Credit crunch: islamic perspective

Chapter I: The evolution of the Islamic financial system

1) Historical background of traditional Islamic finance

Considered as the last monotheistic religion after Buddhism Judaism and Christianity, Islam is not just a religion. It organises all aspects of Muslim life from social issues to commercial awareness.

The Quran and Islamic jurisprudence explain how a Muslim should treat his wife, what he is not allowed to eat and how he should manage his financial obligations.

According to the Islamic concept of «tawhid», the universe (earth and heavens) is a property of God. Humans have been trusted with these benefits and they will be accountable for their acts according to God's justice.

«Whatever you spend, surely Allah knows of it»^18(*)

«On that day you will surely be called to account for the bounty you were granted».^19(*)

Accountable for their acts, Muslims must submit for the Shariah in God's property.

A Muslim must seek justice in all aspects of his life and financing must be interest-free. Therefore and long in Muslim tradition, interest has been negatively perceived and completely forbidden.

A good Muslim follows the «halal» (the good) as opposed to the «haram» (the bad).

«Partake of the good things and work righteousness»^20(*)

Islam developed after the year 632 hegira by the force of the sword.

However its impact diminished in the post world war period with the emergence of the vision of separation of religion from the state affairs.

In fact, in the western world the banking system started to grow in the 17th century with the establishment of the bank of England (1694) and Riksbank Bank (1668).

The industrial revolution created an enhancement for their development.

However the Ottoman Empire which was dominant in the Middle East did not adapt to this situation.

After the collapse of the Ottoman Empire in 1918, it was taken over mainly by French and British colonies which transferred their banking system to the Arab countries occupied.

The people in need for financial services turned to conventional banking.

During the 1970s, the majority of these Arab countries earned their independence.

The increased wealth of the middle-eastern countries, due to their oil production gave rise to a major need for financial intermediation for investment in petro-dollars and the rise of people claiming the need to return to the basis of Islam and to invest according to Islamic principles^21(*).

Islamic banking was first initiated in Egypt by Ahmad Najjar who established banks which could lend money to the masses sharing losses and benefits without claiming interest. This experience was the catalyst of the development of Islamic banks.^22(*).

However this practice is not the oldest.

Some authors reveal the existence of institutions in India starting 1901, and also in Iran and Pakistan establishing «Zakat''^23(*) or insurance companies based on Islamic principles which aim at paying indemnities to the insured when in situation of accidental damage against earning insurance premiums.

Other attempts include a small Islamic bank that was founded in Pakistan according to Haron Sudin ^24(*) to fund Interest-free loans for poor landowners. The experience was unsuccessful due to a lack of funds.^25(*). The money was lent without interest

These examples reveal that the difficulty of establishing a typical Islamic bank didn't stop Muslims from trying to have institutions that followed their beliefs.

The absence of Islamic banks during that period can be explained by the poverty and the fact that the need for banks was limited and the limited individuals who used conventional banks were excused by the law of necessity in the Quran given the lack of institutions that applied Islamic law.

The independence of many Islamic countries during the 1940's through the 1970's and the important resources coming from the petro dollar money were the key factors in changing the panorama and were definitely the catalysts behind the development of Islamic banking.^26(*).

The initial experience was in 1963 in Egypt. Ahmad Al-Najjar was behind the idea of the launching of an interest free bank, the Myt Ghamr Bank^27(*).The bank couldn't stand up to the competition with conventional banks and the experience ended up in 5 years. This first experience was a crossroad for Islamic finance. It proved that Islamic finance is a viable solution. However, it must adapt to the competition by creating new ways. A change in the approach led to the switching to profit and loss sharing contracts.

The idea was incorporated in 1971 with the Nasser Social Bank of Egypt.

Nasser Social Bank had for objective providing loans for students, investment or social insurance purposes. Prohibited from taking interest, it funded itself by taking 2% of the loan granted for administration fees. Nasser social Bank developed into a model for other banks created successively.

In 1969, the organisation of a key Islamic conference^28(*) subsequent to the burning of Mosque Al Aqsa was going to be the mark in Islamic banking development.

A study initiated by this organization led to the creation of an Islamic bank which led into the creation of BID (Islamic Bank of Development) on the 20th of October 1975.

