Islamic Finance: A Guide for International Business and Investment

  • Book Title:
 Islamic Finance Guide
  • Book Author:
Habiba AnwarRoderick Millar
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Religious Foundations of Islamic Finance


Islamic finance and banking products and instruments set out to achieve the same business goals as conventional financial products and instruments, but within the constraints of Islamic rulings. The Islamic rulings have been laid down from various sources which we examine below.

 Their intent is to create a just and socially inclusive system across the broad spectrum of society – and this clearly includes the financial and business elements therein. While neither money nor wealth is, per se, disapproved of, Islam teaches that money must be used in a productive manner and the rewards of wealth should be derived from profit-and-loss sharing arrangements that imply risk-sharing.

These Islamic rulings are codified in Islamic law, or Shari’a. The literal meaning of Shari’a is “way” or “path to the water source”; technically, it refers to the laws contained in or derived from The Qur’an and Sunnah of the Prophet Muhammad and embodies all aspects of Islamic faith including beliefs and practices. In order to understand how Shari’a law operates it is necessary to have basic knowledge of the structure of Islam, and some of the main concepts and terms involved.

Primary sources of Shari’a

Shari’a, though understood narrowly by some as Islamic law, is in reality a complete and comprehensive code of behaviour, governing the moral, ethical, spiritual, social as well as legal dimensions of a Muslim’s private and public dealings.

Shari’a rulings are taken from the Quran  the main Islamic text  and agreed by all Muslims as being both the original words of Allah (God) as revealed to the Prophet Mohammed and infallible. Shari’a is also based upon the Sunnah, the traditions and practices of the Prophet Mohammed. Hadith is the record of the Sunnah. The name of the main Islamic denomination, Sunni, is derived from the word Sunnah, which comprises nearly 85 per cent of Muslims worldwide and has four schools of thought:

  • Hanifi;
  • Maliki;
  • Sha’afi; and
  • Hanbali.

The other denomination is Shia, which follows the Jafiri School of thought. However, all Muslims irrespective of whether they are Sunni or Shia, agree on the Quran and Sunnah and therefore, these are considered as the primary sources for Shari’a.

Secondary sources of Shari’a

Where the analysis of legal issues is not covered precisely in the Quran and the Hadith, the following secondary sources are the basis of particular rulings:

  • Ijma (consensus of scholars on a particular issue);
  • Qiyas (analogical deduction from rulings already derived from the Quran, Sunnah and ijma);
  • Ijtihad (rational independent deduction by qualified Islamic scholars); and
  • Urf (common practice and custom).

The different denominations may not agree on the applicability of all these sources, and the different schools within these denominations may interpret an issue differently based upon these sources, and it is from these differences that disparities in opinion occur when considering Islamic financial products.

Generally, Sunnis give greater importance to ijma than the Shias do. Mohammed Hasim Kamali, professor of law at the International Islamic University of Malaysia, states in his book “Principles of Islamic Jurispru- dence”:

It must be noted … that unlike the Quran and Sunnah, ijma does not directly partake of divine revelation. As a doctrine and proof of Shari’a, ijma is basically a rational proof. The theory of ijma is also clear on the point that it is a binding proof.

Qiyas is the next source of Shari’a and is widely accepted by Sunni Muslims, but not accepted by Shia. Qiyas is where an existing ruling is extrapolated to a connected (but not explicitly mentioned) action. The Shia rather look to aql, or intellectual reasoning, in place of analogy (see next paragraph on ijtihad). While the results of qiyas and aql maybe similar, it is the jurisprudential explanation and its process that causes the debate and divergences. For a law to be upheld, especially one that derives from a source such as the Quran, it is critical that the intellectual process can be proved.

Ijtihad is an increasingly important source in the development of modern Islamic finance. It is an intellectual process where a judgement is made independent of case law or precedent. It allows Islam to develop in new environments. Historically, the influence of ijtihad lessened in the 15th century, and it has been noted that this coincides with the time when Islam ceased to be the leading innovator of modern ideas and practices and the European renaissance began. For some, the debate over ijtihad is more about who can perform ijtihad than the need for it in the first place. Ijtihad is only acceptable if its decisions come from an appropriately enlightened and trained scholar – a mujtahid.

