Islamic Economics and Islamic Finance in the Global Economy:

A System of Principled Investment, Risk-Sharing and Profitability

A thesis submitted in partial fulfillment of the requirements for the degree of Bachelor of Arts in Philosophy, Politics, and Economics

Ramy ElmeligyPomona College

May 2008

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Acknowledgements

I would like to thank Professors Michael Green, Eleanor Brown, and Glenn Hueckel for

their tremendous assistance and availability throughout the duration of this project.

Professor Michael Green has been a favorite professor of mine since I took Social and

Political Philosophy with him in my junior year. Professor Green has been my trusted

advisor and friend since that time. He has counseled me in academic and personal matters

and consistently expressed his confidence in my talents and abilities like few others.

Professor Eleanor Brown has been instrumental in providing encouragement and moral

support throughout the writing process. Professor Brown has given me the motivation to

clear the necessary benchmarks, meet important deadlines, and accomplish what I have

accomplished. Professor Glenn Hueckel has extended a remarkable amount of assistance

in providing the conceptual framework for approaching the questions of this thesis.

Professor Hueckel has lent a great deal of his expertise to the writing of this thesis. It is

not an exaggeration to say that without his help, this document would not have been

possible. Additionally, Professors Green, Brown and Hueckel have all made themselves

remarkably available, even on weekends, to answer any questions I might have and

provide feedback at every step along the way. I would like to thank the Pomona College

Philosophy, Politics, and Economics Department for its support and for a wonderful

interdisciplinary curriculum. The PPE Department has led me along an intellectual

journey encompassing three interrelated and fascinating fields of study. My peers in the

PPE department have been supportive and wonderful friends who have helped me

succeed. Together we have learned a tremendous amount. I would also like to thank the

rest of the Pomona College faculty and staff for their support and kind wishes. My

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experience at Pomona College has been the most important formative experience of my

life. It has definitively shaped who I am, the way I think, the way I view the world, and

my ultimate goals in life. To Pomona College I owe my identity and all my future

successes. My Pomona experience has been one I will never forget and it is with gratitude

and reverence that I will leave the college to enter the real world. Finally, I would like to

thank my friends and family, who were kind enough to share their thoughts and advice

with me during the course of writing this thesis. My friends and family have been my

emotional rock and have supported me through thick and thin in every chapter of my

college experience. They are the most important thing in the world to me, my reason for

being, and the people who have made everything of worth that I have ever accomplished

in this world possible. I owe them all an enormous debt and my endless love and

appreciation. It is to them that this thesis is dedicated.

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Introduction: Islamic Finance: The Big Picture

In the twenty-first century, the business of finance and banking finds itself in a

transitional state, occupying as it does a maturing and developing role in the global

economy. It is an invariable characteristic of the world's finanancial infrastructure that

wherever growth and development occur, they are preceded by a strong framework of

lending for the provision of credit, an robust regulatory framework, and a diverse array of

financial institutions providing various services from holding deposits, to raising capital,

making loans, and managing wealth.

Islamic finance is a form of finance that is compliant with Islamic law, or shariah,

which goes back to the inception of Islam. Recently, this particular variety of finance and

its corresponding institutions have spread all over the world. The notion of financing that

complies with Shari’ah, or Islamic law, goes back to the beginning of Islam, when the use

of financial contracts based in Islamic teachings first became codified as law in Muslim

societies. Since then, Islamic banking has contined to develop as an integral component

of Muslim societies, and with the twentieth century has arrived the development of the

first modern Islamic bank and the creation of modern Islamic finance as a discipline.

The shari’ah is a set of Islamic teachings, legal rulings and jurisprudence based

primarily on one source: the scripture of Islam, the Qur’an. It is a centuries-old group of

rulings and laws based on the teachings of Islam which has been clarified in a process

commonly known as ijtihad, through which it has progressed along with the development

of Islamic states in the world. Historically, the development shari'ah law was moved

forward by religious scholars, known as ulama, who play a transformative role in

moulding consensus interpretations and opinions regarding the application of scripture

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and Sunnah, or folkloric Islamic wisdom, to modern institutions. The convergence of

religious teachings and financial practice reflects a belief in the Islamic notion of tawhid,

or oneness, which is that faith and belief should be translated into all aspects of life,

including economics and finance. Today, this means applying the normative content of

Islamic thought to modern institutions.

Malaysia, Indonesia, Pakistan, and Sudan, among others have produced shari’ah-

compliant Islamic financial institutions, with the last two countries having avoided

interest altogether in their banking transactions, since transitioning to interest-free

systems during the 1980s. Today Islamic financial products are available in over 50

countries, with over 300 IFIs (Islamic financial institutions) spread throughout the world

and growth rates within the industry of 10-15% a year.1 Many major multinational banks,

including Citigroup, Barclays, and HSBC, have begun to offer Islamic financial products

to their customers to meet the needs of the world’s 1.8 billion Muslims, who comprise

over a fifth of humanity. Much of the growth in this industry will be fueled by the growth

of the world population of Muslims, which is projected to increase to 30% of the world’s

population by 2025; as of this writing, 52 of the world’s countries are predominantly

Muslim and these regions continue to develop economically.

There is a wealth of investment potential in the Islamic world, and much of this

capitalization will be sure to flow through IFIs, with the amount of planned expenditures

and foreign currency reserves reaching extaordinary highs in parts of the world where

shariah-compliant financial instruments are in demand. For instance, thanks to increasing

oil revenues and greater economic prosperity in the region, the GCC economies

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(consisting of Bahrain, Kuwait, Omar, Qatar, Saudi Arabia and the UAE) are flush with

cash, posting a collective budget surplus of USD 170 billion in 2005. 2

Islamic financial institutions are gaining traction in far-reaching parts of the

world, including Hong Kong, China and Southeast Asia.3 What is more, Islamic financial

institutions are coexisting well alongside conventional banks in the modern financial

system. Without a doubt, the viability of the Islamic financial system is to a certain extent

dependent on how compatible such institutions are with existing economic institutions.

That such compatibility is attainable appears to be the case. It has been demonstrated,

with over $700 billion in wealth held globally by Islamic financial institutions, that a

transitional economy based on an Islamic system can sustain development comparable to

a traditional market economy. Many of the world’s IFIs are achieving rates of return on

capital and are effectively developing in that part of the world. The Al-Rajhi Banking and

Investment Corporation (ARABIC) in Saudi Arabia has in the past attained returns

comparable with the world’s commercial banks.4 Another prominent example is the First

Islamic Bank of Bahrain, which posted profits of 13 million Bahraini dinars, or almost

$50 million in 2007, up from 20.5 million USD in 2000.5

In short, Islamic financial institutions have taken root in the global financial

system and are rapidly spreading all over the world. Among other things, in this thesis I

will explore the regulatory guidelines of Islamic financial institutions, their offerings, and

vehicles, which combine profitability with societal welfare and a more ethical and

principled basis for investment and growth. I will also explore how shariah-compliant

banks and intermediaries compare to “conventional” banks as vectors of money creation,

as lending and depository institutions, and as drivers of sector-specific and

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macroeconomic growth Additionally, I will examine the ethical and philosophical

rationale behind the development of an Islamic financial system, and what pragmatic

societal aims might they be used to accomplish.

Islamic banking is "the fastest growing segment of the credit market in Muslim

countries" that have them, and "their market share has risen from 2 percent in the late

1970s to about 15 percent today, as measured by assets in the banking system."6 The rise

of Islamic financial institutions and their status as central institutional pillars of modern

Islamic societies merits an exploration of the ethics of investment intended to

accommodate their social mores. It also warrants a look at the economic efficiency and

solvency of Islamic banks, especially as compared to conventional institutions and

instruments of finance, and at the extent to which such institutions should attend to

considerations of social welfare. Ultimately, my thesis is intended to provide a better

examination of the circumstances of Islamic economics, banking, and financial

institutions on the ground, their philosophical framework, and their real effects on the

worldwide Muslim population.

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Chapter 1: Islamic Finance from the 6th Century to the Present

The origins of Islamic banking coincided with the rise of capitalism in the early

Muslim world. Prophet Muhammad himself, in his early years, was a businessman

engaged in a profit-sharing business partnership with a powerful businesswoman,

Khadija bint Khuwayld, whom he subsequently married.7 In accordance with his

example, and with passages in the Qur’an regarding business dealings and lending

practices, Muslim merchants in the early centuries of the Islamic empire developed

transitional intercontinental trade routes that fostered a flourishing system of enterprise.

So-called sarrafs were the financial intermediaries of the early Muslim world who

maintained a transfer payments system and provided credit.8 In the eleventh century, we

read of the rise of the Karimis, a wealthy mercantile family of Medieval Cairo, whose

trading depots spanned the Indian Ocean to the Mediterranean Sea. The Karimis owned

great houses, akin to modern day financial centers: the funduqs, which financed "great

projects" and served as "a type of banking institution for loans and deposits." The

funduqs quickly spread throughout Cairo and to trading centers such as Baghdad,

Cordova, and Damascus, where they facilitated trade in fabrics, oil, produce, luxury

goods, and raw minerals. While creditors in the Islamic world then, as now, were

inconsistent in abiding by the Qur’anic prohibition on interest, trading in the Islamic

world took place on a significant scale.9

Islamic banking, as it exists in the present day, dates back to the early 1950s,

when the first theoretical work in Islamic economics began. Contributions to the present

framework of Islamic banking came from Iraqi, Egyptian, Pakistani, Saudi, and Indian

sources. Among such contributions was the production by Islamic economists in 1953 of

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the two-tier model of Islamic banking.10 Around the same time the Malaysian government

initiated a unique, early form of the Islamic financial institution, the Tabung Hajji, in

1956. This was a government managed fund which collected savings deposits from

Malaysians and reinvested them in real estate, agriculture, and industry. The proceeds of

these investments were used to finance the pilgrimages of Malaysian Muslims.11

The next phase began with the experimental creation in Egypt of a series of banks

with Islamic influence in their charters, prior to the codification of shari’ah rulings

pertaining to interest. The establishment of such banks in Egypt was intended to serve a

social aim, of bridging the gap in the Egyptian economy between the supply of and the

demand for short and long-term loans. These banks had an increasing role to play after

Egypt's liberalization in the 1970s under Anwar Sadat, whose market-oriented policies

actually made it more difficult for the rural and working classes of Egypt to obtain

consumer or investment loans.

The first of these banks, the Mit Ghamr Savings Bank, was established primarily

on a local basis and intended to serve Egypt's rural, agrarian poor, by providing them

with banking services that complied with Islamic precepts. This bank was the first of its

kind, and the first to establish separate windows for demand deposits and for investments.

With modest subsidies from the government, the bank assisted local villagers by

providing loans. The bank also provided capital for investments in infrastructure and

public works projects that locals would not have otherwise been able to undertake. It also

provided them with interest free safekeeping for their money. It is important to note that

the bank was intended to resemble in every way traditional Western lenders, and that its

"observance of the Islamic prohibition on interest" was less out of theological rectitude

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than to meet to the financial needs and "accommodate the religious scruples and political

attitudes of its intended customers." In the MGSB we find the earliest modern usage of

the profit-and-loss sharing model, which was used to invest in local development and

engage villagers in entrepreneurial ventures.

The MGSB’s transitional experiment in socially motivated banking lasted but a

few years. It was ended in the late 1960s. Subsequently the Egyptian government

launched the Nasser Social Bank. Like its predecessor, the NSB refrained from charging

interest, and provided investment and deposit services to locals. However, the NSB was

more explicitly affiliated with and less independent from the government. As a

consequence, its focus was more on providing capital to urban, upwardly mobile, blue-

collar Egyptians on a widespread rather than a local basis. The NSB also directed its

attention to funding charitably oriented and social loans with an eye towards fulfilling

Islamic duty.

The Faisal Islamic Bank was the most wholly Islamic of the early Egyptian

Islamic banks. Founded in 1979, it had an explicit mandate to comply with Islamic

teachings and Shari’a precepts and all its fiduciary activities were conducted as such. As

a private undertaking, it was not subject to government supervision. The FIB periodically

redistributed 2.5% of its profits as zakat, or charity, and made loans on an equity

investment basis. It pioneered some of the profit-sharing methods still in use today. It

also pioneered the profit-sharing method of distributing to borrowers a proportion of the

profits created by the enterprises underwritten by the bank’s loans.12

Egypt was not the only country to offer contributions to the recent wave of

modern-day Islamic banking. The first commercial Islamic bank, the Dubai Islamic Bank,

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opened in 1974 in the U.A.E. The following year the Islamic Development Bank was

founded in Saudi Arabia with the goal of "promoting economic development" in Muslim

countries.13 Throughout the 70s and 80s, under the auspices of national governments and

backed by popular mandates, Iran, Pakistan, Malaysia and Sudan undertook to transform

their entire banking systems to be shari’a compliant in nature. The process by which

these state-mediated transitions to Islamized banking took place varied.

