ISLAMIC BANKING PROSPECTIVE

Introduction Of Islamic Banking
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Islamic banking is based on Islamic law and principles known as shari'a, a system of rules derived from Islamic principles of jurisprudence and dictated by a sometimes modern and sometimes ancient interpretation of the Quran. It is equivalent to conventional banking, except that the investor is rewarded through a share in profit rather than through the payment of interest or riba (usury), which is prohibited under the shari'a. Islamic banking prohibits investment in, or lending to, companies that do business or trade in pork, alcohol, gambling, pornography, and a broad array of entertainment activities. On the other hand, Islamic finance does includes stocks, real estate investments, insurance, currency swaps, sukouk (Islamic bonds based on profit sharing rather than interest payment) and murabaha (a trading transaction where a bank sells a specific commodity at a price plus specific profit agreed upon in advance). There are also other financial vehicles, such as wadi'a and mudharabah, which were discussed in an earlier MEMRI report. [1]

Some Muslim bankers maintain that Islamic economic principles go beyond the narrow issue of riba into broader domains. They argue that these principles are applicable to all aspects of economic activity, and "guide the individual's relationship with his Creator (Allah) in respect to his wealth, as well as his relationship with society, with his partners, and with his legal heirs, and his overall dealings with them." Muslim bankers argue further that "Islam has laid down general principles for every aspect of economic activity, great or small, which are applicable to all situations at all times." [2]

The Islamic system does not allow the creation of debt through direct lending and borrowing; rather it requires the creation of debt through the sale or lease of real assets. Spelling out the regulatory regimes in the Islamic system, a Saudi economist and winner of the King Faisal International Prize for Islamic Studies, offers this explanation: "The asset which is being sold or leased must be real, and not imaginary or notional; the seller must own and possess the goods being sold or leased; the transaction must be genuine with the full intention of giving and taking delivery; and the debt cannot be sold and thus the risk associated with it cannot be transferred to someone else." [3]

This paper will argue that a) Islamic banking is relatively small in assets by global banking asset standards; and that b) there is a considerable amount of deception in many of the practices of the Islamic banks, as asserted by a number of Arab and Muslim critics.


Islamic Banking in a Global Context

Islamic banking has expanded at a considerable pace since the inception of the first Islamic banking institution in Malaysia three decades ago, and it is no longer restricted to banks owned or operated by Muslims. A number of multinational banks, particularly on the European continent, have opened their own branches or windows dedicated to practicing Islamic banking. According to a 2005 study by the International Monetary Fund, the number of Islamic institutions rose from 75 in 1975 to over 300 in 2005, in more than 75 countries. At the time of the study, the total assets worldwide were estimated at $250 billion, and growing at about 15 percent per annum. [4] In 2008, before the advent of the global financial crisis, the 100 largest wholly Islamic banks, ranked by assets, held approximately $520 billion in assets, 90.8 percent of which was owned by the Gulf countries, with Saudi Arabian Islamic banks controlling 49.5 percent, the UAE about 20 percent, Kuwait 17.4 percent and Bahrain about 11 percent. [5] Oman is an exception, being the only member of the Gulf Cooperation Council which does not allow the establishment of Islamic banks within its territory. The governor of Oman's central banks explained this by stating that there is no difference between the country's Islamic banks and conventional banks. [6]

When contrasted with the 50 top banks in the world, the total assets of Islamic banks are not very significant. Measured by their December 2008 balance sheet, the assets of the 10 top banks on the Bankers Almanac list ranged from $3.483 billion for the Royal Bank of Scotland Group, Plc (which is number one on the list) to $1,456 billion for UniCredit, Milan (which is number 10 on the list). Taken together, the 100 largest Islamic banks have assets equivalent to those of bank no. 48 on the December 2008 Bankers Almanac list, namely the National Australia Bank Ltd., with assets of $512 billion. [7] In the second half of 2009, the total assets of the top 25 Islamic banks in the Gulf Cooperation Council (GCC) stood at $218.76 billion. [8] This data indicates clearly that not a single Islamic bank is likely to be included in the world's list of top 50 commercial banks in the foreseeable future. Of course, the central banks in most Islamic countries, which are conventional banks, present a different picture. For example, Saudi Arabia's central bank, the Saudi Arabia Monetary Authority, would be rated fairly high on a global scale.

