Islamic Finance: A Practical Introduction

By Tasnim Nazeer

Islamic finance is a growing industry with an ever-increasing significance in the West: banks offer Muslim-friendly investments; interest-free loans are readily available and more information on the subject, for everyday readers, is essential.

This volume aims to offer a basic introduction to the complexities of Islamic finance in the modern world that will be suitable for STUDENTS and lay readers.

The book has been checked and edited by leading experts in the field, including Professor Khurshid Ahmad, a notable authority.

Up-to-date information.

In addition to introducing Islamic finance the book also explains the religious principles that govern the field.

• Language: English
• Publisher: Kube Publishing Ltd
• Release date: Mar 3, 2020
• ISBN: 9780860377597

Book preview

Introduction

Islamic Finance as a New Paradigm

Islamic finance and banking is growing at an unprecedented rate around the world, and the impact of the Islamic resurgence has played a pivotal role in shaping the growing success of the industry. The objective of this book is to serve as an introduction to Islamic finance and banking with the aim of providing an invaluable resource that can be utilized by students, professionals and those wishing to learn about Islamic finance from its inception to its future development.

The global financial crisis of July 2007,¹ which was the worst since the Great Depression of the 1930s, played a significant role in highlighting the potential of Islamic finance to an international audience. Many conventional banks and financial institutions were left heavily in debt, due to an economic strategy that had built up increased liquidity and uncertainty in mortgage credit institutions in the United States. In addition, many conventional banks that had been dealing with interest and speculations accumulated an excessive amount of debt which led to an economic spill-over into the international economy.

In September 2008² the crisis worsened as the global economy saw a downfall in stock markets, volatile exchange rates and a decrease in international trading. The worldwide economy was affected profoundly, with unemployment at its peak and a drop in industrial production, which further led to a rise in declining incomes and families struggling with financial impediments. Investors, entrepreneurs, businesses, banks, employees and other financial institutions lost out profoundly, which prompted discussion of the foundations of the capitalist financial system.

New ideologies and alternatives to the conventional method of financing were welcomed, and Islamic finance paved the way for a value-based financing that catered for the masses. Islamic economists began to raise awareness of the benefits that Islamic finance contributed in preventing the consequences of another global financial crisis. The Islamic finance industry is therefore seen as a new paradigm that could be used in ethical investment and financial products that can enhance and protect economies worldwide.

An Introduction to the Principles of Islamic Finance

Islamic finance and banking is governed by the tenets of Islam and is based upon the principles of Islamic commercial law. Consequently, the Islamic economic system (as a theoretical framework of Islamic finance) is based upon axioms that construct a code of conduct for Muslims to adhere to when managing their economic activities in an ethical and Shariah compliant manner. Therefore, when understanding the basis of the principles of Islamic finance one has to consider the fact that Muslims believe that economic transactions should take place responsibly, ethically and with the remembrance that Allah (God) is the owner of all wealth. Many non-Muslims find the value-based approach appealing and many have chosen to follow the Islamic financial system when managing their finances.

One of the most important legal aspects of Islamic finance, and one that sets Islamic finance apart from conventional financing, is the absence of ribā (interest). Ribā is an Arabic word that also means usury, and dealing with ribā is a common challenge in the contemporary financial world, which has left many people heavily in debt. Islamic jurisprudence has clearly outlined the complete prohibition of ribā when making any financial transactions or deals in a Shariah compliant manner. From an Islamic economic position, ribā is considered to create a social injustice due to the fact that in a ribā-based transaction, the owner of the wealth obtains profit and the borrower carries all the risk.

This moves on to the next main principle, which is risk sharing, whereby all transactions that are made must be shared by two parties so that both parties have the same level of risk in return for profit. Vice versa, the borrower only pays interest and the owner of the wealth (the creditor) does not share in profit earned by the borrower with the same money. This implies injustice for the weaker party, whether it is debtor or creditor.

Uncertainty, also known as gharar, is another distinguishing characteristic of Islamic finance that must be avoided. Both parties must have complete information about the transactions or contracts that they are getting into. A transaction involving gambling, speculation or any prohibited non-Shariah compliant industries, such as alcohol, haram industries and entertainment that does not comply with the fundamental tenets of Shariah, is also to be avoided when making an Islamic financial contract. In addition to fundamental tenets of Islamic commercial law, according to Islamic economics Islamic finance has to consider additional factors, which are presented in Table 1:

Table 1: Features of Islamic Financial Contracts

These principles and assigned roles to IBF (Islamic Banking and Finance) are supposed to create a value system beyond normal banking by fulfilling maqāsid al-Shariah, the objectives of Shariah as it has been identified through the values and norms of Islamic economics, which are in contradiction with the pure financialization and profit maximization of conventional finance. However, this aspirational goal has not been accommodated since little of the large amounts of wealth associated with Islamic banking has reached the neediest in Muslim societies. Thus the money in Islamic banks circulates among the large corporate interests in oil rich states. It is therefore no surprise that the emergence of the Islamic banking sector coincides with the oil-shocks and the emergence of oil money in the Gulf in the 1970s.

Figure 1: Key Points from the Introduction to Islamic Finance

The History of Islamic Finance and Banking

Islamic business models can be dated back to around 1000–1500 CE,³ when Middle Eastern traders first engaged in Shariah-based transactions between the Middle East and Europe. With the advent of Islam, the Prophet Muhammad (peace be upon him) carried out Shariah-based trading operations for his wife, Khadijah. The tenets of Islamic economic activities were described in the Holy Qur’an in various verses that outlined the economic system through which transactions have to take place. Middle Eastern traders often referred back to these principles when dealing with Islamic business transactions and adhered to risk-sharing without interest and gharar.