The development in Iran, after the Iranian Revolution, of a national Islamic

banking system played a central role in the revival and diversification of the Iranian

economy. The Iranian banking sector re-diverted credit from the service and consumer

sectors to agriculture and industrial production. After the creation of an Iranian Islamic

central bank and the passage of the "Law for Interest-Free Banking" in August 1983, and

the subsequent increase in the Iranian GDP and domestic production, the Iranian

economy was able to substantially reduce its dependence on oil revenues and the

importation of raw materials, intermediate goods, and food. Like their counterparts in

Egypt, Iranian Islamic banks were used to promote income redistribution through

beneficent Qard Al-Hasanah ("kind" or "caring lending") loans to the needy. The

banking sector in many ways served to actualize the will of the Iranian population by

acting as "a major source of finance for achieving many of the social and economic goals

of the Islamic Revolution."

Iran, through its national Islamic banking system, reduced the economy’s

dependency on oil revenues, decrease the size of the Iranian service sector, and increase

the self-sufficiency of Iranian industries.14 The creation of an Islamic financial sector

occurred in conjunction with the reorganization of government along Islamic lines, with

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the banking system functioning as "an integral part of government and… a direct

instrument of its policies." The banking system as an extension of popular Iranian rule

was a logical consequence of the popular mandate that Islam should permeate all levels

of society, and was "a major source of finance for achieving many of the social and

economic goals of the Islamic revolution."15 This development increased the autonomy

and sovereignty of the Iranian people by giving them a degree of control over the cultural

values that would be endorsed through their markets than would neoliberal open-market

policies and free trade.

In Pakistan, by contrast, the transition to Islamic banking was less abrupt. Profit-

and-loss sharing-based financing was introduced alongside interest-based banking in

Pakistan in the early 1980s. Participation Term Certificates, non-interest based financial

instruments were issued in 1982 to take the place of corporate bonds. By 1985 all

interest-based deposit and lending windows in Pakistan were closed down.16

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Chapter 2: The Philosophical Basis of Prohibiting Interest

Only True Creation of Wealth Justifies Profit

The Islamic prohibition of riba, or interest, is based on the Islamic conception of

property rights and notions of what constitutes a valid claim on property. In this view

interest is not a valid claim on property. Charging interest on a loan is considered

unethical and detrimental to society in the Islamic financial system because it is

considered to be the unwarranted creation of an additional property right on the wealth of

the borrower. Islam only recognizes as legitimate property rights that are a result of an

individual’s effort or labor, or that arise as a result of "exchange" or "remittance". 17 The

ownership of money does not, in itself, create additional value, over and above the

principal, and does not entitle a lender to guaranteed profit, without engaging that

principal in a productive activity.

Islamic scholarship frowns upon the idea that individuals or institutions can or

should earn profit without committing to any risk. Investment, in this view, should be

made in the hope but not the guarantee of return, and should be directed only toward

productive ends.18 In the words of the International Association of Islamic Banks, under

an Islamic banking system "wealth would bring more wealth to its owners only when its

use… actually resulted in the creation of additional wealth," as in the creation of new

jobs, the production of new technology, or the discovery of new resources.19 The

potential for productivity is distinguished from credit-worthiness as appropriate criteria

for the extension of credit, and the profit-sharing financier, will seek out projects with the

greatest net benefit.20

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Economically speaking, the argument against interest has to do with the need for

the generation of wealth to proceed from an increase in the productive output of the

economy in order for it not to be exploitative. On a large scale, interest is problematic

because interest charges that accumulate to lenders over time, as in overnight loans

between banks, do not generate actual wealth. For example inter-bank loans are used as a

tool of liquidity management, however, the use of interest in such loans is an ongoing,

uninterrupted commission which accrues on a bank’s balance sheet yet does not equate to

an increase in productive assets. In this sense it is a continuous return which is unrelated

to actual productivity.21 Without engaging that principal in a productive activity a lender

is not, based on the Islamic property regime, entitled to guaranteed profits.22

Comparing interest rates and profit-sharing rates of return as signals which

regulate real rates of investment illustrates the difference. Interest rates act as a

prospective signal which regulate the level of credit, investment and saving in the

economy, based on expected increases in real output. On the other hand, profit sharing

functions to adjust levels of investment in real-time in accordance with retrospective

averaged levels of growth. In the Islamic profit-sharing framework the profitability of

current investments acts as a feedback mechanism, through the rate of return, which

determines the level of investment in the next period, and is based not on projected or

desired growth but on actual ongoing growth of returns. As Zaher and Hassan point out,

even in looking at interest as a way of adjusting the price level in accordance with

changes in the capital stock, "it seems more reasonable to allow next year’s economic

conditions to determine" the extent of this adjustment, "as opposed to predetermining it in

the form of interest".23

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Property Rights and Prohibition of Interest in the Qur'an

To start with, riba, as it is referred to in Arabic, literally means "excess," and is

clearly prohibited in the Qur’anic scripture. It is assumed to mean interest, and the

majority of Islamic thought holds that the practice of charging interest has a corrupting

influence in society. There are several textual Qur'anic citations which explicitly forbid

charging or receiving interest. According to Muslim scripture God has "permitted trade

and forbidden riba." The Qur'an forbids the use of "doubled and redoubled" interest "to

increase people’s wealth," and labels it as "wrongful appropriation of peoples’ property"

(Quran 3:130, 4:161). It states: "O you who believe, fear Allah and give up what remains

due to you of interest if you are indeed believers" (2:278). Moreover, it says that "Those

who swallow usury cannot arise except as he arises who the devil prostrates by his

touch" (2:275).

The history of the discourse on Islamic social welfare incorporates a "deep-seated

and long-established revulsion at the idea that 'money should breed money,'" similar to

the Aristotelian notion of the "sterility of money".24 Indeed, according to Patrick

Honohan, "interest has long been a stumbling block for students of ethics, whether

Islamic or not" who have struggled to reconcile the apparent fact that the use of interest

exploits the "desperation of the needy".25 The poor or needy debtor is fundamentally

disadvantaged in that interest redistributes his wealth to the lender over time. It

inexorably makes those with the means to lend wealthier over time and those seeking

loans to sustain themselves poorer. Further the notion that "an individual who abstains

from consumption, by saving" ought to be rewarded with interest payment is not

endorsed by Islam.26

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In general, medieval Islamic thinkers provided a number of rationales for

prohibiting interest in their exegesis of the Qur’anic text, including the maintenance of

fairness, and the avoidance of exploitation.27 Islamic philosopher Abd-Hamid

Muhammad al-Ghazzali characterized individuals as required to abstain from

"profiteering and other unfair trade practices." Al-Ghazzali's vision of the just state is one

in which equity and justice prevailed in all transactions.28 Muhammad Baqir al-Sadr

wrote that there "could be no reward without work or effort".29 Iqbal Khan condemned

interest on loans made to the poor, on the basis of "social cohesion, social progress and

social equity".30 The consensus regarding riba of its "moral repugnance" is that it

amounts to exploitation of people "driven by need," it creates an "unequal burden of risk

sustained by the borrower," and "an Aristotelian aversion to the 'unnatural' process

whereby, in the payment of interest... money is made from money".31

In modern practice, the illegality of interest is articulated in fatwas, which are

rulings and opinions issued by Muslim scholars. Fatwas pertaining to banking

transactions are produced by state authorities such as courts and legislatures, as well as

by "international juristic councils", including the Institute of Islamic Research at al-Azhar

University in Cairo, The Islamic Jurisprudence Institute in Makkah, and the Fiqh Institute

in Saudi Arabia. The majority agree on what constitutes interest, however, there are some

dissenting opinions. Because of the existence of a wide variety of sources for

interpretations, it is difficult to "speak with any authority regarding the Islamic

permissibility of any given transaction".32 As a result "the Islamic law pronouncements

at... official levels... often contradict one another" and are in many cases inconsistent with

one another. Many examples of this can be observed. Malaysia has permitted trading in

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debt or bay contracts which has resulted in the creation of "a relatively sophisticated

'Islamic Money Market'." This type of trading remains prohibited by the majority of

Muslim states and their religious authorities.33

Some scholars dispute the exact meaning of the Islamic idea of riba, with others

issuing contradictory rulings pertaining to what is permissible in transactions. Some

1 Solé, Juan. "Introducing Islamic Banks into Conventional Banking Systems." IMF Working Paper. Monetary and Capital Markets Development. July 2007. 2 "The Islamic Funds and Investments Report." Ernst & Young. 2007.3 Kuwait News Agency. "Hong Kong willing to lure Islamic investment from Kuwait, GCC." MenaFN.com. 24 Jan 2008 4 Henry, Clement M. Wilson, Rodney. The Politics of Islamic Finance. Edinburgh University Press. 2004. 5 Rafique, Mahmood, "Bahrain Islamic Bank Unveils Strategic Plan"6 Aggarwal, Rajest K. Yousef, Tarik. "Islamic Banks and Investment Financing."7 Hardie, Alexandra R. Rabooy, M. "Risk, Piety, and the Islamic Investor." British Journal of Middle Eastern Studies, Vol. 18, No. 1 (1991), pp. 52-668 El-Hawary, Dahlia, Grais, Wafik, and Iqbal, Zamir. "Regulating Islamic Financial Institutions: The Nature of the Regulated." World Bank Policy Research Working Paper 3227. March 2004.9 Labib, Subhi Y. "Capitalism in Medieval Islam." The Journal of Economic History, Vol. 29, No. 1, The Tasks of Economic History. March 1969. pp. 79-9610 Iqbal and Mirakhor, p. 1011 Henry, p. 1012 Mayer, Ann Elizabeth. "Islamic Banking and Credit Policies in the Sadat Era: The Social Origins of Islamic Banking in Egypt." Arab Law Quarterly, Vol. 1, No. 1. November 1985 pp. 32-50.13 Iqbal and Mirakhor, p. 2514 Khan, Mohsin S. "Islamic Banking: Experiences in the Islamic Republic of Iran and in Pakistan." Economic Development and Cultural Change, Vol. 38, No. 2, January 1990. pp. 353-37515 Ibid, p. 36016 Ibid, p. 36517 Pervez, Imtiaz A. "Islamic Finance." Arab Law Quarterly. Vol. 5, No. 4. November 1990. p. 26318 Hardie, Alexandra R. Rabooy, M. "Risk, Piety, and the Islamic Investor." British Journal of Middle Eastern Studies, Vol. 18, No. 1 (1991), pp. 52-6619 Aggarwal, Rajesh K. Yousef, Tarik. "Islamic Banks and Investment Financing."20 Zaher, Tarek S. Hassan, M. Kabir. "A Comparative Literature Survey of Islamic Finance and Banking." Financial Markets, Institutions, and Instruments. Volume 10, No. 4. November 2001. p. 15721 Ibid p. 15722 Choudhury, Masudul Alam. Money in Islam: A study in Islamic political economy. Routledge Press. London, UK. 199723 Zaher, Tarek S. Hassan, M. Kabir. p. 15624 Tripp, Charles. Islam and the Moral Economy: The Challenge of Capitalism. Cambridge University Press, Cambridge, UK, 2006. p. 6525 Honohan, Patrick. "Islamic Financial Intermediation: Economic and Prudential Considerations." Development Research Group and Financial Sector Strategy and Policy Department, the World Bank. July 2001. p. 326 Presley, John R, Sessions, John G. "Islamic Economics: The Emergence of a New Paradigm." The Economic Journal, Vol. 104, No. 424. May 1994. p. 586.27 Netzer, Miriam. "Riba in Islamic Jurisprudence: The Role of ‘Interest’ in Discourse on Law and State." Spring 2007. p. 10

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interpret the word as referring to an "excessive" charge while others interpret it as

referring to any charge greater than principal and any form of interest at all. Dr.

Muhammad Sayyid Tantawi at al-Azhar University in Cairo issued a somewhat unique

2002 opinion indicating that it was permissible to pre-specify profits and charge a fixed

rate of return. Dr. Tantawi’s ruling was likely intended to improve the Egyptian business

environment for conventional banks. It distinguished between "pre-specified profits," and

riba. The opinion stated that "banks only pre-specify profits or returns based on precise

studies of international and domestic markets, and economic conditions in the society".34

Tantawi was able to draw upon previous opinions which defined riba by the extent of its

harm to individuals and households rather than by its fixed nature. The opinions also

stated that the use of pre-determined percentage shares of profit was not condemned by

the Quran. Tantawi's ruling, however, was in the minority. Reflecting the majority

opinion of most Muslim scholars, the Islamic Fiqh Institute in Qatar quickly issued a

rebuttal in 2003 stating that charging interest as practiced by commercial banks is in fact

impermissible under Islamic law.35 The literature reflects such deviances from the

majority opinion within Islamic scholarship on the issue of interest, what Miriam Netzer

refers to as a "tension between textualism and essentialism" and which can explain in part

the gap between "theory and practice" in Islamic finance.