It should be pointed out that all the figures on the size and growth of Islamic banking must be treated with a degree of caution. As stated by Mahmoud Al-Jamal, a professor of Islamic economics at Rice University (Texas), no official authority is able to provide the International Monetary Fund with credible data on the financial and investment products of the Islamic banks. As he says, there are no "clear statistics about the activities of the Islamic banks, their number, and their branches." [9]


Criticism of Islamic Banking- Financial Smoke and Mirrors

Islamic economic institutions claim to operate on the basis of "zero interest." However, critics of Islamic banking argue that the fundamental practice of charging interest (e.g., charging a premium on the principal amount of the loan, for the time value of the loaned money) is not truly eliminated in Islamic banking, but is merely relabeled and disguised using various legal tricks. The Financial Times, drawing on the book Islamic Banking - A $300 billion Deception by a former adviser to Islamic banks, Mohammad Salim, [10] referred to these practices as "financial smoke and mirrors." [11] Arab and Muslim critics have likened them to "contractum trinius," a method devised by European bankers in the Middle Ages to circumvent the church laws against charging interest on borrowed money. [12]

In an article in the Kuwaiti daily Al-Qabas, titled "The Non-Usury Deception," Kuwaiti banker Ahmad Al-Sarraf maintains that dealing with conventional banks is less costly than dealing with the Islamic banks. Founded on principles and practices developed over centuries, the conventional banks know their way around, while the Islamic banks have yet to find their bearings, in the absence of traditions to guide their activity. Citing fundamentalist cleric Professor Hamid Al-'Ali, who teaches Islamic culture in a college in Kuwait, Al-Sarraf explains that the Islamic banks disguise usury by inventing documents that appear on the surface as sales documents, but that are actually interest-bearing loans. Therefore, anyone who distinguishes between traditional and Islamic banks is ignorant, he says. Al-Sarraf adds that most of the Islamic banks are guided by well-paid clerics who are employed by the bank, and issue rulings according to the bank's needs. The entire corpus of paperwork created by these Islamic banks, Al-Sarraf concludes, is in violation of the rules of the shari'a and is inherently deceptive. [13]


The Deceptive Mechanism of Murabaha

One common instrument of deception is what is known as murabaha (the word is derived from Arabic ribh, meaning "profit"). This refers to a mechanism in which a borrower enters into a mark-up or cost-plus financing contract with a lender. In daily usage, murabaha means a sale of an item on mutually agreed profit. Technically, it is a contract of sale in which the seller declares his cost and profit. As a financing technique, it involves a request by the client that the bank purchase for him certain merchandise, real estate, or consumer durables such as cars or household appliances. Since the client lacks the cash to make the purchase himself (otherwise he would not have turned to the bank), the bank buys the item and sells it to the client on deferred payment. Repayment, usually made in regular installments, is specified in the contract. The bank's profit is calculated either on a percentage of cost basis or as a fixed amount.

Critics have questioned the alleged religious foundation of murabaha because the profit margin attached to the total amount of the sale is tantamount to riba - it is interest in disguise. However, experience teaches that financial deals, no matter how religiously controversial, are nearly always sanctioned by the well-paid clerics employed by the Islamic banks. [14] Muqbil Saleh Ahmad Al-Dhukair, a professor of economics at King 'Abd Al-'Aziz University, points out that the Islamic banks determine their profit margin by checking the interest rates prevailing in the markets. [15] It is hardly surprising that customers have complained bitterly about these "deviations" from the Islamic banks' religious objectives. In fact, many have complained that most Islamic banks collect more profit than the conventional "usury" banks.

After 15 years of studying the Islamic banks, Dr. Mohammad Ibrahim Al-Rumaithi, a professor of Islamic economics at the University of the United Arab Emirates, has concluded that there are three types of Islamic banks: those that adhere to the shari'a and are less preoccupied with making profit; those that ignore the shari'a completely, and those that only carry the title "Islamic." All three, Al-Rumaithi maintains, violate the shari'a in various ways." [16] In fact, the head of the Salafi movement in Kuwait, Abdul-Rahman Abd Al-Khaleq, has denounced the system of murabaha as deceptive, stating, "Pursuing what is haram [forbidden] openly is kinder towards Allah than attempting to deceive him." [17] The issue of usury deception by Islamic banks was also the subject of a symposium held in Riyadh in 2007, in which the participants pointed to "an alarming expansion" of these deceptive practices. [18]

Professor Mahmoud Al-Jamal has said that Islamic mortgage companies likewise "use cheap tricks to attract customers and entice the believers to pay more for less. All that these companies sell to their customers is holy water sprinkled over a real estate mortgage." [19]


Absence of an Effective Supervisory Authority

As already mentioned, Islamic banks often employ resident shari'a scholars to rule on deals when questions arise regarding their Islamic nature. These scholars often issue contradictory edicts regarding what is permitted and what is forbidden. Experts on Islamic banking have warned that these jurisprudence controversies [al-jadal al-fiqhi] place the future of Islamic banks at risk. [20] At a symposium organized by the Dallat Al-Baraka Group (a major Islamic banking group in Saudi Arabia), held in Jeddah in 2008, scholars and experts called for sustained in-depth study and research into Islamic economy and banking, in order to make them more acceptable and viable. [21]

