Conventional Versus Islamic Finance:
How to Make a Real Difference?
Dr. Shamim Ahmad Siddiqui
Professor of University of Brunei Darussalam
1. Introduction
The financial sector of an economy is supposed to support the underlying
economic system which is in turn based on a particular world view and
political and economic doctrines. Conventional finance has developed over
several centuries originating from Europe and United States in support of a
capitalist system that does not allow much room for religious based ethics.
Individuals with any religious concerns in that system are supposed to make
their own personal adjustments. Conventional finance is now being adopted
by most countries of the world especially after the demise of Soviet Union in
the nineties.
As an Islamic economic system allows private property and appreciates the
role of markets in determining prices in different markets, many Muslim
economists may find the basic principles of an Islamic economic system
relatively closer to capitalism compared to that of a socialist system. It is,
however, important to note that an Islamic economic and its financial system
must be in line with Islamic teachings. In my view, the basic objectives and
goals of an Islamic economic system are distributive justice, fairness and
fostering Islamically desirable behavior among people, without unnecessarily
sacrificing allocative efficiency. Its financial system should not only
contribute in achieving these goals but also avoid financial dealings that
involve prohibited elements such as excessive speculation (mysir or qimar),
unnecessary uncertainty (gharar) and riba (usury and / or interest).
Financial institutions developed in the capitalist system often involve
elements that are questionable from an Islamic perspective. For example, in
conventional banking guaranteeing of principal amounts as well as interest
accrued on them by commercial banks is a fundamental requirement. This
necessitates commercial banks to (mostly) rely on fixed income assets
resulting in a particular distribution of income pattern and a possible source of
financial instability. Islamic banking on the other hand requires that amount
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deposited in banks for the purpose of income generation should be treated as
investible funds that are prudently invested by banks in Islamically
permissible ways and any profits (or loss) accrued are shared fairly. Similarly,
the current rules of the game in other capitalist institutions such as markets for
shares and bonds, insurance, futures, options, etc. have some elements of
mysir and / or gharar that could be questionable from an Islamic perspective.
Financial institutions and practices under an Islamic economic system
would either create new institutions or change the rules and practices of
existing institutions of the capitalist system to make them compatible with its
overall goals. This is not a trivial job and requires concerted efforts by Islamic
religious scholars, Muslim academics and practitioners to continuously
evaluate existing theories and practices and working of different institutions.
Meanwhile, in proposing any suggestions for reforms, in my view, the
following methodology should be adopted:
• One should be very clear about the basic goals and principles of Islamic
economics and finance
• In deriving these goals and principles must give higher importance to the
verses of the Qur’an, and then to Ahadith (in this order)
• The rulings of the past Muslim jurists should be looked at while firmly
keeping in mind
1. the spirit of the relevant Qur’anic and Prophetic injunctions and the
particular time and social environment in which the rulings were made
2. the consequences of those rulings in the past – whether they contradicted
the spirit of the Qur’anic or Prophetic injunctions
3. the possible consequences of implementing those rulings at present with a
clear understanding of the functions and workings of contemporary economic
and financial institutions
4. the possibility that some of these rulings could be wrong in absolute terms
(irrespective of time) or may not be appropriate for our time
5. the acceptability or applicability of a ruling should be based on the
consequences of that ruling for our time, and not necessarily on whether the
ruling represents the view of the majority. A minority view could be more
convincing, appealing and better aligned with the spirit of the Qur’anic verses
and / or Ahadith.
• One should accept the possibility that two different views on an issue could
be equally strong, convincing and even valid. It is, therefore, possible that
Conventional Versus Islamic Finance: How to Make a Real Difference?
33
Islamic economic and financial systems implemented in different countries
may have some distinct features. Accordingly, the impact of distinct policies,
regulations and institutions prevailing in different countries should also be
compared to determine their relative advantages and disadvantages. If
necessary or desirable, an open minded discussion should continue to narrow
the differences.
This paper highlights major differences in the working of the conventional
and Islamic finance, critically evaluates some current practices in Islamic
finance, and proposes ideas for the real progress of an Islamic financial
system. I conclude this section by pointing out that issues in Islamic
economics and finance are primarily discussed here for those Muslims who
are conscious of their religious duties. However, I always keep in mind that it
should be presented in a way so that it helps (a) those Muslims who are not yet
convinced, to understand the need for Islamic economic and financial reforms
and its possible positive implications (b) the non-Muslims to comprehend, if
not appreciate, why many Muslims are concerned about such reforms.
The organization of the paper is as follows. Section two describes my
views on the basic goals of Islamic economics. In section three, I present basic
principles of Islamic finance. Section four highlights the differences between
conventional and Islamic banking and potential benefits of Islamic banking.
In section five, I criticize the current status of Islamic banking and suggest
some practical steps for implementing a profit and loss sharing Islamic
banking. Some ideas on the working and management of Islamic insurance
companies are conferred in section six. In section seven a brief discussion on
issues related to Islamic capital markets instruments is presented. Finally, in
section eight, I give some concluding remarks.
2. The Basic Goals of Islamic Economics
The financial system of an economy is a sub-system of its economic system. It
is, therefore important to understand the basic nature of an Islamic economic
system before one can deliberate on the characteristics of an Islamic financial
system. According to Monzer Kahf, "(A)ny economic system should be
founded on an ideology which provides the economic system with its basis
and objectives on one hand and its axioms and principles on other".1 He further adds that, "(T)he validity of an economic system can be tested by its
1. Kahf, Monzer (1989), p. 43.
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internal consistency, its compatibility with the systems organizing the other
aspects of life, and its provision for improvement and growth".1
Kahf's proposition raises the following questions. What is the basic goal
and objective of an Islamic economic system? On what ideology is this goal
and objective based? What are its axioms and principles? Why the dominant
economic doctrine of the contemporary world is unsuitable for a Muslim
society? Why Islamic economics?
In my opinion, there are two interrelated basic objectives of different
systems organizing economic, social and other aspects of life in a Muslim
society. First, is to implement the commands of the Creator with our firm
belief that they are definitely beneficial for all human beings. The second
objective is to help its people in leading their individual and collective lives
according to the teachings of Islam. The underlying ideology is that man has
been put to test during this earthly life. He has been endowed with instincts for
both good and bad deeds, and then told what is good for him and what is
harmful; what would take him to falah in both worlds and what would throw
him in disgrace. An Islamic social system, that includes its economic system,
is supposed to help Muslims in following the right path and make it easy to
avoid wrongdoings.
I would pick three verses from the Holy Qur’an to make my point clearer.
The first is
"Whatever [spoils taken] from the people of those villages God has turned over to his
Apostle __ [all of it] belongs to God and the Apostle, and the near of kin [of deceased
believers], and the orphans, and the needy, and the wayfarer, so that it may not be [a
benefit] going round and round among such of you as may [already] be rich. Hence,
accept [willingly] whatever the Apostle gives you [thereof], and refrain from
[demanding] anything that he withholds from you; and remain conscious of God: for,
verily, God is severe in retribution." (59:7; my italics and underline)2
This verse highlights the importance of distribution of income in Muslim
societies. It is a command of the Creator to let wealth move around all the
sections of a Muslim society. This job cannot be left to individuals only. It is a
collective obligation of Muslims that must be carried out by the agency of the
government. Every economic and financial policy of the government should
strive for improving distribution of income pattern in the society. Siddiqui
(2001) has emphasized that this Ayah provides one of the basic principles of
Islamic economics i.e., the government of a Muslim country has an obligation
to prevent the concentration of wealth in few hands even if the income or
1. ibid.
2. (59:7), as translated by Muhammad Asad in the Message Of The Qur'an.
Conventional Versus Islamic Finance: How to Make a Real Difference?
35
wealth could have been acquired through proper means. This provides a clear
justification for the government to use, among others, tax and transfer policies
to impede concentration of wealth (beyond the income allocated to different
factors of production through the production process).1 It is also important to
note that individual Muslims are asked to willingly accept any government
decision to take away some of their wealth that they might have earned
lawfully.2
One must admit that in any society, many people would be tempted to
become rich even if at the expense of others or by exploiting others. On the
other hand, people belonging to relatively lower income groups could become
jealous and envious of the rich. Such feelings are integral parts of human
instincts. However, in the two verses below, Muslims are asked by their
Creator to control such instincts:
"O You who have attained to faith! Do not devour one another's possessions
wrongfully _ not even by way of trade based on mutual agreement _ and do not
destroy one another: for, behold, God is indeed a dispenser of grace unto you! And as
for him who does this with malicious intent and a will to do wrong _ him shall We, in
time, cause to endure [suffering through] fire: for this is indeed easy for God." (my
Italic) (4: 29-30)3
and
Hence, do not covet the bounties which God has bestowed more abundantly on some
of you than others. Men shall have a benefit from what they earn, and women shall
have a benefit from what they earn. Ask, therefore, God [to give you] out of His
bounty: behold God has indeed full knowledge of everything. (4:32)4
While Muslims are supposed to follow their Creator’s command, the
government of a Muslim society is supposed to devise policies that would
make it easier for people to follow these commands. Economic and financial
policies and accompanying regulations that are just, fair, and un-exploitative,
would inhibit the kind of undesirable human instincts mentioned in the above
two verses.
In contrast to Islamic economics, neoclassical school of economic thought
provides basic postulates for existing capitalist system. Many adherents of this
1. How to promote a better distribution of income among different factor of production is the topic of my
other paper, Siddiqui (1996).
2. For further discussion on this issue please see, Siddiqui (2001).
3. Asad Muhammad, The Message of The Qur'an. It is important to note that in the translation of this Ayah,
Asad has adopted the meaning of "illa" as not even instead of its usual meaning except. Please see his
explanatory note # 38 of Chapter IV. However, for our current purpose any of these meaning is appropriate
although the one adopted by Asad is more forceful. As I understand, it implies that economic or business
transactions must be based on inherent justice and not only apparent agreement of the concerned parties.
4. ibid, p. 109.
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school claim that economics is a science and has to be value free. They
emphasize that individuals are knowledgeable and rational people who
maximize their utility or pleasure by acquiring maximum possible level of
goods, services and leisure. A free market economy, where individuals pursue
their self interest to maximize their utility, not only allocates resources
efficiently and maximizes output in the economy but also distributes this
output among different factors of production according to their contribution in
the production process. The outcome is thus both efficient and not unethical.