Following the creation of BID, some national banks were created: Dubai Islamic Bank (1975-1976), Kuwait Finance House (1977) Faisal Islamic Bank of Sudan, Faisal Islamic Bank of Egypt, Jordan Islamic Bank and Bahrain Islamic Bank among others.

In 1981, another generation of Islamic banks appeared with Dar EL Maal El Islami & El Baraka Group. This gave Islamic Banking an international flavour. However it was not until 2004 that Islamic Bank of Britain was launched in the United Kingdom^29(*). Lately, Sri Lanka launched an Islamic Bank^30(*). Overall there are 300 working Shariah compliant institutions in the world today.

2) Islamic principles

Islamic principles are revealed in the Quran, (it is Islam's Holy Book revealed successively by God to the prophet), the acts of the prophet and his opinions (the Hadith), the consensus of the community (Ijmaa and Fiqh) and the reasoning by analogy (Qiyas).

Islam is believed to be the first religion to bring social and economic justice. Exploitation of the weak is mainly prohibited in Islam. This social reform was forwarded by two major prohibitions: the prohibition of «Riba» and the prohibition of «Gharar».

A) The Islamic perception of interest or prohibition of Riba

According to the Oxford dictionary interest is «the extra money that one pays back when one borrows money or that one receives when one invests money»^31(*)

The lender receives money for its savings and the borrower pays interest because he owns the money and the agent makes money because he linked them together.

Interest is an important factor in the economy. It keeps the economy in motion.

Historically, interest was the subject of two concepts: biological and compensatory.

In the eastern society, loans were compared to biological life, for example animals and plants in a sense that a loan can generate benefits like plants and animals can biologically reproduce themselves. Therefore interest is legitimately justifiable^32(*).

However the doctrine of usury at that time prohibited the fact that money generates money and therefore, paying interest was not justified.

A totally opposite view was that interest was a compensation for the loss the lender would incur by lending the money. Literally, the Latin root for interest «intereo» means to be lost and interest originates from this word.

`'It is easy to see that if there is any doubt about repayment there must be interest for no one will voluntarily part with money, as a commercial transaction, in return for anything less than a 100% probability of the principal being repaid»^33(*).

Interest as a practice was condemned by all the religions except Judaism.

«Lend freely hoping nothing thereby» (Luke 6:35) says the Bible and is regarded by many annotators as a condemnation for interest in the Christian religion.

Whereas Judaism considered interest illegitimate but did not forbid it explicitly.

The philosophers adopted the same approach; Aristotle condemned interest and considered finance.^34(*)

Interest or Riba has been one of the most important topics in Islamic law. Riba had been mentioned 20 times in the Quran and it means literally «to increase».

a) Riba in Fiqh:

The Fiqh distinguishes between two different types of Riba: «Riba el nassia» and «Riba al fadel».

Riba al-fadel occurs from the discrepancy in the measures of quality in an immediate contract there is a difference between the counter values of commodities of the same kind.

It could be a difference in weight, currency or scale. An example would be an exchange of low quality commodities to good quality commodities.

Riba al nassia (Quranic Riba) occurs when the delivery of the commodities is delayed. For example: it takes the form of an increment on the loan received by the lender (due to a delay).

It is recommended that unless the commodities in question are of a different kind, the exchange should happen on spot and to the same counter values

Riba al nassia occurs in loans whereas Riba el fadl occur in sale and exchange transaction.

b) Riba in the Quran:^35(*)

Riba was prohibited successively in the Quran.

From the undesirability of Riba^36(*), revealed in Surat el Room to the express prohibition in Surat Imran^37(*) to having a war with God in Surat Al Baqarah^38(*).

 

c) Riba in the Hadith of the prophet:

The prohibition is also mentioned in the Hadith of the prophet: 

The Prophet (saw), cursed the receiver and the payer of interest, the one who records it (the contract) and the two witnesses to the transaction and said, «They are all alike (in guilt).»

 

Jabir ibn Abdullah, giving a report on the Prohet's farewell pilgrimage, said: The Prophet (saw), addressed the people and said, «All the riba al-jahiliyyah is annulled, the first riba htat I annulled is our riba, accruing to al-Abbas ibn Abdul Mutalib (the Prophet's uncle).»