Professor Samir 'Aabid Sheikh, of the Center for Research in Islamic Economics at the King 'Abd Al-'Aziz University in Jeddah, has pointed out that most Islamic banks operate under a shari'a supervisory authority in their country. However, he adds, Islamic financial institutions work closely with many conventional (usury) banks all over the world, and it is difficult for the supervisory authorities to examine their dealings with these banks. 'Aabid Sheikh therefore suggests that "it is necessary to introduce [mechanisms] to actively supervise the banking transactions carried out by [the Islamic] banks." [22]


Conclusion

In order to survive, Islamic banking must observe the rules of the shari'a and at the same time keep afloat in a highly competitive market. So far, however, it has failed to establish a distinct identity or to draw a clear demarcation line between its mode of operation and that of the conventional "usury" banks. The establishment of a rigorous supervision system consisting of clerics, who do not necessarily understand the business of banking, could spell disaster for Islamic banking. How to remain Islamic but also competitive is the greatest challenge that Islamic banks will have to deal with in the future. In the meantime, they also have to contend with a chorus of critics who accuse them of, at best, violating the rules of the shari'a, and at worst of deliberate deception.

Although Islamic banking is gaining ground, it remains on a very small scale by global standards. In order for it to reach the economies of scale and play a significant role in a globalized world economy, Islamic banking will have to strike a fine balance between the rules of the shari'a and global banking practices that are rapidly changing, particularly with the advent of internet banking. In the 1970s, renowned economist E. F. Schumacher developed the notion that "small is beautiful." After last year's global crisis, the new slogan will most likely be "small is not competitive" - and if one cannot compete on a global scale, one is destined to perish.

FIRST ISLAMIC BANK IN HONG KONG

ISLAMIC BANKING IN HONG KONG
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Hong Leong Bank has been granted approval by the Hong Kong Monetary Authority to open the city’s first Islamic finance banking window. This will allow Hong Leong to expand its existing portfolio of Islamic finance products into mainland China, West and North Asian markets from its current base in Malaysia.

Malaysia is trying to establish itself as the Islamic finance hub of the region. Islamic finance is based on Islamic law, or Shar’iah, which prohibits the collection of interest and includes aspects of ethical banking, for example avoiding investments in pork, prostitution or gambling. Profit and loss sharing is also an integral part of Islamic finance. Typically, providers of Islamic finance are keen to point out that they don't just target Islamic investors -- but rather a broad spectrum of potential clients, be they people looking for ethical options or those simply seeking good returns by well-managed banks.

Hong Leong’s approval to offer Islamic finance banking window is in line with Hong Kong’s plans announced last winter to attract Islamic banking and capital to the city. Indeed, Hong Kong has also said it wants to become Asia's hub for Islamic banking. The city sees the addition of Islamic finance as key to maintaining its position as an international finance centre.

Initially in Hong Kong, Hong Leong will only offer its Commodity Murabahah security, a product based on the price mark-up and used in liquidity management. Eventually, Hong Leong plans to offer other Islamic banking products, including ijara (leasing), mudaraba (profit sharing) and musyarakah (partnership).

PROGRESS OF ISLAMIC BANKING

INTRODUCTION OF ISLAMIC BANKING
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More than three decades have passed since the first Islamic bank Mit-Ghamr, began its operations in Egypt and more than ten years have passed since the Islamic Republics of Iran and Pakistan opted for an Islamic banking system. This period, particularly the last ten years has seen a surge of interest in the analytical and operational aspects of Islamic banking. Aside from the fact that a third country, Sudan, has adopted an Islamic financial system, a number of Islamic banks, financial institutions and transactions have emerged all over the world. Additionally, recognizing the market potential of Islamic finance, an increasing number of Western banks and financial institutions have begun providing portfolios, transactions and instruments that are essentially non-interest based.


The feasibility and viability of non-interest based financial transactions, instruments, institutions and systems are no longer in question: neither is the legitimacy of academic research in these areas. Given that until the late l970s and early 1980s the concept and the modes of transactions that could avoid the use of interest rate as the central balancing mechanism between the supply of and demand for financial resources were virtually unacknowledged, the speed of growth of interest-free financial institutions, transactions and instruments has been impressive. Equally important has been the growth of scholarly interest in the subject.


