Background

Historical Background and Development of Islamic finance

Islamic finance is estimated to have been a more than US$1.3 trillion-dollar industry in 2013. The consistent growth of Islamic finance is partly due to the strong support from the non-Muslim community that accepted Islamic finance due to its ethical dimension, in addition to its competitiveness and profitability. Islamic finance is not a medieval system reserved only for the Muslim. Instead, it is a flexible and modern system developed to ensure compliance with Islamic principles that insist on fairness and justice to all.[1]

It promises considerable commercial and social benefits, including the encouragement of real trade and business over mere speculation, partnership relationships between capital providers and managers rather than creditor-debtor relationships and the promotion of a fair and equitable finance system. The wisdom of these principles can be seen in the aftermath of the recent global recession. Excessive speculative activities by financial institutions in the form of debt trading and subprime mortgage almost lead to the collapse of the whole system. Many countries were badly hit and some actually went bankrupt.

A cursory look at the derivative activity reveals that, the total notional amount of derivatives traded in the global over-the-counter (OTC) markets reached $673 trillion in June 2008, which is around 11 times the total market value of the publicly traded firms and the global output, separately. The volume of OTC derivatives more than doubled from 2007 to 2008, as a result of a rapid increase from $16 trillion to $35 trillion, with the interest rate (IR) derivatives holding the first place. In simple word, people are speculating using money that they don’t even have, at 10 times the price of the actual asset.

The rejection of gambling and other excessive speculative elements in contracts under Islamic finance makes them more resilient to global financial disasters. These benefits, among others, are responsible for the dramatic growth of Islamic finance as they provide alternative to those interested. 

Islamic finance has shown resilience during the past few years at a time when global recovery has slowed and conventional banking in Western countries has remained under pressure. It is not unaffected by broader global macroeconomic problems with some Islamic banks exposed to the volatile real estate markets. In the Middle East, especially the Gulf, Islamic finance has benefitted from economic and financial stability in most countries, despite political unrest in a few.

There is no coercion for non-Muslims to accept or use Islamic banks or other Islamic financial products.[2] For example, around 40 percent of Malaysia’s total population is non-Muslim. The fact that so many non-Muslims voluntarily choose Islamic financial products is an indication of the competitiveness and profitability of Islamic finance. Its competitiveness is partly based on a series of fixed principles and prohibitions that lend more certainty to the system. The amount of repayment must be clear in Islam.

Islamic commercial law also offers practical alternative to conventional commercial law. Rather than being rigid or inflexible, it is very adaptive to modern environments because it consists of various useful and general principles that uphold morality, fairness and justice. This is reflected in the following hadith on Islam’s respect for freedom in trade and commerce:

When the prices of goods have increased, the people come to the Prophet (s.a.w.) and said to him: Messenger of Allah, control the price for us! To this the Prophet said: ‘Allah is the Controller of prices, the Taker, the Disposer, and I hope that when I met (Him) none of you will claim against me for having committed injustice to him in blood and property.[3]

This illustrates that the concept of a free market is upheld in Islam as long as it remains just for the people. Islamic principles differ from their secular financial counterparts because there are some basic principles and prohibitions that cannot be changed, including the prohibitions on taking riba or interest (common in conventional banking) and the presence of uncertainty or gharar in trading.

One of the defining aspects of Islamic finance is the total rejection of usurious practice. It is strictly forbidden to give someone a loan with the agreement that the loan must be paid together with interest. This is unfair and history has shown that many injustices are associated with usurious practice. In the past, when borrowers cannot repay their loan, although due to circumstances beyond their control, the borrowers were often subjected to slavery. Sometimes, their family members will also be forced into slavery. Modern day slavery still occurs when borrowers were occasionally forced to live a pauper life due to their inability to pay their debt although it might be due to matters beyond their control. The wealthy financial institution will shift the entire risk and burden to the borrower/customer. Their only concern is the repayment of the loan together with the interest. If the borrowers cannot pay, the borrowers might go bankrupt. On the other hand, when the banks failed to repay their billion-dollars financial obligations during financial crises, taxpayer’s money are often used to bailout these banks. Islam is strictly against such injustices. 

Understanding and appreciating the subject of Islamic commercial law has proven difficult in the past because the materials were typically only available in classical Arabic books.[4] Very few books on the subject had been written in English.[5] Due to the more recent emergence of Islamic banking system, a great deal of research on Islamic commercial law is now available.

A simple example can be made to illustrate the modus operandi of Islamic finance. For example, Johnny wanted to purchase a car at the price of USD 50,000. Under the conventional system, Johnny will borrow the money from a bank and will have to pay some interest e.g. USD 40,000. In total, Johnny will have to pay USD 90,000. This is forbidden in Islam because interest is not allowed. There are various alternatives offered under Islamic finance. For example, the Islamic bank can purchase the car from the dealer at the price of USD 50,000 and sell it to Johnny at the price of USD 90,000 by installments. Hire purchase is also possible. Despite some apparent similarity, the Islamic bank is actually taking real risk. If the car is defective, the Islamic bank might be responsible for selling defective goods. Accordingly, the Islamic bank must proceed with due diligence. The risk is not solely shifted to Johnny.