Of course this assertion has been challenged by critics of neoclassical school
of thought. Siddiqui (1996) contains some discussion on this issue and further
references.
3. The Basic Principles of Islamic Finance
In every economy almost all production and commercial units require
financial resources which may not be readily available from their own
(internal) sources. On the other hand many economic units (households and
businesses) have surplus funds that they would like to invest for earning
additional income. The financial system of an economy provides a framework
of financial intermediation by different institutions to help these deficit and
surplus economic units to meet their needs. Commercial and investment
banks, markets for stocks and bonds, insurance companies, pension funds,
etc., are financial intermediaries that constitute financial system of a capitalist
economy. The performance of a financial system and its various components
could be measured in terms of its relative efficiency, stability, its ability to
solve problems of different groups involved in the system, fairness, and the
nature of the attitudes it nurtures among different participants of the system. It
may not be very difficult to observe that an economic doctrine that absolves
itself from making any value judgments will naturally assign relatively lower
importance to the last two measures just described.
Like other areas of social life, Islamic teachings require that transactions in
trade, commerce, production of goods and services and financial
intermediation should follow some basic principles. Some of these
requirements are clearly understood and largely adhered by the faithful. For
example, trade or financial dealings of forbidden goods and services (such as
pork, pornography, gambling) is clearly prohibited and there is hardly any
controversy about it. A clear understanding of some other requirements and
their implementation is, however, far from settled. The most important of
them that is relevant for banking and finance is to refrain from riba, gharar
and mysir.
Conventional Versus Islamic Finance: How to Make a Real Difference?
37
3.1 Avoidance of Riba, Gharar and Mysir
Islamic scholars emphasize that riba (usury and/or interest), gharar (uncertain
or unclear elements in business contracts) and mysir (transactions tantamount
to be gambling) should be avoided in trade and financial dealings. The issue of
riba is of paramount importance for Islamic banking and finance and will be
discussed thoroughly. In the context of financial transactions, gharar could be
thought of as looseness of the underlying contract such that one or both parties are
uncertain about possible outcomes or obligations. Alternatively, there could be an
element of gharar if a contract could be read in a number of ways such that one party
could easily deceive the other party.1
The issue of gharar in our time has been most frequently mentioned in the
context of insurance. Many religious scholars (due to some misunderstanding)
had initially claimed that dealings in conventional insurance involve gharar.
They argued that it was not known in advance who would benefit from
insurance claims in a particular period and what amount would be eventually
paid in claim settlements. Furthermore, it was also contended that insurance
seemed to have an element of mysir as it was possible for someone to claim a
huge amount for which only a small premium was paid. A number of Muslim
economists convincingly refuted both these claims. 2 However, one of the
objections that has remained valid to this date with respect to conventional
insurance is that most of the proceedings of insurance premiums are kept in
interest bearing instruments. 3 The establishment of Islamic insurance
companies commonly known as takaful, is to make them conforming to the
teachings of Islam.
The issue of mysir has been often referred in the context of the working of
modern day stock markets, and markets for options, futures, etc. It is claimed
that these markets are mired with excessive speculative activities. For
example, in stocks markets people trade in stocks for making quick capital
gains rather than focusing on dividend payments.4 Apart from the issue of
mysir, it could also be argued that the basic goal of a stock market is efficient
financial intermediation, which can be better realized if dividend payments
are directly made the focal point of the market.
The same may apply to forward and future markets for commodities where
the primary rationale for their establishment was to reduce risk and
1. Bacha (1999).
2. For an excellent discussion on this issue please see Siddiqi, M.N. (1985).
3. It is also being argued that, instead of allowing some individuals or group to insure others, people facing
similar calamities in future should somehow get together, form their own insurance companies and share
the cost and benefits collectively. Please see Kahf (1994). Alternatively, an individual or group could offer
to establish and run such companies / organizations on behalf of the subscribers who would be the actual
owners of such companies.
4. For a good discussion on this issue please see Tag-eldin (1998), Ackacem (1999) and Kia (2001).
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uncertainty about future prices for both consumers and producers. It is
questionable if these markets generally achieve this ultimate goal. Apparently
they have become places for excessive speculation or mysir and need careful
evaluation by Muslim economists and financial experts for their acceptability,
or to come up with possible reforms to make them conform to Islamic
teachings. Even if these markets do provide some useful services, their
acceptance, in my opinion, should be linked with the acceptance of the general
behavior it creates among the participants. One should also contemplate to see
if the perceived benefits could also be achieved through other means. Some
risks in investments and businesses are inherent. Providing opportunities to
individual investors and businesses to reduce or avoid risk may appear
sensible. However, it would be difficult to reduce the total inherent risk of a
sector of the economy; one individual or business can only try to shift risk to
other. The solution lies in a risk sharing mechanism that is efficient, achieves
the underlying goals, avoids excess speculation tantamount to mysir, and is
fair to all parties involved.
The primary reason for establishing Islamic banking was to avoid interest,
the main apparatus of conventional commercial banking. Interest being one of
the most important element of many financial dealings in the contemporary
world, we now turn to have a deeper look into the issues related to Islamic
banking and its modus operandi to avoid interest.
3.2 Rationale for Prohibition of Interest
The basic case against interest is drawn from the Qur’anic prohibition of riba.
Indeed there are arguments against treating bank interest as riba that is
prohibited by The Qur’an. Similarly, it is widely accepted view among
contemporary Islamic scholars that charging a higher price for a deferred
payment sale of a good is allowed in Islam. Shamim Siddiqui (2006, 2006b &
2007) has dealt with these arguments and views at length and concludes that not
only bank interest does come under the definition of riba, but the non
acceptability of higher price for deferred sale is essential to avoid any
contradiction in this regard. I cannot go into the detail arguments and
counterarguments here but would like to discuss few points.
It is reasonable and important to admit the fact that whenever a person gives any
type of loan (not charity) to any one, it does have an element of sacrifice in the
following three senses: (i) there is anxiety whether the loan would be paid back
or not (ii) a possibility of missing a profitable opportunity during the loan period
and (iii) the loaned amount may be needed for important and urgent personal
consumption.1 However, in order to promote brotherhood and fraternity among
1. This proposition is valid irrespective of whether people have a positive, zero or negative time preference.
Conventional Versus Islamic Finance: How to Make a Real Difference?
39
human beings, Islam prohibits charging of any interest on consumption loan. But
to deny the reality that, in general, there is some sacrifice made by the lender
would be wrong. Muslims are asked to make that sacrifice. Although there could
be many cases in which people do feel good after giving loans to friends and
relatives or to fellow human beings in distress even when they understand that
there is a possibility of default. Islam encourages giving Qarde Hasanah (loan
without interest). It also asks Muslims to give more time to the borrowers in case
he/she is having problem in paying back --- all to promote humanity and a
reward in the here after. The least desirable thing for a Muslim, who has been
approached by a fellow human being for consumption loan, is to make an excuse
gently and politely. But to give consumption loan and then ask for an increment
over the original is unquestionably prohibited.
A possible objection to this assertion could be the existence of inflation in a
modern monetized economy. This raises several issues: Can there be inflation
(sustained increase in general price level) without increasing the supply of
money beyond certain limit? If no, should an Islamic economic system then
permit occurrence of inflation through its monetary policy (changes in stock of
money)? If yes, then under what circumstances? Shamim Siddiqui (1994)
addresses these issues and concludes that it is possible to avoid the occurrence of
inflation under an Islamic economic system. However, even if we admit that
some positive level of inflation is a common feature of any modern economic
system (Islamic or otherwise) and that it is not purely a monetary phenomenon,
it only allows a case for indexing consumption loans to make adjustment for
inflation. The main problem with indexing even consumption loans is that it
makes inflation acceptable and gives a freer hand to the government to create
money. It encourages her to become prodigal and avoid taking politically harder
decisions to generate financial resources from other sources (generally through
taxes) or to reduce avoidable expenditures.
An Islamic economic and financial system, therefore, must follow a monetary
policy that makes inflation targeting as its main goal. Recent international
experience shows that for a credible central bank achieving short as well as long
term price stability is not as difficult as once it was thought. As a corollary, very
low levels of inflation could allow sale on deferred payment by incorporating the
cost of inflation in uniform prices for cash and credit sale (same as uniform
prices are charged for cash and credit card payments) provided that the time
period is not too long. For consumer durables such as automobiles and houses I
will suggest an alternative later in this paper.
In case of production loan, the lender is allowed to accept a fraction of the profit
if he also agrees to share the losses. The rationale is again based on the notion of
human fraternity and brotherhood. In Islamic system of humane relationship and
social justice, it is unethical on part of some of the providers of the business
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funds to ask for fixed positive return irrespective of the outcome of the business.
On the other hand, it would be unjust on part of the borrower to pay only a
predetermined (small) rate of interest even if he is able to make a big fortune out
of the business. Similarly, it is unjust to pay the lender a nominal rate of fixed
interest when the rate of inflation is higher than this rate and the borrower is able
to make a substantial profit. This is the case in Pakistan and many other
developing countries where borrowing from commercial banks has become a
cruel source of exploitation of bank depositors.1
It could be admitted that some individuals in the society may not have any other
resources to earn a living (an old or disabled person) but a small amount of
savings which they would not want to put to risk. Some special arrangement
could be made for those individuals such as creation of a welfare fund by each
business using their savings in the production process, which can dispense
necessary relief to them in case of a business loss. Alternatively, their savings
could be put under some government department or prudent private agencies,
indirectly controlled by the government, who can efficiently manage diversified
portfolio even if that leads to a relatively low level of returns. But on the pretext
of presence of such individuals (e.g., old or disabled persons), a general
permissibility of institution of business interest goes against the Islamic sense of
social justice. Similarly, the need of financing of small business loans (and those
consumer durables) is very important. However, the best way to tackle these
financing in an Islamic society is to establish specialized financial institutions
that give loans for genuine needs without interest (more on this issue later in this
paper).
3.3 Rationale for Avoidance of gharar and mysir
As mentioned above, gharar or uncertainty in business contracts and dealings
could lead to exploitation of one or more parties involved. It may sow the seed of
an opportunistic or selfish behaviour among some parties at the detriment of
others. Avoidance of gharar achieves twin goals of protecting the just rights and
interests of all parties involved in a business or financial transaction as well as
reducing the chances of committing an Islamically undesirable act at individual
level.
