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The notion of ‘Islamic finance’ was born during the tumultuous identity-politics years of the mid-20th century. Indian, Pakistani and Arab thinkers contemplated independence from Britain, and the independence of Pakistan from India, within a context of ‘Islamic society’. Islam was assumed to inspire political, economic and financial systems that are distinctive and independent of the Western (capitalist) and Eastern (socialist) models of the epoch. The term ‘Islamic economics’ was coined by Abu al-A‘la Al-Mawdudi, whose students and followers worked to develop an ostensible Islamic social science (Kuran 2004). Mawdudi’s influence on Arab Islamists began with the writings of Sayid Qutb, the father of modern Arab political Islam, whose quasi-exegesis Under the Qur’anic Shade referred exclusively to Mawdudi’s writings on economic matters. Mawdudi’s migration from majority-Hindu Indian society to majority-Muslim Pakistan thus became a prototype for Islamist migration away from secular political and economic systems.

From Islamic Economics to Islamic Banks

In the first few decades of its existence, Islamic economics focused on comparative economic systems (a fashionable field at the time) as well as neoclassical and Keynesian modelling with a highly stylized homo islamicus (a moral and ethical individual who shuns excessive greed and consumerism) in place of mainstream economics’ homo economicus (a selfish utility and profit maximizer) (Haneef 1995).

As a byproduct, Islamic banking emerged in the Islamic economists’ literature as a financial system based exclusively on profit-and-loss sharing, which was argued to be more equitable and stable (Chapra 1996; Siddiqi 1983). In the process, Islamic economists focused on the Islamic prohibition of riba or usury, which they interpreted as a prohibition of all interest-based lending, in accordance with earlier interpretations of the Judeo-Christian canon.

Classical Islamic jurisprudence had interpreted interest-based lending, the cornerstone of fractional-reserve depositary banking, as riskless – and therefore illegitimate and inequitable – return for idle capitalists. Indeed, the importance of credit and counterparty risk for any financial analysis remains conspicuously absent from the writings of the Islamic-economics faithful. The preferred financial model, they postulated, would be based on the ancient silent-partnership model known in Islamic writings as mudaraba, corresponding to the Jewish heter iska and the Christian-European commenda (Udovitch 1970).

An ‘Islamic bank’ was envisioned as a two-tier silent partnership. Thus, deposits seeking a return (as opposed to fiduciary deposits, for which 100 per cent reserves are required) would not be guaranteed loans to the bank, but rather silent-partnership investments in the bank’s portfolio. In turn, the bank’s investments of those funds would not consist of loans and acquisition of debt instruments, but rather profit-and-loss sharing investments in other silent partnerships. Thus, the Islamic bank would serve its financial intermediation function (pooling of return-seeking savings and diversification of investments) through profit-and-loss sharing. This idea continues to serve as the cornerstone of Islamic banking today, despite being thoroughly debunked by prominent jurists (Tantawi 2001; El-Gamal 2003).

Potential loss of return-seeking deposits was assumed by Islamic-banking proponents such as the Islamic Financial Services Board (IFSB) to encourage depositor-monitoring and risk-mitigating market-based discipline. Thus, the grossly inadequate depositor-protection measures supported by the industry have focused on transparency of operations and profit-distribution mechanisms (IFSB 2006).

The Practice of Islamic Banking

This risk-sharing model has continued to shape the liabilities side of Islamic banks’ balance sheets, with a few exceptions in Europe and the United States, where regulators have required Islamic financial providers that function as banks to guarantee deposits. The assets side of Islamic banks and financial providers, on the other hand, has utilised multiple structured-financial models to replicate loans and fixed-return securities that limit the banks’ exposure to credit risk. The transformation from the idealistic profit-and-loss sharing model of Islamic economics – which continues to be hailed as the ‘Islamic ideal’ by industry practitioners and commentators – to replication of modern financial products and markets in ‘Islamic’ garb coincided with the increased importance of classical methods of Islamic jurisprudence and a limited rhetorical role for Islamic economics.

