About the author: Moin Kermani, ENG., MBA is a founding President of two Islamic Finance Institutions in Montreal and teaches at John Molson School of Business, Concordia University. He previously worked at Alcan Aluminum and British Petroleum Companies.
What is the Islamic financial system?
In essence, it aims to eliminate exploitation and establish a just society by the application of Sharia, the Islamic religious law. The establishment of a just society is one of the main objectives or ‘maqasid’ of Sharia law.
Islamic finance can be seen as a model of ethical investing. Its practitioners and clients need not be Muslim, but they must accept the ethical values conforming to Islamic law.
Private ownership is permitted and so is a return on investment in goods and services. However, interest on lending money is not permitted as money is merely seen as a measure of value and not something having value on its own. Charity is greatly encouraged and a wealth tax called Zakat is obligatory on wealthy individuals.
Since private ownership is permitted and profit is uniquely tied to entrepreneurship and risk-taking, some authors see this as pure capitalism. Other authors take note of the social values and the spirit of cooperation in Islamic Finance and define Islamic finance as capitalism with a heart.
Sources and characteristics of Sharia law
The two primary sources of Sharia law are the Muslim holy book ‘Quran’ followed by the recorded sayings and actions of Prophet Mohammad -the Sunnah . A further important source of Sharia law is the consensus of Islamic scholars or Ijma- as long as such rulings are not in contradiction with the two primary sources.
The main characteristics of Sharia law as applied to Islamic finance are as follows:
- The prohibition of Riba or interest and the sharing of profit and loss.
- Transparency in transactions and the prohibition of gambling (Maysir) and speculation (Gharar). Prohibition of trading in options & derivatives and speculative trading in commodities are included in this principle.
- All transactions must be backed by a tangible asset or by a service.
- Prohibition of investment in immoral or forbidden activities.
- The emphasis on cooperation to obtain mutual benefits.
The differences between Islamic finance and conventional finance
As we have seen above, Sharia law prohibits interest, gambling and speculation. However, the essential difference is philosophical and it is this philosophy that can explain the reasoning behind these prohibitions. As mentioned earlier, the objective of the Islamic financial system is to eliminate exploitation and promote justice. Interest is seen to be exploitative because it favors the lender financial institution which is guaranteed a fixed return while the entrepreneur who puts in all the effort has no such comfort and is left exposed to all the risks.
A scholar has said : “One of the important sources of unjustified earnings is receiving monetary advantage without giving a just counter-value”. In the light of this statement, it is easy to see why there is a prohibition on interest, gambling and speculation. Islam permits a return on an investment or loan that will create a useful asset or service but prohibits making money out of money.
Islamic Finance and the recent (2008) Financial Crisis
If the principles of Islamic finance were used in the conventional banking system then the financial crisis would have been avoided. Islamic Finance promotes business based on legitimate and equitable projects. There is a close relationship between financial flows and productivity. This property isolates business firms from the risk of financial leverage and speculative activities. In addition, the sharing of profits and losses between parties ensures a high level of transparency. The recent financial crisis was based on risky sub-prime mortgage loans and the repackaging of these loans in complex financial derivatives. All these financial products were based on interest, speculation and lack of transparency which are prohibited in Islamic finance. Indeed, the Islamic banks were amongst those least affected by the financial crisis .
Current Status of Islamic Finance
It is estimated that assets currently managed by Islamic financial institutions are about one trillion US dollars with a growth rate of 10 to 15 %. There are more than 300 Islamic financial institutions spread over 75 countries including Canada and USA. There are over 250 Islamic mutual funds and the sale of Islamic asset based bonds (Sukuk) is about 25 billion US dollars.
Islamic Finance initiatives in Montreal
Two companies are in operation for about twenty years. By far, the most important and successful is the Qurtuba Housing Cooperative that finances home purchases for muslim individuals and families using a diminishing partnership agreement called Musharika Mutanaqisa. This arrangement is independent of interest rates and is similar to a rent to own arrangement. The other company uses Islamic contracts for the purchase of cars, computers and commercial equipment. The contracts used most often are cost plus financing and lease to own arrangements.
A Islamic insurance or Takaful program is also available to clients in collaboration with a major Canadian cooperative insurance company.
Some criticisms and observations regarding the current practice of Islamic Finance
The question arises, if Islamic finance principles are so appealing, why it is not in majority use? Perhaps, it is under a different secular name. The answer is that it is a new industry, although based on relatively old concepts and it is suffering from a number of growing pains. This industry is suffering from competition with the much better established conventional finance, a tendency to mimic conventional products, catering to sharia compliance but not to attaining sharia objectives and a lack of consistency in interpreting, applying and auditing of Sharia rules. It should be noted that the modern economic environment is considerably different from the time Sharia law was initially developed and the Sharia rules require reform or “Ijtihad” for dealings in the current economy. Another important obstacle is that Islamic Finance is not considered compatible with fractional reserve banking which is so prevalent in the modern world.
Conclusion
The future of Islamic Finance is linked to the economic and political power of Muslim communities around the world especially those in Muslim majority countries. More importantly, it is linked to the success of many similar ethical finance systems seeking to reform the current conventional banking and finance systems. The political and economic strength of the states and institutions practicing the conventional system is such that it is hard to predict a big change in the near term.