Similarly, avoidance of mysir or qimar in business and financial transaction
would allow individual Muslims to refrain from gambling like acts that makes
people believe they can earn large money quickly and without too much effort. It
1. The above cannot, however, be an analogy for disapproving fixed payment to labor. It is not too difficult to
see through the difference. Labor is generally paid wage as current income for current consumption for living.
There is nothing wrong if a well to do labor risks all his labor for a share in profit, or some workers agree to link
part of their income to uncertain performance of the business entity. But to expect that workers in general should
agree to exchange their labor totally for an uncertain income will be unjust.
Conventional Versus Islamic Finance: How to Make a Real Difference?
41
is being claimed by many observers, both Muslims and non Muslims, that the
markets for shares and different kinds of derivatives are mired with excessive
speculation that reaches the level of mysir prohibited in Islam. It is also being
claimed that these markets allow the shrewder players to manipulate that causes
harm to small ones.1 While this may not be true any more as smaller traders have
now option to invest through fund managers, the intense trading activities in
these markets does create an atmosphere that unnecessarily keep people
continuously thinking about the changing values of their wealth. After all,
repeated and multiple buying and selling of shares throughout the day and week,
hardly affect the performance of the companies or the overall profits of those
companies. One can ask a very simple question as to what will be lost if trading
in secondary markets is allowed only once a week or once a fortnight?
One can make the argument that stock markets, even if they create unnecessary
speculative activity under the current rules of the game, at least act as important
financial inter-mediators in the economy by increasing the acceptability and sale
of shares at the primary level. However, the desirability and importance of
markets for futures and derivatives is much more questionable. Apparently they
are seen beneficial as tools of risk management. However, from an Islamic point
of view, the level of speculative activities generated by these markets make them
questionable. Moreover, whether they really help in stabilizing prices over time
and thus help economic agents better plan their future, is not very clear. One has
to also see if the same perceived benefits could be achieved through different
institutional arrangements. The agricultural support price system that helps both
consumers and producers through stabilizing the prices over time is a good
example.
4. Conventional and Islamic Banking
The main difference between the two banking systems is that Islamic banks
are supposed to work without charging and giving interest. Rather than
charging a predetermined fixed rate of interest to those who want to use
banks’ funds for trade, commerce and production, Islamic banks are ideally
required to have a profit and loss sharing arrangement with them. On the other
side, the depositors have two choices. First, they can keep all or part of their
money in an Islamic bank in a no-risk account. The bank will keep this money
as safe deposit and guarantee the principal amount (it could be suggested that
Islamic banks should not use these deposits for investment i.e., a 100%
reserve requirement for such accounts). Alternatively, depositors can choose
to put all or part of their money in investment accounts. Islamic banks will use
the proceedings of these accounts to make investments in trade and
1. Please see Tag-eldin (1998).
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production. The profits made by Islamic banks are then shared with
depositors. To avoid gharar, the details of profit and loss sharing
arrangements are completely and clearly known to all parties in advance.
The Islamic sense of social justice requires that all parties directly or
indirectly financing in a business should share the risk of the business. The
banks should combine shareholders’ equity funds with those of their
depositors and provide these funds to the ultimate users: traders and
producers. All parties of this business arrangement should share the benefits
as well as the risks of these investments.
Conventional banks have to guarantee the principal and accrued interest by
law, whereas Islamic banks will violate their very basic principles if they give
such guarantee (to their investment-deposit holders). In principle, Islamic
banks are not supposed to ask for collateral. In order to avoid risk, the
integrity, capability/competence of the potential user of banks’ funds (or the
entrepreneurs) and the viability of the trade or business proposal are given
much more importance in comparison to conventional banks. Banks being
equity provider of a business would be given the right to inspect all financial
accounts of the business. This is normally not the case when conventional
banks provide loans on interest.
A number of conventional commercial banks all over the world go
bankrupt every year due to bad loans or bad economic condition or both. To
be competitive, Islamic banks have to be prudent and efficient. However, even
when banks are working prudently, they could still face insolvency due to an
overall downturn in the economy. The sharing principles of Islamic banking
would channel negative consequences of a genuine downturn to all parties
involved: depositors, banks and traders/producers. The depositors may get a
lower than normal return in some years. In extreme cases, a negative return is
also a possibility. However, one should also keep in mind that when most
businesses would realize better returns, both shareholders of Islamic banks
and their depositors should also receive higher than normal returns.
Conventional Versus Islamic Finance: How to Make a Real Difference?
43
4.1 Islamic Banking in Theory: Some Suggested Advantages
A number of theoretical works examined the implications of preferred Islamic
modes of finance in the contemporary world. In their theoretical work,
Siddiqui and Zaman (1989a & 1989b) have shown how the application of
mudarabah and musharakah techniques of finance has the potential to
enhance investment and could also generate a more equitable desirable
income distribution pattern.1 Their models confirm the intuitive point that
compared to a debt arrangement, both under deterministic and probabilistic
framework, mudarabah and musharakah finance could lead to higher level of
investment as new (marginal) projects would be under taken as long as they
are expected to give a positive rate of return, however small those rates might
be.2 It also shows that under these Islamic techniques of finance, compared to
a debt system, a greater portion of profits is allocated to the providers of funds
if the economy is doing well. On the other hand, in bad conditions, the
providers of fund receive a lower return and in extreme cases they may get a
negative return. This has a stabilizing effect on the economy.
Siddiqui (1994) further discuss how an economy based on the institution of
interest is inherently unstable (a proposition so elegantly presented and
championed by prominent Post Keynesian economist, Hyman Minsky), and
how the Islamic techniques of finance based on profit and loss sharing have
the potential to provide financial stability. It emphasizes the point that
mudarabah finance is particularly capable of attracting those potential
capable entrepreneurs who are unable to provide any collateral. This possible
increase in the supply of entrepreneurs would decrease the bargaining power
of existing entrepreneurs and can lead to a desirable distribution of income by
discouraging concentration of wealth in fewer hands. Siddiqui (1994) also
addresses the problems one would face under Islamic techniques of finance
and argues that those problems are not insurmountable. He points out that any
serious attempt to implement profit sharing financing would require, at the
initial stages, commitment and often supervision and intervention by the
government.
5. Contemporary Islamic Banking: Has There Been Any
Significant Achievements?
Siddiqui (2007) observes that contemporary Islamic banking has hardly
achieved anything significant. By and large, using debt like transactions, it has
contributed in the continuation of conventional commercial banking. For
1. Siddiqui (1989a, 1989b).
2. Under a debt arrangement projects are not under taken if the rate of return is less than 1 + the rate of
interest.
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Saeed (1998), Islamic banks have been pragmatic and avoided profit and loss
sharing techniques of financing because of the inherent problem of risk
involved mainly because of the problems of moral hazard and adverse
selection.
For me, the argument that in contemporary societies the problems of moral
hazard is insurmountable and banking with reasonable rate of interest is the
only solution for the kind and level of financial intermediation provided by
conventional banking, is much more acceptable than the claim that current
activities of Islamic banks are in line with the spirit of Islamic teachings. The
basic problem is the acceptance of deferred payment sale at higher than cash
price by some past and most of the Fuqha of our time. Siddiqui (2007) argues
that allowing deferred payment sale at higher than cash price and then taking a
stand against bank interest is not tenable. It creates a lot of confusion among
ordinary Muslims and compels the scholars to tremble in defending their stand.
One can argue that Islam, on one hand, allows any rate of implied or hidden
interest through bay muajjal with higher than cash price but, on the other, does
not allow even a low rate of interest on cash loan! Indeed, in Pakistan traders
involved in bay muajjal often charge a very high hidden interest rate (reaching
up to 50% and beyond). The argument that Islam accepts the validity of
positive time value of money in case of bay muajjal but does not allow the
same in loan on cash is equally indefensible.1
Indeed, conventional commercial banking has its benefits and
disadvantages. Our main objection against it is that it is based on something
that is prohibited by Islam and our belief that its alternative based on a more
justified system of profit and loss sharing must be more beneficial. That it
would be difficult to be implemented is also not questioned. However, one
must examine whether Islamic banks and the governments of Muslim
countries have put reasonable effort to establish the proposed system. After all,
current conventional banking has been established after a long period of trial
and error and had required many laws, regulations and development of
necessary institutions (such as central banks, deposit insurance, etc.) for its
health and survival. Neither the Islamic banks nor the governments of Muslim
countries have taken the challenge of profit and loss sharing Islamic banking
(PALSIB) seriously enough. On the other hand, I don’t know if there is a
single member of any shari’ah board of any Islamic bank who questions the
validity of debt like transactions.
It was expected that the position of ordinary depositors of commercial
banks many of whom are unable or incapable of investing in other instruments
of capital market, will be improved from the profit and loss sharing Islamic
1. For a detail discussion on these issues, please see Siddiqui (2006 b).
Conventional Versus Islamic Finance: How to Make a Real Difference?
45
banking after effectively becoming shareholders of Islamic banks. However,
it is quite evident that they are still treated as depositors of commercial banks.
As they are more or less assured of their return (never mind if it remains
meager!), they remain depositors like any other commercial bank.
As most Islamic banks have been heavily involved in consumers’ loan,
they have also joined hands with other commercial banks in spreading
consumerism to new extents. Even a rich country like Brunei Darussalam
where most of its Muslim customers do banking with Islamic banks,
indebtedness has become a major social issue. Recently the government had
to intervene and put a ceiling on the amount of loan that commercial banks
(not excluding Islamic banks!) can give to government employees.
Looking at this situation one has to ask, what really went wrong? In my
opinion the answer is that everybody involved in establishing Islamic banking,
including academics, did not realize the complexity and enormity of the job at
hand. The issue of moral hazard and adverse selection was not a new
phenomenon in banking and it should have been visualized that it would take
some time to overcome or control this problem. The sensible approach should
have been taking a gradual and cautious approach. There was no need to give
an impression to the Muslim depositors that returns on different types of
deposits would be as good (if not better) than the conventional banks.
Actually the funds could have been solicited only from committed Muslims
and Muslim governments after giving a complete picture of the difficulties of
the job at hand. The desire to keep the depositors happy and not deserting
Islamic banks, unlimited availability of debt like financing and a somewhat
sympathetic shari’ah board (one for each bank!) led to the easy solution in
which we find the Islamic banking industry today.