Early models in the subcontinent during the 1950s and in Egypt during the 1960s notwithstanding, the true beginnings of Islamic banking and finance occurred in the mid-1970s. Islamic jurists including the Shiite scholar Baqir al-Sadr and many Sunni scholars in Egypt, Saudi Arabia and elsewhere collaborated with Islamist bankers to replicate loans using ancient contract forms. Baqir al-Sadr, in his classical work The Non-Usurious Bank in Islam (long out of print), had attempted to use similar structured products to replicate guaranteed bank deposits on the liabilities side. However, since risk-sharing depositors were clearly beneficial to the shareholders of Islamic banks, and because the latter drove innovation in Islamic banking through the retention of lawyers and religious scholars, most of the ‘innovations’ were restricted to the assets side of the balance sheet.

Murabaha (Cost-Plus Sale) Financing

The workhorse of Islamic banking has been the murabaha (cost-plus sale) contract. The logical evolution of this form of finance is indicative of the general methodology of Islamic finance to this day. In the early 1980s, Islamic banks in the Gulf were flush with petrodollars, and Western corporations were eager to borrow from them as Western-bank credit dried up following the petrodollar-driven Latin American debt crisis. Islamic banks resorted to the easiest ancient trick: introducing a property to separate lent principal from repaid principal plus interest.

In the simplest ruse, the bank could have sold some commodity to its potential borrower on credit (for principal plus interest payable later), and then bought it back for cash (principal paid immediately), thus effectively replicating the cashflows of the loan, with the commodity making a round trip from bank to customer and back. However, this ancient ruse was forbidden by name as same-item sale resale (bay‘ al-‘ina). In practice, one credit sale and one spot sale of liquid commodities were still used to accomplish the desired goal by conducting the second spot sale with a third party.

Interestingly, Al-Rajhi Investment Company in Saudi Arabia, which has one of the strictest religious-scholar boards, received a question on the legitimacy of the credit sale of gold, and ruled that such sales were disallowed because gold is a monetary commodity. Promptly thereafter, the same board was asked if platinum can be sold on credit, and issued a fatwa that this was permitted. Thus, Islamic banks could simply trade precious metals, acquiring an amount of platinum (or other metal excluding gold and silver) equal in value to the desired loan principal. The metal was then sold on credit to the Western borrower under a murabaha contract, with a credit price equal to the desired principal plus interest. The customer was then able to sell the metal quickly to receive the desired borrowed principal, perhaps less a small transaction cost.

This was the juristic solution first popularised by the late banker Sami Humud in his book Evolving Banking Transactions in Accordance with Islamic Law (1976). The prohibition of riba (usury) in the Islamic canon and subsequent juristic analysis left room for such ruses. The Qur’an merely mentioned riba in the abstract without specifying precisely which transactions were thus forbidden. The Prophetic tradition merely listed six commodities: gold, silver, dates, wheat, barley and salt, all of which were used at some point as commodity monies in the ancient world, stipulating that those may be traded only hand-to-hand and in equal amounts measured by weight or volume. One school of jurisprudence (Hanafi) expanded the prohibition to all commodities measured by weight or volume, but still did not treat them as money. Therefore, while trading platinum now for platinum later, or trading gold now for silver later, would both be deemed impermissible based on the Hanafi interpretation, trading platinum now for dollars later was considered permissible.

Interestingly, the Halacha, developed by Jewish scholars prior and in parallel to the development of Islamic Fiqh, forbade such embedded-interest credit sales (Reisman 1995, p. 112). In contrast, all major schools of Islamic jurisprudence (four Sunni and four Shiite) have allowed credit sales at prices possibly exceeding the spot price. Initially, this was only a method for seller financing. Thus, the financier needed first to acquire the property before selling it on credit. In addition, to give the contract an Islamic flavour, the industry adopted the name of an ancient cost-plus sale – murabaha, a contract devised to protect buyers who were unfamiliar with market prices, allowing them to negotiate prices by negotiating markup over revealed cost.