28 Mehmet, Ozay. "Al-Ghazzali on social justice: Guidelines for a new world order from an early medieval scholar." International Journal of Social Economics. Vol. 24, No. 11. 1997. 29 Wilson, Rodney. "The Contribution of Muhammad Baqir al-Sadr to Contemporary Islamic Thought." Journal of Islamic Studies Vol. 9 No. 1. 1998. p. 58.30 Tripp, p. 2631 Ibid, p. 12632 El-Gamal, Mahmoud A. "Interest and the Paradox of Contemporary Islamic Law and Finance." Rice University. p. 333 Ibid, p. 534 Ibid, p. 1035 Ibid, pp. 5-7

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Chapter 3: Islamic Economic Thought

The traditional discourse of economic thought has chiefly focused on two main

types of arrangements of the means of production within society, the first being

capitalism and the other socialism or Marxism. The two can be contrasted along many

dimensions. Capitalism stresses the relative importance of the individual. Socialism

emphasizes communal welfare. Capitalism champions property rights and minimal state

intervention in economic affairs. Socialism subjects economic transactions to the power

of the government. Capitalism extols the virtues of competition even if it produces class

divisions or inequality, preoccupied as it is with the “search for relative advantage”

(Tripp, p. 55). Socialism strives for perfect equality among all classes of society. A great

deal of scholarship has been devoted to the respective merits of each system. To date,

neither has been shown to be perfect. The flaws of free-market competition are obvious

from the exploitative and unjust, conditions found in the early stages of industrialization.

Socialism has found its way into many of the world's welfare states but has thus far failed

to produce an efficient and prosperous society that is based solely on its ideas.

In the midst of this discourse, another, alternative form of economic thought has

arisen that has largely been overlooked in the Western world: Islamic economics.

Increasingly visible through the prevalence of Islamic financial institutions, Islamic

economics originated and developed as a means to reconcile the structures of a market

economy with the ethical considerations of Islam. Like Marxism, Islamic economics

seeks to reduce the class divisions and inequality within society. However it also strives

to attain the technological and material advancement that capitalism provides.

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Goals of the Islamic Society

The social aims of Islamic economics are the reduction of inequality between the

rich and the poor, the establishment of justice and transparency in all transactions, and the

allocation of society’s resources to the needy and unfortunate. Islamic economic thought

is rooted in the notion that economic activity in an Islamic framework is governed by

ethical and communal constraints rather than the rational constraints of neoclassical

economics. The discipline of Islamic economics took shape through the efforts of

Muhammad Iqbal in India, Abu Al-A'la Maududi in Pakistan, and Muhammad Baqir al-

Sadr and Sayyid Qutb.36 Baqir al-Sadr's book "Iqtisaduna: Our Economics" was

especially influential in the writings of later Islamic economists.37 Islamic economics

rests on a conception of rationality that is different from the secular Western notion.

Islamic systems of economics are intended to promote transparency, honesty and

frugality in financial dealings, and "stimulate generosity" and charitable giving.38

Whether they are successful in accomplishing this is disputed. Investment according to

the tenets of Islam must also abide by ethical constraints, such that they do not promote

activities considered to be unethical or sinful (Hardie, Rabooy, 1991). This has resulted in

the development of Islamic equity funds which steer clear of business that engage in the

promotion of goods or services deemed unlawful in the Islamic world.39

In Islamic economics the individual acts in accordance with the greater good of

society. The scholarship regarding Islamic finance makes the distinction between Homo

36 Ibid, p. 1537 Wilson, p. 4838 Kuran Timur. "Islamic Economics and the Islamic Subeconomy." The Journal of Economic Perspectives. Vol. 9, No. 4. Autumn 1995. pp. 155-173.39 Maurer, Bill. "Engineering an Islamic Future: Speculations on Islamic Financial Alternatives." Anthropology Today. Vol. 17, No. 1. February 2001. pp. 8-11.

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economicus and Homo islamicus, the former being the "selfish and acquisitive" rational

actor of the majority of contemporary economic thought and the latter being the "paragon

of virtue" that constitutes the Islamic ideal for just conduct (Kuran, 1986, Samers,

Pollard, 2007).40 The Islamic economic actor operates according to ethical as well as

budgetary constraints, including dedicating income to charity and complying with

"community preferences".41

Islamic intellectuals brought together admiration for Western industrial

achievement with a communal emphasis on "moderation and fairness... between the

propertied and the propertyless." Ahmad Khan believed Muslims should emulate the

European industrial economies that had created well-being, prosperity and wealth. The

Egyptian Muslim jurist Rifa-ah al-Tahtawi, along with his contemporaries in Istanbul,

Iran, and India, was "inspired" by the "dynamic... economic activity of the great

European cities" and their "technological invention and wealth." At the same time,

Tahtawi held that property ownership needed to conform to the "public good," in order to

meet the standard of shari'ah. The scholar Muhammad 'Abduh judged social institutions

and property holdings on the basis of how much they contributed to "material prosperity

and cohesion of the society". Shaikh Shaltut made the argument that "sound utility

required both the productive use of capital and the conditions that would ensure that it

was used for generating beneficial ends".42

This notion of societal benefit constituted the concept of al-maslahat, or

alternatively, Maslahah. In order to carry out the Maslahah, each individual in society

40 Pollard, Jane. Samers, Michael. "Islamic banking and finance: postcolonial political economy and the decentring of economic geography." Center for Urban and Regional Development Studies, Newcastle University. 26 February 2007. 41 Mehmet, p. 120642 Tripp, p. 84

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must take into consideration the way his actions will affect others in society, whether

they will contribute to or detract from the greater good. This is done with a consciousness

of the moral impact of one’s deeds in the universe and the individual’s knowledge that he

or she is being judged by God. The individual in society acts as the agent, or

"vicegerent," of God on earth. The fulfillment of God's purpose necessitates the

reinterpretation of economic and societal institutions from an ethical standpoint.

Islamic economics is described by Islamic economist Syed Naqvi as residing

within an axiomatic ethical framework that consists of four poles: Tawhid, Adl, Ikhtiyar

and Fardh. These are Unity, Equilibrium, Free Will, and Responsibility. Islamic

economics organizes itself according to these four issues. Tawhid, or unity, is the concept

of the oneness of being, which fosters "social harmony though universal brotherhood"

and is intended to promote the integration of political, social, and religious institutions

under God. Al-Adl or Equilibrium is a societal configuration in which the "needs of the

least privileged in society" are prioritized above all others. The Quran's discussion of

wealth, commands Muslims to see "that it does not concentrate in the hands of those who

are rich among you" (Quran 59:7). A society in which the poor are not looked after and

are exploited for the rich embodies the opposite of Adl, which is Zulm. In conjunction

with this, inequality may be permitted if it stimulates welfare-increasing growth. Ikhtiyar

or free will is the Islamic notion that the individual has liberty to make right or wrong

choices which influence outcomes. It is a relative, as opposed to absolute freedom, in

which the individual is constrained by avarice or liberated by justice and piety. Fardh is

responsibility to God and to the poor. This is embodied in tending for the needy and

ensuring that economic transactions create positive benefits or externalities beyond

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individual profit. The concept of Fardh is increasingly relevant with respect to issues

such as environmental quality and public health, which create a tradeoff between social

and private costs and a corresponding corporate responsibility to minimize this tradeoff.

If these four principles are observed, the outcome of the Islamic society will be the

avoidance of "extremes of wealth and poverty," and the creation of a "harmonious

relationship" between them.43

Social Critique of Western Economic Theory from the Islamic Standpoint

In this way Islamic economics and Islamic financial institutions originated as alternatives

rather than complements to Western economic and financial institutions. Not only did

they serve the purpose of assisting individuals who have a religious or ethical basis for

choosing to engage with strictly shari’ah compliant financial products and institutions,

but they were the basis for a society based on a different set of norms and with a different

pattern of resource distribution as its end goal. Some scholars go so far as to assert that

Islamic economics originated as part of an attempt to "defend Islamic civilization against

foreign cultural influences."44 But it is far from clear that this explanation is satisfactory.

There is a lot more to the development of Islamic economics than the xenophobic

impulse to shut out Western influence. However, Islamic philosophers and economic

thinkers were highly critical of some of the forms and structures of capitalism in the

West.

From the standpoint of Islamic economics, the value-neutrality of Western

economics is incompatible with social justice. Islamic economics advocates what is

43 Naqvi, Syed Hawab Haider. Islam, Economics, and Society. Kegan Paul International. London, England. 1994.44 Kuran, p. 156

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referred to by Tripp, Pollard, Samers and others as a "moral economy". It is normative as

opposed to positive. A theme of Islamic thought was the "fragmentation and anomie" and

the "commodification" created by industrialization, which brought with it "the dissolution

of social bonds".45 Capitalism places an emphasis on property rights and legal-formalism

but permits exploitative conditions. Its emphasis on accumulation tends to be at the

expense of lower socio-economic tiers. This is similar to the Marxist critique of

capitalism.

A chief criticism of Western economic norms is that its basic principles, such as

the neoclassical model of the economy, the concepts of individual utility, and ideas such

as Pareto-optimality, do not include anything like the Fardh principle of social

responsibility discussed above. Much of the literature on Islamic economics emphasizes

the fact that the capitalist system can produce suboptimal outcomes, especially for the

propertyless and the disadvantaged in society.

The Islamic critiques of the capitalist framework originated in reaction to the rise

of industrialization in European society. As mentioned above, Islamic intellectuals sought

for Muslim societies the growth and prosperity that were attainable through capitalist

means. At the same time, they were highly critical of what they perceived to be the

debasing effects of amoral materialism on society. Islamic thinkers sought to reconcile

the Islamic vision of the just society with the advancement of capitalist methods. They

believed that at the same time that society benefited from the positive effects of capital

accumulation, distributive justice and moral fortitude needed to be safeguarded against

encroachment by "the dark side of economic progress," or what Shakib Arslan called "the

45 Tripp, p. 81

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political influence of European [economic] imperialism". The "economic arrangements"

of capitalism, it was argued, needed to be judged on the basis of the "benefit they were

thought to bring to the community as a whole".

The Islamic social critics diagnosed many ills of the capitalist society which were

not compatible with Islam. They wrote that capitalism created alienation and division

among members of society. It reduced relations in society to instrumental relations

between employers and laborers. Unrestrained, capitalism was held to be responsible for

"social disintegration, acquisitiveness and class resentments" in addition to "poverty and

unemployment". Muhammad Abduh believed that unbridled capitalism endangered

important moral qualities such as "compassion, mercy, solidarity and cooperation".

Muhammad Iqbal railed against capitalism, saying that its "inhuman competition" and

"ruthless egotism" had endangered the "spiritual unity" of civilization. Said Halim Pasha

described modern capitalist culture as "based… on material egoism" and "only another

form of barbarism" resulting from "over-developed industrialization". Abd al-Rahman al

Kawakabi viewed modern industrialism and capitalism as "a form of tyranny and

oppression". The Islamic social critics sought to achieve brotherhood, trust and unity

among men, and the maintenance of "moderation and fairness... in relations between the

propertied and the propertyless". The individuation and materialism that capitalism

promotes were fundamentally at odds with these goals. For Rafiq al-'Azm, in the Islamic

society "the shari'a... provided the only possible framework for a moral economy that

ensured solidarity, cooperation, and the independence of the individual to act within

boundaries that would be just and equitable".46

46 Ibid, p. 29-55

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The positive nature of Western economics elevates considerations such as

efficiency and maximization above ethical considerations, hiding the "moral vacuum"

that underlies it.47 Naqvi asserts that the assumptions which characterize positive

economics are based in oversimplification and "non-consequentialist" disregard for the

end-result. For example, the "rational" assumption of individual preferences derived from

utility maximization is merely a status quo assumption that does not hold in all cases.