I don’t see any hope that there will ever be a consensus against the validity
of debt like financing. It is, therefore, suggested that instead of wasting time in
continued arguments, the Islamic critics of contemporary Islamic banking
should put all their efforts in working for alternative PALSIB as a variant of
Islamic banking. We already have a fairly good idea as to what went wrong
with the current Islamic banking; it would be now somewhat easier to take
necessary steps to set the correct direction for the desired destination. That the
road would be bumpy and movement could be slow is not disputed; right
direction, steadfastness and keeping the destination clear in sight will
eventually achieve the objective.
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5.1 How to Establish PALSIB: Some Suggestions1
There are four parties involved in commercial banking each with their own
interest; funds providers (or savers), funds users, commercial banks and the
government. The role of government is to make relevant rules and regulations
and establish institutions for smooth running of the commercial banking, and
to safeguard the interests of the bank owners (who provide initial funds or
owners capital), funds providers, and the funds users. Furthermore, by
allowing commercial banks to create money and empowering central banks to
stand for them as the bank of last resort, the government has the right,
responsibility and a stake in smooth running of the banking sector as the
general public also benefit from the stable and growing level of economic
activities partially made possible through financial intermediation.
A basic requirement for the eventual success of PALSIB is that all these
four parties have enough commitment, compulsion and incentives to carry out
what is required of them. There is no denial that some of them (especially the
funds users), at least occasionally, following their instincts of self or group
interest would tend to drift from the ideal. A necessary environment has to be
created through rules, regulations and their implementation that could
minimize such behaviors.
As mentioned earlier conventional commercial banks have grown over
centuries creating many institutions to support its smooth running. Even now,
in a free market era, they are the most heavily and extensively regulated
industry constantly under watch by the central banks. The backbone of
conventional banking is (a) the right of the depositors to their principal
amount (up to a certain limit) in nominal terms and any interest accrued no
matter what happens to a bank and its fund users, which necessitates (b)
provision of loans to the funds users only against collateral. Both the
depositors and banks thus are supposed to be risk averse by design. The banks
are actually discouraged to offer higher rates of returns as it may require them
to charge higher rates to their funds users raising the chances of higher
incidences of business failures. The system has thus resulted in very low
levels of assured returns to the depositors that, in many countries even do not
reach to their rates of inflation. This is a new kind of injustice that is often not
given due consideration in Islamic banking literature.
While assuring the depositors of their principal and interest accrued
on them is the backbone of conventional banking, such assurance is a negation
of PALSIB unless the amount is deposited as an amanah (safe custody) in
which case the principal would be protected and a service charge for safe
1. The contents of this section are heavily drawn from a recent paper presented in a conference in Kuala
Lumpur; please see Siddiqui (2007).
Conventional Versus Islamic Finance: How to Make a Real Difference?
47
custody and other facilities imposed. There is a whole lot of difference in
these two types of arrangements and requires a completely different and new
approach of thinking, attitude, operative methods and supporting institutions
to do this kind of banking. By doing banking with murabaha and its variants,
not much was done to move in this direction.
5.1.1 Changes in Attitude and Approach
Perhaps the most important thing for PALSIB is the attitude of the bankers.
They must be trained to do a different type of banking. Conventional bankers
are trained to ascertain the provision and value of collateral before giving a
loan. PALSIB requires that they train their staff for evaluating the fund users
(more importantly their integrity and capability), their business plans and
monitor their operations and activities after deciding to invest funds with them.
It would certainly increase the cost of banking operations, more so during the
initial period of PALSIB until devices are created that would minimize the
cost of screening, checks and inspections. However, this has also potential to
increase the total returns of PALSIB banks. Furthermore, as banks will be
involved in financing diverse businesses in different sectors of the economy as
co-sponsors of projects or businesses, they will be in a better position to give
valuable guidance to the funds users. This would reduce the chances of over
investment in a particular sector or region of the economy.
PALSIB should be initiated in countries where the governments and
central banks are fully supportive of the idea and ready to do whatever
necessary to establish it. The top managers for PALSIB banks should be
chosen from a pool of bankers who know the importance and complexity of
the job and eager to offer best of their abilities. The next step would be to pick
middle and lower level staff who are appropriately educated, intelligent and
capable. They should be then trained extensively to work in the evaluation and
monitoring departments of the banks.
The success of Grameen bank and its founder must be a reminder to all
those who thought that banking without collateral was not possible. This bank
has shown that if the staff is trained for a purpose and they are involved with
the fund users, commercial banking is possible without collateral even when
the borrowers are the poorest of the poor. If Islamic banks had done necessary
home work and put required efforts, they could have shown the world that
commercial banking is possible without involving interest.
5.1.2 Dividend Markets
The continued low levels of returns to depositors has also, at least partially,
contributed to the growth of mutual funds that are increasingly providing
comparative services with higher returns by investing in liquid assets such as
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readily tradable stocks and bonds. They never face a bank run situation as the
depositors are never assured of their returns and they can always liquidate
their assets to meet any demand of withdrawal. PALSIB is close to the
concept of (non-money market) mutual funds.
Indeed, commercial banks are different from mutual funds and they
do provide funds to many small producers to start new businesses or to expand
their businesses. As they have to guarantee the principal and interest to their
depositors, they cannot be allowed to invest beyond a limited amount in
stocks and other risky assets. As PALSIB is based on the concept of
non-guaranteeing a fixed and positive return to their funds providers, they
would be well placed to invest a large fraction of their funds in stocks. While
this may be seen as PLALSIB banks being involved in PLS mode of finance,
too much exposure to stocks may keep the value of their assets and returns to
their funds providers discouragingly unstable. This leads to another related
issue in Islamic finance, the elimination of mysir (or gambling like
transactions) in general and from the stock markets in particular.
It is often claimed that the current modus operandi of stocks markets
creates an efficient and extremely liquid system. Any new information
quickly adjusts the prices of stocks through continuous buying and selling of
stocks. The system also allows liquidating one’s position with ease and speed.
The focus of participants, however, remains on making quick capital gains
rather than earning through dividends. There is no denial that many of the best
minds in the world try to gather and process information to make intelligent
buying and selling of stocks. But I hope one should also admit that the system
still creates such an immense level of speculative environment and drive to
outsmart others that it hardly conform to Islamic teachings of patience and
cooperation. One should also consider that stock markets are part of capital
markets that are mainly responsible for financial intermediation. Stock
markets, as secondary markets for shares, make the underlying asset attractive
and thus facilitate initial sale of stocks that provides the resources needed for
business expansion by growing companies. One can argue that a market of
stock that makes the stock less liquid but reduces the amount of speculation
and induce people to focus on dividend payments would be better suited for
Muslim communities. I call it dividend markets.
The basic goal of dividend markets would remain the same as the
conventional markets i.e., efficiently allocating the investible funds to the
productive units of the economy. One of the requirements for listing in
dividend markets could be that companies must not be violating any Islamic
injunction including that they arrange all their financial needs through
non-debt instruments. Establishment of PALSIB and dividend markets will
thus help both of them in achieving their goals. Banks under PALSIB will be
Conventional Versus Islamic Finance: How to Make a Real Difference?
49
able to invest their funds in dividend markets earning regular income through
dividend. The requirement that both PALSIB banks and companies listed at
dividend markets only deal in profit and loss sharing transaction could also
lead to devise a mechanism for even short term financing through profit and
loss sharing methods.
The idea is to bring reforms in the current working of stock markets
by making dividend payments the most important variable instead of capital
gains. For example, one can argue what will be lost if people are allowed to
trade shares only once a week or for that matter once in a month. Similarly,
companies could be restricted in their decision about retained earnings,
allowing most of the profits necessarily going every period to the share
holders. Any new investment by a successful company could be attracted
through new shares many of which could be sold to PALSIB banks.
5.1.3 Funds Providers, Central Banks and shari’ah Boards
PALSIB banks should be asked to accept investment and non investment
accounts. The non investment accounts would not pay any return and will
require 100% reserve requirement. PALSIB banks could be allowed to charge
a nominal fee for providing different kinds of banking facilities. The
investment accounts on the other hand should not be subject to any reserve
requirement but would not be allowed to invest more than what is provided by
its original owners and investment accounts holders. The central bank should
be the most important account holder of every PALSIB bank and must keep
an active account providing necessary liquidity if needed for investment or
meet demand for withdrawal. As a special account holder of the PALSIB
banks, the central bank would closely watch the investment activities of these
banks. The central bank would thus be able to control the supply of money
without involving open market operations that involves interest.
Each central bank should constitute a National Shari’ah board consisting
of shari’ah experts, Islamic economists, prominent ex-bankers, and
contemporary financial experts from business and academia. This would
enhance the quality of the judgments and avoid the perceived conflict of
interests of the members. It will also lead to standardizing PALSIB products
within a country.
The central bank should make sure that the activities and financial standing
of PALSIB banks are transparent to a level that the conventional or other
Islamic banks have never reached. While the concerns of International
Accounting Standard for banks and the compliance to BASEL II must be
addressed, the central banks should come up with their own standard for
accounting practices, accounts certification system and capital adequacy
requirements based on the nature of their PALSIB products.
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To create the right environment for PALSIB, central banks should be
constitutionally asked to make price stability as their main responsibility and
given necessary autonomy to achieve this goal.
5.1.4 Gradualism
It is important to realize that PALSIB cannot be established overnight. A lot of
patience is required. However, things should not be left open ended. The
PALSIB units at the central banks, top managers of PALSIB banks, shari’ah
board members and other relevant government agencies should sit together to
determine the speed of work in different aspects of PALSIB and come up with
bench marks. The shari’ah boards should also be looking into the need to
make changes such as operating rules of traditional mudarabah and other
modes of financing. It has been often argued by Islamic bankers that they are
handicapped by not having any control over the activities of mudaribs. Rules
of mudarabah could be changed to allow the rab-ul-mal to take part in the
management, supervision and monitoring of a business. Similarly, with the
help of the government, central banks must establish banking tribunals to
make speedy resolutions of conflicts between PALSIB banks and their funds
users.