The contract that emerged in the 1970s was formally known as ‘cost-plus sale to the customer who ordered the initial purchase’ (murabaha lil-‘amir bil-shira’). It was initially subject to scholarly controversy, especially as bankers added provisions to eliminate all forms of risk other than customer credit. In order to eliminate property-related risks, which were ironically the basis on which jurists allowed earning a return on the transaction, they allowed banks to stipulate that the eventual buyer must guarantee to buy the property on credit once the bank acquires it. Eventually, wide consensus emerged and the contract became the workhorse of Islamic banking practices, from large multi-million-dollar loans to Western corporations to retail-bank secured lending.

Tawarruq (Monetization) Financing

In order to reduce transaction costs, especially for retail customers who wished to borrow cash, Islamic banks in Gulf Cooperation Council (GCC) countries revived another ancient financial trick: monetization. This transaction is very similar to the cost-plus commodity-sale finance model, with the added complication that the Islamic bank executes all three legs of the transaction: (i) buying the principal’s worth of metals at the spot price, (ii) selling said metals to the customer on credit for principal plus interest, and (iii) selling the metals back to the dealer, as the customer’s agent, for the spot price less a small fee. All three transactions can be concluded within minutes via fax.

This transaction avoids the forbidden two-party sale–resale trick by adding not only one commodity as a degree of separation between lent principal and repaid principal plus interest, but also a third-trading-party degree of separation (the metals dealer) so that every two parties formally trade the commodity only once. The commodity still completes a round-trip (dealer → bank → customer → dealer), spot cash in the amount of desired principal completes one trip (bank → dealer → customer), and the credit-sale-price payment of principal plus interest occurs in the future (customer → bank). This three-party variation on same-item sale resale was also known in ancient and medieval practice, and deemed forbidden or reprehensible by most schools of law. Some medieval scholars within the Hanbali school of jurisprudence, which is dominant in the GCC, had permitted this practice. Despite the fact that the most respected 14th-century scholars ibn Qayim and ibn Taymiya forbade the transaction (as merely an expensive and potentially more hazardous type of usury/riba), contemporary Hanbali jurists who dominate one juristic council in Saudi Arabia permitted the practice in 1998. The same council later forbade the organised practice of Islamic banks using this contract in 2003, but the practice continued to thrive.

Ijara (Lease) Financing, Securitization and sukuk (Islamic Bonds)

Despite juristic approval of credit-sale-based financing methods, the practice remained suspect in scholarly as well as general Islamist circles. In addition to objections that the practice merely replicated interest-based financing with interest characterised as profit or markup, there were problems with securitization and trading of receivables from murabaha and tawarruq facilities. Those problems arose from the fact that most jurists, with the notable exception of those in Malaysia, forbade trading of debts, except under very strict transfers at face values and resale to the debtor. This prevented the development of secondary markets that would allow banks to diversify their portfolios and sources of funds. Lease financing provided a partial solution to both problems: it was ostensibly based on real assets that continued to play a role throughout the life of the financial facility, and it was possible to trade lease receivables on secondary markets as ostensible shares in the leased assets.

Jurists were adamant that Islamic lease or ijara financing must be truly asset-based, and therefore must be structured as operating rather than financial leases. However, recent advances in structured finance – which helped corporations such as Enron to move debts and interest payments off balance sheets through sale-leaseback structures – had blurred the line between operating and financial leases. As a result, a prestigious juristic council declared in 2008 that more than 80 per cent of lease-based bond (sukuk) structures were unIslamic, since material ownership of the underlying assets was not real.

Developed initially as another mode of secured lending, lease financing proceeded by acquiring durable assets and leasing them with an option to buy – principal plus interest passing to the lessor as rent plus potential final payment. For banks in countries that forbid them from owning real estate, special purpose vehicles (SPVs) received credit that were used to acquire the assets and lease them till maturity. Shares in those SPVs were treated as shares in the leased properties, thus allowing them to trade on secondary markets. In the United States, such structures were used to originate mortgage loans that were then securitized through Fannie Mae and Freddie Mac, and marketed both domestically and in the cash-rich GCC, especially after the second wave of petrodollar flows began in 2001.