2. A Brief Historical Review of Theory and Practice


The last three decades of developments in the theory and practice of Islamic banking can be divided roughly into two equal periods. In the first period, the efforts of Muslim scholars were concentrated basically on raising the consciousness of Muslims regarding the issue of Riba. Thus, considerable emphasis was placed on moral, philosophical and religious arguments against the institution of Riba; economic arguments were given less prominence. The exception was the writings of Shaikh Mahmood Ahmad and Anwar Iqbal Qureshi who meticulously combed through nearly all theories of interest developed since the time of Adam Smith to show that there had been no satisfactory theory of interest rate. They went further; analyzing the writings of economists such as Keynes, Bohm Bowerk, Cassels and Samuelson, and argued that an objective assessment of these writings would lead one to believe that all of these writers held a reasonably strong conviction that the existence of a fixed and predetermined rate of interest was an impediment to the process of economic growth and development.


On the question of substitutes for the rate of interest mechanism, most Muslim scholars believed, that in financing individual projects, the best instrument would be profit-sharing. Much to their credit, however, they fully recognized that once there is a move from individual project financing to institutional banking, profit-sharing could not be efficiently employed to perform all the functions of modem interest-based banking.


Although profit-sharing has now become the pre-eminent method of Islamic banking, it is important to emphasize that, strictly speaking, the position of Shari’ah on the freedom of contract is flexible. It holds that any transaction subject of a contract is permissible so long as, specifically in case of financial transactions, it does not contain any element of Riba and/or Gharar. Although some debate continues on the definition of Riba, there is a strong enough consensus among Muslim scholars to have at hand a firm operational definition of this concept. Gharar can be defined as a situation when either party to a contract has information regarding some element of the subject of contract that is withheld from the other party and/or the subject of contract is something over which neither party has control. Classic examples include transactions involving birds in flight or fish not yet caught. More modern examples include transactions whose subject is not in the possession of one of the parties and there is uncertainty even about its future possession. Clearly then, types of future contracts in which one of the parties is not demonstrably in possession of the commodity is not permissible. However, a known producer of a commodity is permitted to engage in future transactions via Salaf or Salam transactions for which a spot contract is made for delivery at some future date.


It follows, therefore, that it may be possible to develop a variety of non profit- sharing methods of financial transactions that meet the basic requirement of Shari’ah; a prime and very important example is the method of al-Qard al-Hasan. Hence, if a financial system operates primarily, or even mostly, with modes that are not profit sharing but satisfy the requirements of the Shari’ah, the system is not rendered un-Islamic. This is a very important point, because many critics of the present practices of Islamic banks contend that much of these banks’ transactions, e.g. Murabahah, Installment Sales, Leasing or Salaf, are not profit-sharing methods and that these transactions resemble interest-based transactions. While the latter may be true in that, for example, Installment Sales may resemble interest-based transactions, the fact is that the former is permitted by the Shari’ah but interest-based transactions are not, even though they may produce identical results.


From an economic point of view, however, a system that operates primarily with profit-sharing mechanisms has advantages that are not obtained in a system that, although Shari’ah compatible, operates mostly with non-profit-sharing methods. The most important drawback of the latter type system is that it does not have, or it has not yet developed, ways and means of promoting long-term investments and has to limit itself to short-term and trade transactions. While single banks operating on this basis may not have a discernible impact on the economy, a total system operating on this basis can hamper the process of capital accumulation and, thereby, economic development and growth of the economy.


While in practice not much happened in the first half of this period in so far as banking institutions were concerned, an important development was the growth of al-Qard-al-Hasan funds in Islamic countries, including Iran. These funds were basically of two kinds. The first, attached to, and/or, located in the Masajids, would collect funds from those able and, for a small administrative charge, provide interest-free loans for those who needed them. The second, was much like financial co-ops or credit unions where a fund would be set up by selling shares to members who could borrow a multiple of these shares in the form of interest-free loans. Much of the loans provided by both types of funds were used for consumption purposes.


3. Review of Analytical Developments


While the concept of profit-sharing based Islamic banking emerged clearly as the dominant substitute for interest-based banking by the end of the l970s, much of its analytical underpinnings and theoretical justification were developed in the late l980s. As Islamic resurgence gained momentum and as Muslims began to pin their hopes and aspirations on Islam to provide a third alternative to Communism and Capitalism, attention was focused on the Islamic economic system in general and banking in particular, Many saw Islamic solutions of man’s economic problems as unworkable. In particular, the immediate intuitive response to elimination of fixed interest rates was that without this mechanism there would be a financial mark failure; demand for loanable funds would be infinite while its supply zero, so that a banking system without an interest rate would be neither viable nor feasible The challenge for Muslim scholars was to demonstrate that such would not be the case by building on the works of earlier Muslim scholars on profit-sharing based banking.


The ongoing research in the area of finance and contract theory was of considerable importance to the understanding of how financial markets work. A very simple but crucial insight of Muslim scholars made it possible to tie in the developments modern theory of finance and Islamic banking i.e., the notion that prohibition of Riba meant elimination of all fixed-fee debt contracts and that an Islamic financial system would have to be primarily equity based.


