Dummy 1 Good morning.
Dummy 2 Good morning to you too!
Dummy 1 I saw this ad for Islamic banking products you are selling. Made me curious. Can you tell me what is this?
Dummy 2 Sure! This is a savings account which works under Mudaraba. You will get a profit share based on …
Dummy 1 No no. What I want to know is, why is this called Islamic banking?
Dummy 2 [Awkward silence] Well you know there is a Shariah board. Allah swt has forbidden interest and permitted trade. And you will get a share …
Dummy 1 above was me, four years back, trying to find a bit of information on Islamic finance. So I hit a few Islamic banks to find out more on this. Surprisingly, I found that the people (dummy 2) I asked were as vague in their understanding as I was. Islamic finance. Islamic banking. Used generally in an interchangeable fashion. The general reaction to these words tend to be as follows:
- Rubbish! You cannot link Islam with finance, as they are based upon completely opposite ideology.
- I do not understand what it is about. I am also comfortable with conventional financial system. Islamic finance will not make much difference for me.
- Islamic finance is the correct form of finance. Allah swt has forbidden interest and permitted trade. Islamic finance is financing based on profit sharing (mudaraba) or partnership (musharaka).
Although the reactions vary, they originate from the same lack of understanding. Followers of Bushism[i] would probably say that this is a misunderestimated topic. My intention here is to briefly set the tone on Islamic finance, so the reader neither misunderstands nor underestimates Islamic Finance.
What Islamic finance is
Islamic finance deals with financial aspects in our day to day activities, and forms a very small part of Islamic law (Shariah). Islamic law intends to protect and preserve the basic necessities (darurriyat) of man, to prevent anarchy and chaos from corrupting the society. They are:
- Religion (Deen)
- Life (Nafs)
- Family (Nasl)
- Intelligence (Aql)
- Property (Maal)
Shariah law stipulates policies and injunctions through which the above necessities are sustained through time. For example, marriage is permitted to preserve family, but adultery is forbidden as this is a social evil. Likewise, alcohol is forbidden because it harms intelligence (i.e. we lose our self control) as well as life.
Islamic finance tries to achieve – insofar as the financial sector is concerned – mostly the preservation and protection of the last darurriyat – property. Hence there are laws that regulate transactions to achieve our wealth goals, but forbid trespassing on rights of others.
For example, you can utilize your wealth (for growing it) with a bank, but you cannot charge interest on the capital invested. Similarly, the bank will also invest using interest free mechanisms, which is used by individuals as well as corporations. There are Islamically accepted modes of charging profit on investment, which will be the income for the bank. When investing in stocks, there will be certain screening mechanisms to filter stocks that abide by Islamic regulations[ii].
Apart from growth, wealth also need to be transferred. For passing wealth to next of kin, there are estate planning laws (faraid) for distributing the wealth. Zakat is mandated on the rich, because the poor have a right on it.
What Islamic finance is not
Islamic finance is not just based on profit sharing or partnership. People only know these two forms because they are the easiest to recall. There are many other forms of Islamic financial contracts such as leasing, sale, safe custodianship, agency etc. Islamic finance is not something out of this world. People usually expect an Islamic financial product to be miraculously different, as they always want to know what is special about this. Take the beef of two cows for example – one sacrificed in an Islamic manner and the other electrocuted to death. Can you differentiate between the end result – the beef? No, they look just the same. Likewise an Islamic savings account will look the same as a conventional savings account, but there are subtle differences – as there are in the beefs – that make them halal or haram.
Banks are not the only Islamic financial institutes. A broad range of financial institutions, such as leasing, microfinance, capital markets, venture capital, insurance etc practice Islamic finance. We only hear about banks because the other institutes do not actively promote their products.
Why do we need Islamic finance?
