Introduction to Islamic Banking and Finance. M Kabir Hassan
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Islamic law forbids Riba (interest) just like all monotheistic faiths, including Christianity and Judaism. This view on interest is taken up by all Abrahamic faiths and other distinguished scholars in history.
Aristotle commented on interest as follows: Of all modes of getting wealth, this is the most unnatural. Moreover, Thomas Aquinas said: To take usury for money lent is unjust in itself, because this is to sell what does not exist and this evidently leads to inequality which is contrary to justice.
In mainstream economics literature, we also find criticism of interest. John Maynard Keynes in his seminal book General Theory of Income, Employment, Interest and Money commented as follows:
Interest to-day rewards no genuine sacrifice, any more than does the rent of land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital.39
The term Riba in Islamic finance refers to any stipulated increase over the principal amount of loan. Thus, the term Riba incorporates usurious loans as well as modern-day interest in banking, debt markets, and contracts.
Islamic law does not guard capitalists with a fixed return on money capital to accumulate more wealth without bearing any potential loss in the commercial undertaking for which the loan was provided. Instead, Islamic law makes it necessary for money-capital owners to bear the risk of the productive enterprise to earn any legitimate growth in money capital. Islamic law permits profit on the trade of assets including consumer goods and capital goods if the seller has the ownership and risk of the goods prior to bringing them for selling to others. In Islamic law, Bai means a sale transaction between buyer and seller in consideration for a price. After executing Bai, the ownership and risk transfer from the seller to the buyer. Islam permits Bai; however, Islamic law does not permit earning money from lending money without undertaking risk in a productive enterprise.
Further, Islam emphasizes transparency in relations and economic exchanges. Thus, it prohibits Gharar (uncertainty) in a transaction that can potentially lead to significant losses down the road due to misinformation.
Gharar implies significant uncertainty in any contract regarding the details of the contract, such as specification, quantity, and quality of the subject matter. Gharar is also there when there is ambiguity about price, mode of delivery, and payment terms.
Islam also forbids Maysir (gambling) due to its negative effects on distributive justice as well as on the moral standards of earning a livelihood. Since Islam forbids Maysir, it implies that most contemporary financial derivatives, convertible securities and the contemporary system of insurance also stand prohibited if they involve an element of Maysir. In contrast, Islam encourages striving to earn a livelihood through labour, and if there is surplus wealth, Islam encourages that it is invested in real productive enterprise and the payoffs shared from the productive enterprise equitably. This ensures distributive justice, employment of idle resources and circulation of wealth through growing real sector economic activities.
In the financial contracts, Islam emphasizes transparency, full disclosures, rule abidance, justice, truthfulness, and excellence in conduct, both in letter and spirit as elaborated in the previous section.
Islamic financial institutions comply with Islamic rules to offer financial services in the areas of (i) financing real assets through sale, lease and equity-based modes of financing, (ii) investments in real assets and enterprise, and (iii) risk management through mutual risk sharing.
Finally, Islamic social finance comprises institutions which aim to perform the redistributive function by wealth and asset reallocation from the rich to the poor, from the haves to the have-nots, and from the wealthy to the deserving people through institutions, such as Zakat (a wealth tax on people owning wealth above a threshold amount known as Nisab) and Waqf (Islamic endowments). Property-based Waqf can earn income through the rents on properties. In turn, these proceeds can be used to finance the needs for social development. Cash Waqf can provide Qard Hassan (interest-free loans) to the needy in sectors like education, health, and agriculture.
Thus, we see that the Islamic finance ecosystem has sufficient variety of institutions as rules and product structures to meet the contemporary financial needs responsibly and ethically in line with Islamic principles. Figure 1.1 shows the major institutions in Islamic finance architecture. Islamic finance can be divided into commercial and social finance, which together cater to the needs of all the broad sections of the society.
1.1.5Economic value proposition of Islamic finance
Financial institutions provide facilitation in intertemporal exchange of funds between saving-surplus and saving-deficient units by providing delegated monitoring and investment management services efficiently.40 In the direct potential exchange between saving-surplus and saving-deficient units, there is a double coincidence problem in terms of (i) matching cash flow needs and availability and (ii) the preference for maturity in investment and financing. Unlike in spot exchange, information asymmetry between the counterparties in an intertemporal exchange of funds requires diligent monitoring and enforcement of contract terms. Financial institutions provide intermediation services to reduce these transaction costs for both counterparties.
Figure 1.1. Islamic finance architecture.
From the Islamic viewpoint, the critical element is that the intertemporal exchange of funds shall not include any increase over the principal amount of the loan. There are two alternatives to meet this restriction. One alternative is that if a money loan is provided, then no increase over the principal amount is charged. The second option is to provide financing for the acquisition of an asset by either selling it or providing it on lease. In both cases, the financial institution has to own, possess, and bear the risk of an asset in possession before selling it or providing it on lease. In such a way of financing, the Islamic financial institution can earn a profit on credit sale or rents on providing the usufruct of an asset in its ownership to the client.
To enable households and firms to meet various financial goals in conformity with Shari’ah principles, Islamic finance was theorized and then practically implemented as an alternative financial system in the twentieth century. The first modern Islamic commercial bank, Dubai Islamic Bank, was established in 1975. Since the year 1975, several Islamic financial institutions have been established in different financial sectors like banking, insurance, and asset management.
According to some scholars, there are some distinctive features inbuilt in Islamic banking which link it automatically with the real sectors of the economy. The necessary requirement of only providing funds for assets that are produced in the real sector of the economy links the financial payoffs with the real assets. Since the returns for the financial institution are linked with the performance of the asset, it ensures more prudence in monitoring and risk management by the financial institution and hence safeguards the investments of depositors.41 Furthermore, asset-backed financing ensures that the size of the financial sector does not exceed the real size of the economy by necessitating the provision of finance only for the genuine purchase of assets.42
1.1.6Islamic banking: Growth and profitability
At the global level, Islamic banking started as social finance in the middle of the twentieth century. In Egypt, Mit Ghamr Islamic Savings Bank was established in 1963 by El-Naggar. Almost at the same time, Tabung Haji or Pilgrims Fund Corporation started operations in 1963 in Malaysia to help Muslims save to meet expenses of the Hajj journey.43
Then, the Islamic Development Bank (IDB) was established in 1974 to provide financial support to member countries for