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A Brief History of Islamic Finance, Banking, Investing, & Economics

Islamic finance is intended to be an alternative financial system based on the rules laid down in Islamic law, the Shari'ah, which is articulated in the Qur'an and Sunna.

The industry has its roots in the post-colonial period in the 1950s, when scholars in many previously colonized and newly independent states worked to develop a new economic system, a third way between capitalism and socialism based on the assumption that Muslims will have a larger social interest in their economic interactions than non-Muslims; they will be homo Islamicus rather than homo economicus, as conventional economics assumes.

This larger social interest will manifest itself in a new form of economic interaction resulting in greater social equity in Islamic societies than is possible in secular Western societies. The new Islamic economics, over time, began to merge into becoming a niche sub-field of economics, relying on conventional economic tools to challenge traditional economic thought in designing post- colonial economic policies for Muslim-majority newly independent states. As Islamic economics became more similar to conventional economics, a new field within finance was taking shape, largely in the Gulf Cooperation Council region and Malaysia, Islamic finance. The first Islamic banks that are still in operation today opened in the middle 1970s following the first oil crisis in 1973-1974 as the pool of money in the Middle East drastically increased following the inflow of petrodollars, and many large investors within the region desired to invest their money in Islamically-compliant, or in the current parlance, Shari'ah-compliant ways.

Islamic finance is based on the prohibitions of riba and gharar, usually translated as usury and risk, respectively, as well as prohibitions of investment in forbidden (haram) businesses, universally agreed to include industries making significant portions of their income from alcohol or pork. Other common prohibited industries are tobacco, defense/military and entertainment (movies, gambling, pornography, etc.) and interest-based financial firms. Companies invested in also have to meet financial screens relating to their debt levels. One of the common standards is the one adopted by the Dow Jones Islamic Market Index:

  • Debt to 12 month trailing average market capitalization ratio less than 33%;

  • Cash plus interest bearing debt certificates to 12 month trailing average market capitalization less than 33%; and,

  • Accounts receivables divided by 12 month trailing average market capitalization less than 33%.

One of the additional requirements is that scholars in the Shari'ah with knowledge of finance be consulted and then issue a fatwa (religious decree) certifying that the products are Shari'ah-compliant. Most institutions rely on a Shari'ah board that they employ to rule on new products and maintain the Shari'ah-compliance of existing products.

When the Islamic finance industry was being developed, the first challenge was to find a way to structure a financial system without using interest. Since the time value of money (the difference in value of holding $1 today versus $1 tomorrow) is not zero, even in an Islamic system, another way had to be devised to compensate Islamic finance consumers and providers for the time value of money. In the conventional financial system, this is done by assigning an interest rate on loans to compensate lenders for the time value foregone by making a loan. Under an Islamic model, this is impossible, since interest is seen as riba, and therefore prohibited. Early scholars looked back to the height of the Islamic civilization and the financial products employed then to avoid the problem of riba and the jurisprudence relating to financial practices, the fiqh al-mu'amalat. The financial system was based on a system of profit-and-loss sharing with a few products employing a fixed profit amount and a few that allowed payment for a product that did not yet exist (e.g., a farmers' crops at the end of the season). While it was not clear whether these products were suited to current financial markets.

The products that early Islamic financial practitioners envisioned using were mudaraba, musharaka, salam, and istisna', and ijara with the cost-plus financing murabaha playing a minor role. Mudaraba and musharakaare two similar ways of financing business and mudaraba is a special case of musharaka. In musharaka, two (or more) partners form a business with each providing capital and agreeing upon the proportions of any profits they each will receive. In the case of losses, they will be liable for losses in the exact ratio of their capital contributions. Under mudaraba, one partner supplies the entire capital and the other provides labor. They distribute profits in an agreed-upon ratio, but the rabb ul-mal (the capital provider) is completely liable for any losses and the mudarib (the provider of management and labor) loses only his efforts.

Salam provides the Islamic alternative to forwards, and was used primarily by farmers who needed financing to farm before the products would be ready to sell. The salam contract allowed them to agree to receive full advance payment for a certain amount of crops at a certain future date. The istisna' contract allowed a similar transaction for goods being produced with a set schedule for when production was to be completed and for when payment is made. Ijara is a leasing contract that allows the owner of a tangible item (e.g., a house) to lease it to another party for a fixed payment over a fixed duration. Finally, the murabaha contract was one similar to a cost-plus transaction where the seller purchased a good for the buyer and the buyer received the item and paid the seller the price plus a mark-up ('profit') at a specified future date.

Despite the best intentions of the early Islamic finance practitioners, it is unclear whether the medieval-era contracts are appropriate for modern finance and in a very different legal and regulatory environment. For example, the typical way an Islamic financial institution finances a house is through a murabaha (cost-plus) sale, which requires the financial institution to purchase and own property, which in the U.S. is generally prohibited. An exception was made by the Office of the Comptroller of the Currency (OCC), the U.S. government agency that administers national banks, because the product was ruled to be functionally equivalent to a conventional home loan. However, since the OCC ruled that "the economic substance of the [murabaha home financing] will be functionally equivalent to secured real estate lending" (Interpretive letter #806) and the loan documents show the implied interest rate in the loan, it is unclear how the financing use of murabaha, where a fixed rate of 'profit' is de facto substituted for interest, is in compliance with the substance of Islamic law. The transaction was originally intended only as a contract for sale; the use of murabaha for financing has been a recent shift. Critics like Mahmoud El-Gamal, a professor at Rice University, argue that by focusing on the contract forms, rather than the substance and intent of the Shari'ah, Islamic finance risks losing legitimacy if it is seen merely as a form of arbitrage.

Alternative methods of structuring Islamic finance focus more on the similarities with socially responsible investing and question whether focusing on archaic contract forms provides the best way to attract Muslims (and non-Muslims) to the Islamic financial industry. While Islamic socially responsible financial products have not become mainstream, there are efforts to create Islamic microfinancing, Islamic socially responsible investment funds, Islamic mutual insurance, and Islamic banking that does not rely upon Shari'ah arbitrage, but focuses on using the credit union model whereby banks are owned by its depositors and thus share in the risk and profit of the banks' operations.

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