4. Developments in Financial Theory and Islamic Banking


The period under consideration saw an explosive development regarding knowledge of financial risk, of understanding how to measure it, and how to manage it and how to manage it. Over this period capital asset pricing theory portfolio theory, options pricing theory, and efficient market theory developed rapidly. Almost concurrent with these theories, new instruments of market-based risk management developed, including options, futures, sophisticated mutual funds, collateralization, and derivatives. At present these are rather large markets, yet none of them existed before the l970s. Private sector entities, such as corporations and financial institutions, are now devoting considerable resources to management of financial risks. Many of these developments have increased our understanding of why people tend to prefer fixed nominal contracts. They are, therefore, relevant to the theory of Islamic banking. In this section, we review briefly some of the most important developments in modern financial theory that have direct implications for our understanding of how Islamic banking, based on profit-sharing, works.


Briefly, between the late 1950s and mid-l980s four areas of research in financial theory yielded important results:


a. Standard Modigliani-Miller theorem showed that under certain assumptions, the method of finance would be irrelevant to the capital structure of a firm under conditions of perfect capital market, implying that for debt financing to be preferred over equity finance other factors such as taxes or other capital market imperfections would have to play a role;


b. Modern portfolio theory was developed showing the importance of risk diversification and how efficient portfolios can be constructed;


c. The concept of ‘capital market imperfection’ was more precisely defined in terms of ‘information imperfection’ of ‘failures’. Concepts of asymmetric information, moral hazard, and adverse selection went a long way in explaining a large number of capital market phenomena as well as behaviour of capital market participants; and finally


d. Modern contract theory was developed which, interalia, showed how contracts between principals and agents could be designed that would be compatible with desired results. Most importantly, this literature stressed the importance of providing incentives for agents and that any incentive structure must have managerial rewards depending significantly on firm performance, rather than on fixed payoffs.


It is important to mention one more development in modern financial theory. Beginning in the late 1950s, Western economists tried to answer two fundamental questions that had not been satisfactorily addressed. These were: (1) why did banks develop and (2) why were all their operations based on fixed-fee contracts? These questions were importantly, albeit indirectly, relevant to the theory of Islamic banking.


The traditional explanation for the existence of banks had relied, first, on the ability of banks to intermediate between the preference of lenders for short-term liquid assets and the preference of borrowers for long-term illiquid liabilities, by transforming maturities thereby issuing claims of the kind depositors prefer and purchasing the kind of liabilities which borrowers prefer to issue. Secondly, the traditional answer argued that banks, by operating at high volumes, benefit from economies of scale that would lower their average costs incurred in gathering information on borrowers and in managing portfolios.


The modern theory of finance has refined these explanations and added new ones. Briefly, it argues that in modern economies, investment depends crucially on the availability of credit. Extension of credit to any investor, in turn, is based on information. Ascertaining that an individual is creditworthy requires resources, and standing by that judgement, providing or guaranteeing credit entails risk taking. When there are information imperfections and financial markets are incomplete, particularly when secondary markets for claims issued by individuals and small companies are lacking and transaction costs are non-zero, banks emerge as financial intermediaries that specialize in gathering private information as well as the monitoring and enforcement of loan contracts. Thus, in addition to their important function of serving as social accounts, banks play a crucial role as screening devices for allocation of credit. Asymmetric information literature suggested that not only banks, as intermediaries, save on duplicated monitoring costs, but also on indirect costs of transmitting information through signals. By diversifying risks across assets, banks are able to provide signals at lower cost.


These results have an important implication. The more incomplete the financial markets and the greater the information imperfection, the larger the need for banking institutions. This makes banking institutions indispensable, particularly for developing countries, including all Muslim countries, where capital markets do not exist or are very thin.


The second question, of why do banks operate on a fixed-rate basis, has been much harder to explain. Not only the fixed payoff but also related questions regarding the necessity of interest rate ceilings on bank liabilities and other controls and regulations such as non-interest bearing required reserves, control on asset portfolios, entry controls and, finally, deposit insurance without adequate response of insurance premia to asset risks, needed answers.


Implicit understanding had been that without a fixed payoff and all other related controls and regulations, a highly competitive banking environment would result in risky bank asset portfolios as well as risky deposits and this state of affairs was deemed undesirable. It has not been shown, however, why in the presence of deposit insurance and required reserves, banks’ investing in risky assets is inherently bad. Incidentally, even the modem-day explanation, that since long-term investments are illiquid, their presence in banks’ asset portfolios make bank runs more costly for everyone, does not explain why the presence of risky assets should precipitate bank runs. Additionally, it has been shown that if preferences are risk-neutral and the choice of risk level is unobservable, it would be an inefficient choice to sacrifice higher-mean asset payoffs. Consequently, if banks exist solely to save on transaction and monitoring costs in asset choice, there is no explanation of why their liability cannot or should not be all-equity. Asymmetric information literature, however explains that since debt-type contracts are reinforced by threat of bankruptcy and since fixed payout commitments diversify the risk of losses through early liquidation of illiquid assets, debt-type contracts dominate.