5.1.5 Cultivating a Reservoir of Islamic Entrepreneurs
Notwithstanding a possible objection to the term Islamic entrepreneurs, in my
opinion, there is a need and opportunity to produce entrepreneurs that are
properly trained and motivated to do business at different scales in an
Islamically desirable way. Siddiqui (2005) emphasizes the importance of
entrepreneurs in general and for an Islamic economic and financial system in
particular. Academic and professional training for different levels of
managers should include all aspects of Islamic business ethics. Finally, the
certification to do business could be awarded after taking a public oath to
uphold the moral commitment required of them. After all, is it not the case that
society expects a particular standard of morality from our doctors, teachers,
preachers, etc., more than ordinary citizens? Entrepreneurship is vital for any
economy; morally upright entrepreneurs could be produced through proper
training and creating a high social status for them in the society.
5.2 Financing of Consumer Durables and Micro or Medium Size Loans
Commercial banks have been in the forefront for financing consumer loans
specially that of automobiles and housing. Many of these loans are provided
against expected stable stream of future income or collaterals and paid back in
installments with accrued interest. First of all, there is no denial that such
Conventional Versus Islamic Finance: How to Make a Real Difference?
51
financing facilities do provide an important service to millions of people.
However, if one accepts the notion that any amount of interest paid (that is
over and above a compensation for inflation, in my opinion) is Islamically
unacceptable, how would then the banks under PALSIB system continue to
provide loans for consumer durables?
I propose that availability of reasonable funds for consumer durables should
be available through government resources. We should keep in mind that
under an Islamic system the commercial banks will not be allowed to create
money and hence an added room for (non inflationary) money creation will be
available to the government. A part of this resource plus an appropriate
amount from government tax revenue could be channeled for financing
consumer durables and housing. The management of these funds could be
given to specially created government institutions for these purposes.
Alternatively, these entities could be allowed to be established in the private
sector who would receive the required funds from the government along with
a reasonable percentage as fees for their services. An added advantage of this
arrangement will be that, through proper guidelines given to these institutions,
the government should be able to curb the rampant consumerism currently
seen in many Muslim countries.
Micro financing is a relatively new phenomenon. Its founder, Dr. Younus has
clearly shown the world that through an appropriate approach loans could be
given to the poorest of the poor without involving collateral. The key to his
success was the way bank employees engaged themselves with their funds
users. Some people have criticized his organization for charging a high rate of
interest. However, one has to see the motive of his organization which was to
help as many poor as possible through a sustainable non profit organization
(interest was not charged to make money but to cover the cost of operation and
expand the helping the poor activity (not making money through interest).
Indeed if the government could provide funds, there would be no need to
charge any interest at all. Also an appropriate structure of profit and loss
sharing arrangement could also be developed to finance such loans with
proper training and organizational set up.
Works on similar line have to be done to cater the needs of small and medium
size enterprises. With the level of advancement in information technology and
improvement and innovation in forensic accounting, the supervision and
monitoring of even small business are not as difficult as it used to be.
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6. Islamic Insurance or Takaful
As in case of banking, for an Islamic perspective, one has to examine if the
practices and procedures used in conventional insurance businesses involve
riba, gharar or mysir. According to Siddiqui (2006a), a survey of literature on
Islamic insurance shows that the subject has reached a level of maturity and
some of the questions raised against the very concept of insurance by earlier
Islamic religious scholars has been successfully answered. The debate on such
questions were conducted on the general premise that any institution
developed by non Muslims could be adopted by Muslims if it benefits them in
different spheres of life and does not involve a transaction that is repugnant to
the teachings of Islam.
There now seems to be an agreement that the basic problem with
conventional insurance companies is that a significant portion of their assets
are based on riba. The only other issue on which there seems to be a
noteworthy controversy is the permissibility of life insurance. Other than the
issue of life insurance, a pertinent question is about the organization of an
insurance company. It appears that, apart from the issues of riba and life
insurance, an objection against conventional insurance was its organizational
setup. For example, it was asked how an individual or group of individuals
could be allowed to insure another set of people against calamities.1 It was,
therefore, suggested that an Islamic insurance company must be set up by the
very people (or with their collaboration) who need insurance-cover against
any mishap. This brought the concept of Islamic insurance nearer to that of
mutual insurance companies developed in the west in the nineteenth century
although the use of simpler versions of the same could be traced back as far as
3000 BC.2 I will elaborate on some aspects of this issue and conclude that the
main problem could be related to distributive justice, supposedly the foremost
concern of Islamic economics and finance.3
As riba remains the most troubling subject of conventional insurance from
an Islamic perspective, the availability of riba free assets and their suitability
for insurance companies becomes a crucial issue for an Islamic insurance
1. For example see Monzer Kahf (1994), p. 34. He argues that shari’ah prohibits earning any return or
profit by guaranteeing somebody else’s responsibility.
2. Like Arabs in the Middle Ages, over 5000 years ago, in China, insurance was seen as a preventative
measure against piracy on the sea. Nearly 4,500 years ago, in the ancient land of Babylonia, traders used to
bear risk of the caravan trade by giving loans that had to be later repaid with interest when the goods arrived
safely. In ancient Rome, burial clubs were formed to cover the funeral expenses of its members, as well as
help survivors monetarily. In India, the term Rig Veda suggests that a form of "community insurance" was
prevalent around 1000 BC and practiced by the Aryans (Smith, 2004, p. 1). Prophet (SAW) allowed the
pre-Islamic institution of Aqila (a form of insurance) to continue.
3. For a discussion of objectives of an Islamic economic system, please see (Siddiqui, 2001).
Conventional Versus Islamic Finance: How to Make a Real Difference?
53
system. As we have already discussed the issues related to Islamic banking, let
us now move to the issue of life insurance.
6.1 The Controversy over Life Insurance
In the western tradition, a life insurance policy is a contract whereby an
insurer agrees to pay a designated recipient a specified sum of money on the
occurrence of a certain event. The three basic plans are term, whole life and
endowment insurance. With term, a fixed sum is payable if the insured dies
within a specified period; with whole life, the sum is payable on death
whenever it may occur. For endowment insurance, the insured receives a fixed
sum at the end of a specified period if he or she is still alive; otherwise a
designated recipient receives the amount at the time of the insured’s death.1
A number of objections are raised against the practice of life insurance.
Among others, Nejatullah Siddiqi (2000) and Masum Billah (undated) have
convincingly refuted these objections. In our opinion, some objections against
the practice of life insurance were raised because of the very use of the
terminology “life insurance”! The term appears to imply that the insurance
companies are insuring life insurance policyholders against their death! This
is indeed never the case and Islamic insurance or takaful companies have
rightly replaced the terminology of life insurance with family takaful to
remove this confusion.
Let us have a bit deeper look at what is fundamentally involved in a life
insurance agreement. When a person purchases an endowment life insurance
policy (the most general form of life insurance), he agrees (to save and) to
make periodic payments (premiums) to an insurance company for a specified
period of time in order to receive a certain amount of money at the end of the
term of the policy. In a term life insurance, it is possible that an individual may
not be saving any amount for a life insurance company. He may instead
paying an yearly premium to the company and his heirs may get a substantial
amount if he dies in that year; same as a house owner may get a substantial
amount of money from an insurance company in case his insured house is
destroyed by fire. That the transaction and the underlying agreement are not
similar to gambling should be very clear: an insured person does not wish to
die; rather he and his heirs pray for his health and well being. They normally
do everything to keep the person healthy. The main goal is not to become rich
quickly but to leave something for the family if the person dies during the
insured period.
There are many other individuals who are involved in similar contracts,
purchasing policies with varying terms and values from the company. Each
1. Goldstein, p. 5.
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one of them is primarily interested in saving for the future, for himself and for
his family members. This is purely an act in their self-interest and an act that
should be, in our opinion, Islamically permissible. The following Hadith is a
clear proof of its acceptability:
"Narrated by Saad bin Abi Waqqas (R): The Holy Prophet (SAW) said: It is better for
you to leave your offspring wealthy than to leave them poor asking others for help..."
Masum Billah also emphasizes that life insurance policy does not contravene
the principles of ‘Mirath’ and ‘Wasiyah’. In a life insurance policy, the
nominee(s) is nothing more than a trustee, as held by the supreme court of
Pakistan. The nominee is under an obligation to receive the benefits over the
policy on behalf of the heirs of the deceased (assured) and distribute the
benefits among the heirs of the deceased in accordance with the Islamic
principles of Mirath and al-Wasiyah.1
Masum Billah also refers to Al-Zarqa, Al-Alwan and Adil Salahi in
supporting the view that the nature of life insurance policy is similar to that of
a retirement pension scheme which is generally regarded acceptable by
Ulema.2
There is however, some difference between a life insurance and pension
schemes specially the term life insurance. In a term life insurance it is possible
to buy a life insurance on year-to-year basis same as an automobile insurance
or fire insurance for a year. In case the person dies, his nominee would get the
face value of the insurance coverage. If he remains alive he would loose the
premium. Hundreds and thousands of people buy such insurance and pay a
premium not because they want to die and get unlawful money from others
through the insurance company but to arrange something for their heirs in case
they face death. All the participants in this scheme are happy to live on and
don’t mind that their premium has gone to a families who lost their bread
earner or caretaker. In this regard, in our opinion, there was no need to
introduce the terminology of tabarru in takaful literature. Any contribution
made to a fund by a person to that he could himself be a beneficiary (the
probability of which is more or less similar to that of any other participant)
could not be termed a donation. It unnecessarily invites criticism by the
detractors of Islamic economic and financial system.
The people who manage these companies, make investigations about the
persons being insured and the claims being made, and invest funds prudently
and efficiently, should be eligible to get fixed salaries and / or a share in the
1. ibid.
2. Ibid.
Conventional Versus Islamic Finance: How to Make a Real Difference?
55
surplus. The management of insurance companies could be formed in
different ways. Managers of insurance companies could be hired (as
mudaribs, using the Islamic terminology) by the very people or their
representatives who pay the premium. Alternatively, these managers can
establish an insurance management company and offer their services as
mudaribs. Similarly, another group of people seeking profits can provide fund
through buying shares to run a stock insurance company. In next sections we
will argue that while all these arrangements could be Islamically permissible,
the choice of an organizational setup should be made in accordance with the
goals of an Islamic insurance.
