Putra Mosque, Kuala Lumpur, Malaysia

Introduction to Islamic Finance

What is finance?

The financial industry has developed over centuries and covers a wide range of subjects including banking, credit, investment and insurance. Among the key functions of finance is the reallocation of resources between those who have a surplus and are willing to invest in exchange for an expected return in reward for the risk involved, and those who need to borrow in order to finance a project or conduct a transaction. In other words, finance is a tool for reallocating funds between the haves and have-nots of society.

Conventional finance is a multi-trillion dollar industry, and as a consequence of increasing globalisation, individuals and businesses can invest or borrow funds from specialised markets across the world. However, the industry itself is seldom concerned with the moral and ethical dimensions to which these funds are applied or how they are generated, with exception to funds raised through illegal activities. Rather the primary goal of finance, especially when seen from a corporate lens, is to maximise the value of its enterprise through profit maximisation with little regard no central concern to how it is earned or where it is applied and to what social costs (Banks, 2011).

What is Islam?

Islam is the world’s second largest religion founded by the Prophet Muhammad who lived in the 7th century AD. Muslims believe that Muhammad was the last in the line of prophets sent by God, just as the prophets Abraham, Moses and Jesus were before him, to guide mankind to monotheism and teach them the right path which leads to guidance in this life and salvation in the next. Islam is not only concerned with the relationship between man and God but also advocates justice, equality, and mercy in all interactions and accountability on the Day of Judgement before God.

The core of the Islamic tradition and faith lies in the principles and values found in the Quran and the traditions of the Prophet Muhammad (sunna). The Quran and sunna are the two primary sources of Islamic law. Whereas the Quran contains legal principles and injunctions dealing with subjects such as rites, marriage, divorce, succession, commercial transactions and penal laws, the prophetic traditions record the sayings, actions and tacit approvals of the Prophet. The traditions of the Prophet thus provide a much wider coverage of topics of legal import.

The two main secondary sources of law are ijma’ (consensus) and qiyas (analogy) which are based on ijtihad. Ijtihad pertains to the intellectual effort of expert jurists to find solutions to contemporary problems which are not mentioned in the fixed texts of the Quran and sunna.  Other considerations include the general welfare of the people (maslaha) and ‘urf (prevalent custom) so long as they do not contradict the basic tenets of the Quran and sunna.

The Islamic legal system, then, begins with the premise of divine revelation. This system, the Shar’ia, refers to the commands, prohibitions, guidance, and principles under Islam which the believer must follow in order to obtain guidance and salvation in the hereafter. Islam’s vision for humanity is not just to prescribe rites of worship to create a personal relationship with God, but also to guide humanity to the realisation of its moral potential and to take up its role as God’s deputies on earth.  Humanity is therefore morally responsible for the prosperity of the earth and its inhabitants, including animals and the environment, and given moral and legal principles and parameters to do so.

What is Islamic finance?

Islamic finance is a term that reflects financial business that is not contradictory to Shar’ia principles. An important principle in Islamic law is istishab, the ‘presumption of permissibility’. This dictates that the original ruling for every matter is permissible unless proven otherwise. However, there are core practices of conventional finance which are non-compliant to essential Shar’ia requirements. This means Islamic finance must take on distinctive features with an innovative approach which distinguish it from conventional finance in order to remain true to Shar’ia principles while being competitive against conventional finance at the same time. For example, conventional finance, especially the banking industry, is based on taking deposits and giving out loans while charging interest as a premium. This is strictly against the Shar’ia since money in Islam is a medium of exchange and cannot earn money by itself, and so in Islamic banking alternative relationships must exist between the bank and customers which must be asset-backed, such as  trading, leasing and investment activities.

In other businesses, conventional products such as insurance and capital markets could be based on elements that are not approved by Shar’ia principles such as uncertainty (gharar) in insurance and interest in bonds and securities. Conventional insurance is considered non-compliant because the protection provided by the insurer in exchange for a premium is uncertain as to its amount as well as its occurrence. Conventional bonds are non-compliant because the holder of the bond is paid the principal and interest, which is forbidden.

Other prohibitions pertaining to conventional practices could involve purchasing or selling goods and services that are unlawful from a Shar’ia perspective. This could involve non-halal food products such as pork or animals not slaughtered according to Islamic principles, alcohol and drugs, services related to gambling, and pornography. To summarise, conventional business practices could be non-compliant from a contractual structure perspective (if they are based on interest and uncertainty) or from a transactional perspective when they are involved in the production, sale or distribution of goods and services that are unlawful from a Shar’ia perspective.

The Islamic finance banking industry is strongest in Malaysia and the states that constitute the Gulf Cooperation Council (GCC), Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates. However, Islamic banks are opening elsewhere in the Middle East thanks to the Arab Spring and further afield, including in Britain, Turkey, Indonesia, Singapore, South Africa and Pakistan.

What are the basic features of an Islamic financial system?

In their Introduction to Islamic finance, Zamir Iqbal and Abbas Mirakhor (2011) outlined the basic principles of an Islamic financial system which is worth quoting in full.

Prohibition of interest:

Prohibition of riba, a term literally meaning “an excess” and interpreted as “any unjustifiable increase of capital, whether in loans or sales,” is the central tenet of the system. More precisely, any positive, fixed, predetermined rate tied to the maturity and the amount of principal (that is, guaranteed regardless of the performance of the investment) is considered riba and is prohibited. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of “interest” as widely practiced. A direct implication of the prohibition of interest is that pure debt securities with predetermined interest rates are also prohibited.