The upshot of all these results derived by modern theory of finance is that, in a world of perfect information, ceteris paribus, there is no reason why debt-type contracts should dominate equity-type contracts. In the presence of imperfect information when the need for monitoring arises, to demonstrate the superiority of debt-type contracts one needs additional assumptions, at least, regarding the risk preference of lenders and borrowers, institutional setups and the incentive structure embedded in the relationship of principals and agents. Generally though it has been shown that efficient contracts require incentive-compatibility in order to induce agents to deliver in accordance with the terms of the contract. It has been demonstrated that efficient contracts are possible with Islamic methods. The most recent published example is a paper by Presley and Session in the May 1994 issue of the Economic Journal.


By the mid 1980s economic and financial theory had demonstrated that there were disadvantages in fixed-payoff contracts that dominated interest-based banking. First, these contracts create inefficient default or non-performance incentives. To overcome this risk, fixed-payoff contracts need the additional stipulation of threat of bankruptcy, early liquidation of illiquid assets and/or collateral. Second, in the presence of asymmetric information, debt contracts suffer from adverse selection effects (i.e., beyond a certain level of interest rates, lower quality borrowers are supplied credit) and moral hazard effect (i.e., applicants undertake greater risks in reaction to the contract). These last two effects are sufficiently strong that the net return may be lowered as the banks increase the interest rates charged, therefore, market equilibrium may be characterized by credit rationing. Consequently some groups may be excluded from the credit market although the expected returns of these groups investment may be higher than those who receive credit. Equity finance, however, is free of adverse selection and moral hazard effects. Third, fixed-fee contracts create a fundamental conflict between the interests of the borrowers and those of the lenders. The borrowers consider the upper tail of the distribution of investment payoffs while the lenders are concerned about the lower tail of the distribution. In the case of equity finance the expected return to an equity investor would be exactly the same as the expected return to the project itself, thus avoiding the conflict of interest between lenders and borrowers that exists in debt-type contracts. Fourth, with fixed-fee contracts, the banks are primarily interested in safe and well-established borrowers, therefore, new borrowers will find it difficult and/or expensive to obtain credit in order to finance their investments. Fifth, in the down-phase of an economic cycle or as a result of unforeseen shocks, interest-based banks may be forced into a liability-management mode where, in order to maintain their present deposits and attract additional depositors, they increase their deposit rates while their earnings reduce, thus leading to a banking crisis.


Drawing on these findings, Muslim scholars, conceptualizing Islamic banking as one in which assets and liabilities of banks are acquired on a profit-sharing basis, derived important propositions in a relatively short span of time. Briefly, it has been shown that in such a system: (a) the real values of assets and liabilities would be equal at all points in time; (b) the prospect of instantaneous equilibrium between the asset and liability side of the banking system, means that, by necessity, there must be a close relationship between investment and deposit yields; (c) since the return to liabilities of the banking system is a direct function of the return to asset portfolio of the system and since assets are created in response to investment opportunities in the real sector of the economy, it will be the real sector that determines the rate of return to the financial sector rather than the reverse; (d) adjustment to shocks that results in banking crises and disruptions of the payments mechanism of the country is more rapid than in the conventional system; (e) there will be no disruption in the intermediation process of the banking system nor is there any reason to believe that savings and investment processes will be impaired; (f) savings and investment need not decrease and if the Shari’ah rules regarding contracts, including full disclosure requirements, are observed, both will increase; (g) monetary policy can be effective in stabilizing the economy (this has been shown both in closed and open economy models); (h) in an open economy context, to the extent that mobilized external resources (through profit-sharing modes) are channeled into productive investments, such investments can be expected to generate a stream of returns at least sufficient to repay the associated external liabilities; and finally, (i) again in an open economy context, there will be two-way capital flows, i.e., there is no reason to expect only capital outflows, the net results depend on the domestic relative to external rates of return.


In summary, from a theoretical standpoint, there is no reason to suggest that an Islamic bank or an Islamic financial system cannot fulfill the basic tasks required of any financial intermediary or a system. Indeed, it is possible to argue that, under certain circumstances, they can do better.


5. Operational Challenges and Prospects


Both the theory of Islamic banking and the rapid expansion of Islamic banks recent years have demonstrated the viability and feasibility of non-interest-based operations. This must be surprising to those who believed that banks and financial systems could not operate in a modern economy without reliance on an interest rate mechanism. Indeed, experience has shown that Islamic banks are powerful means of mobilizing resources. Operationally, however, both the Islamic financial systems in the three countries that have adopted it as well as individual Islamic banks face challenges that need to be addressed.