Another point worth mentioning here is that although there are other
modes of savings available, life insurance, like pension schemes are generally
constructed for longer terms. These schemes are also relatively less flexible
compared to other savings alternatives such as mutual funds and fixed savings
deposits in allowing the policyholders to withdraw their accumulated savings
without any penalty. Similarly, long-term bonds, another mode of saving, are
bought and sold in the secondary markets whereas savings with insurance
company cannot be negotiated in any secondary markets making it less liquid.
This long term savings arrangements through life insurance policies allows
insurance companies to make long term investments and get relatively higher
rates of return. The provision that in case of the death of a policyholder, an
endowment life insurance company would pay to the heirs the full amount of
his insurance policy is also an incentive to make serious commitment for
long-term savings.
The primary goal of conventional stock insurance companies is to
maximize profits for its owners (equity holders). The policyholders
themselves, on the other hand, theoretically own mutual insurance companies.
All other things equal, the policyholders should be relatively better off by
joining a mutual insurance company. However, the existence of both types of
the companies for a very long period of time proves that ‘other things’ may
not always be equal. Obviously, the first thing that naturally comes to mind is
the issue of equity and efficiency. Any movement towards mutualization of a
stock insurance company or a demutualization of mutual insurance to a stock
insurance company must be related to equity and efficiency. Islamic insurance
or takaful, must be required to run under such organizational and regulatory
framework that they naturally move toward achieving both equity and
efficiency.
Kathy Smith points out that in the United States, it wasn't until 80 years
later (after 1840 when first time the concept of insurance got prominence),
that life insurance really took off in a big way. The key to its success was
reducing the opposition from religious groups in that country (Smith, p. 2).
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The concept of takaful and family takaful is becoming more and more popular
and acceptable. It is hoped that the remaining objections would soon come to
an end and the focus and energies of both theoretician as well as the
practitioners would now be shifted to set the goals of an Islamic insurance
system and suggested ways to achieve these goals.
6.2 Goals of Islamic Insurance
After rebutting all the objections against the concepts of insurance including
that of life insurance, the next pertinent question is what should be its
objectives and goals? Indeed, changing the name of general insurance to
takaful and that of life insurance to family takaful should be welcome, but it is
only a change in name and not in substance.
If we look at Islamic insurance as a subset of an Islamic economic and
financial system, its goals could be defined accordingly. In the context of
Islamic insurance or takaful, the avoidance of riba and the requirement that
policyholders be put at the centre stage by adopting an appropriate
organizational setup, are primarily means of providing social justice in the
society. Let us now look at some of these issues in more detail.
6.2.1 Provision of Non-Riba Assets for Insurance companies, and Islamic
Banking
There is a consensus that Islamic insurance business must avoid all
transactions that involve riba. Indeed many takaful companies claim that they
are already complying with this requirement by (i) having a sharing
arrangement with their policyholders, and only dealing with Islamic banks
and other Islamic financial funds that are shari’ah compliant for investment.
This way they are partly putting the onus of removing riba from business
transactions on other Islamic financial institutions. To some extent, their
claim seems to be justified. However, as we have already discussed, for many
people, the performance of Islamic banks in eliminating riba has been far
from satisfactory.
It is important to emphasize that the benefits of Islamic banking could
not be realized unless profit sharing modes of finance becomes the dominant
methods of financing. These benefits, among others, include a better average
returns (than what exists presently) to the depositors of Islamic banks and
meaningfully higher than the prevailing rate of inflation. Thus avoidance of
riba by takaful companies should be a source of better returns to their
investments and consequently to their policyholders. Although, unlike the
conventional insurance companies for whom riba is not an issue, takaful
companies are in a better position to invest in equity-based assets, they would
prefer to avoid excessive risk in their infancy. One can expect that as they
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57
grow in size and maturity, both Islamic banks and takaful companies should
be able to hold increasing levels of equity based assets to get rid of riba or
riba-like transaction in reality. The emergence of my proposed dividend
markets has the potential to further improve the performance of takaful
investment portfolio.
6.2.2 Preferred Organizational Setup for Islamic Insurance
After riba, another important issue is the organizational form of Islamic
Insurance companies. The two existing models of conventional insurance
could be termed as stock insurance and mutual insurance companies? 1 A
mutual life insurance company is a company with no common shareholders,
and instead owned by its policyholders who share in the company's surplus
earnings. In some country, policyholders with voting rights (who agree to take
the down side risk of the company) elect all members of the board of directors.
Unlike the stock insurance companies which are legally owned by their
shareholders, a mutual company has no access to common stock. Its managers
are supposed to work like mudaribs, for the benefit of the policyholders
sharing the profits / surplus of the company.
Takaful concepts are similar to cooperative and mutual insurance principle
with added restrictions on investment made in Islamically permissible and
more flexibility in capital formation (Patel, p. 8). Commercialization of
takaful has, however, produced several types of Islamic insurance each
reflecting a different experience, environment and perhaps a different school
of thought (Patel, p. 9). One thing is, however, clear; Islamic insurance
companies must be required to make their policyholders at the center stage.
Although, the takaful companies are supposedly working on the basis of
mudarabah, the ratio of surplus given to the policyholders is exclusively
determined by the management. Similarly, policyholders have hardly any role
in companies’ portfolio decisions. As discussed earlier, there could be three
different ways to form an Insurance company:
1. Managers could be hired as mudaribs by policyholders or their
representatives and paid fixed salaries and / or a share in the surplus generated
through premium and investments.
2. A group of individuals can establish an Insurance Management Company
and offer their services as mudaribs to potential policyholders, and could
suggest alternative surplus sharing arrangements.
1. A mutual life insurance company is a company with no common shareholders and for which all members
of the board of directors are elected by the policyholders. A mutual company has no access to common
stock.
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3. Another group of people could form a stock insurance company, select its
managers and provide insurance services to possible policyholders. The goal
of the company would be, to maximize profits for its shareholders.
We would like to emphasize that the third option should not be termed
technically un-Islamic provided that insurance companies formed as public
limited companies avoid riba. The shareholders could be seen as individuals
who provide initial funds to establish an insurance company and share the
surplus or profits. However, as their main goal is to maximize profits for the
shareholders, the policyholders’ interests are secondary to them and the issue
of distributive justice comes to the picture. The same may be the case if an
insurance company is established by one individual (or by a company as its
subsidiary as has been the case with all three Islamic insurance companies of
Brunei Darussalam) who runs the company on his own, controlling the
surplus sharing ratio and making all investment decision itself. However, the
benefit of having a mutual Islamic insurance company is that it would remove
the need to pay profits to the stock holders who are paid mainly because of
their initial contribution through purchase of shares. Mutual Islamic insurance
companies should be favored for its potential to provide distributive justice in
the economy. The problem of provision of initial amount needed to start an
insurance company could be solved by requiring the newly establishing
companies to raise money through Islamic banks on a profit and loss sharing
basis for the initial few years. Alternatively, governments of Muslim countries
could establish a fund especially for this purpose.
6.3 Mutual Insurance Companies in the Western World: What
Can We Learn from their Experiences?
It would be interesting to mention the case of Quebec province of Canada. The
origins of mutual life and health insurance companies in Quebec are fraternal
benefit societies and the co-operative movement, which has been called "an
economic system whereby individuals are part of democratic associations
they own equally and, where individuals obtain goods and services they need
at cost prices." These origins characterize Quebec companies and help explain
the differences between Quebec life and health insurance companies and their
Anglophone counterparts. The fraternal benefit societies and the co-operative
movements often developed in reaction to the excesses of capitalism and are
based on solidarity and mutual assistance1 (Goldstein, p. 7, my italics).
1. This is a point of view that seems to have been accepted by the Quebec National Assembly. However,
American legislators have always been convinced that mutual companies are capitalist in nature (Goldstein,
p. 7)
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Several points are important to note here. Mutual insurance companies
could be seen as cooperatives that try to offer insurance service at cost price
and avoid excesses that are normally present in a capitalistic profit seeking
institution. In our opinion this is an important view that could be shared by
takaful companies. Whether a mutual insurance or a takaful company
achieves this goal would depend on its organizational setup and actual
working and performance. Goldstein observes that for all practical purposes,
neither shareholders in large corporations nor policyholders in large mutual
companies have available any practical mechanism for playing a meaningful
role in the selection of management or participating in corporate governance
matters generally. The boards of directors of both types of large organizations
are largely self-perpetuating bodies who make decisions with very little
shareholder/policyholder influence (Goldstein, p. 7). Because of this both of
them could be seen as capitalistic in nature.
Goldstein notes that in the United States, many demutualizations were
brought on by financial problems. In some cases, it happens that management
does not wish to retain the mutual form, preferring forms of compensation
comparable to stock option plans in some private companies. The need for
regulations can differ depending on the situation of the mutuals and on the
reasons for the push to transform. He suggests that in every case, regulatory
measures should be fair and equitable (Goldstein, p. 7).
Goldstein also mentions that it should be borne in mind that, although there
are differences in the products offered by mutual insurance companies and
stock insurance companies, the main differences between them have to do
with voting rights and the level of dividend participation provided for the
contract obtained through purchase of an insurance policy (Goldstein, p. 7).
When they buy a participating policy, policyholders acquire, along with
specified benefits, certain rights that are not transferable. These include: the
right to borrow against the cash value of the policy; the right to dividends, if
and when such dividends are declared by the board of directors; and, on a
winding up in the case of an insolvency, the right to rank ahead of any
creditors of the company and also to rank ahead of shareholders in a stock life
company. A non-participating policy gives the holder no right to participate in
the distribution of the surplus Goldstein, p.5).
Goldstein also notes that above all, the chances for successful
transformation of a company are related to its initial health and to the motives
for transformation. Whatever the legislative or fiscal context, success in
transformation is more likely for a healthy company than for an unhealthy one.
When a company has difficulties, access to capital becomes critical to the
ongoing operations (Goldstein, p. 10).
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A number of mutual companies in the west have decided to go for
demutualization mainly to raise funds. Before they are allowed to do that the
regulatory authorities had to see the desirability of such move primarily to
safeguard the interests of different types of policyholders. Regulatory
authorities of Muslim countries can get useful insights from a thorough and
continuous study of the mutualization / demutualization process in the west. It
would help them in formulating and / or reformulating their own regulations
governing their takaful companies in light of the goals of Islamic insurance
and actual existing practices of these companies.