"Pareto-optimality" is a utilitarian condition which does not differentiate between the

welfare of the rich and the poor and hence can coexist with impoverishment. 48 Further,

the assumption of "homo economicus" as a self interested rational actor is not welfare-

maximizing in all cases. Self-interested behavior often produces a "prisoner's dilemma"

in which cooperation would "yield a superior collective outcome". For this reason, the

normative nature of the Islamic world view is at odds with "strictly procedural and

consequence insensitive" theories of justice, as Robert Nozick's libertarian entitlements

theory.49 

Often, capitalist structures produce conditions with disregard for their effects on

local populations. One example is Egypt in the early twentieth century. At that time

colonial power dominated along with a "self-serving view" of the global economy in

which "Great Britain and Western Europe were seen as industrial centers, while countries

like Egypt contributed vital agricultural products and raw materials". Egyptians were

critical of the exploitation and overdominance of foreign companies selling goods such as

sugar, salt, and soda, which took advantage of the "war torn economy by charging

inflated prices and paying high dividends to their foreign share holders".50 Muhammad

47 Ibid, p. 3648 Naqvi, pp. 60, 6249 Ibid, p. 48

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Tal’at Harb, the founder of Egypt’s flagship commercial bank, Bank Misr, criticized the

"dominant role of foreign capital" because it operated with disregard for the "welfare and

solidarity of the Muslim community"51.

Ozay Mehmet criticises the "pro-capital bias of western economics". Profitability

in neoclassical economics requires deviation from perfect competition, and the creation

of oligopolistic or monopolistic disequilibrium. Western markets account for value in a

"self-centered, egoistic" way which does not account for "social value as in the case of a

collectivity or community of individuals". Particularly in the development framework,

Mehmet suggests it is the basis for the exploitation of the natural resources of developing

countries, which are "grossly underpriced". The Western model enables multinational

corporations to extract rents from economies whose goods are "shadow priced" to allow

the extraction of profit. In these economies wages remain artificially depressed and rents

are extracted. Mehmet argues that in this way the structures of capitalism are "promoting

wealth concentration in the West at the expense of local/indigenous people".52

Muhammad Choudhury implicates the capitalist/monetarist money motive and the

desire for speculative gain for the "widespread inequity and social evils" that characterize

the global financial system. The nature of the money supply in capitalism is such that it

leads to "distortionary expectations" as well as an "excess accumulation of wealth" that

causes "extensive social deprivation". This excess cushion of money is used by

speculators who profit from the spread between interest rates on different forms of

secondary money. Fluctuations in the business cycle make it possible for "the speculative

50 Tignor, Robert L. "Nationalism, Economic Planning, and Development Projects in Interwar Egypt." The International Journal of African Historical Studies, Vol. 10, No. 2. 1977. pp. 186-187.51 Tripp, p. 3052 Mehmet, p. 1215

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venturist" to profit through arbitrage and "extract from the economy... a rent that gets

monetized by... interest". Changes in world price levels are in part a function of this

"avaricious" motive which is referred to by Keynes as the "animal spirit for speculative

gains".53

While undoubtedly the engine of growth in the Western world, it is true that

capitalism does not produce optimal social outcomes in all cases. Islamic thinkers

believed it had the capacity to "poison social relations" and "reconstituted" them "in ways

that… seem materialistic, functional, and shorn of the values that… imbued social

intercourse with meaning". Islamic economics is intended to offer an alternative by

"curbing the commodification of life and remedying inequality".54

Goals of an Islamic Economy

As can be seen from the preceding discourse, there is much more to the Islamic economic

system than the simple prohibition of interest laid out in the Qur’an. Mohsin S. Khan at

the International Monetary Fund is quick to point out that "although the elimination of

interest is certainly a central tenet of the Islamic economic system, it is by no means an

adequate description of the system as a whole or, for that matter, even of Islamic

banking." Islamic economics consists of an institutional framework which is intended to

promote "specific patterns of social and economic behavior for all individuals." Beyond

simply establishing rules for permissible financial activities, it also produces its own

conceptions with regard to such issues as "property rights, the incentive system,

allocation of resources, types of economic freedom, the system of government decision

making, and the proper role of the government".55 Shariah-based economies promote

53 Choudhury, pp. 1-354 Tripp, pp. 48-51

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transparency and accountability in economic exchange, particularly in the context of

poorly regulated developing countries. As mentioned, early Islamic thinkers such as Al-

Ghazzali emphasized the importance of social justice and equity in society, and the

conception of the economic individual as an ethical rather than a rational actor, whose

concern for charity and community preferences takes precedence over his own.

Part of what hampers the efficacy of development in Muslim and other developing

countries are "agency problems" stemming from the willingness of "entrepreneurs… to

use funds from their firms for their own consumption or perquisites or wasteful, negative-

return investments" and the fact that "the cash flows… from the entrepreneur’s project

are not verifiable to a court of law."56 Timor Kuran, despite taking a dim overall view of

the efficacy of Islamic banking in achieving some of its ends, concedes that the creation

of "Islamic subeconomies" consisting of Islamically owned and operated businesses may

create positive externalities and is "providing palpable benefits" that help to address the

agency problems faced in developing countries:

…an Islamic sub economy helps its participants cope with the prevailing

adversities by fostering interpersonal trust… they reduce their costs of

negotiating, drafting, monitoring, and enforcing agreements; relative to

people who must constantly guard against being cheated, they incur lower

transaction costs.57

55 Khan, Mohsin S. "Islamic Interest-Free Banking: A Theoretical Analysis." Staff Papers – International Monetary Fund, Vol. 33, No. 1. March 1986. pp. 1-27. 56 Aggarwal, Rajest K. Yousef, Tarik. "Islamic Banks and Investment Financing."57 Kuran, Timur. "Islamic Economics and the Islamic Subeconomy."

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The creation of "Islamic subeconomies" promotes the instrumental freedoms Amartya

Sen describes as "transparency guarantees," which are necessary to promote the

functioning of economic agents in an atmosphere of trust and security.

Charitable Giving and Poverty in Islamic Economic Thought

The above discussion does not mean that an individual who is not seeking funds

for an entrepreneurial purpose will be barred from access to capital in society. The

accumulation of wealth in Islam brings a certain measure of responsibility to seeing that

such wealth is used for the promotion of charitable ends. From the outset the Qur'anic

tradition elevated almsgiving to a place of prominence in Islamic life. Michael Bonner

states that in early Islam a great deal of economic activity involved the poor. This was

reflected by the creation in early Islamic society of an "economy of poverty," in which

charity was the basis for many economic transactions.58

The Qur’an enjoins relief to debtors who cannot repay their debts, stressing the

importance of charity as among the most highly valued of good deeds, and saying that "If

the debtor is in a difficulty, grant him time till it is easy for him to repay. But if ye remit it

by way of charity, that is best for you if ye only knew" (Quran 2:280). In the Qur’an we

find: "O you who believe, spend of the good things that you earn and of that which We

bring forth for you out of the earth" (Qur’an 2:267). It is considered praiseworthy to

spend and give charity "for the poor who are confined" and "cannot go about in the land"

(Qur’an 2:273). These verses are intended to promote a financial infrastructure of Islamic

society such that in the long run it is as equitable as possible. The charitable and equity

focused aspects of Islamic economics are intended to improve the lot of the less

58 Bonner, Michael. "Poverty and Economics in the Qur’an." Journal of Interdisciplinary History. Vol. 35, No. 3. Winter 2005. p. 396

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advantaged in society at the same time that profit is sought for the owners of capital. It is

a central pillar of Islamic teaching, and thus incumbent on Muslim society, to carry out

the duty of charity, or zakat, through the creation of charity funds intended to serve the

welfare of the poor. The Zakat is an obligatory tax on Muslims which is intended to

ensure "the productive use of wealth".59 Charity and redistribution is required of all

Muslims because property in the Islamic view originates from God, and all humans have

an equal claim on it at the outset, similar to Locke’s notion of property held in common.

In Islam all property is conditional and ownership is connected with "a good greater than

the satisfaction of individual wants," because God has "entrusted humans with its use,

encapsulated in rules such as the payment of zakat".60

59 Pervez, p. 26160 Ibid, p. 256

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Chapter 4: Understanding the Structure of Islamic Financial

Institutions

Islamic Financial Institutions (IFIs) are an effort to provide the Islamic world with

financial intermediation services that conform to their ethical and religious background

and preferences. Islamic financial institutions utilize their own forms of financing which

avoid the use of interest. A substantial literature has arisen describing the properties of

Islamic financial institutions. It is difficult to characterize the field in one broad swoop,

due to variation between individual IFIs. Thus it is useful in discussions of Islamic

economics and Islamic financial institutions to separate the field’s theoretical constructs

from actual practices, which vary from case to case and may in some cases abrogate

prohibitions such as that on interest.

It is possible to regard the implementation of an Islamic or shariah-compliant

financial system in two contexts. One is in an examination of the process by which

Islamic "retail banking is implanted in traditional financial systems".61 In this case it is

more instructive to consider the Islamic financial institution as a financial intermediary

intended to provide the benefits of conventional intermediation (i.e. with respect to

diversification, return, consumption lending, and investment financing) to markets which

require compliance with a set of normative ethical and religious requirements. The other

is in the holistic context of Muslim society, in which case one can regard Islamic

financial institutions not just as providers of a service to a particular market, but as agents

that are "expected to participate actively in achieving the goals and objectives of an

Islamic economy".62 In the first case conventional banks can "tap the growing pool of…

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investors attracted to Shariah-compliant products" through the creation of "Islamic

windows" for deposit and investment. In the second case, "stand-alone Islamic banks"

may be created, or entire economies overhauled.

Partnership-based Investment

It is difficult to characterize the structure and activities of all Islamic financial

institutions as there is a great deal of variance in their implementation between countries.

However there are certain features that can be ascribed to all of them based on the roles

they are required to fulfill. For instance, the means by which an Islamic bank carries out

its payments, financing and investment activities tends to be the same across the board. In

order to understand the forms that financing can take in Islamic financial systems, what

follows will be a basic outline of the structures and the different types of contracts that

comprise shariah-compliant finance in IFIs.

The key contrast between the Islamic form of banking and the Western model is

the manner in which the payment system is structured and the amount of deposits

required on hand. Similar banking systems were proposed for use in the United States by

some of its foremost economic minds, including Henry Simons, Milton Friedman and

Charles Kindleberger.63 The chief advantage these offer is that real-time depreciation of

total wealth in economy is synchronized with fluctuations in the real rate of return on

bank equity. In the Islamic model, it is argued, the money supply would not be "allowed

to overstep the supply of goods and services," and should "eventually curb inflationary

pressures in the economy." In theory the use of profit-sharing arrangements in lieu of

61 Sole, Juan. 62 Khan, p. 263 Ibid, p. 3

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interest will mean that "the return on capital will depend on productivity," which will "in

effect improve the efficiency of capital allocation." 64

Profit-and-loss sharing is, in many treatises on the subject, the flagship form of

financing available to Islamic financial institutions, perhaps in part because it accords

well with the "communal dimensions" of Islam.65 This type of financing is generally

conducted by a "partnership" between the bank itself and the entrepreneur who manages

the capital. In "PLS" financing, (which may take the form of Mudaraba, or Mushakarah),

depositors who would receive interest returns in a conventional bank are shareholders

who receive a variable rate of return. Rates of return are conditional upon the conditions

of the market and the profitability of the endeavor. Investors and depositors are

shareholders in their banks who have in effect purchased an equity claim to a portion of

the proceeds from the bank’s activities. In the PLS model "shares of expected profit are

determined ex ante, while the actual rate of return on investments is to be determined

only ex post, on the basis of realized profit." Unforeseen circumstances are thereby

accounted for in the real rate of return realized by the investor.66

100% Reserves and the Two-Windows Model

One oft-cited feature of the hypothetical Islamic financial institution is the

separation of the bank’s investment activities from its role as a depository and the

maintenance of 100% reserves for demand deposits. In this "two windows" model two

types of accounts exist. Transactions deposits are directly involved in the payments

64 Aggarwal and Yousef, p. 9865 Pollard and Samers, p. 31566 Baldwin, Ken, Dar, Humayon A, and Presley, John R. "On Determining Moral Hazard and Adverse Selection in the Islamic Firm." Center for International, Financial, and Economics Research, Department of Economics, Loughborough University.

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system and are equivalent to demand deposits in a conventional banking system. While

the nominal value of such deposits is guaranteed, no return is paid on them. In exchange,

the depositor is not exposed to the risk created by the bank’s investment activities.67 For

demand deposits the model necessitates the maintenance of 100 percent reserves.