The most important among these challenges is the fact that, while it has been relatively easy to create a system in which deposits do not pay interest, the asset portfolios of Islamic banks do not contain sufficiently strong components that are based on profit-sharing. The main reasons for this are: (a) lack of a legal and institutional framework to facilitate appropriate contracts as well as mechanisms to enforce them; and/or (b) lack of appropriate menus containing a broad range and a variety of maturity structures of financial instruments. Consequently, a relatively strong risk perception has become associated with profit-sharing methods in particular and Islamic banking in general. This, in turn, has led to concentration d asset portfolios of the Islamic banks in short-term and trade-related assets with inimical effects on investment and economic development. The problem is exacerbated by the fact that Muslim countries, as is the case in much of the developing world, suffer from a lack of deep and efficient capital and money markets that can provide the needed liquidity and safety for existing assets. The absence of suitable long-term instruments to support capital formation is mirrored in the lack of very short-term financial instruments to provide liquidity.


a. The challenges facing individual Islamic banks


Impressive as the growth record of individual Islamic banks may be, the fact is that at present, those banks have mostly served as intermediaries between the financial resources of Muslims and major commercial banks in the West. In this context, this has been a one-way relationship, so far. There is still no major Islamic bank that has been able to develop ways and means of intermediating between Western financial resources and the demand for them in Muslim countries.


It also appears that individual Islamic banks face difficulties in fund placement because they have had a major bias towards short-term, secured, low-return but liquid investments. The challenge for these institutions stems from motivational and technical factors.


Motivationally, their basic aim appears to have been that of demonstrating the viability of Islamic banking without taking too many risks. Admittedly, this is a noble and a very important objective, however, although they have succeeded in this effort and have managed to create a market niche for Islamic banking, they do not seem to have achieved the market depth that could ensure long-term profitability and survival. This stems from the fact that they appear to be far behind in technical innovations and financial market developments that in recent years have revolutionized finance and capital markets. There is no evidence that these banks have made any large investment in research and product development, nor is there any evidence that new financial products developed in recent years, particularly in equity derivatives, have been utilized to any significant degree by the major Islamic banks. This is unfortunate because the market opportunities that these banks have been able to develop, to allow funds from Islamic communities to be placed in Islamically permissible portfolios, can and will be exploited by more efficient and innovative Western financial institutions that already have or will discover this market niche.


While there is considerable room for competition and expansion in this field, the long-term survivability of individual Islamic banks will depend on how rapidly, aggressively, and effectively they can develop techniques and instruments that would allow them to carry on a two-way intermediation function. They need to find ways and means of developing marketable Shari‘ah-based instruments by which asset portfolios generated in Muslim countries can be marketed in the West as well as marketing Shari’ah-based Western portfolios in Muslim communities.


b. The challenge of adopting an Islamic financial system


The most important challenge for Islamic banking is in its system-wide implementation. At present, many Islamic countries suffer from financial disequilibria that frustrate attempts at wholesale adoption of Islamic banking. Financial imbalances in the fiscal, monetary and external sector of these economies cannot provide fertile ground for efficient operation of Islamic banking. Major structural adjustments particularly in fiscal and monetary areas are needed to provide Islamic banking with a level playing field. Additionally, adoption of a legal framework of property ownership and Contracts that would clearly specify the domain of private and public property rights as well as stipulation of legally enforceable rights of parties to contract that fully reflect the requirements of the Shari’ah, are necessary to allow an operational framework conducive to efficient operation of Islamic banking.


An Islamic financial system can be said to operate efficiently if, as a result of its adoption, rates of return in the financial sector correspond to those in the real sector. In many Islamic countries fiscal deficits are financed through the banking system. To lower the costs of this financing, the financial system is repressed by artificially maintaining limits on bank rates. Thus, financial repression is a form of taxation that provides governments with substantial revenues. To remove this burden, government expenditures have to be lowered and/or revenues raised. Massive involvement of governments in the economy makes it difficult for them to reduce their expenditures. Raising taxes is politically difficult. Thus, imposing controls on domestic financial markets becomes a relatively easy form of raising revenues. Under the above circumstances, it is understandable why governments would have to impose severe constraints on private financial operations that can provide higher returns to their shareholders and/or depositors. This makes it very difficult for Islamic banks and other financial institutions to realize fully their potential. For example, Mudarabah companies that can provide higher returns than the banking system would end up in direct competition with the banking system for deposits that are used for bank financing of fiscal deficits.