All type of financial transactions is permissible under Islam, unless such transactions contained harmful and prohibited elements. The religion is generally permissible in nature although there is restriction when necessary. For example, drinking intoxicating drinks like liquor or wine is prohibited in Islam. Therefore, financing liquor or wine factory is also forbidden. Islam recognizes that there are benefits of drinking intoxicating drinks but the Quran, the no.1 source of Islam, also warned that the harms and dangers outweigh the benefits. Accordingly, such intoxicating drinks are forbidden in Islam for Muslim.

Many challenges exist. The rapid advance and commercialization of Islamic finance presents numerous complex policy and legal considerations that will definitely test the existing international and national framework as it processes the substantial differences between Islamic and conventional finance systems.[6]

The application of Islamic principles nowadays is challenging as the Western-based financial system is not meant for it. Working alongside the conventional financial system, Islamic banks need to understand that the general standard and guidelines applicable to conventional banks are also applicable to Islamic banks. At the same time, Islamic banks are also exposed to some problems associated with the conventional financial system. For example, due to excessive speculative activities in the real estate area, the price of real estate might reach its bubble and exploded. When the price of real estate collapse, Islamic banks will be more exposed as Islamic banks are often more attached to real trade and commerce, due to the prohibition of making money by charging loan interest.

Another example is the monetary system. The current monetary system has departed from the traditional monetary system, which was based on gold and silver. Uncontrolled and unmonitored monetary systems in which paper money can be printed almost without limit are conducive to conventional interest-based or usury-based systems, but their sustainability has been questioned.

The current system is full of uncertainty. For example, is there any real limit to how much money could a state produce? In the past, money, in the form of gold or silver, is earned from trade and commerce. Nowadays, money is printed, not earned. This fiat or paper money actually has no value of its own and when the currency lost its value, the paper money will be worthless. For illustration, the United States owed trillions of dollars to China but in theory, it can repay the loan by simply printing more money. Islamic banks, operating in this commercial reality, have to be aware of the problems associated with the current system because any negative effect will definitely hit the Islamic banks as well, being part of the system.

The next challenge is to come out with new commercial and add-value products. Regardless of the names of the products, if they are good and offer something more to the customers, the customers will prefer them. Islamic bank must be creative and meticulous. However, the selective application of Islamic finance in a largely conventional financial system has its own challenges. Legal concepts such as separate legal entity also complicate the application of Islamic principles, particularly profit-sharing, because an Islamic financier has to consider the fact that financing or ‘investing’ activity must take into consideration the moral hazards of the separate legal entity concept because the allocation of risk might be difficult to balance in reality.

To truly adhere to a principle such as profit-sharing, there should be a shift in an advisor’s role from mere financier to investor and risk-taker, although this is easier said than done. However, this book proposes that the short-term and long-term benefits of a better risk allocation system, as promoted by Islamic finance, well outweigh the disadvantages.

Islamic finance still has a long way to go:[7]

• An estimate of 70% of Muslims have no access to basic financial services;
• Only 28% of the adult population in OIC member countries uses formal financial intermediaries;
• Less than 50% of adults in OIC countries in Sub-Saharan Africa have a deposit account. In developed countries the number of accounts exceeds the number of people by far.

           

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[1] In Islam, the elements of kindness and fairness are fundamental to every aspect of life, from law to commerce. Unfortunately, misconception and misinterpretation by some Muslims that adopted excessively strict yet inaccurate view negatively impact the image of Islamic legal system. Such excessive interpretation is wrong because Prophet Muhammad himself always chooses the simpler and easier view whenever he must decide. 

[2] In countries such as Malaysia where Muslims are the majority, Islamic law has been partially applied towards the Muslims and Shariah courts have been established. The jurisdiction of a Shariah court is clearly limited to Muslims. Meanwhile, as part of the Malaysian government’s policy, Islamic finance has been introduced in the country as an alternative to conventional finance. This policy is fully supported by the private sector, particularly the banking and insurance sectors. Therefore, in Malaysia, most conventional banks also possess Islamic finance windows. This means that conventional banks typically offer Islamic finance alongside common conventional services.

[3] Imam Malik, al-Muwatta, p.297 as quoted in Razali Hj. Nawawi, Islamic Law on Commercial Transactions (CERT Publications SdnBhd 2009) 36. Hadith to similar effect was reported by Ahmad, Abu Dawud, al-Tirmidhi, Ibn Majah, al-Dari and Abu Y'ala.

[4]Razali Hj. Nawawi, Islamic Law on Commercial Transaction (CERTS Publications Sdn Bhd 2009).

[5] For example, see N.D Coulson, Commercial Law in the Gulf States (Graham & Trotman 1984) and Ernest Kay, Legal Aspect of Business in Saudi Arabia (Springer, 1979). For an introduction to Islamic law, see Mohammad Hashim Kamali, Shari’ah Law: An Introduction (One World Publications 2008).

[6] For example, the collection of interest or usury has long been the backbone of conventional finance, as reflected by the creditor-debtor relationship between bankers and their clients, whereas the rejection of interest or usury is one of the defining features of Islamic finance. If the conventional financial landscape is forced upon Islamic finance, there will be injustices including double-taxation and much more. This is because the taxation regime for loan is generally more flexible than for sale and purchase of commodity. In simple words, Islamic bank will have to pay more taxes for similar transaction if the legal and regulatory framework is not modified.

[7] ‘Islamic finance in OIC member countries’, OIC Outlook Series May 2012