Good governance, no corruption, transparency, proper accounting could
make a mutual company efficient and beneficial for masses and especially the
poor in the economy. The same must be true for takaful companies. It has been
observed that as the co-operatives or mutual companies grow, they become
less effective in servicing the poor. The government can play a role in
encouraging establishment of takaful companies by providing the initial
capital. As many mutual companies in the west have gone through the process
of demutualization and access to capital is the major reason for conversion to
a stock company, the governments of Muslim countries can also provide
necessary funds to avoid demutualization of mutual takaful companies. This
should be done on a case to case basis whenever a genuine reason is given by
an existing takaful run by honest and efficient mudaribs.
One of the reasons mutual insurance company were established was that
they required little initial capital and most of the fund were provided through
premium (Murphy, p.3). If necessary, the government may be able to provide
some additional fund at initial stages of the establishment of a takaful
company. This would allow competent and experienced individuals to use
their expertise in insurance by setting up takaful management companies and
act as mudaribs. Goldstein analysis of the issues raised in relation with
demutualization of mutual insurance companies in Canada gives many
insights about the working of mutual insurance companies. Takaful
companies may face similar issues in the future as they become larger and
their managers / owners become less interested in the welfare of the
policyholders. Takaful companies largely setup as subsidiaries of other stock
companies have hardly engaged their policyholders as real participants or
owners of the company as normally practiced by real mutual companies in the
west.
It is also important to observe that while demutualization is more common
in the United States, most of the large insurance companies in Canada are
mutual insurance. A deeper comparative study of these and other western
countries could provide many insights for the nascent takaful industry.
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7. Islamic Capital Market Instruments
Capital markets deal with long term securities ranging from one to thirty years
maturity. The main instruments of these markets are stocks, bonds and
mortgages. Although Islamic Funds, banks and takaful companies have
devised a mechanism to invest in stock markets, there has been no move to
establish pure Islamic markets for shares with its own rules and regulations.
On the other hand, Islamic bonds or sukuks have become a popular investment
vehicle for these institutions and a good source of raising funds for Muslim
governments as well as public and private enterprises. The last three years has
seen an extraordinary expansion of this market.
Islamic mortgage companies were first established in the United States
with very small funds. They devised a rent sharing mechanism based on
diminishing musharakah for house financing. Many Islamic banks as well as
some conventional banks now have facilities for such mortgages.
Theoretically, there is one important substantive difference between Islamic
and conventional mortgages. In case of a diminishing musharakah, if there is
a default and subsequent liquidation of the house, the proceeds would be
divided according to the ownership ratio at the time of default. I am not sure if
Islamic mortgage companies incorporate this element in their documentations
and act accordingly. Another point that is not generally emphasized in Islamic
finance literature is that if the concept of diminishing musharakah is carried
out to its logical perfection, the changing market value of the house could
create a complex liability and ownership structure even if it has a potential for
a just deal for both parties. Again, it is not clear if Islamic mortgage schemes
do incorporate this in their financing documentation.
As mentioned in section five, in my opinion, ideally the governments of
Muslim countries have to come up with special institutions / arrangements to
deal with house financing without involving interest of any kind. The
financing of commercial and industrial land and structures could be left for the
private sector.
I will now briefly look at some of the issues related to stocks and bonds
markets and give some suggestions for making a real difference between
conventional and Islamic instruments for these markets.
7.1 Markets for Shares
I have already touched the issue of stock markets in the context of Islamic
banking. There are several issues related to the acceptability of dealings in
shares of public limited companies under contemporary capitalistic setup and
the accompanying rules and regulations. The basic idea of a public limited
company with its own independent identity and right to issue shares to raise
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funds for business expansion is now widely accepted by Islamic scholars, and
rightly so. The existence of a secondary market for shares enhances the initial
sale of shares in the primary market allocating the required funds for
expansions of different deserving companies. The share holders accept the
risk of the business and entitled to share the profits. However, there are some
restrictions on such companies from an Islamic point of view.
Indeed, unlike the conventional system, Islamic public limited companies
cannot be involved in the production and distribution of Islamically prohibited
goods and services. Islamic funds rightly exclude such companies from their
investment portfolio. Almost all conventional companies partially depend on
debt financing and often put some of their liquidity in interest bearing assets.
To solve this problem, contemporary Shariah scholars have ruled that
companies with debt to market capitalization below a certain limit (ranging
from 33 to 50%) could be considered for investment. With this ruling there
has been little incentive left for anyone to think about establishing a company
with 100% equity funds to attract funds from committed Muslims.
As mention in section five, in my view, the current rules and regulations
for stock markets allow excessive room for speculation. From an Islamic
perspective the emphasis should move from quick capital gains to dividend
earnings. Even reducing the number of days of trading (say from five times a
week to once in a week) in markets for shares would drastically reduce the
level of speculation without, in my opinion, any reduction in the actual
economic benefits emanating from these markets. I hope that in the near future
there would be at least one Muslim country that will take a serious step to
establish a dividend market for Islamically acceptable companies to provide
an avenue of investment for both Muslim individuals and Islamic depository
institutions.
7.2 Market for Islamic Bonds or Sukuks
Long term bonds of different maturities are issued by different tiers of
governments, their agencies, and large corporations to raise funds by paying
fixed returns to holders of such bonds. These bonds are regularly rated by
rating companies and freely traded in secondary markets. They are attractive
investment for those individual and institutional investors who are looking for
fixed streams of income in the future.
In order to achieve the same goal of generating stream of fixed income for
different maturity, the concept of sukuk, generating fairly stable stream of
income without explicitly involving interest, became an instant attraction for
Islamic financial institutions with increasing excess liquidity at their hands.
murabaha sukuk, ijarah sukuk, salam sukuk, mudarabah and musharakah
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63
sukuks, are all designed to more or less achieve the same purpose. The
structure of ijarah and salam sukuk described by Obaidullah (2005) can
provide the essence of sukuks and some issues related to them.
Sukuk-Al-Ijarah
Ijarah has been suggested as an ideal alternative for structuring debt securities.
Sukuk-al-ijarah, sometimes referred to as ijarah bonds or ijarah certificates
are created when the funds raised by the Special Purpose Vehicle (SPV) are
invested in ijarah operations. The SPV issues sukuk-al-ijarah to investors;
raises funds and utilizes the same for purchase of the assets (required for use
by the company). The assets are then given on lease to the company in
exchange for periodic rentals. The ijarah rentals when received by SPV from
the company (as per the terms) are passed through to the holders of the
instruments. 1
Unlike murabaha, the ijarah instrument is not evidence of debt, but of a
pro-rata ownership of the asset(s) that is on ijarah. As such, the instrument
can be freely priced in the secondary market and can change hands at any
negotiated price. This is not possible in a murabaha sukuk where funds are
used by SPV to buy the required assets for the company and then sold on
deferred payment basis at a higher price. The sukuk certificates then
representing debt cannot be sold for other than their face value. The ijarah
instrument, however, functions like any other debt instrument, since the
periodic ijarah rentals can be predicted with a reasonable degree of certainty.2
The yield on some forms of ijarah instruments may not be pre determined,
since there might be some maintenance and insurance expenses that are not
perfectly predictable in advance. Consequently, in such cases, the amount of
rent given in the contractual relationship represented by the instrument
represents a maximum return subject to deduction of this kind of maintenance
and insurance expenditure. It may be noted here that holders of ijarah sukuk
are part-owners of underlying assets and as such, are exposed to risks
associated with ownership of the assets. They are also required to maintain the
asset in a manner that the lessee is able to derive the expected benefits from it.
3
Indeed if the rents are not predetermined and ownership of the assets
remained with SPV with a probability that the company may not want to
continue to renting the assets and may not be asked to eventually purchase the
1. Obaidullah (2005, pp. 165-66).
2. Ibid.
3. Ibid.
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assets at a predetermined price, ijarah sukuks could become a widely
acceptable risk sharing financial instrument of Islamic capital market. The
current practice is, however, quite different. The rental payment is hardly
linked to the performance of the asset or that of the company in general. At the
end of the maturity period, the assets are supposed to be necessarily bought by
the company at the face value. The same mechanism is at work when the SPV
instead of buying a new asset, securitizes an existing asset of the company and
lease it back. The final outcome is equivalent to that of a conventional bond
issue. No wonder the returns to most sukuks are linked with an interest rate
benchmark (LIBOR). Of course in case of traditional bond the assets of a
company are not involved explicitly but its ability to generate funds through
bonds is dependent on its reputation and expected streams of income.
Moreover, a possible default on its part would necessarily lead to liquidation
of some of its assets to be paid to the bond holders.
Sukuk Al-Salam
Salam-based securities may be created and sold by an SPV under which the
funds mobilized from investors are paid as an advance to the company in lieu
of a promise to deliver a commodity at a future date. All standard shariah
requirements that apply to bai-salam also apply to sukuk al-salam, such as,
full payment by the buyer at the time of effecting the sale, fungibility or
standardized nature of underlying asset, clear enumeration of quantity, quality,
date and place of delivery of the asset and the like. At the same time the SPV
can appoint an agent to market the promised quantity at the time of delivery
perhaps at a higher price. The difference between the purchase price and the
sale price is the profit to the SPV and hence, to the holders of sukuk. Such
sukuk obviously involve market risk as the price of the underlying asset may
go down instead of moving up in future.
The market risk or price risk for the investors can be mitigated if a third
party makes a unilateral promise to buy the commodity at a predetermined
price at a future time period. Since the SPV representing investors need not
participate in the market, it would be insulated from price risk. This third party
may be one of the prospective customers of the company. The unilateral
promise is binding on this customer. Once the rights resulting from the
promise are transferred to the SPV, it assumes the role of seller to the third
party customer at the specified future date. The SPV is able to realize a higher
predetermined price without participating in the market. The risk mitigation
can some times come through sovereign guarantees. Istisna-based instruments
or sukuk may be created in a similar fashion.1
1. Obaidullah (2005)
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Musharakah and mudarabah sukuks could also be structured on the
principles of risk and profit sharing basis. One can only hope that the
musharakah sukuks recently issued by two prominent companies in the UAE
will make a real difference for Islamic sukuk markets by implementing the
real spirit of the instrument.