There is no separate Islamic field on medicine, engineering, communication etc. Why then, Islamic finance? Why – for a Muslim – is an Islamic savings account acceptable in Shariah while the conventional one is not? I borrow words from a research by Dr M Nejatullah Siddiqi [iii]. The answer lies, firstly, in the involvement of interest in the conventional system and secondly, in the perception that the conventional system is not geared towards achieving the goals of the Shariah. Prominent among these goals are justice and fairness and general welfare of the people.
Conventional financial institutions, theoretically, aim to serve individuals – mainly shareholders – and are run purely by profit motive. Their accountability lies to shareholders only. There are three main elements in conventional finance which are prohibited in Islam:
- Taking of interest (riba)
- Presence of major uncertainty in contracts (gharar)
- Elements of gambling (maysir)
In the Sunnah, our prophet Muhammad (PBUH) has mentioned that riba is of seventy three kinds, the lightest in seriousness of which is as bad as one’s marrying his own mother; for the Muslim who practices riba goes mad[iv].
Widespread usage of conventional financial mechanisms have repeatedly shown us how wealth is accumulated in the hands of a few. Take the recent global financial meltdown or the LIBOR manipulation scandal. Each of these events have been driven by individual greed, where some have become extremely rich, whereas the general people have suffered.
For practitioners of Islamic finance – accountability lies to shareholders, but more importantly to Allah swt. On the day of judgment, we have to answer for the wealth entrusted upon us all. If we have usurped the wealth of others, a severe punishment awaits us. We even need to pay Zakat out of our own wealth, to purify our heart and our wealth from greed.
Islamic financial institutes aspire to objectives greater than wealth accumulation. They aim for social stability and progress. An Islamic bank will look to invest in sectors with business potential. Islamic insurance companies will bring together people facing similar risks who mutually cover each other in times of distress. Islamic stock scrutiny will enable pious investors to avoid questionable industries and gain halal earnings on their investments. It will avoid certain industries such as tobacco, alcohol, casinos, weapons etc altogether.
An Islamic financial system also plays a major role in wealth distribution through Zakat, Waqf etc. These are mechanisms designed to achieve a balance in society by wealth transfer from the rich to the poor. As we are well aware, conventional financial system – with its capitalistic self serving objectives – do not have any such social goals.
How does Islamic finance benefit us over conventional finance?
There are individual gains as well as social gains to be had in adopting Islamic finance. As an individual, you benefit by:
- avoiding interest, which has been strictly forbidden in Islam, and carry dire consequences if practiced
- getting investment from banks if your business has good potential
- contributing to social welfare by participating in Zakat in a proper manner
- getting mutual coverage in takaful, which also promotes the spirit of brotherhood
- earn returns in here (i.e. on your money) and the hereafter (i.e. on your good deeds)
Society gains from Islamic finance because:
- Zakat, Waqf etc are practiced regularly which ensures wealth distribution from rich to poor
- Productive and potential sectors get funding as investment assessment is based more on project viability than on ability to repay
- Non productive and value destroying sectors such as tobacco, casinos, weapons etc are demised over time
- Fairness in transactions are achieved and contractual uncertainties are minimized
- No man made Global Financial crisis or LIBOR manipulation
Having said all that, let me reiterate that Islamic finance is a very broad subject. I have touched very briefly on the topic here, so that the reader gets some perspective into Islamic finance. Should opportunity permit, I will try to explain other concepts in Islamic finance in greater detail, and especially on the concept of riba. May Allah swt grant us knowledge (ilm) to understand these topics and engage in Islamic finance in our daily financial transactions.
[The writer is a banker, who started his career in Islamic finance. He now pursues a degree (Chartered Islamic Finance Professional) in Islamic finance from the International Center for Education in Islamic finance]
[ii] No investing in alcohol, movie making. Debt must be <33% of the Market Capitalization etc.
[iv] Narrated by Hakim on the authority of Ibn Mas’ud
[iii] Former Professor, Center for Research in Islamic Economics, King Abdulaziz University, Jeddah.