While Muslim countries may, for legitimate reasons, opt for an Islamic financial system, for the economy as a whole to benefit fully from the operations of such a system, it is necessary that (a) government expenditures are fully rationalized, (b) revenues from taxation, and those derived from property legitimately placed within the government domain by the Shari’ah, are raised to meet the expenditure needs the government, (c) the financial sector is liberalized so that returns to this sector reflect returns to the real economy, (d) equity markets are developed to allow financing of investment projects outside banking institutions, and, finally, (e) the structure of the banking system should be such as to allow strong banking supervision and prudential regulation commensurate with the risks involved in various transactions.* To accomplish the last objective, the banking structure can be tiered in accordance with principal Islamic financial transactions. It is reasonable to assume that risks involved in Musharakah or Mudarabah financing, are different from those involved in trade-type financing. It follows, therefore, that prudential regulations of these transactions should be different.


6. Conclusions


By and large, Islamic banking has worked reasonably well, given its short history, but it does face challenges. Nearly all of these challenges are, however, technical in nature and can be met given that sufficient resources can be committed to this task. For instance, developing a suitable menu of Shari’ah-compatible financial instruments is a technical problem that can and will be solved. There is no reason to believe that financial engineering cannot span the existing menu of assets to create a much larger variety of instruments of different maturity structures to serve the needs of the market. The rapid growth of emerging equity markets in developing countries is a very hopeful sign that, with strong commitment in the next decade much of hit existing institutional and technical bottlenecks that may have hampered mote efficient operation of Islamic banking will be removed.


The most serious challenge to Islamic banking, however, is in its system implementation Without a sizeable effort at structural reform and adjustment that provide Islamic banking with suitable grounds for efficient operation, its wholesale adoption as the cornerstone of the financial system will face difficulty that will detract from its efficacy as an alternative system.


Distortions introduced into the economy by, inter alia, massive government intervention and controls, an inefficient and weak tax system, financial repression, lack of capital markets, unavailability of a well-targeted and efficient social safety net, lack of a strong supervisory and prudential regulatory framework in the financial system and, finally, the deficiency of a legal and institutional framework that provides Shari’ah-based definitions of property rights as well as the rights of the parties to contracts, does allow the efficient operation of an Islamic financial system. These distortions need to be removed from the economy to minimize waste and promote efficient resource allocation. Their removal prior to or in conjunction with the adoption of Islamic banking can be expected to create the dynamics necessary for non-inflationary and sustainable economic growth.


These distortions by increasing the risks to price stability also increase the risk of contracts that do not promise a fixed nominal payoff. While Islamic moods of transaction shift more risks to the investor, the risk environment has to be such that the investor can count on credible government policies that would maintain stable prices. If we have learned anything since the break down of the Bretton Woods systems, it is that the choice of a monetary and fiscal system determines the types of risks and uncertainties that the society bears. Individuals reduce the cost of risks and uncertainties associated with a given monetary or fiscal regime by refusing to share in the risks of projects and opt instead for safe, rather than risky, assets with fixed nominal payoffs, rather than payoffs that are outcome-dependent.


It is unreasonable to assume that if provided with two instruments with similar risk characteristics but one with higher expected payoff, as is the case with Islamic instruments, people would prefer the one with the lower payoff. The problem is that in many Muslim countries people have to be concerned not only with the risks of the financial transaction itself but with price stability affected by a plethora government-induced distortions and inefficiencies. If in addition to the risks of the investment projects, the investor has to be concerned with the credibility of government policies, or arbitrary government decisions or distortions that threaten long-term price stability in the economy, he/she will be reluctant to invest in contracts that do not provide fixed nominal payoffs.






* It is not an accident that, at present, Islamic banking is making its most promising progress in Malaysia. This country has one of the least repressive financial systems, no fiscal deficits, low inflation, low interest rates, and a dynamic and vibrant equity market as well as a strong private sector.















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FOUNDATION OF ISLAMIC FINANCING

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, 57:7).


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 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 it.


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”. (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.


9. Jahl mufdi ila al-niza’,


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


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 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 banking.


Profile of Early Islamic Financial Contracts


Mudaraba,


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.


Wakala,


i.e. agency. Business is managed by an agent appointed by the principal-owner. Agent’s compensation may take different forms.


Ju’ala,


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


Ijara,


i.e. leasing.


Salam,


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


Istisna’,


i.e. salam applied to manufactured goods, with the possibility of payment in installments as the goods are delivered.


Urboon,


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 deposit.


Murabaha,


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 history.


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 ‘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 region.


(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. 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 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.


Murabaha,


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 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 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 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 working.


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 1990s.


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 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.


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 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, Switzerland.


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 globalization.


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 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 preoccupation.


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 inconvenience.


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.


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. 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


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 speculation.


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 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 experiment.


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.


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 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 attention.





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