Islamic Finance

Islamic Banking has been increasing in popularity over the past decade but has also been of particular interest due to the global financial crisis. However, the Islamic banking industry is still small compared to the conventional system (accounting for 1% of total assets), and indeed the main criticisms are that the banks are not really ‘Islamic’, but rather a marketing tool to attract deposits from the Muslim population that deal with conventional banks, and to offer Islamic loans and investments that are merely labelled as being ‘Shari’a compliant’. Furthermore, the largest segment of the Islamic banking industry is in sukuk (bonds) issued by governments, large corporations and indeed the Islamic banks themselves and is used to finance their operations. Again these instruments have been viewed with much scepticism – none other than by leading Shari’a scholars involved in reviewing their structure and legality from a strict Shari’a compliance perspective.

Indeed, Islamic banks have to operate, whether they like it or not, in a global financial system that is deeply rooted in Riba (interest), and so at some point in their cycle of operations will touch or be forced to deal in Riba, even though this is explicitly prohibited by the Qur’an. However, the fact that Islamic banks are at least trying to operate within this system is a good start, and there are ongoing developments particularly in Malaysia and Bahrain to ensure that the banks operate within the Sharia.

Interest is explicitly prohibited in Islam as well as in Hinduism, Judaism and Christianity. However, despite the prohibition, the practice of usury and interest continued, despite various attempts in various periods of history to prevent its spread. Interest and debt continued to exploit the needy and ensured that wealth was concentrated within a minority class. The Prophet’s last sermon instructs Muslims to ‘give up what is due to you in interest’ and the Qur’an and Hadith are full of admonitions to those involved in interest based lending.

The fundamental concept of Islamic economics (drawing from the Qur’an, Hadith, as well as the works of numerous economists, social scientists and reformers such as Al Tusi, Ibn Khaldun and Shah Waliullah) is a just social and economic system that has balance and an equitable distribution of income. The laws on Zakat (alms giving) and inheritance for example ensure that wealth is distributed across the community and is not concentrated. “Those who spend their wealth by night and by day, secretly and openly- for them their reward is with their Lord.” (Al Baqarah: 274).The likeness of those who spend their wealth in the Way of Allah is the likeness of a grain that sprouts seven ears – in every ear one hundred grains. Surely Allah grants increase to whom He wills. And Allah is Vast, Knowing (Al  Baqarah: 261).

Islamic banks, therefore, cannot be separated and viewed in isolation as a ‘banking system per se’ as they effectively and realistically need to form part of and be integrated into a wider Islamic ‘economic system’. Nevertheless, the concepts of Islamic banking are based on the divine command not to deal in debt/interest: “Those who devour usury shall not rise up save as someone crazed by the touch of Shaytan. That is because they say, ‘Trade is like usury, but Allah has permitted trade but has forbidden usury.” (Al Baqarah: 275).

As trade is permitted and indeed encouraged (the Prophet Muhammad (s.a.w.s) was a merchant trader known as Al Amin – the honest / trustworthy), Islamic banks are in theory businesses involved in the buying and selling of real assets, not in the circulation of financial ‘monetary’ debt and interest. Furthermore, Islamic banks should partner with their customers in business ventures (i.e. take on the role of equity based investors) rather than lend money at interest (i.e. debtor / creditor relationship).

By way of example, an Islamic mortgage will mean that rather than lend a customer a sum of money to buy a house and then leave a debt / interest commitment on the customer, the Islamic bank will buy the house on behalf of its customer and then lease or rent out the property to the customer who makes lease / rental payments to the bank. Ownership of the property can pass in stages from the bank to the customer as the rent is paid (a practice known as ‘diminishing Murabaha’), or under other forms of contract when the last rental payment is made (Ijara). These Islamic financing arrangements benefit the bank and customer as they both have rooted economic interests in a common financial asset (the property) rather than just in a monetary asset (loan / interest) in the case of a conventional mortgage which has many disadvantages. In particular that the bank is able to on-sell its ‘mortgage’ to other banks and indeed, as was the trigger for the recent financial crisis, allow the banks to provide mortgages to customers they know will be unable to make the mortgage payments and yet make profits from them by bundling lots of ‘bad mortgages together’ and selling them as high quality investments to other banks, pension funds, insurance companies etc. around the world, many of whom trusted that they were good mortgages. Not only were these banks dealing in prohibited interest, they were also deceiving others and gambling / speculating (Gharar / Maysir) which are also explicitly prohibited under Islamic law. As the Islamic bank under an Islamic mortage is the actual owner of the property, it has a legal ownership interest in the property and hence will need to ensure that the customer is able to duly make the lease / rental payments at all times and hence avoid the extreme imbalances created by conventional mortgage practices. Furthermore, as no speculative activity is undertaken, house / property prices will not experience sharp rises or falls – one could also say that under a just and equitable Islamic economic system (in theory), there would not be the extremely high property prices relative to average incomes in an economy in the first instance.

The other fundamental concept in Islamic banking is that where a commercial business venture is concerned, the Islamic bank should become an equity investor in the business either in full or in an agreed proportion to equity capital from its customer. In other words, there is no debt.  These financing arrangements are known as Mudaraba and Musharaka (partnership) and are based on profit / loss sharing, rather than debt principal and interest payments. Again, the benefits of these Islamic structures to the health of an economy are that no large (structural) economic imbalances are caused by the provision of excessive debt and interest – which, again, result in speculative trading activities. Furthermore, equity investors analyse and screen potential investments very carefully – whereas debt providers can lend large quantities of money without truly understanding the dynamics or nature of the business. Again, as with conventional mortgage structures, the debt that is created can be traded with ‘parallel’ instruments created by banks and others that have no viable real economic interest in the actual business itself. Furthermore, the banks create money easily (due to the fact they only need to operate on limited real capital). This artificial system of capital formation is prohibited under Islamic law and means that an Islamic bank should easily be able to absorb any losses on its investments as it is 100% fully capitalised rather than fractionally capitalised at 8-10%, as is the case with conventional banks.

In summary, the global financial crisis has essentially drawn into sharp focus the fact that excessive debt and speculation in addition to the actual structure and operations of conventional banks is built on very weak and fragile foundations that cause deep economic imbalances. Furthermore, the very nature of ‘capitalism’ means that there will always be exploitation for the sake of profit, and that this results, as we all know too well, in a very uneven distribution of income and with extremely high asset prices in addition to the depletion and squandering of the earth’s natural resources. It is estimated that 3.8 billion people live in poverty, with no access to clean water and are malnourished. The underlying fundamental concept of an Islamic economic system is that there is a fair and balanced distribution of income and that this essentially begins at the individual level to spend in charity and not to hoard wealth.

Allah is the ultimate ‘owner’ of everything and as his agents / Khalifas we have the highest responsibility to manage resources, real and financial to benefit the community and those in need. Capitalism sees ‘man’ as ultimate owner and the accumulation of wealth for the sake of political and social ‘control’- the impact of this is all too clear.

The future of Islamic banking’s healthy growth and success is essentially one of education – in particular in the rich area of Islamic economics which does not feature in our primary or secondary educational system. Education in this field is critical to understand the foundations of Islamic economic and social justice, to stimulate informed debate and to help achieve the changes needed.
Mohamed Hamam