It was only in the 1970s that Islamic finance and banking in its modern form began to emerge, and has since then become an increasingly popular way of financing, which has received demand from both Muslim and non-Muslim countries around the world. Islamic finance began to flourish exponentially and gave rise to the first recognizable Shariah compliant project in Egypt, called the Mit Ghamr,⁴ which was a Shariah-based savings scheme. Mit Ghamr was predominantly a risk-sharing business. The first Islamic banking model was introduced in Egypt in 1963⁵ and went on to pave the way for subsequent developments of Islamic banks and institutions in the developing countries.

By 1975,⁶ the Finance Ministers at the Organization of Islamic Countries (OIC) decided to establish the first Islamic bank, the Islamic Development Bank (IDB). The fundamental goal of the bank was to enhance developmental needs by providing financial assistance and support for OIC countries based on the principles of Shariah. The main aims of the IDB were to be an established international financial institution that aided in nurturing Islamic finance services and fostered development of the industry in a Shariah compliant manner. The IDB was unprecedented in being the very first international financial institution to run its financial services in a Shariah compliant way. There are currently fifty-six countries⁷ that are members of the IDB and OIC and the bank has evolved significantly following the rise in demand for Islamic finance around the world.

Since the establishment of the IDB, there have been many Islamic financial institutions and conventional banks set up around the world aiming to cater to the demand for Shariah compliant services. Many mainstream banks, such as HSBC, have set up Islamic windows to offer Islamic financial services to customers who wish to conduct their finances according to the principles of Islam. The Islamic banking industry was further spurred through the IDB, as it was the first time that an international financial institution was in support of conforming their financial services in adherence to the principles of the Shariah.

The fact that the Islamic finance and banking industry is growing at an unprecedented rate is due to historical factors that have paved the way for the sector to develop. Historically, conventional commercial banking could not easily offer funds to industrialists, entrepreneurs, traders and manufacturers without the interest-based system. There was no clear alternative to the commercial banking sector in the post-colonial period of Muslim countries, even though the principles of Islamic finance were set in place as early as the times of the Prophet Muhammad (peace be upon him).

After the independence of Muslim countries and the failure of their economic development, the 1970s was a key period for the Islamic financial industry to emerge. However, due to the industrial revolution, many companies sought to obtain funds from conventional institutions, as there were not enough sources to fund their own companies without the use of commercial borrowing. Financial intermediation, which was much sought after by companies in the 1970s, was the main reason for the success of a type of commercial banking that left ethical and religious considerations behind. As a result of the impending industrialization, Muslim borrowers who wanted to follow Islamic principles in the commercial world were left with little choice, unless there was the development of an Islamic financial institution that would meet the needs of managing their finances. The western banking sector had begun to promote commercial banking as opposed to social financing and was not grabbing the interest of the Muslim world. This brought about a realization of the need for interest-free banking as an ethical method of financing that is based on a smooth flowing banking system.

The Muslim countries began developing Islamic banking institutions that aimed to cater for small businesses and provide assistance to businesses that did not want to use commercial banking. Nasser Islamic Bank was developed in 1971⁸ and began operating a year later with the purpose of providing interest free loans that was based on a profit sharing system. In 1975, Dubai Islamic Bank began operating its services for interest free Islamic banking and by the 1980s more Islamic financial banking institutions were being set up, such as Al Bakarah group in the Gulf. Many Muslim countries, such as Malaysia, Iran, and Bangladesh, established Islamic banking sectors and set up their own Islamic banks with support from their governments. In addition, non-Muslim countries responding to the needs of Muslim investors, such as the Philippines, Denmark and Luxembourg, also began to tap into models of Islamic finance and establish Islamic banks.

In the twenty-first century there has been an increase in demand for Islamic banking, with the establishment of many Islamic banks and windows in major western countries such as the UK. This rise was due to the global economic crisis that left many businesses and banks heavily in debt. The crisis, which mainly affected the western world’s commercial banking sector, businesses and entrepreneurs, highlighted the flaws of the conventional banking system. The Islamic finance system was brought into the spotlight and many investors and entrepreneurs, who had lost out on conventional banking investments, now started to recognize Islamic finance as a new possible alternative.

The Islamic finance and banking industry was noted as having many benefits in comparison to the commercial banking system, primarily because it is based on a strict no interest policy. There could not have been a better time for Islamic banks and institutions to develop, as many people began desperately looking for alternatives to commercial banking in order to avoid another economic downfall. Many investors began looking into the advantages of ethical-based investments and financial methods that avoided the use of interest and speculation. Undoubtedly, the global economic crisis which shook the world played a pivotal role in arousing awareness of the Islamic finance and banking industry. The crisis had also raised concerns regarding the conventional financial system and capitalist methods of managing the economy that had taken rise around the world, through predominantly interest and speculative-based products, in banks and financial institutions.

The innovation of Islamic finance and banking provided people with an alternative to managing their finances with risk sharing models in comparison to conventional modes of financing. Due to the ethical principles of Islamic finance, both Muslims and non-Muslims found Islamic financial products and services appealing. Muslims wishing to utilize Shariah compliant finance in adherence to their faith, and non-Muslims who also wanted to manage their finances in a socially responsible manner, began seeking out global Islamic financial institutions. This opened up the scope for the development of fully-fledged Islamic banks and Islamic windows, which began to emerge in conventional banks to cater for the growing demand.

Major Islamic financial hubs were prospering, and international financial centres such as the United Kingdom began to see a rise in opportunities to offer Shariah compliant banking services. Al Rayan Bank (previously the Islamic Bank of Britain) was established in early 2004 and is the UK’s first ever fully-fledged Islamic retail bank. The UK also issued the very first Islamic bond