Abu Hurayrah (ra) narrated that the Prophet (saw), said: «riba has seventy segments, the least serious is equivalent to a man committing incest with his own mother.»

 

Abu Hurayrah (ra) narrated that the Prophet (saw) said: «»God would not allow four persons to enter paradise or to taste its blessings: he who drinks wine, he who takes riba, he who usurps an orphan's property without right and he who is undutiful to his parents.»

d) Contemporary views on Riba:

There is a consensus among Muslims on the fact that Riba is prohibited. The views however diverge on what actually constitutes Riba.

Two different views on Riba can be observed:

According to some Muslims interest in the sense of any increase in the charges over a loan is prohibited^39(*).

According to another point of view interest in its moral definition is prohibited in the sense that it means exploiting the others economically. They consider the commercial loan allowed.

The most important verse related to Riba in the Quran is «lakum ru'usu amwalikum» (you are entitled to your principal) «la tazlimuna wa la tuzlamun» (Do not commit injustice and no injustice will be committed against you»).

The literal interpretation of the verse emphasises on the first part considering the second part as an explanation.

However, is this the correct interpretation or should we consider the rationale behind the interpretation?

In this verse borrowing is linked to injustice.

A consideration of the situation in the Islamic time supposes that only the poor would ask to borrow money. There were no laws for protection and only the needy would accept to pay interest as otherwise he would not have access to the funds.

However in our modern life taking a loan doesn't equate to poverty.

Modernist views on Riba analyse it from the scope of the cause of the prohibition which is injustice.

This view is supported by main Islamic banking scholars such as Fazlur Rahman, Muhamad Asad and Said Al Najar)^40(*).

They base their views on the historical context during the pre-Islamic period and they consider that pre-Islamic Riba was not equivalent to today's concept of interest because one party was rich and the other was poor^41(*).However, according to Muhamad Ayub who quotes the SAB(Shari'a Appelate Bench)«It is not to say that commercial or productive loan were not in vogue when Riba was prohibited .More than enough material has come to prove that commercial and productive loans were not foreign to Arabs»^42(*)

In this moral definition Riba could be described as undue profit.

So according to that concept when the money is provided to feed the poor, no interest should be taken for a consumption loan however if it is a production loan Riba is legitimate.

This neo-revivalist view is the dominant one in the contemporary debate and constitutes the base of modern Islamic banking.

The prohibition of interest has a serious impact on the financial transactions a Muslim can perform:

A Muslim cannot perform the daily standard operations of a conventional bank. Islamic banks are banned from taking any interest on provided loans or granting any interest on deposits. Charges for services are acceptable but should not be related to the financial value of the service.

B) Gharar

The prohibition of interest is one of the pillars of Islamic finance. If Riba receives increased attention that doesn't mean that Gharar is less important.

There is no clear definition of Gharar. The word in Arabic means cheating and uncertainty and in practice in Islamic finance, Gharar implies most often speculation.

In Islam, a contract which contains an element of uncertainty, risk or speculation is deemed to be void^43(*).

The sources that prohibit Gharar are the Quran and the Hadith of the prophet.

The prophet banned the sale of a «fish in the sea^44(*), the messenger forbade sale of what in the wombs, sale of the contents of the udders, sale of a slave when he is a runaway,»^45(*)

«Whoever buys foodstuffs let him not sell them until he has possession of them»^46(*).

«He who purchases food shall not sell it until he weighs it»^47(*)

Each of the above operations includes an element of Gharar (uncertainty, risk, speculation).

In the Hadith, the prophet forbids an operation called «talaqi al rukban». It refers to a salesman who buys goods on the borderline of a market for a lower price then sells at the market price trying to take advantage of the ignorance of the buyer.

To prevent Gharar in a transaction, the contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transaction.

In summary, the concept of Gharar covers 2 elements of the contract: the subject matter and the price.

These two main elements are important to the contract. Otherwise the contract won't be legally binding. If they have an element of Gharar, the contract will be void.

Risk is inherent to all contracts. The scholars make the difference between two types of Gharar, «gharar khatir» (excessive or absolute) or uncertainty to the essential elements and «gharar qalil» (relative or nominal) or uncertainty to subsequent elements which are not considered key and which can be easily eliminated from the contract.