Investment deposits form the majority of an Islamic bank’s capital. Investment deposits

do not have reserve requirements.68 Investment depositors own an equity stake in the

bank and are entitled to a share of the bank’s returns on investments but also bear some

of the bank’s risk. Compared to a conventional financial institution, the IFI has lower

leverage for its capital. Under all circumstances an adequate cushion of capital must exist

to protect risk-averse transactions depositors, a consideration which is factored into the

capital adequacy requirements imposed by the AAOIFI (Accounting and Auditing

Organization for Islamic Financial Institutions) and the IFSB (Islamic Financial Services

Board). On the other hand, PLS assets held in investment accounts are not included in the

Islamic bank’s computation of its risk-weighted assets.69

Deposits in Islamic banks may also be classified as belonging to three types: non-

investment deposits, unrestricted profit-sharing deposits, and restricted profit-sharing

deposits. The first category corresponds to the window for demand deposits and the latter

two correspond to the window for investment deposits. For non-investment deposits,

banks perform the fiduciary role of guaranteeing the principal. The investment deposits

are held on a trust basis and do not count as liabilities for the bank. The risk is borne by

the investors, and the Islamic banks are "liable only in the case of gross negligence,"

67 Iqbal and Mirakhor68 Grais et al69 Muljawan, Dadang. Dar, Humayon A. Hall, Maximilian J.B. "A capital adequacy framework for Islamic banks: the need to reconcile depositors’ risk aversion with managers’ risk taking." Applied Financial Economics. Vol. 14. 2004. pp. 429-441.

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making the investment deposits a "contingent liability".70 The banks also perform an

agency role for profit-sharing deposits, selecting investments, engaging in monitoring,

oversight, and information gathering. These unrestricted deposits give "full authorization

to the bank to take all decisions relating to the investment process." The restricted

category of profit sharing deposits are maintained by the depositors themselves and the

bank only assumes administrative duties.71

Transparency and the Two-Tier Model

Another common designation for the structure of the Islamic bank is the "two-

tier" model of banking. In the first tier, depositors engage in an agreement to "share the

profits accruing to the bank’s business" while supplying the capital that forms the basis

for creation of further assets by the bank. These deposits are shown on the liabilities and

equity side of the bank's balance sheet.72 In the second tier, entrepreneurs may participate

in an investment with capital or by offering their services and expertise, in return for a

share of the profits. The profits also flow back to the bank’s shareholders.73 Because all

the players in the investment process share in the rewards and risks, credits and debits on

the assets side are reflected on the liabilities side in the profits paid out by the bank.

According to the capital adequacy guidelines published by the IFSB, in such a system,

Tier 2 assets may constitute no more than 100% of Tier 1 assets.74 Because shareholders

have a vested interest in profit and are not shielded against loss the two-tier system

guarantees built-in due diligence and exercise of maximum transparency, with

70 Pervez p. 26671 Muljawan, Dar, and Maximilian72 Grais et al73 Iqbal and Mirakhor p. 11074 "Capital Adequacy Standard for Institutions offering only Islamic Financial Services." Islamic Financial Services Board. <http://www.ifsb.org/index.php?ch=4&pg=140> December 2005.

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instantaneous adjustment and early detection of any investment error. Grais et al write

that "direct market discipline is embedded" in the risk sharing principle and "any negative

shock to an Islamic bank’s asset returns is absorbed" by shareholders and depositors.

Islamic Instruments of Capital Financing

Four basic principles characterize contracts in the Islamic financial system. First

is risk-sharing. This a proportional distribution of the risk and return involved in a

financial venture involving multiple parties, and the limitation of liability to the extent of

each party’s share in the capital stock. Second is materiality. Materiality is defined as the

simple provision that all financial instruments must be linked to a real underlying

exchange of goods or services. This is the basis for the normative claim that Islamic

finance reduces speculative excess. Third, exploitation in any form may not be involved

in an Islamic bank’s transactions. Finally, the production or consumption of haram or

prohibited commodities may not be financed. 75

The system of Islamic finance has developed asset classes for issuance in the

primary and secondary markets, which correspond to bonds, securities, and loans. Within

the context of the basic model exist a number of financial instruments and contracts that

fulfill all the major needs of transaction in an economy. Broadly, Islamic financial

instruments can be divided into two categories, profit-sharing and mark up. Profit sharing

or PLS finance resembles the venture capital model. Entrepreneurial effort is combined

with capital from a single or multiple financiers and the returns are shared. Mark up is

similar to debt used by corporations in that a fixed return is charged for the transaction.

The financier purchases the input and supplies it to an entrepreneur in exchange for an

75 Hardie, Rabooy. p. 59

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agreed upon mark-up. Additionally, the lease, or Ijarah is a form of lease of tangible

assets, similar to a traditional lease without the involvement of interest. The Ijarah

involves the creation of a special account for the commodity involved in the transaction,

and payments are of mark-up plus principal.76 Murabahah and Ijarah are the predominant

class of underlying assets backing the issuance of Islamic bonds, which are discussed

below in greater detail.

Equity-based Instruments

Mudarabah is a mode of financing in which surplus funds are loaned to an

entrepreneur to be invested in a productive enterprise in return for a predetermined share

of profits. Mudarabah tends to be employed "in investment projects with short gestation

periods and in trade and commerce."77 In this contract the borrower acts as a trustee or

agent of the bank to act on its behalf in securing productive and profitable utilization for

the capital provided. Each party is compensated according to risks involved and agreed

upon profit sharing ratio of contract. Similarly, Mushakarah is an equity based

partnership, in which contribution of capital to the investment comes from multiple

parties, and the profits are apportioned based on the proportions of capital contributed.

Each stakeholder is compensated in accordance with the percentage of assets they hold

compared to the total. Despite being the focus of a great deal of Islamic economic theory,

the "PLS" categories of Islamic finance, Mudarabah and Mushakara, are employed in a

minority of the transactions underwritten by Islamic financial institutions.

76 El-Gamal, Mahmoud Amin. "Overview of Islamic Finance." Department of The Treasury Office of International Affairs Occasional Paper No. 4. August 2006. <77 Khan, Mohsin S. "Islamic Banking: Experiences in the Islamic Republic of Iran and in Pakistan."

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Debt-based Mark-up Contracts and the "Murabaha Syndrome"

Financing is also undertaken in the form of Murabaha, or mark-up, contracts,

which are used by entrepreneurs to purchase commodities on credit. The financier

purchases the input and supplies it to an entrepreneur in exchange for an agreed upon

mark-up. When the entrepreneur has produced a final product using the input provided by

the bank, the sum agreed upon in the contract is paid back.78 Gamal describes Murabaha

contracts as "securitized claims to the stream of fixed payments plus interest" which are

"functionally equivalent to interest-bearing loans".79 Honohan describes them as

"payment smoothing" instruments which enable the client to maintain a steady cash

outlay as opposed to the variable returns of a profit-sharing arrangement.

Murabaha transactions comprise the majority of financing undertaken by IFIs in

the world today. This is known as "Murabaha syndrome". For example, the assets of

Islamic financial institutions in Malaysia are only minimally comprised of profit-sharing

measures, and are predominantly indexed to floating market interest rates.80 The

prevalence of Murabaha financing is thought to be a function of the institutional

environment in which Islamic banks operate. Inadequate legal protections in many

Muslim countries make profit-sharing exceedingly risky. The choice of debt financing is

rational for banks, both Islamic and non-Islamic, in these environments.81

Criticisms of Murabaha state that it is not a Islamic form of finance, and point out

that Murabaha transactions "seem to be elaborate subterfuges for interest-based financial

transactions".82 The fact that the majority of Murabaha financing is indexed to market

78 Iqbal and Mirakhor79 Gamal p. 1580 Chong, Beng Soon. Liu, Ming-Hua. "Islamic Banking: Interest-Free or Interest-Based?" October 2007. 81 Aggarwal and Yousef , p. 95

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rates such as LIBOR, leads some to conclude that Islamic banking differs only

superficially in practice from conventional debt.83 These criticisms may overlook some of

the subtleties of the structure of the transaction. Banks may still assume a certain degree

of risk even when their profits are based on a mark-up, by virtue of owning the asset

before transferring it to the owner, and by virtue of the intermediary act of securing a low

price for the commodity or input concerned.84

Bay’ contracts

Bay’ contracts are sales contracts which may stipulate immediate or deferred payment.

Bay in itself implies the sale of a commodity good, while Bay’ al-Dayn is the sale of a

debt or liability. In Bay al-Salam contracts payment is immediate and delivery is deferred

while in Bay’ al-Muajjil delivery is immediate and payment is deferred.85 Such contracts

introduce an element of price and market risk to the dealings of Islamic intermediaries.

Sukuk/Bonds

Sukuk have come to be used as the standard instruments of monetary policy and liquidity

management by governments and central banks in a number of Muslim countries. The

first issuance of sukuk was the creation by the Malaysian government in 1983 of "Islamic

sovereign certificates—known as Government Investment Issues (GIIs)" which served

the function of monetary expansion and contraction. Beginning in 2001 these securities

began to be backed by debt and traded in secondary markets. The Sudanese government

created a similar set of financing instruments, Government Investment Certificates, which

82 Vogel, Frank E. Hayes, Samuel L. Islamic Law and Finance: Religion, Risk and Return. BRILL. 1998.83 Chong and Liu 84 Vogel and Hayes 199885 Iqbal, Mirakhor An Introduction to Islamic Finance: Theory and Practice.

4

are "based on a pool" of Islamic securities and are "used to raise long term financing" and

Government Mushakara Certificates, which "have maturities of one year." These

Sudanese instruments are "linked to state-owned banks" and their returns are based on the

banks’ performance.86 The Central Bank of Bahrain also followed suit by issuing its own

commodity and lease-backed securities in 2001.

The issuance of sukuk is a transitional step in the development of an Islamic

interbank market to promote better liquidity management by Islamic banks of what are

generally illiquid assets.87 The IMF has published research demonstrating that the

simulated inclusion of Sukuk bonds in bond portfolios resulted in a significant decrease in

downside risk relative to portfolios consisting only of Eurobonds, by anywhere from 11%

to 32% depending on the market. This data demonstrates that Sukuk instruments may be a

valuable means of diversification, not only through their differing durations, but the "very

different behavior of Sukuk prices in the secondary market" and the fact that they

"represent ownership stake in an underlying asset" rather than the issuance of pure debt.

As of 2007, the market for sukuk had grown to $50 billion, with issues coming from

sovereign borrowers and international corporations.88

86 Honohan, p. 1087 Sole, p. 2288 Cakir, Selim. Raei, Faezeh. "Sukuk vs. Eurobonds: Is There a Difference in Value-at-Risk?" IMF Working Paper. 2007.

4

Chapter 5: Islamic Financial Institutions and Risk Management

Factors in the international banking environment have resulted in a unique and

challenging risk environment faced by Islamic banks. Increased market volatility, new

financial innovations such as developments in the derivative market, the shift away from

traditional lending towards "fee-earning activities" by institutional investors with direct

market access, increased competition, and a changing regulatory environment are among

the changes to which Islamic financial institutions are being forced to adapt.

An analysis of the risks faced of Islamic financial institutions also requires the

recognition of the gap between "theory and practice" in Islamic finance. Because the field

of Islamic economics is still in a transitional state and the existence of Islamic financial

institutions is relatively new, the degree of uniformity between such institutions is low.

The way Islamic financial institutions are conceived in the academic literature and the

actual practices of these institutions do not always accord with one another, and often

diverge. The theoretical models of Islamic banks generally are unable to account for the

social and economic conditions in which the banks operate and the political interests that

they may be answerable to. They must compete with conventional banks and lack access

to the same secondary markets as their conventional counterparts. It would be more

equitable, therefore, to attempt to conceptualize the functioning of an Islamic bank ceteris

paribus, in an environment in which the same degree of institutional development and

regulatory framework exists with respect to economic transactions. Furthermore, the

nature of Islamic law, its interpretation, and the religious authorities involved differ from

region to region, affecting the operation of individual institutions. 89 Gamal writes that the

89 Grais, Hawary, Iqbal. "Regulating Islamic Financial Institutions: The Nature of the Regulated."

4

interpretations of Shari’ah law can come several different sources: at one extreme, from

authoritarian state regimes of Islamized states or legislative acts of Muslim countries,

from the rulings of independent councils like those mentioned above, or, at the other

extreme, from the interpretations of individuals.

Governance Risks

Among the risks Islamic financial institutions face, include risks related to their oversight

and governance mechanisms. Venture financing in the form of profit-sharing contracts

suffer from a shortage of information and oversight which creates disincentive for their

use. Without such controls, entrepreneurial partners in Islamic investments are likely to

underreport the performance of the venture or shirk their effort. Financiers in these

contracts often have "particularly weak ownership and control rights – much less than

would be demanded by conventional venture capitalists".90 For this reason Grais and

Kulathunga argue in favor of greater investment by Islamic financial institutions in "the

collection of loss information and adoption of loss data management systems" as well as

the implementation of "risk management methodologies." Among the poor existing

practices that are presently in place in Islamic financial intermediaries are "lax credit

standards… poor portfolio risk management," and "lack of attention to changes in…

external circumstances."

