the convergence of the Islamic and conventional
systems.
 The benefits claimed include the following:
– It is believed that convergence has contributed to the rapid expansion of
Islamic finance and has enabled the system to avoid isolation at global level.
– Product designs were modified to comply with Islamic requirements.
– Convergence helped to replicate mainstream products.
– Educational institutions in Muslim countries could now easily configure with
mainstream structures to facilitate cooperation for the exchange of ideas,
students and scholars.

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 Nevertheless, not all see the convergence of the systems as an
unmixed blessing.
 Convergence has, in a way, compelled the Islamic institutions to adopt
global norms and the policy makers have relentlessly pushed them in
that direction.
 As a result, most Islamic financial instruments look as though they are a
sub-set of those used in the conventional system.
 Even as convergence has largely been unidirectional, the impact of
Islamic finance on the conventional system in some measure cannot be
denied.
– First, Islamic finance has added new, even novel, channels that are
supportive of global financial paraphernalia.
– Second, Islamic finance has certainly shifted the attention of policy makers to
moral and ethical concerns in financial governance and management.

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 For whom the bell tolls?

 The merits and demerits of convergence apart, there are some

questions of social significance that also need to be addressed.
 One such question is: for whom was Islamic finance conceived by its
pioneers and to what ends? Although they experienced conventional
banks operating around them, Muslims could not utilize their services
because they used interest and adopted other non-Islamic practices.
 The pioneers of Islamic finance therefore wanted to create banks that
operated in observance of Islamic requirements to serve the Muslim
community.
 Islamic institutions were supposed to help achieve maqasid-al-Shari’ah,
distributive justice, as treated in the Islamic wealth-related principles.
 These principles cover basic needs (food, shelter, health care, etc.), the
elimination of poverty and the reduction in income inequalities.

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 The fulfilment of basic needs was one of the prominent
topics preoccupying writers on economic development
during the 1980s, but it soon paled into insignificance as the
agenda moved towards investment priorities in national
plans, for which the necessary political will was found
lacking for a variety of reasons.
 the reduction in income disparities and poverty eradication
has recently aroused much concern at the domestic and
global levels.
 Islamic banks may find these areas more suitable for action
now that corporate social responsibility is moving up the
policy agenda.
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 Objectives and principles of
Islamic finance
 The principles of Islamic finance are derived from interpretations of the
Qur’an and the Sunnah and are intended to meet the broad objectives
(maqasid) of Shari’ah.
 The five maqasid, including the protection of life (nafs), religion (din), wealth
(maal), progeny (nasl) and intellect (aql),are too generic.
 The central point of these maqasid is that wealth must be generated from
legitimate trade and asset-based transactions.
 Financial activities must have a social and ethical dimension to benefit the
community at large.
 Giving or taking interest—the use of money for making money—must be
shunned.
 Putting money into activities that Islam considers inappropriate on moral
grounds, such as gambling or the making of alcohol, drugs, pork and others
that cannot be specified is prohibited.

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 Linkage to the real economy

 An important feature of Islamic finance is that it serves the real economy.

 Each financial transaction is to reflect linkage with a real economic
activity.
 Some real good or service must underpin it.
 The difference between the Islamic and conventional financial systems is
not in the existence of the linkage—both systems have that—but resides
in the intention behind each transaction and the length of the chain that
links each transaction.
 In Islamic finance, the transacting parties must intend to transfer real
benefit both ways across the money divide.
 The settlement of price difference alone, in terms of profit or loss, as in
conventional markets, is neither the objective nor allowable in the Islamic
system.

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 Participatory finance
 Islamic banking was conceived to replace interest-based financing.
 Participatory finance, of which mudarabah and musharakah were thought
to be the permissible forms, was the natural alternative precept to interest.
 Since the dawn of the twenty-first century, theoretical writings on Islamic
finance and realities on the ground have both unceasingly challenged
these earlier ideas.
 Justice demands that the providers of capital must share the risk with the
entrepreneurs if they wish to have a share in the profit.
 This could probably be accepted as one justification for the profit-and-loss-
sharing (PLS) contracts.
 PLS contracts are considered equitable not because they imbibe the
capitalist concept of risk, but because their legitimacy in the first place
derives from the sources of Shari’ah.

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 Time value of money
 Money embodies purchasing power and grants a command over real
resources; parting with money involves an opportunity cost.
 Islam allows the recovery of this cost as an addition to the price in the
case of real assets if payment is deferred.
 The proliferation of deferred payments in Islamic finance has been rapid.
 Participatory finance, on the other hand, has been slow to develop,
despite the encouragement of the policy makers. It is estimated today
that they comprise no more than a 20% share of total Islamic finance
assets, on a liberal estimate.
 This has indeed caused anxiety among policy makers, for two reasons.
– First, the safety of fixed-return contracts has led to the increasing imitation
and adaptation of conventional products and procedures.
– Second, their low-risk lure has hampered the venture capital growth, which is
detrimental to economic development

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 Shari’ah-compliant versus
Shari’ah-based instruments
 One question hotly debated in the Islamic finance industry is ‘how Islamic
is Islamic banking?’
 The relevance of the question was raised when Sheikh Muhammad Taqi
Usmani, of the AAOIFI, a Bahrain-based regulatory institution that sets
standards for the global industry, said in 2008 that 85% of sukuk, or
Islamic bonds, were un-Islamic (Usmani, 2007).
 Usmani is the top scholar of modern-day Islamic finance, so coming from
him, this statement is like Adam Smith saying that free markets are
inefficient.
 Several leading scholars have since preferred to classify the current
Islamic finance products as either Shari’ah-compliant or Shari’ah-based.
 Shari’ah-compliant products, they say, are those which mimic their
conventional counterparts, making just cosmetic changes to satisfy
religious sensitivities.
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 Shari’ah-based products are those which observe the real spirit of the
Shari’ah; they incorporate Islamic norms into their substance.
 Islamic finance products structured according to musharakah principles
should, therefore fall into the Shari’ah-based category.
 The debate, in essence, concludes that Shari’ah compliance is a
necessary condition for a product to be Islamic in form, but in addition, it
must meet the sufficiency condition of being Shari’ah-based in
substance.
 The compliant-versus-based issue has an important corollary:
manifestation versus intention.
 The law, including Islamic law, takes manifestation as evidence of
intention because God alone knows what intention guides each of the
parties to enter a contract.

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