In opposition to Riba, the gharar qalil does not render the contract void.

Gharar can occur according to Nabil Saleh^48(*):

-There would be no want of knowledge regarding the existence of the subject-matter.

-There would be no want of knowledge regarding the characteristic of the subject matter or the identification of their species or knowledge of their quantity or the date of future performance. If any

-Control of the parties over the exchanged counter-values should be effective.

Uncertainty towards the existence of the subject matter cannot occur in an Islamic contract. However a subject matter can be a thing in the future at the time of contracting provided its future existence is certain^49(*).

Uncertainty towards the possession refers to the «fish in the sea» and to naked selling which refers to the selling of derivatives without the actual ownership and this is void in Islamic contracts.

The price must be determined at the time of the signature of the contract. A contract based on the ongoing price is void. In this matter, a decision on a forward foreign exchange contract was declared void by the court of Cassation of Abu Dhabi». The intention of both parties was to generate profits from the fluctuation of the various currencies. They would not know the result of their speculation until the transaction was closed. When the subject of a transaction is not assessed and is not known to either party and is based partially on luck. It is misleading. They become (...) illegal bets''^50(*).

C) Maysir

Last but not least, the Quran forbids «Maysir» or gambling because it comes from Satan who «wants only to sow enmity and hatred among you, and hinder you from the remembrance of God and from prayer»^51(*)

A transaction which involves gambling is prohibited. One must not ignore the fact that all commercial transaction include an element of risk.However.it depends on the intention of the person.

`'The distinction between prohibited speculation and legitimate commercial speculation is not clear»^52(*). An equity investment in a company is legitimate if the investor aims at keeping the share and participate in the productivity of the company. However, if the aim is purely to sell the shares for speculation purposes then the transaction involves Maysir and is prohibited^53(*).

3) The development of Islamic finance

Today, Islamic banking is a developed industry. This development has led to the development of Islamic finance with fully fledged panoply of products and services.

Funds managed accordance to Islamic law is worth USD 500 bn according to the FSA (Financial Services Authority)^54(*). With 300 Islamic financial institutions, the industry is considered to have reached critical mass compared to its status 300 years ago.

Starting from minor trials in 1963, three factors^55(*) have led to the development of Islamic finance to its current sophistication levels. The first one was the establishment of the Islamic Development Bank. One of the major objectives of this bank was promoting Islamic finance .The help of the Accounting Organisation for Islamic Institutions (AAOIFI) was effective lately. This bank proved the Islamic bank experience viable.

One third of the trade financing by IDB has been for oil imports, USD 1.5 bn were invested in project finance over the 1995-1999 period.

The second factor easing the development of Islamic finance was the oil price rises; a lot of national banks were created trying to use the benefits of this oil to poorer Muslim countries.

The third factor was the contribution of Islamic Fiqh, and the modernist view on Riba.

Trying to suit the customer's needs by presenting various services, multiple techniques were created. These techniques attracted a lot of criticism from more conservative Islamic scholars.

After the initial expansion many Islamic banks, in order to attract customers, Islamic banks followed two strategies:

The first was to widen the range of services on offer so they can meet the client's financial needs like offering international transfer of funds.

Also they offer financial schemes and housing loans where for example a property was purchased on behalf of the client who had to repay by instalments.

The competition of Islamic banks with conventional banks increased, especially as the latter started offering Islamic accounts or Shariah based products.

In order to make profits from their liquidity, Islamic banks unable to invest in government bonds started to invest in sukuks. Malaysia rose as the pioneer in Islamic banking.

The establishment of the Bahrain money market was the trigger to the emergence of Islamic markets for securities.

Three countries expressed the ambition of making their entire banking system in conformity to the Shariah: Iran, Sudan and Pakistan.

However, in most of the others countries the two systems cohabited, which made it more challenging for the Islamic banks with less clear objectives.

Islamic banking is well established now in the international community and some issues have been taken to increase its credibility.

The development of Islamic financial methods has led to the development of different forms of financial institutions. These vary between Islamic banks, Islamic windows, Islamic investment banks and funds, Islamic mortgage companies, Takaful companies and international Islamic financial markets.