The governance risks faced by Islamic banks include risks related to negligence or

oversight in the management of an Islamic bank. Monitoring by IFIs is made particularly

difficult due to the limited menu of financial instruments available at their disposal.91

90 Honohan, Patrick. "Islamic Financial Intermediation: Economic and Prudential Considerations." Development Research Group and Financial Sector Strategy and Policy Department, the World Bank. July 2001. p. 891 Ibid, p. 8

4

These include operational risks such as the failure of internal controls, legal difficulties of

enforcement, management of inventories, and cancellation risks in non-binding contracts.

Other forms of governance risk include fiduciary risk, transparency risk, Shariah risk, and

reputation risk. Fiduciary risk arises from inadequate screening, monitoring, and due

diligence with regard to projects, or from mismanagement of funds and violated of the

trustee role undertaken by the bank. Transparency risk stems from the failure of a bank to

disclose "reliable and timely information" which "enables users… to make an accurate

assessment of a bank’s financial condition and performance, business activities, risk

profile, and risk management practices." Shariah risk is unique to Islamic banks in that

they run the risk of noncompliance with the provisions of Shari’ah law in their banking

practices. Reputation risk derives from the possibility of damaging the trust of investors

due to "irresponsible… behavior of management."92

Credit Risks

Murabaha credit risk is the risk of nonpayment by the client after delivery of the asset. In

Bay’ or Istisna contracts banks are exposed to the risk that the counterparty may fail to

supply, may fail to supply in a timely fashion, or may supply goods of inferior quality.

Mudaraba investments carry the most credit risk as the bank enters such agreements as a

principal but in many cases lacks the right to monitor or manage the project which is

undertaken by the Mudarib. Iqbal and Mirakhor note that to minimize credit risk

associated with their investments banks must "maintain good quality data on past

performances of the counterparty" in order to "determine the probability of default."

Additionally, they may obtain collateral or pledges to secure against this risk.

92 Iqbal, Mirakhor An Introduction to Islamic Finance: Theory and Practice.

4

Market Risks

Market risks consist of the risk that fluctuations in prices, yields, or rates will

diminish the value of assets held by banks. Among the indexes which may expose a bank

to risk are rates of return, benchmark rates such as LIBOR, foreign exchange rates, and

equity and commodity prices. This can impact, for example, the amount of mark up

added to a contract in a Murabaha trade financing instrument, because the rate is

typically defined at the outset of the contract, and the benchmark to which it is pegged

may increase over the life of the contract, leaving the bank unable to benefit from the

increase. Similarly, the fluctuations in prices of commodities in the interval between sale

and delivery of the product also create a market risk; Yields on securities such as sukuk

are also subject to this. Market risk primarily results from the deferred nature of the

transactions undertaken by an Islamic bank. However, it can generally be hedged by

entering into a parallel contract.

Equity investment risk is a type of market risk that is specifically applicable to

Mushakara and Mudarabah due to the importance of monitoring and disclosure in such

contracts. The informational asymmetries that characterize them mean that financial

transparency and close supervision are crucial in minimizing equity investment risk. Even

with all of these safeguards in place the possibility of losses on capital exists. As a result,

part of the bank’s due diligence lies in the selection of projects to ensure their soundness.

An additional component of this risk is the uncertainty inherent in the cash flows from

such projects and the absence of secondary markets for this type of investment.

4

Business Risks

Business risks are a category of risks inherent in the Islamic bank’s business

environment, including financial sector infrastructure, legal and regulatory factors, and

macroeconomic and policy concerns.

Rate of return risk results from the possibility that the real rates of return on an

Islamic bank’s investments will diverge from the expectations of investors on the

liabilities side. The combination of equity based and mark-up based instruments can

serve to compound uncertainty relative to the yield provided by interest bearing

instruments.

Minimizing rate of return risk lies in managing the expectations of investors. RoR

risk often takes the form of displaced commercial risk, when a bank is under pressure to

pay a higher dividend than originally agreed upon. One "self-imposed" method of

mitigating this risk is for IFIs to "waive their portion of profits" to prevent investors

withdrawing their funds. A side-effect of this redistribution of capital stock to maintain a

certain level of profits is that it can lead to "insolvency in extreme cases." It has become

established practice for some Islamic banks to set aside "profit equalization reserves"

intended to "smooth future returns" and improve the banks ability to bear negative shocks

in its dividends. "Investment risk reserves" are another form of reserves for which capital

is taken exclusively from investment deposit accounts.

RoR risk may also take the form of withdrawal risk, which is the risk that

investors will withdraw their funds to deposit them at a commercial institution.93 Bank

runs are still a possibility in the context of an Islamic financial institution, which

93 Iqbal, Mirakhor

4

shareholders are free to exit at any time, particularly if depositors panic. To safeguard

against withdrawal risk, banks have to maintain a sufficient level of capital and liquid

assets.94 For this reason, under all circumstances an adequate cushion of capital must exist

to protect risk-averse depositors, a consideration which is factored into the capital

adequacy requirements imposed by the AAOIFI (Accounting and Auditing Organization

for Islamic Financial Institutions) and the IFSB (Islamic Financial Services Board). Per

the rules established by the Islamic Financial Services Board (IFSB), Islamic financial

institutions have capital adequacy requirements imposed on them to insure their fixed-

claim liabilities. To this end, Islamic banks must employ high-risk PLS equity capital

only in a certain proportion to other forms of capital. Furthermore, PLS assets are not

included in an Islamic bank’s computation of its risk-weighted assets.

Liquidity Risks

Liquidity risk is a difficulty faced by an Islamic bank which requires external funding in

order to make payments on their liabilities. The illiquidity of many of the assets held by

Islamic banks combined with the difficulty of accessing cost-effective financing combine

to produce this risk. The difficulty of finding such financing stems in part from the

limited number of shariah-compliant money and interbank markets in existence.

Assets Liabilities Management risk is another form of treasury risk which results

from a mismatch in the maturities of the assets and liabilities on a bank’s balance sheet.

In theory, Islamic banks are less prone to this type of risk by virtue of the fact that that

profits, losses, and negative shocks are immediately passed through to investors; the

"risk-sharing" and pass through features of IFIs distributes the risk among investment

94 Honohan, p. 9

4

account depositors and shareholders. Lastly, hedging risk arises from the general failure

to adequately manage the other types of liquidity risk.

4

Chapter 6: Profitability and Incentives in Islamic Banking

It has been shown that Islamic financial institutions can be transitioned to a neoclassical,

Keynesian economic framework. A number of economic models have modeled money

demand and aggregate demand under profit-sharing and interest-free systems. These have

more than anything demonstrated the viability of such a system.

Macroeconomic Stability in PLS

The Islamic bank is more than the interest-free structure. Islamic finance includes the

creation of a "complete system that prescribes specific patterns of social and economic

behavior for all individuals" that encompasses not only positive, but normative

prescriptions for the structure and role of financial systems in society. Interest is

condemned in the interest of working towards the production of a society in which

inequality is minimized and the welfare of the worst off is continuously improved.

It has been seen that "there may be circumstances in which an Islamic banking

system would be relatively more stable than the traditional, or interest-based banking

system in the face of certain types of shocks". Mohsin H. Khan addresses claims that a

system in which interest is prohibited diminishes incentives for "savings and investment"

by pointing out that Islamic economics still permits a return on investment, as long as that

return is not fixed. The substitution of a real rate of return for a fixed interest rate does

not "affect conclusions about standard banking and macroeconomic behavior".95 He also

points out, that Islamic banks, if categorized under the rubric of "equity participation

systems," are really just variants of preexisting "proposals for reform of the traditional

95 Khan, p. 7

4

banking system" made by prominent theorists of Western economics, among them Henry

Simons, Milton Friedman, and Charles Kindleberger.96

Khan’s formal model of the Islamic bank is developed in two contexts: a

Keynesian one in which prices are fixed and real output is endogenous, and a classical

model in which the price level is assumed to be flexible and output is assumed to be

endogenous. His model includes a capital market, a money market, and a goods market.

Additional conditions of the capital markets are that banks are the only intermediaries

between savings and investment and economic agents hold savings in the form of

deposits whose nominal value is not guaranteed. In the event that a bank is unprofitable

and its share value falls, the rate of return on deposits may become negative. The banking

system’s assets in this model correspond to y/r, or real net income divided by the real

percentage yield or real rate of return on shares. Its liabilities correspond to S/P, or the

nominal value of shares divided by the price level. Khan incorporates the liquidity theory

of preference by showing that the demand for real money balances will vary inversely

with the real rate of return on shares.97

By modeling real aggregate demand under such a system he is able to

demonstrate that "real income adjusts… to any shocks to excess aggregate demand,"

which are "absorbed by changes in the values of shares held by the public in the bank."

By contrast, the inflexible nature of the deposits in a conventional bank render it more

vulnerable to a "divergence between real assets and real liabilities" and hence to systemic

instability resulting from disruptions to the payments system.98

96 Khan, pp. 3-797 Ibid, p. 1098 Ibid, p. 20

5

Investment, Information, Profit-Sharing Ratios and Incentives

The behavior of Islamic banks and firms in a profit-sharing contract has also been

modeled. These models demonstrate how profit-sharing ratios and overall capitalization

affect the level of investment, as well as modeling the effects of exogenous factors on

real rates of return, and the nature and effects of the incentive structure under a profit-

sharing as opposed to an interest-based contract.

The Islamic bank can be viewed in a two-period general equilibrium model of

investment, under conditions of uncertainty with regard to the state of nature and

asymmetric information between banks and borrowers. As in Khan’s model, it is assumed

that borrowers are not guaranteed fixed returns or the maintenance of the nominal value

of their deposits. Another condition attached to their model is that both banks and firms

have "the same information about the uncertainty regarding the project’s return," an

assumption that is modified for some of the other attempts to build economic models of

the Islamic bank.99

This model finds a significant elasticity of investment with respect to the total

equity capital of the bank and the bank’s profit sharing ratio, although the relation is

much greater for the former than for the latter. In the long run, the model predicts that

investment will increase by more than seven percent for every ten percent increase in

equity capital in a profit-sharing scenario. These predictions are borne out by actual,

interpolated data for the Kuwaiti Finance House which indicate that capitalization and

profit-sharing ratios have a substantial effect on total investment100.

99 Bashir, A. Darrat, A.F. Suliman, M.O. "Equity Capital, Profit-Sharing Contracts, and Investment: Theory and Evidence." Journal of Business Finance and Accounting. September 1993. 100 Ibid, p. 648

5

In the absence of fixed interest payments, some of the firm’s production

uncertainty is in fact avoided, resulting in a higher overall level of investment, due to a

lower cost of acquiring capital. Under such a system, the only ex ante costs facing the

firm are those of depreciation and inflation. Two scenarios exist under the model: one in

which the profit-sharing ratio is determined ex ante and the level of investment

determined endogenously, and another in which the level of investment is determined ex

ante and the profit-sharing ratio determined endogenously.

In the first case, the profit –sharing ratio must be determined so as to maximize

the bank’s utility while inducing the firm’s participation. The optimal ratio will be one

which has done both, and will be "state-independent" assuming that "both the bank and

the firm have similar information about the state of nature a". Altering this assumption

introduces new considerations of adverse selection which are not addressed in this model

but certainly warrant investigation, as acknowledged by the authors, who note that "if the

two parties have different information about the distribution of a, the contract would be

contingent upon the private information concerning a, having adverse effects on the level

of investment". 101

Comparing Interest Contracts and Risk-Sharing Partnerships

The ability of a bank to find accurate information about the creditworthiness,

intentions, and actions of a borrower are a factor in its profitability. Factors that have to

do with the willingness or ability of banks to collect adequate information about the

creditworthiness or profitability of borrowers and investments exacerbate asymmetric

information.

101 Ibid, p. 641-642

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The available literature examines asymmetric information in interest-based

contracts on the macro and on the micro level. A key element in the propagation of

financial crises is the "informational advantage" possessed by "borrowers… over

lenders," which stems from the fact that "borrowers know more about the projects they

want to undertake than lenders". Stated another way, the manager (synonymous with

borrower) of an investment project "is able to observe the demand or productivity

conditions affecting the project before committing to production decisions; and… he

alone observes his personal level of effort".102 Hence it is possible for a borrower or

manager to maintain the privacy of information with regard to his investment project, in

the interest of profiting from the financing transaction itself. The proper incentives,

therefore, must be in place to insure that banks take every effort to only extend loans

where their information about the borrower is as complete as possible.