I must emphasize that for a real difference both the funds providers and
funds user have to change their attitude. More specifically, the funds providers
and their managers should skill in designing appropriate risk sharing
mechanisms rather than putting all their efforts in devising tools for risk
avoidance. The funds users on their part should be candid and ready to share
the fortunes appropriately when it comes their way. This will also allow them
to reduce their burden in case of a loss. That is the essence of Islamic finance!
If the real spirit of ijarah, salam, istisna, mudarabah and musharakah is
allowed to work in sukuk structures, only then sukuks will make a real
difference.
7.3 Markets for Derivatives: A Brief Islamic Appraisal of
Conventional Financial Engineering
According to Obaidullah (2005), products of financial engineering and
derivatives such as, futures (and forwards), option and swaps provide certain
benefits to market participants exposed to certain kinds of risky situations.
Given the complexity of modern business requiring advance planning, and the
many risks arising out of fluctuations in prices and rates in markets for
commodities, currencies, and other financial assets, the maslahah seems to be
real and substantial. However, in forming the basis of legislation, maslahah
such as above is to be accorded a lower priority than the Quran, or the sunnah,
or ijma. Among the various shariah norms the ones that are the most
important are freedom from riba, gharar and qimar or mysir. Prohibition of
riba, gharar and qimar are central to Islamic law of contracts in view of the
strong Qur’anic condemnation of these elements. While a small amount of
gharar is even tolerable, the prohibition is the strongest on the issue of riba
and qimar. The so called risk management products would be admissible in
the Islamic framework, only if they are free from these elements. Clearly,
fulfilling certain social needs or providing certain maslahah does not by itself
constitute a strong enough ground for permissive legislation. The most
significant objection against futures and options is that these are invariably
settled in price differences only and never result in actual delivery of the
object of exchange. How does one use derivatives for gambling, or
speculation of a variety akin to a game of chance?1
1. Obaidullah (2005), p. 175.
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Commenting on Kotby (1990), Suwailem (1996) also advocates for a
cautious approach before going too far in accepting different option strategies
for Muslim investors. He claims that option contracts appear to mimic bay
al-urboon, and apart from the fact that past fuqha have differing opinion on
the legality of bay al-urboon, a closer look at option reveals that it does have
an element of betting. Suwailem disputed Kotby’s emphasis on the
permissibility of speculation under shariah to make his arguments in favour of
options. He notes that while it may be permissible to speculate on the future
prices of horses but making bets on their performance is not acceptable.
Suwailem also points out the zero-sum game nature of option in arguing
against the permissibility of option. On the question of forward sales too,
Suwailem disagrees with Kotby that a bank guarantee would make dealings in
forwards acceptable from an Islamic point of view. He points out the
similarity of forward contract with that of bay al kali which is generally
treated unacceptable under shariah, to minimize the dependency of trade on
promises.
Kamali (1996, 1997) and Bacha (1999), however, forcefully argue for the
permissibility of futures and options for the benefit of Muslim investors.
Kamali argues that markets for options were developed in response to high
volatility in stock and currency markets. He also thinks that trading in futures
will allow Islamic banks and other funds to profitability use their liquidity.
Both Kamali and Bacha also believe that financial derivatives are very
important risk management tools and their unacceptability by shariah will
deprive Islamic financial institutions of an important modern instrument and
put them in a disadvantageous position. They emphasize that the chances of
any party not fulfilling their commitment (and hence the possibility of gharar)
under the rules and procedures of organized markets for options and futures is
almost nil. It is, therefore, unjustified to relate trade dealings in markets for
futures to bay al kali (exchange of debt for debt as both the payment and
delivery is deferred to a future date). Kamali also emphasizes the importance
of freedom of contract in Islam unless clearly prohibited.
I tend to agree with Professor Kamali and Bacha that the current rules and
procedures of derivatives markets remove the chances of default by any party
in different derivative markets and hence the old rulings against forward
trades not be relevant anymore. However, in my opinion, before a firm
decision could be taken on derivatives, it is important to clearly understand
the cost and benefits of these instruments. Whether we accept the validity of
different kinds of derivatives should be based on a thorough understanding
and evaluation of their functions, benefits and, from an Islamic point of view,
the kind of behaviour they cultivate among different participants. For example,
it is argued that markets for futures are able to link spot and future prices of
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67
commodities through speculation and arbitraging activities. But could it be the
case that it is the existence and opportunity to make futures deals that, at least
partially, responsible for creating continuous oscillation in spot prices through
incessant speculation about future demand and supply conditions?
Digressing slightly from the topic, I would also like to point out the
apparent attempt to use the validity bay al-urboon by a number of past fuqha
to justify trade in options. The basic idea in bay al-urboon is the sincerity
shown by both buyers and sellers in making a commitment for a real sale. The
buyer, not having all the money at hand to make the deal final, get some time
to arrange for full payment. Instead of just making a promise to buy he pays
some money that could be adjusted in the price. The seller also makes a
serious commitment by agreeing not to sell the good to another person even if
he can get a better price unless the first person is not able to make full payment
by the time stipulated in the contract. It is clear that both buyer and seller
involved in the sale are convinced about the appropriateness of the price or the
value of the good involved. The buyer who has paid deposit money has an
upper hand in the sense that he may decide not to buy the good even if he is
able to arrange the money for full payment. But he would do that only if the
same good is available at a lower price somewhere else and the price
difference is more than the deposit money. Isn’t it fair that he is allowed to do
that and loose his deposit money? As far as the seller is concerned, it is likely
that he would make an urboon contract only if he knows that a chance of
getting a better price is very low. To me whether bay al-urboon is valid or not,
the behaviour of seller and buyer is quite different from what we observe in
option trading.
The volume of options trading that involves shares of different companies
has even surpassed the volume of trading in those shares itself. It is not known
how this impacts the volatility of share prices that, according to Kamali, was
the reason for introducing the markets for options in the first place. One can
also raise questions about the primary argument in favour of markets for
commodity futures that they provide price stability and hence peace of mind
to both the producers and ultimate users of these commodities. Intuitively, it
appears that price stability over time to all producers and consumers of a
commodity could not be provided through markets for futures. Another point
in favour of these markets is that they allow risk averse economic units to shift
their risks to those economic agents who are ready to take risk through
speculation even if in that process a number of them burn their fingers; at the
end of the day they do provide a useful service to the economy. One has to
really make sure that it is indeed the case as many people, both Muslims and
non Muslims, view these markets as avenues for betting game rather than a
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genuine transfer of unwanted risk. I repeat a quotation used by Suwailem
(1996) representing the views of a US congressman:
“Those who deal in ‘options’ and ‘futures’ contracts, which is merely gambling,
no matter by what less offensive name such transactions be designated, neither add to
the supply nor increase the demand for consumption, nor do they accomplish any
useful purpose by their calling; but on the contrary, they speculate in fictitious
products. The wheat they buy and sell is known as ‘wind wheat’ and doubtless for the
reason that it is invisible, intangible, and felt or realized only in the terrible force it
exerts in destroying the farming industry of the country”
Thus from an Islamic point of view, one has to look at the effective
motivation of the participants in markets for derivatives. It is claimed that the
basic purpose of the participants is to either avoid or minimize risk or to make
better future planning by removing uncertainties. I am not sure if the majority
of the players in these markets go there with these things in mind or they just
want to make a quick gain by being better speculators (or luckier!) than others,
thus involved in a kind of soft gambling (with much better odds than casinos).
One has to also see if there could be other institutional arrangements to
meet the genuine concerns of economic agents. For example, since the
emergence of floating exchange regime, no alternative arrangements has been
proposed or tried to avoid the massive oscillation in foreign exchange markets.
Similarly, in order to stabilize prices for commodities over time, hardly any
new mechanisms are suggested. Even if there are no new measures at the
international level forthcoming, Muslim economists and financial experts
should make efforts to come up with new arrangements or institutions to
address the genuine needs of different economic agents. By accepting the
current institutions of western capitalism that are questionable, we are unable
to generate the required motivation and commitment for such efforts.
8. Concluding Remarks
The continued advancement of western countries during the last several
hundred years in science, technology, institution building and the resulting
economic and political power, has been phenomenal. Many aspects of this
advancement in science and technology have benefited mankind in general
and the whole world including Muslims acknowledge and appreciate them.
The accompanying material benefits it provided to the masses of the western
countries (and some others who followed their footsteps) have also been
substantial. Parallel to scientific and material advancement, there have been
changes in social relations and individual attitudes which are either seen as a
progress in itself or an unavoidable cost of progress. The whole journey of this
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progress has been carried out without any reference to the Creator; what
should be the nature of relation between man and his Creator and between
man and man has been left to man himself to decide. What is good or bad at
the social level or what individual acts and attitudes are acceptable, is decided
by the majority of their societies under the influence of powerful intelligentsia
that became increasingly arrogant with achievements in science and
weaknesses of their religious communities. Moral values of
Judeo-Christianity traditions were discarded one by one.
Indeed as Muslims we have to avoid that path. While every effort should be
made for progress in all areas of knowledge and education that would improve
economic conditions of Muslim masses and strengthen the political power of
Muslim countries, we must remember the Qur’anic notion that it is the
obedience to our Creator that would ultimately bring us falah in both worlds.
If one accepts the goals of Islamic economics and finance I presented in
sections 1-3 as well as my views on interest and other financial market
instruments, then it is not inappropriate to suggest that we still have to go a
long way. The institution of interest has continued albeit under the cover up of
different names. There has been no serious effort to remove the institution of
interest (the hallmark of Islamic finance) in the real sense and establish an
alternative profit and loss sharing banking. Similarly, even if we have
achieved something in the area of Islamic insurance, there is much room for
improvement to make it such a humane institution that would attract even the
non-Muslims. Some sign of that possibility has been noticed in Brunei
Darussalam and possibly elsewhere. The current efforts in Islamic finance
appears to be centered on devising risk minimizing tools for Islamic financial
institutions, more or lees, on the pattern of their conventional counterpart
some of which are questionable from Islamic perspective. As all risk of
business in an economy cannot be thrown away, Islamic finance should
concentrate its efforts to minimize total risk and on devising fair and just
mechanisms of risk sharing rather than encouraging the attitude of shifting the
burden of risk on others. I hope, in this paper, I have raised some issues that
may lead to some debate and eventually correct the direction of Islamic
finance.
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International Conference on Islamic Finance - Proceeding
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