In 1991, the Accounting and Auditing Organization for Islamic financial institutions (AAOIFI) was established to issue, audit and govern accounting standards especially for Islamic Financial Institutions.

The main body for supervision in the Islamic banking space remains the international financial services board based in Malaysia which plays a role equivalent to that of the BASEL committee on banking supervision in conventional banking.

* 18 ^_ Quran (3:92)

* 19 ^_ Quran (102:8)

* 20 ^_ Quran (23:51)

* 21 ^_ Frank E.Vogel and Samuel L.Hayes, Islamic Law and Finance Religion Risk & Return(Kluwer Law International,Nethrlands,2008) 5

* 22 ^_ Nathalie Schoon, » Islamic Banking and Finance» (Spiramus Press Ltd, London, 1999) 8.

* 23 ^_ Zakat is a compulsory financial religious duty on Muslims to pay2.5% of their wealth and assets each year for charity works.

* 24 ^_ Simon Archer and Rifaat Ahmed Abdel Karim,» Islamic Finance: Innovation and Growth» (Euromoney Books and AAOIFI) 30.

* 25 ^_ Rodney Wilson, Banking and Finance in the Arab Middle East, New York,1983.

* 26 ^_ Ibid 21

* 27 ^_ Simon Archer and Rifaat Ahmed Abdel Karim, Islamic Finance: Innovation and Growth (Euromoney Books and AAOIFI) 30.

* 28 ^_ Simon Archer and Rifaat Ahmed Abdel Karim Islamic Finance: Innovation and Growth - Chapter 1 (Euromoney Books and AAOIFI ) 4

* 29 ^_ 25 organizations offer Islamic finance services in the UK.

* 30 ^_ http://www.newhorizon-islamicbanking.com/index.cfm?action=view&id=10782&section=news&return=latest&return_action=view&return_id=83

* 31 ^_ Hornby, A.., Oxfrod Advanced Learner's dictionary(New York ,2000).677-678.

* 32 ^_ Newby Gordon, A History if the Jews of Arabia, Columbia S.C.,1988,p.56.

* 33 ^_ Homer,Sidney,A History of Interest Rates,p.74

* 34 ^_Saleh N.A ,Unlawful Gain and Legitimate Profit in Islamic law (Cambridge University Press,Cambridge,1986)12

* 35 ^_ Saleh N.A ,Unlawful Gain and Legitimate Profit in Islamic law (Cambridge University Press,Cambridge,1986)42

* 36 ^_Quran,30:39

* 37 ^_ Quran,3:140

* 38 ^_ Quran, 2:275

* 39 ^_ Muhamad Ayub, Understanding Islamic Finance (2007)50.

* 40 ^_ Abdullah Saeed, Islamic Banking and Interest: a Study on the prohibition of interest and its contemporary interpretation(1999)

* 41 ^_ Ibid

* 42 ^_ Muhamad Ayub, Understanding Islamic Finance (2007)50.

* 43 ^_ Muhamad Ayub, Understanding Islamic Finance (2007)59.

* 44 ^_ Ibn Hanbal.

* 45 ^_ Ibn Maja.

* 46 ^_ Bukhari.

* 47 ^_ Bukhari.

* 48 ^_ Saleh N.A, Unlawful Gain and Legitimate Profit in Islamic law (Cambridge University Press, Cambridge, 1986)66.

* 49 ^_ Simon Archer and Rifaat Ahmed Abdel Karim,Islamic Finance: Innovation and Growth (Euromoney Books and AAOIFI)23 .They refer that gharar applies to buying on margin and dealing on stocks and options .

* 50 ^_ Abu Dhabi Court of Cassation Judgement no.158&208/18 reported in Price and Tamimi United Arab Emirates Court of cassation Judgements 1989-1997(Kluwer Law International :19980,p.23.

* 51 ^_ Frank E.Vogel and Samuel L.Hayes, Islamic Law and Finance Religion Risk & Return (87).

* 52 ^_ Atif Hanif,'Islamic Finance an Overview' [2008] International Energy Law Review 1.

* 53 ^_ Ibid

* 54 ^_ Ibid.

* 55 ^_ Simon Archer and Rifaat Ahmed Abdel Karim, Islamic Finance: Innovation and Growth (Euromoney Books and AAOIFI) 30.