Mishkin says that "banks are eminently well suited to solve" moral hazard and

adverse selection problems by virtue of their "expertise in information collection about

firms" and their corresponding ability to "screen good borrowers from bad borrowers" as

well as "engage in lower cost monitoring". The more effectively banks can perform the

role of informational intermediary, the less likely are the effects of a shock in investor

confidence or a liquidity crisis to be felt throughout the entire economy as a decline in

aggregate economic activity. Miskin’s discussion of asymmetric information assigns a

central (though not exclusive) role to this phenomenon in the propagation of financial

crises. Primarily, it highlights the manner in which "the asymmetric information approach

provides a transmission mechanism for how a decline in the money supply leads to a

decline in aggregate economic activity," with banks playing a major role in exacerbating

102 Presley and Sessions

5

the "adverse selection and agency problems" that ultimately reduce overall investment.103

Hence, in contrasting conventional and Islamic financial institutions, a major criterion

should be whether the proper incentives are in place for a bank to exert its responsibility

to monitor and manage investments.

In the pure wage or interest-based scenario, banks and borrowers are to some

degree insulated from the effects of questionable investments. Borrowers bear less risk

relative to banks, and banks bear little risk proportionately to depositors, creating a

"conflict of interest" that "implies that lending and investment will be at suboptimal

levels."104 In the context of financing activities, Mishkin states that the deficiency of

information available to lenders creates the incentive for managers/borrowers "to engage

in activities that may be personally beneficial but will increase the probability of default

and thus harm the lender." One incentive he describes is for borrowers "to shirk and…

not work very hard."

The existence of this incentive is documented by Sessions and Presley, inter alia.

According to Presley and Sessions, an interest-based contract between a lender/capitalist

and a borrower/manager produces a suboptimal outcome relative to a profit-sharing

contract. They describe an economy in which two states exist: "good" and "bad". In the

"bad" state, marginal revenue product (and hence incentive) is lower, and the level of

capital (relative to effort) increases to the point where marginal returns are below the

"productively efficient level." This results because of the diminished profit incentive on

the manager to exert additional effort, in conjunction with the lack of accountability over

his exertion, which is essentially private information. A manager is more likely in an 103 Mishkin, Frederic S. "Asymmetric Information and Financial Crises." NBER Working Paper No. 3400. July 1990.104 Ibid,p. 7

5

interest-based contract "to substitute capital for effort and thereby reduce effort cost,

which is not public knowledge," as a result of his advance awareness of the state of

nature prior to production decisions. The goals of the entrepreneur can be aligned with

the goals of the capitalists, and the contract is incentive compatible in the event that the

manager "personally bears the entire risk of adverse shocks." Given a risk-averse

manager, the payment of a fixed return is inefficient because the incentive to exert

additional effort is not present. The manager will choose an "individually optimal level of

effort… contingent on the specified level of investment".

Equity financing, of the type used in Mudaraba and Mushakara contracts, among

others, results in a different incentive structure and a different allocation of risk between

parties. For one, the Islamic banking model does not employ deposit insurance nor does it

guarantee any nominal or real rate of return to depositors. Should a bank’s existing

investments operate at a loss, the losses will be passed through. The incentives are in

place for banks to refrain from taking excessive risks with their existing capital or from

leveraging it too highly, thereby reducing moral hazard (Hamid, Bashir).105 In ideal

conditions, assuming monitoring costs are not prohibitive, an IFI would employ a

venture-capital model in which responsibility is on the bank not only to manage its risks

but to participate in the management of entrepreneurial ventures and to carefully vet its

relationships with borrowers to minimize the entry of low-quality borrowers into the

market.

It has been found that Mudaraba contracts under asymmetric information can

introduce a more efficient revelation mechanism. A profit sharing arrangement may be

105 Bashir, Abdel-Hameed M. "Risk and Profitability Measures in Islamic Banks: The Case of Two Sudanese Banks." Islamic Economic Studies. Vol 6, No. 2. May 1999. pp. 9-10.

5

more likely to induce a bank to carry out its managerial role effectively than will an

interest based contract. Because the effort exerted by a manager "affects the relationship

between capital investment and the outcome of the project," it makes sense to tie the level

of the manager's compensation to the outcome of the project itself. The structure of

returns to the agent "creates an explicit mapping between the remuneration of capital and

the outcome of the project" and act as an "efficient revelation device" given the

informational advantage possessed by "managers… over investors".106 Mudaraba

agreements may be structured to include an information rent which is intended to

"overcome the temptation of the agent to lie." In this respect, equity financing may

possess some theoretical advantages, including a different incentive structure and risk

distribution than debt financing. Khan has highlighted the possibility that equity-financed

Islamic financial institutions may offer greater stability and protection from insolvency

through the absorption of losses. Under ideal circumstances, with appropriate oversight

mechanisms in place, the risk-sharing property of PLS may also create an improved

incentive structure by giving both borrowers and lenders a stake in an investment’s

profitability. Siddiqi and others have found that "interest free… equity participation

contracts are more efficient compared to the fixed interest based arrangements".107

In many cases, these advantages may be eclipsed by other factors, including the

information-sparse and environment in which Islamic banks operate. This means that

PLS financing exposes Islamic banks to a number of costly risks, including credit risks,

governance risks, and rate of return risks. Many Islamic banks have not achieved the

internal controls required to maintain the intensive monitoring necessary to resolve

106 Presley, Sessions, p. 584 107 Darrat, Ali F. Ebrahim,

5

agency issues such as truthful disclosure of information and to screen out high-risk

borrowers. Entrepreneurs have a disincentive to accurately report their profits and to put a

maximum level of effort into their investments. This is in large part due to the fact that

these parties are "compensated less than their marginal contribution". Moreover, property

rights in many developing Muslim nations are not "properly defined or protected".

Further, the relative lack of secondary markets for the trading of these instruments, the

lack of input provided by stakeholders, and the high degree of risk generally involved all

provide disincentives for the use of these forms of financing.108

As a result, PLS financing is used to a minimum, with banks rationally choosing

investment portfolios that are predominantly debt-based through the use of Mudarabah

transactions (Aggarwal, Yousef). In Malaysia, for example, only 0.5% of financing takes

the form of a profit-loss sharing contract (Chong, Liu 2007). On average the proportions

of PLS are more favorable, with one estimate placing the percentage of Mudaraba and

Mushakarah assets on the balance sheets of Islamic banks at a combined 23% percent

(Iqbal 2005). Nevertheless, the fact that the majority of this debt-based financing is

indexed to market rates such as LIBOR, leads some to conclude that Islamic banking

differs only superficially in practice from its conventional counterparts (Chong, Liu

2007). In particular, Chong and Liu’s findings, which are based on a relatively narrow

cross-section of Islamic financial institutions worldwide, seem to show that returns

offered by Islamic banks scarcely deviate from those of conventional deposit rates, in

large part due to competitive pressures from conventional banks and significant

withdrawal risks.

108 Dar, Humayon A. and Presley, John R. "Lack of Profit Loss Sharing in Islamic Banking: Management and Control Imbalances." Economic Research Paper No 24. Loughborough University.

5

Chapter 7: Islamic Finance, the Business Cycle and Economic Volatility

The architecture of Islamic financial institutions creates a number of unique implications

for macroeconomic stability, including monetary velocity, the price level, inflationary

pressures, and business cycles. In this section I will explore some of the ways in which

the elimination of interest rates and the use of equity as banks’ primary instrument of

finance affect macroeconomic variables.

The financial structures of Islamic banks correspond to several of the arguments

advocated by Western monetary theorists for the long-term stabilization of prices and

mitigation of the business cycle. Some of these economists’ writings predate the

inception of modern Islamic economic theory by several decades, while others appear

around the same time. These theoretical discussions correspond with some of the real-

world empirical results of implementations of Islamic banking.

There are three major aspects of an Islamic financial system which may render it

less prone to disruption and macroeconomic shocks. One is the equity-based financing

system, which prevents asset-price divergences and ensures a correspondence between

assets and liabilities. Another is the absence of interest rates, which in a conventional

economy act as distorting signals.       

Iqbal and Mirakhor claim that Islamic financial institutions are less prone to

inflationary pressure and destabilizing influences such as the devaluation of assets. It is

claimed that the "constrained debt-carrying power of economic units" acts as a stabilizing

force to minimize the business cycle. The Islamic bank is limited in the ability to

refinance its obligations through debt. As a result "the term and structure of the assets and

liabilities of [Islamic] economic units are closely matched". Where such ‘economic units’

5

"finance a long position in assets by issuing short-term liabilities… their viability

depends on the price and extent of the availability of refinancing," and they become

highly "vulnerable to interest rate fluctuations". In the extreme, the costs of financing

increases throughout the economy, and the "cost of production" increases in addition to

the "probability of illiquidity and insolvency for a significant number of firms and

financial institutions" and the ability or willingness of banks to refinance their positions

decreases.109

Islamic Finance and Banking Reform

The financial structures of Islamic banks provide a sound mechanism for the long-

term stabilization of prices and mitigation of the business cycle. Reformist proposals for

"narrow banking," stabilization of the money supply, and the elimination of deposit

insurance all suggest a sound economic rationale—the absorption of shocks to business

or consumer confidence—for the stabilizing features of Islamic financial institutions.

Simons and the Financial Good Society

One of the earliest advocates of price-level stability was Henry Simons. Simons

argued for changing the financial architecture of the United States to make monetary

policy more effective and mitigate periodic cycles of inflation and deflation. The goal of

changing the "monetary rules of the game" in this way was to "prevent… the affliction of

extreme industrial fluctuations"—that common cold of industrial economies, the business

cycle.110

109 Iqbal and Mirakhor110 Simons, Henry C. Economic Policy for a Free Society. Univeristy of Chicago Press, Chicago, IL. 1948.

5

The financial disturbances of greatest concern were perpetuated by "extreme

alternations of hoarding and dishoarding". Short-term obligations issued by banks and

corporations create "abundant money substitutes during booms". When aggregate

demand is sluggish, a sector of the economy undergoes a shrinkage, or the economy as a

whole begins to lapse into depression, "hopeless efforts at liquidation" of the secondary

monies results (Ibid, p. 166). A financial system so structured would be "repeatedly

exposed to complete insolvency". Government intervention would be necessary to

forestall such insolvency in the event of bad bets and margin calls. A perfect example is

the $10 billion bailout by the Federal Reserve of Bear Stearns, a multinational global

investment bank, in 2008. John Mauldin, president of Millenium Wave Advisors, writes:

"If Bear had not been put into sound hands and provided solvency and liquidity, the

credit markets would simply have frozen… The stock market would have crashed by

20% or more… We would have seen tens of trillions of dollars wiped out in equity

holdings all over the world."111 The Bear Stearns debacle was a watershed event in a

housing market crisis that precipitated massive devaluations, left the economy reeling,

and required massive government action. Simons wrote, accurately, that all it would take

to precipitate such a massive attempted liquidation would be "a relatively small decline of

security values". In order to mitigate the repercussions of the business cycle it would be

necessary to institute "equity and common stock in place of fixed money contracts".112

Hence, a major source of financial instability is the ability of corporations to

borrow and lend and create their own "near-moneys" and short-term obligations. Simons

proposed the use of 100 percent equity financing by corporations, funded by "100 percent

111 Mauldin, John. "Thoughts on the Continuing Crisis." Frontline Weekly Newsletter. 21 March 2008. 112 Simons, p. 165-167

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reserve banking," which approaches what he called "sound debt policy". Corporations

that traded on a "shoestring of equity, and under a mass of current liabilities" were

"placing their working capital precariously on call" and hence at risk in the event of the

slightest financial disturbance. In the ideal economy, nothing would be circulated but

"pure assets" and "pure money," rather than "near moneys," "practically moneys," and

other precarious forms of short-term instruments that were responsible for much of the

existing volatility. Simons advocated non interest-bearing debt and opposed the issuance

of short-term debt for financing public or corporate obligations. He opposed the payment

of interest on money, demand deposits, and savings, rather advocating the use of service

charges for the "warehousing of money."113

In what Simons called the "financial good society," banks would play a

substantially different role, more akin to "investment trusts" than anything else (229).

Simons advocated the separation of deposit and transaction windows, as implemented in

the Islamic bank, and the institutional separation of banks as "lender-investors" and banks

as depository agencies. The primary benefit would be to enable lending and investing

institutions to focus on the provision of "long term capital in equity form" (233). Banks

could be "free to provide such funds out of their own capital" (236).114 Short-term

interest-based commercial loans would be phased out, since one of the "unfortunate

effects of modern banking," as Simons viewed it, was that it had "facilitated and

encouraged the use of short-term financing in business generally".115

In the interest of stability, Simons envisioned banks that would have a choice of

two types of holdings: long-term bonds, or consols, and cash. Simultaneously, they would

113 Ibid, p. 225-237114 Ibid, p. 229-236115 Ibid, p. 168

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hold increased reserves, up to 100%. Simons saw this as beneficial in that its ultimate

consequences would be the prevention of "bank-financed inflation of securities and real

estate" through the leveraged creation of secondary forms of money.