The development of new financial products clearly creates situations where there are no direct references from primary  sources  complex financial products being inventions of the modern era and not conceivable in the 15th century. Therefore, the acceptability of ijma, qiyas and ijtihad is of great importance to Shari’a board members in deciding whether new financial products can be Shari’a-compliant or not.

Fiqh al-muamalat

Fiqh a- muamalat are laws regarding relationships between human beings which include economic transactions. Many of these were established centuries ago. During Islam’s “golden age”  approximately the period from the time of the Prophet Mohammed until the fall of Al-Andalus in 1492  the Islamic world developed the most sophisticated system of trade and currencies the world had yet seen. The processes created during this period provide a broad basis from which to construct and extrapolate rules that can be applied to modern day financial transactions.

Core principles

Shari’a as applied to finance is based around two core concepts. The first is that the charging of interest, commonly denoted as riba, is forbidden. This is to avoid exploitation; apart from a lender profiting at the expense of a borrower by charging high interest rates, if a lender gets a fixed return (eg. 6 per cent), and a borrower makes very high profit (eg. 30 per cent), then it is unfair to the lender and vice versa. The second major element is that activities that are not halal (permissible) in Islam are therefore not permissible to be involved in economic transactions, whether that be the granting of loans for haram (unlawful) activities or investing in companies that conduct unlawful activities. The general principle of permissibility of economic activities in Shari’a is that every economic activity is permissible unless explicitly prohibited.

The implications of not being able to charge interest are far-reaching, as interest in one form or another plays a role in most conventional financial products. The finer interpretation of the lender not profiting from the borrower, however, does give more room for manoeuvre, and we shall see that certain products interpret this in different ways.

The screening of investments and loans to ensure that they are not for businesses or projects that operate in Shari’a unlawful activities is also a complex and, to an extent, subjective process. Activities that are haram, or unlawful under Shari’a, but are legal under western norms are generally those activities which are also socially unacceptable to some degree or another in the West.

The most obvious of these commercial activities would be pornography, alcohol and armaments. In addition to these are the food- related haram activities, such as the rearing and manufacture of pork-based products. Finally, there are also activities which are haram because they involve gharar, which refers to excessive uncertainty of outcome or subject matter or date of delivery of goods/asset under contract. Another prohibition is qimar (or maysir), which refers to gambling or games of chance, and clearly many forms of speculative business activity can come under this heading as well.

Ultimately, whether Shari’a-compliant financial products are created or not comes down to the decisions of the financial institutions’ Shari’a boards who examine the products and decide whether they are legitimate or not from the Shari’a perspective. Their opinions may differ due to nuances of interpretation of various sources and school of thought they follow.

Liberals and conservatives

Approaches to Islamic development have often been categorized as either being liberal (ie. “if it is not specifically prohibited then it is permissible”) and conservative (ie. “if it is not specifically permitted then it is prohibited”). This stark division does not really work with respect to developments within Islamic finance, as Shari’a board members are almost always making judgements on new issues with the assumption that economic activity is permitted unless prohibited, so they are to that extent all liberal in their approach. However, there is undoubtedly a difference in approach between some boards and others. Some require strict adherence to basic Shari’a principles, such as those in Saudi Arabia, and may be termed as having an approach based on “prudence”. While others are more “market-oriented” in approach, particularly in Malaysia, and may give exemptions to normal principles considering the situation as a “law of necessity”.

An example of this would be the development of bai al-inah contract, which has been developed and used in Malaysia as a loan product, but has not been approved in the Gulf Cooperation Council (GCC) region. Malaysian Shari’a scholars see bai al-inah as permissible, as it comprises “two independent sales between sane persons”, and any mutually agreed sale of a halal  good/asset  between  two sane persons is acceptable to Shari’a. However, scholars in the GCC region (and other markets) look at the structure in totality, and as it resembles a conventional loan structure, they object to its permissibility and favour tawarruq, which involves at least three parties.

Malaysian Shari’a scholars see bai al-inah as a necessary step in developing a full spectrum of products that can replicate conventional financial products; but they are seeing it as only a “stepping stone” product that will be superseded in time by a more Shari’a-compliant products as the market increases in sophistication.

These differing approaches clearly cause divergence of opinions and are now being focused on ever more closely as the Islamic financial authorities seek to establish greater standardization and harmonization of products globally.