Bond structures were easily adapted from these financial forms. An entity that wished to issue a bond would create an SPV, which sold shares for the amount of financing desired. The proceeds of that sale were used to buy some asset from the originator, which asset was promptly leased back. The originator would thus collect the proceeds of the sale of its asset as principal, and pay principal plus interest in the form of rent and/or a final repurchase price, which payments were passed through to the sukuk or bond holders. An added advantage of this structure is that the payments were made ostensibly on shares in ownership of the real asset, thus the contract could be advertised as a form of partnership, which appealed to the earlier political-Islam inspired literature on Islamic economics.

Jurists further facilitated securitization of debts by allowing a portfolio of asset-based and purely debt-based receivables (that is, lease-based and credit-sale-based, respectively) to be traded as long as the asset-based component exceeded 51 per cent of the total face value (Usmani 1998). This strange provision clearly imposed no significant constraints on securitization, since successive portions of pure-debt receivables could be bundled iteratively with the same asset-based ones, which could be bought back repeatedly for the purpose of bundling with pure-debt tranches. Thus, Islamic finance became an equal partner in the credit bubble the ensued in the first decade of the 21st century. In fact, the volume of sukuk remained sufficiently small (relative to demand by Islamic banks) to merit abnormally high prices and low yields relative to conventional debts issued by the same entities.

Islamic Mutual Funds

A widely publicised area of Islamic finance was the development of ‘screening’ methods to identify ‘Shari‘a compliant’ stocks. These screens excluded stocks of companies with significant forbidden activities (such as breweries), and also of firms with excessive debt or interest income. The debt screen chosen by the industry was particularly perplexing, as it excluded firms with debt to market capitalization ratios exceeding one-third. This rule clearly forced fund managers to buy high and sell low in highly volatile markets. Moreover, the rule diverted funds away from Muslimowned companies, which were not allowed any degree of unsecured-loan leverage, in favour of western firms with moderate levels of leverage. The financial screens themselves had no foundation in Islamic law or reasonable economic analysis, starting as they did at 5 per cent debt to assets and evolving during the tech-stock bubble of the late 1990s into 33 per cent of debt to assets and then 33 per cent of debt to market capitalization. It is not clear whether and when these rules can be replaced with sensible ones.

Takaful (Islamic Insurance) and Derivatives

One of the fast-growing sectors in Islamic finance is an Islamic alternative to commercial insurance known as takaful (mutual support). The rhetoric of this sector is based on the idea of mutual protection against losses, but most takaful companies to date have not been structured as mutual insurance companies (in which policyholders and shareholders are the same individuals). Instead, takaful companies are generally shareholder-owned and act through silent partnership or agency to invest the policyholders’ premiums and pay legitimate claims in the form of ‘voluntary contributions’ – thus avoiding the Islamic prohibition of gharar, which includes trading known amounts (policy premia) for uncertain future amounts (on potential valid insurance claims). The prohibition of gharar was also invoked to forbid derivative securities, but forwards and options were easily synthesised from the ancient contracts of salam (prepaid forward sale) and ‘urbun (downpayment call option), respectively.

Substance and Form

El-Gamal (2006, 2008) has argued that the essence of the ancient religious law was regulatory. It is well known in financial economics that financial innovators eventually find means to circumvent outdated regulation, thus increasing systemic risk. Financial crises later propel political and economic authorities to impose further regulations for innovators to circumvent. In this regard, the ancient religious regulations enshrined in medieval Islamic jurisprudence, especially if interpreted naively as prohibitions of certain contracts and permissions of others, are woefully out of date, and therefore ceased to perform their regulatory function centuries ago. Indeed, that is precisely why majority-Muslim societies had abandoned those outdated contract-based frameworks before the Islamist revisionism of the mid-20th century. The ancient law, which is not uniquely Islamic, does contain many lessons for today’s societies – Muslim and otherwise. However, rent-seeking behaviour by bankers, lawyers and religious scholars on the one hand, and incoherent pietism and adherence to fictional Utopian history on the other, have prevented societies from adapting this centuries-old accumulated human wisdom for any purpose beyond short-term self-enrichment and identity-political appeasement, both of which increase rather than ameliorate systemic risks.

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