Finally, Simons believed the price level needed to be more flexible to

accommodate fluctuations in output and employment. To this end, he advocated a

minimum of short-term borrowing, and a maximum of government control over the

circulation of money. This would result in an economy with a greater tolerance of

disturbances and the prevention of "accumulated maladjustments" all coming to bear at

once on the economy. In sum, Simons’ chief problem was with a financial system in

which the movement of the price level was in many ways beholden to the creation and

liquidation of short-term securities. To Simons this threatened financial instability.

Interest Rates, the Business Cycle, and Speculative Excess

Dar and Presley note that many Western economists implicate interest rates in

their efforts to "explain cyclical fluctuations in terms of a divergence between the natural

and the market rate." In the banking system as it stands is that the market rate of interest

"is determined by monetary forces in the loanable funds market, for example, money

supply growth and bank credit creation, and the natural rate is determined by the

profitability of investment". Wicksell was the first to postulate that cyclical fluctuations

might be tied to the divergence between market and natural rates of interest. Hayek took

Wicksell’s notions a step farther, using them to explain how interest rates acted as

distorting signals which exacerbated booms and depressions.

The ability of banks to modulate the supply of credit through regulation of the

interest rate renders "bank money supply… infinitely elastic" (). Banks are free to create

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liabilities without restraint, and "competition in the credit market" will drive rates down

and lead to the expansion of credit. A bank that is flush with liquidity and seeking to

compete will lower its rates below the natural rate, which increases the demand for loan

capital; this increased demand for credit results in an increase in investment, which

"surpasses the amount of voluntary saving taking place." Following this expansion, there

is a rise in the "demand for consumer goods… driving up the market rate… and leaving

some investment projects already begun unprofitable".

Irving Fisher and John Maynard Keynes were also "critical of the part played by

interest rates and bank credit in the cyclical process". Keynes saw instability as arising

from the inequality of saving and investment, and Fisher blames "the procyclical nature

of lending policies" for the recurrence of "over-indebtedness," which resulted in distress

selling, bankruptcy and "elimination of debt-financed speculation," as well as contraction

of the money supply.116

Muhammad Choudhury believes that interest rates contribute to the prevalence of

speculation in the world economy. In Choudhury's view, interest rates fuel unpredictable

movements of price levels, which have enabled speculators to profit from their

movement. The movements are derived from the "individualistic perceptions of costs

imputed to subjective events". Islamic economics is a normative discipline which

discerns between financial transactions on the basis of their merit. The way that money is

used has an "ethical relevance" because it can be used as a means of transaction or for the

purpose of speculation, and arbitrage. Choudhury argues that the use of interest in a

monetarist system, in which "restrictive money supply" puts pressure on "interest rates,"

116 Dar, Humayon A. and Presley, John R. "Islamic Finance: A Western Perspective." International Journal of Islamic Financial Services, Vol. 1, No. 1.

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is a mechanism of global oppression by helping "to sustain rentiership" and speculative

activity. The "shift of world economic activity from industry to financial institutions" has

given interest a disproportionate role in the movements of money around the world,

because of the "direct relationship between credit and interest payments". As a result,

"usurious activities" are a major effect of the global financial system. The use of interest

within a monetarist framework, by creating a pure profit motive for the creation of

secondary forms of money, "has caused economic activity to shift from productive

enterprise to the holding of monetary assets". 117

Stability of Velocity and Money Demand in Islamic Financial Systems

Empirical data supports the hypothesis that the introduction of Islamic banking and the

elimination of interest improve the stability of money demand in the economy. The

literature suggests that monetary policy is more effective at regulating the supply of

interest-free than interest-based monies. The demand for interest-based monies is subject

to the control of forces beyond the monetary base and the rate of saving. Muslim nations

that have passed laws prohibiting the use of interest in the bank system have decreased

volatility in their monetary systems. Among these are Tunisia, Iran, and Pakistan.

Amir Kia shows that interest rates play a substantial role in modulating demand

for money. His research demonstrates that the transition to an interest-free money supply

in Iran improved the overall stability of the money supply. Kia’s empirical research

shows that the velocity of interest-free money in Iran varied within a substantially smaller

range and was substantially "less volatile" after the introduction of Islamic banking in

Iran than it was before. The demand for interest-free money remains stable despite

117 Choudhury, pp. 1-5

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economic shocks and policy and regime changes. On the other hand, interest-bearing

money, the demand for which is formed by "forward-looking" agents, is "found to be

unstable".118

In his work on Pakistan and the Islamic Republic of Iran, Ali F. Darrat comments

that stable and predictable velocity of money, is a crucial feature of an economy with

stable growth and effective monetary policy. There is a significant statistical gap between

the behavior of velocity of interest-bearing as opposed to interest-free money supply. In

his discussion of the velocity of money in Iran, Darrat notes that velocity of interest-

bearing money, which he denotes with VQ, fluctuated from "a high of 24.03 in 1960 to a

low of 3.07 in 1989," with year to year changes "equally dramatic with a standard

deviation of 5.14". Velocity of interest-free money, on the other hand, "ranges from a

peak of 9.23 in 1961 to a trough of 2.89 in 1985 with… a standard deviation of only

1.75". Velocity for interest-bearing money in Pakistan ranges between 21.11 in 1961 to

4.83 in 1996. Velocity of interest-free money in Pakistan "is very close to being a

constant," from a peak of 4.34 in 1975 to a low of 2.71 three years earlier, and a standard

deviation of only 0.32.

Darrat’s studies demonstrate that "there exists a significant… relationship

between the interest-free money stock and the monetary base" in Iran and Pakistan

whereas there is "no reliable long-run relationship… between the interest-based money

and the monetary base in either country." His findings lend strong support to the notion

that the interest-free monetary aggregate is much more controllable than the interest-

based. Statistically, 75 percent of "total variations" in growth of interest free money

118 Kia, Amir. "Interest-Free and Interest-Bearing Money Demand: Policy Invariance and Stability." Emory University Department of Economics.

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supply are explained by growth in base money (deposits + currency) versus only 36

percent of interest-based growth. He concludes from his results that interest-free

monetary systems are superior in terms of allowing policymakers to exert effective

control over the monetary supply, combat inflation, and maintain price stability, as has

been conclusively shown in Iran and Pakistan.119 Darrat has also shown that fluctuations

of velocity of interest-free money in Tunisia have historically been "very smooth and

stable" ranging from 4.05 to 3.25 over a twenty-year period. This is in contrast with a

range of 83.50 to 6.50 for interest-bearing money over the same period and accompanied

by dramatic year to year changes. These results provide further evidence that the size,

demand for, and velocity of interest bearing money are resistance to policy control.

Darrat concludes in favor of the "relative efficiency of the interest-free monetary system"

and its "structurally stable public demand for financial assets".120

Kia and Darrat establish several criteria for a "well-functioning monetary system,"

including a well-behaving aggregate demand function, a stable money supply, and policy

invariant money demand. Profit-sharing deposits in Iran were the most stable and policy

invariant. They conclude that "The elimination of interest-based financial transactions in

Iran" beginning in 1984 and the use of profit-sharing has "strengthened Iran’s financial

stability and provided the Central Bank with credible and reliable monetary policy

instruments". Empirical studies of Iran have shown that interest free banking systems fare

better on measures of velocity, stability of money demand, stability, and policy

controllability. As discussed previously, after Iran introduced interest-free banking, the

119 Darrat, Ali F. "On the Efficiency of Interest-Free Monetary System: A Case Study." August 2000. 16-19120 Darrat, Ali F. "The Islamic interest-free banking system: some empirical evidence." Applied Economics, 1988. p. 422-425

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"mean and variance of income velocity of money were lower". Furthermore, through an

empirical model of money demand in Iran, Kia and Darrat were able to show that demand

for profit-sharing deposits is "structurally stable and policy invariant". According to their

study, the introduction of interest free banking made the demand for money more

responsive to policy control.121

Pradhan and Subramarian write that stability of money demand is a key factor in

the performance and success of developing economies. They note that "monetary policy

which seeks to limit supply to its demand facilitates the tasks of demand management

and… the achievement of price stability." They advocate constrained growth of the

money supply.122 Choudhury writes that the intended use of money is to "service real

transactions demand" and retain its function as a medium of exchange. However its use in

the global economy has shifted away from this. The use of interest rates has been used to

fuel the creation of excess demand for real money balances, which is "capitalized by

speculators for gains," leading to total "indeterminacy in defining value" and decreased

worth of money as a "standard for valuation".123 Whereas, if the price level and the

amount of money in the economy were linked to the "market value of exchange," there

would be just enough in the economy to meet "transactions demand".124 Interest is an

excess over this minimum worth. In the developing world in particular, "financial

dependency" on the "loanable 'excess reserves' of commercial banks of industrialized

nations" has weakened the domestic banking sector.125 For developing countries that are

121 Kia, Amir. Darrat, Ali F. "Modeling Money Demand under the Profit-Sharing Banking Scheme: Evidence on Policy Invariance and Long-Run Stability." November 2003.122 Pradhan, Basanta K. Subramanian, A. "On the Stability of Demand for Money in a Developing Economy." Centre for the Study of Globalization and Regionalization, University of Warwick, Coventry, UK.123 Choudhury, p. 16124 Ibid, p. 13125 Ibid, p. 22

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especially debt-dependent, this is particularly problematic. Industrialized nations simply

promote their "self-interest" through "banking policies" and the departure of the

"institution of money from its real market functions".126

Hence it can be seen that there is a link between interest rates, money supply

exceeding demand, and the instability of demand for real money balances. The empirical

evidence bears out this hypothesis, with evidence from Tunisia, Pakistan, and Iran

demonstrating that the removal of interest-based deposits has a damper effect on the

velocity of money in the economy.

126 Ibid, p. 32

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Conclusion

Islamic financial institutions are increasingly serving the needs of the world’s Muslims.

The world's IFI's, couched in the backdrop of Islamic economic principles for ethical

investment and development, collectively comprise a unique and innovative financial

system. The reponse of Islamic philosophers to capitalism have laid the groundwork for

the modern institutional system that is in development today. Out of Islamic writings and

teachings has grown a multifaceted subset of the financial industry which has enabled the

economic and political participation of hundreds of millions of pious Muslims. The forms

and structures of Islamic economics and modern IFIs propose a very different path of

growth and ultimate economic objective. Islamic finance resurrects the principle of risk-

sharing in a new way, making it the cornerstone for financial intermediation. However,

the industry is still in a formative stage. New financial innovations, contracts, and

transactions continue to diversify the possibilities within the Islamic financial universe.

Substantial amounts of capital promise to be diverted towards these institutions.

Strengthened regulations, improved safeguards and more fully developed capital markets

will be required. In the United States, the American Finance House Lariba is credentialed

as the largest interest-free Islamic finance house of its kind. It offers personal loans and

mortgages to consumers with a shariah compliant preferences. In the global economy,

international banks such as HSBC and Barclays have lent their capital to the formation of

Islamic banking windows. The Dow Jones Islamic Market Index, launched in 1999, in

addition to the Kuala Lumpur Shariah Index, and the Financial Times Stock Exchange

Global Islamic Index, as well equity indexes in Malaysia and Turkey, have all arisen

within the last ten years. These indexes reflect the growing market capitalization in the

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Muslim world and the growing movement towards Islamically acceptable investments.

As well, the Islamic Financial Services Board, or the IFSB, and the Accounting and

Auditing Organization for Islamic Financial Institutions, or AAOIFI, as well as the

International Islamic Rating Agency have all come into being for the purpose of

establishing standard international regulations for Islamic financial institutions.127 Events

such as the Geneva-based conference on "Islamic Finance: Integration into the

Mainstream" demonstrate the increasing relevance and importance of these institutions to

the international financial community of investors and institutions. This increasing

standardization and international recognition, as well as the improving regulations and

infrastructures in the developing world, hold a promising future for the development of

Islamic finance. Ultimately this may lead to the realization of the goals of the earliest

Islamic economic thinkers in society, and the combination of egalitarian ideals, such as

the redistributive notions of Islamic teaching, with capitalism.

127 Syed Ali, Salman. "Islamic Capital Market Products: Developments and Challenges." Islamic Development Bank Group. Islamic Research and Training Institute. Occasional Paper No. 9 2005. p. 18

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