This prohibition is based on arguments of social justice, equality, and property rights. Islam encourages the earning of profits but forbids the charging of interest because profits, determined ex post, symbolize successful entrepreneurship and the creation of additional wealth. By contrast, interest, determined ex ante, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses. Social justice demands that borrowers and lenders share rewards as well as losses in an equitable fashion and that the process of wealth accumulation and distribution in the economy be fair and representative of true productivity.

Risk sharing:

Because interest is prohibited, pure debt security is eliminated from the system and therefore suppliers of funds become investors, rather than creditors. The provider of financial capital and the entrepreneur share business risks in return for shares of the profits and losses.

Asset-based:

The prohibition of debt and the encouragement of risk sharing suggest a financial system where there is a direct link between the real and the financial sector. As a result, the system introduces a “materiality” aspect that links financing directly with the underlying asset so that the financing activity is clearly and closely identified with the real-sector activity. There is a strong link between the performance of the asset and the return on the capital used to finance it.

Money as “potential” capital:

Money is treated as “potential” capital—that is, it becomes actual capital only when it is combined with other resources to undertake a productive activity. Islam recognizes the time value of money, but only when it acts as capital, not when it is “potential” capital.

Prohibition of speculative behavior:

An Islamic financial system discourages hoarding and prohibits transactions featuring extreme uncertainty, gambling, and risk.

Sanctity of contracts and the preservation of property rights:

Islam upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of asymmetric information and moral hazard. Islam places great importance on the preservation of property rights, defines a balance between the rights of individuals, society and the state, and strongly prohibits encroachment on anyone’s property rights.”

What is the viability of Islamic finance? – The global financial crisis and we can learn

By the 2007-08 global financial crisis, Islamic finance had already become a part of the mainstream of global finance with a substantial sum of Shar’ia-compliant financial services being offered by global institutions such as HSBC, JPMorgan and others. The trend on the part of international financial institutions was mainly driven by the desire to tap into the rapidly expanding Islamic markets as opposed to admiration for its ethically-based principles and other merits.

However, it was the Islamic financial institutions’ outperformance of conventional banks during the crisis when attitudes towards Islamic finance became more positive and a model from which the conventional banking industry could learn from.

Ibrahim Warde (2012), adjunct Professor of International Business at Tufts University, divided the crisis into three phases:

“In the first one, the decline in US real estate prices drew attention to subprime loans, which, it turned out, had through the miracle of securitization found their way onto the balance sheets of major international financial institutions.

In the second phase, losses suffered by such institutions triggered claims for which major Wall Street firms and other companies such as insurer AIG were utterly unprepared. Indeed through highly lucrative and unregulated credit derivatives known as ‘credit default swaps’, high-flying financial firms had in effect insured countless institutions (and one another) against defaults, and now they had to pay up. As the world’s leading global financial institutions discovered the time-bombs on their balance sheets (in the form of toxic assets and unfunded liabilities), they realized that they were essentially insolvent: the ensuing credit freeze caused a global financial meltdown which soon spread to the real economy.

The third phase of the financial crisis was thus a global economic recession which would have turned into a depression were it not for massive government intervention worldwide. It is only then that Islamic banks started to feel the effects of the meltdown.”

The global financial crisis would never have happened had certain Islamic financial practices been implemented by conventional banks. Many of the practices that caused the financial freeze would not have been accepted by the Shari’a Boards of Islamic financial institutions, which each is required to have. For example, neither the securitisation of subprime loans (which is a sale of debt) nor credit default swaps (which are the sale of promises and are rife with gharar) are impermissible.

The resilience of Islamic finance during the global crisis has renewed confidence within the Islamic financial industry and won acknowledgement from conventional circles of its stability and future potential. Islamic finance has been growing at an annual rate of 15-20% over the past decades and by 2015 it is projected to be worth US$2.8tn, according to the Islamic Development Bank. Established hubs of Islamic finance like those in the GCC are expanding their geographical influence and there are new entrants to the market such as Turkey and countries affected by the Arab Spring. In addition, there is strong demand from Western countries with a significant Muslim population such as the UK, Germany and France as well as from huge emerging markets, such as India, Russia and China. There is also growing market penetration of Islamic financial products due to its growing acceptability in many markets. One pertinent example is the Islamic insurance industry (takaful) which makes up only 1% of the global insurance market despite the fact that Muslims make up almost a fifth of the world’s population. With the growing supply and demand of Islamic financial services and institutions borne in mind, as well as the increasing penetration of the massive untapped potential of Islamic financial products amongst the majority of the Muslim population, perhaps the viability of an alternative, ethically-driven system of finance is not as far-fetched as is often believed.

References:

Banks, E, 2011. Finance: The Basics. 2nd ed. London and New York: Routledge.

Iqbal, Z. Mirakhor, A., 2011. An Introduction to Islamic Finance: Theory and Practice. 2nd ed. Sinapore: John Wiley & Sons

Warde, I. 2012. Status of the global Islamic finance industry. In: C.R. Nethercott. D.M Eisenberg, ed. 2012. Islamic Finance: Law and Practice. Oxford: Oxford University Press. Ch.1

Suggested readings: See for more details: http://www.islamic-finance.com/study_reading.htm

Glossary: See for more details: http://glossary.reuters.com/index.php?title=Islamic_Finance

 

 

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