Modern era Islamic finance

It is generally agreed that modern Islamic finance is a creation of the modern era; the clear prohibition of riba meant that western banks were never established on this basis and nor were there benefits of providing a pooling of reserves and flow of liquidity to fund economic ventures. As such, the modern era of Islamic finance – though practices of profit and loss sharing such as mudaraba and musharaka predates the advent of Islam  started to evolve from around the beginning of the 20th century in Egypt, when the first western bank to open in a Muslim country (Barclays) set up a branch in Cairo.

The arrival of western banking prompted Islamic scholars to appraise its use of interest and seek ways to avoid it. By the 1950s, alternative models were being presented to conventional banking through partnership and mudaraba financing.

By the 1960s, the first Islamic finance-based institutions were appearing; for example, in Egypt, the Mit Ghamr Savings Association was established. Importantly, Mit Ghamr was modelled on western banking institutions (German regional savings banks) and was not a bottom-up creation for Islamic finance. The bank was successful and appealed to devout Egyptian farmers, but it was closed in 1968 by the Egyptian government which was unsympathetic to private enterprise. At the same time in Malaysia, which was dominated by western banks, Tabung Haji was established  another savings organization, this one with the purpose of enabling Muslim pilgrims to save gradually towards their annual Hajj pilgrimage in Saudi Arabia through Shari’a-compliant saving. Tabung Haji has undergone  various transformations since then, but it remains the oldest Islamic finance institution in the world.

The 1970s saw the emergence of a number of Gulf-based Islamic banks, notably Dubai Islamic Bank and the Islamic Development Bank. The first

Islamic insurance (takaful) company was established in 1979  the Islamic Insurance Company of Sudan.

The 1980s saw national economic systems declaring their intent to go to full Shari’a systems, backed by the 1981 Organization of the Islamic Conference in Khartoum. The International Monetary Fund started to publish information on Islamic financial structures and across the Muslim world, scholarly interest increased and a wide spectrum of products developed.

With the establishment of the Accounting and Auditing Organisation for Islamic Financial Institutions in 1990, and the Islamic Financial Services Board in 2002 setting out new standards for Islamic finance and development of financial services, the institutional infrastructure started to become much more sophisticated and western banks and institutions started to involve themselves through offering non-interest bearing bonds and indices designed for the Shari’a market.

A century after Barclays opened its Cairo branch, the Islamic finance sector was just starting to broaden its appeal to the mass retail market. It has developed at a substantial rate in the last quarter of the 20th century, each decade seeing more and more sophistication and broadening of its market. In the early years of the 21st century, it is poised to expand exponentially into the retail banking sector and become the fastest growing element of global banking. As it grows, the examination of financial products and business processes by senior Muslim scholars continues to become more sophisticated and profound. Debate and controversy will continue as certain new products emerge, which some may consider to go against the spirit of Shari’a, although their constituent elements themselves are permissible. Only through this continual invention, appraisal and reappraisal will a strong, flexible yet compliant Islamic finance structure fully develop, and expand across the world’s markets.

The Development of Islamic Finance in the UK


Most of the growth of Islamic finance in the UK has taken place over the last five years. But the existence of Shari’a-compliant transactions in London’s financial markets dates back to the 1980s. Commodity murabaha1 type transactions through the London Metal Exchange were used, in significant volumes, to give liquidity to Middle Eastern institutions and other investors that fostered the development of a wholesale market in the UK. This did not, however, cater for retail Muslim consumers, as the products developed at the time were aimed exclusively at wholesale and high-net-worth investors. These products were relatively uncomplicated in structure and fell outside the scope of the regulators.

Retail Islamic products first appeared in the UK in the 1990s, but only on a very limited scale. A few banks from the Middle East and South East Asia began to offer simple products, such as home finance. However, these compared unfavourably with their conventional equivalents in several respects, including their generally uncompetitive pricing. Most of these

products did not fall within the regulatory framework, so consumers did not have the same protection as other consumers; for example, the availability of the Financial Ombudsman Service and the possibility of redress from the Financial Services Compensation Scheme. The growth of the retail market remained slow throughout the 1990s and early 2000s.

Much has changed since then; both on the wholesale and the retail side, the quality of products has improved, a wider range of products has become available, and more players have entered the market. Today, London is seen by many firms, including Islamic as well as non-Islamic, as an increasingly important global centre for Islamic finance.

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