Essence of Islamic Finance Part I


Having completed his Masters in economics, Rizwan Rahman worked at the World Bank in Bangladesh, acting as a researcher for the Senior Economist. After returning to the UK, Rizwan pursued his legal studies while concurrently working at leading law firms. In 2008, he was introduced to Islamic finance through undertaking an internship at European Finance House (now Qatar Islamic Bank). Rizwan has since worked at the Islamic Finance Council and BMB Islamic. At Edbiz Consulting, he is jointly responsible for product development, drafting of legal documentation to ensure legal and Shari’a / Shariah compliance and conducting market research and analysis. He is also senior editor for Edbiz Consulting Publications.

There are two main criticisms of the current Islamic banking and finance (IBF) industry: the first one is that given the proliferation of fiat currency, and not commodity currency, one cannot have an IBF industry in the first place. Perhaps a revolutionary idea, there is no shortage of supporters, and there have even been attempts to create a gold dirham and silver dinar as legal dinar. Mints in Dubai and Malaysia issue currency according to weight of gold and silver. The Malaysian State of Kelantan have even issued dinars and dirhams as legal tender although this is not recognized by the central government, and has limited usage.

The far more pervasive and ongoing criticism of IBF is that the products on offer resemble those offered by the conventional financial sector. Most of the products have some linkage to interest rates, and the economic substance of some products appears to replicate the economic substance of an interest based product. This discourages some people from entering the industry, regarding it a sham. For adherents, the attraction lies in the fact that Shariah scholars have rubber stamped these products, so in their minds there is some indelible connection between the Prophet’s juristic sense and the decisions passed in today’s IBF industry.

The criticism is not without merit. Exploring this further, it soon becomes clear that IBF is based upon two pillars: adherence to Islamic law as interpreted by the scholars, and the values of the conventional financial system. To explain further, an investigation into IBF’s history – and by extension global financial history – will help in our understanding of the essence of this nascent industry.

Proponents commonly say that IBF originated from the time of the Prophet. In the passing of legal opinion on contemporary IBF products, recourse to classical legal rulings is par for the course. But the link between today and yesterday is tendentious at best. The Prophet lived in far more primitive times with the economy simple and based on mercantile relationships. For that matter, the global economy at the time was archaic. This was the state of affairs until the 14th century, when we begin to see the development of a number of financial innovations including the formations of the bank.

Perhaps the most significant innovation was the Catholic Church’s acceptance of interest. Once considered a sin (although surreptitiously practiced) the Protestant theologian John Calvin declared in the 16th century that small interest charged for the disbursement of loans was acceptable. This completely revolutionized trade and the financial markets. Soon after, Goldsmiths (who used to offer security to gold deposits) in England realized that the gold they were protecting could be lent out, or rather the receipts identifying deposits of gold could be lent, and at an interest. Here we had the start of fractional reserve banking.

During this time interaction between Islamic East and Christian West was increasing. The Crusades and the conquest of Islamic Spain had created tensions between the two blocs, but trade and political relationships between Christian lands Islamic empires, particularly the Ottomans ensured relationships between the two flourished. In trade, came the exchange of ideas. Arguably, between the 7th and 13th century Islamic East was the source from which the West learned. Contemporary scholars have argued that a few substantive and procedural legal concepts were borrowed from Islamic law. We know that the Italian trade contract, the commenda, was taken from the Islamic mudaraba. However, as the West grew, Islamic East power began to wane.

By the 19th century, when the Ottoman Pasha Muhammed Ali looked favourably to the French systems, Muslim intellectual dominance had fallen dramatically. Colonialism was altering power structures and with that Muslims became observers and followers rather than producers. The East Indian Company showed the power of a multinational company, an idea completely foreign to Islamic legal thinking. This was not a state, the traditional loci of widespread power, but a coterie of people linked together to form a legal personality. The idea of a company having legal personality posed serious questions to Islamic commercial law. In Islamic law, there was no such thing and there was certainly no idea of limited liability. Islamic law considered that those investing should be responsible for covering any losses that the business incurs. For that matter, businesses in Islamic lands were small scale, one off relationships. This is not to say that capitalistic thought, free trade and profit maximization were absent from the merchants in Islamic lands, but the concepts underpinning a commercial relationship were far more simple, based on a large part on trust, and certainly not anthropomorphic.

Limited liability, legal personality and the perpetuity of the company allowed people to invest their money, comfortable in the knowledge that any investment made, would be the loss amount. With the formation of joint stock companies and the maturity of the stock markets, arms length individuals could invest creating a greater pool of income for the funding of the company. However, the entry of stock markets in the Islamic world, the first being in Istanbul in, was met with suspicion from the Shariah scholars. Such a concept was not present in Islamic legal thinking.

The final days of the Ottoman Empire was marked by reforms characterized by the desire to incorporate Western laws, and financial systems without divesting Islamic ideas. Unfortunately, the dominance of Western ideas was too great. For one thing, through colonialism, through increased GDP, through increased affluence, the West was evolving into prosperity. The Islamic East was suffering. Hence, it was natural for many secular people to look to the West as the fount for success, and regard Islamic laws as hampering development and progress. In what followed was the creation of two groupings: the Muslims looking at the secular West as the wellspring for ideas and innovations, and those Muslims who feared that their religion was being diluted by encroachment of Western (liberal) ideas. The antagonism played itself out in social space, the political space and the financial space. It became far more controversial in the 20th century.

2 thoughts on “Essence of Islamic Finance Part I

  1. Mr. Rahman, you bring up quite a lot of very intricate and deep points. First of all, there are some things that people don’t realize

    1. Conventional banking as we know it is quite a new phenomenon and was frowned upon throughout the ages because of the Church’s views against it.
    2. A few centuries ago the Church was the UN, USA, Russia and China combined and their acceptance of ‘small interest rates’ was the last nail in the coffin of prohibition of this concept. However, later did we realize as evidenced by the thoughts of John Maynard Keynes that interest rates, however small have a tendency to escalate left to its own devices; which leads back to the very problem we started with.
    3. In the early years of Islam, we were the Ivy league of knowledge and intellectuals from East to West took their lessons from us. In fact, they used to travel for months to Arabia in order to translate their works back into their language which had been destroyed during the revolutions (e.g French and others). This fact is hard to believe today considering quite a few Muslims are now known for their ‘shrewdenss’ instead of their intellect.
    4. Finally, most importantly, if you really believe and are afraid of the repercussions of usury as laid out by the Quran then instead of poking holes in the system, one’s time would be better spent finding ways around it.

    Again, great article and one I feel should be more commonplace given the presence of aware Muslims such as yourself in academia and practice.

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