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DESPITE strong disagreements on the Islamic mode of financing, Islamic banking is one of the fastest growing industries in the world. According to one estimate, global Shariah-compliant assets are estimated at $1.4trn.
Then why are the masses still sceptical about its authenticity? The simple answer is lack of awareness about what does and does not constitute an Islamic transaction.
The terminology ‘Islamic financial system’ does not paint the true picture of what an Islamic financial system truly is as a whole. Undoubtedly, riba (interest) is prohibited in all forms, from receipt to payment. But there are other Islamic doctrines related to risk-sharing, individual rights and duties, property rights, maintaining promises, and keeping sanctity of contracts etc — that make the system Islamic, in essence.
It is wrong to consider only banking as an Islamic system, since it also extends to capital formation, capital markets and all types of financial intermediation. However the Islamic realm prohibits individuals from riba (interest), gharar (uncertainity) and maisir (gambling), and no exception is acceptable.
In Islam, income from whatever source — be it land, labour, capital or enterprise — must be determined by the supply of the work effort associated with the factors of production. Here, work efforts must be associated with the taking of risk in the project it is invested, which makes the profit or income generated from the factor of production permissible. Lending money to earn interest is not associated with work efforts or risk, which makes it prohibited in Islam.
Islam makes distinction between money and capital, where money transforms into capital only through enterprise, as in the case of the profit-and-loss sharing mechanism in which the profit is not fixed or guaranteed, and loss is shared equally between the manager and the capital investor. This is also an argument against interest, as it entails that the net income (either profit or loss) generated through the conduct of business must be shared on agreed upon terms.
Islam makes distinction between money and capital, where money transforms into capital only through enterprise, where the profit is not fixed or guaranteed, and loss is shared equally between the manager and the capital investor
Islam has redefined the creditor/debtor relationship as that of partners in a project. All of these elements also exist in western literature, where interest is opposed on the grounds that it exploits the borrower and creates income inequality — the very reason Islam prohibits interest. Interest is prohibited by all revealed religions, including Judaism and Christianity.
The Islamic mode of financing adopts an asset-based approach, where financial institutions are entitled to earn profit, or rent, on the underlying asset, as opposed to interest, which is the backbone of the conventional banks. Islam does not prohibit an individual or institution from earning profit, provided that the earned amount is permissible and not sourced from impermissible, or Haram, activities (wine, gambling etc).
Islamic banks work on the risk-reward principle. An underlying activity is not allowed unless and until the banks take the risk for the activity to ascertain its validity and permissibility. Secondly, Islamic banks finance most of their transactions through a partnership profit-and-loss-sharing mechanism, such as Musharakah (joint venture between parties) and Modarbah — where one party acts as the financer (Rab-ul-mal) and the other as the manager/agent (Mudarib).
Other Islamic modes of financing that are used include Murabaha — a trade-based mode where the seller has to disclose the price of the goods plus the profit charged — besides other trade-based modes like Mujjal, Isitisna and Salam. Lastly, Ijarah is a rent-based financing mode used by Islamic financial institutions.
Conventional banks are established under the idea of capitalism, where capital, a factor of production, deserves an interest risk-free reward which is unacceptable according to Islamic law.
Islamic financial institutions offer a competitive process for financing globally. In fact, they are price takers instead of setters, because of their small share in the large market. This forms the basis of a wrong perception about Islamic finance, because the outcome is the same as that of conventional banks.
Charging profit in a business transaction is a business decision. According to Shariah, fair play is required and no specific rate of profit is settled. It is the process of the transaction in the Islamic contract that differentiates Islamic finance from conventional finance. Islamic financial instruments prevalent in the industry are based on trade, rent, and profit-and-loss sharing mode.
Therefore, the main difference between a conventional bank and an Islamic one is the mobilisation of finds from savers to entrepreneurs. Islamic banks provide the same services as their conventional counterparts, except for impermissible activities. Islamic financial institutions also cannot lend cash. However, that need is fulfilled by either the supply of an asset or through a profit-and-loss sharing mechanism.
Therefore it’s time for the general public to start understanding the true essence of the Islamic financial system in the context it is. The Islamic financial system is Islamic in nature, except that the system itself needs time for developing standards and a mechanism for smooth running and adherence to Shariah.
Islam is not against the idea of earning profit or income, but prohibits using ‘interest’ as a mode to earn income. Interest is the increase on the principal amount that has been loaned, whereas the money is only used as a medium of exchange and not as a factor of production independently.
Moreover, interest has been seen as a great factor in creating income inequality and socioeconomic disparity, as riba exploits other individuals and concentrates wealth in a few hands — a global problem, for which economists are exploring solutions.
Published in Dawn, Economic & Business, December 22th , 2014
