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Islamic Finance: A Real Alternative?

Posted by hidayathfund on September 24, 2009


Dr. Mohamad Akram Laldin, Executive Director of the International Shari’ah Research Academy for Islamic Finance, discusses the key principles behind Islamic Finance and how this method of banking could prove to be a viable alternative in the current crisis.

“O you who believe! Do not devour your property among yourself falsely, except that it be trading by your mutual consent; …” (Qur’an 4:29)

Islamic finance is a holistic system founded upon the principles articulated in the Qur’an and the traditions (Sunnah) of Prophet Muhammad (peace be upon him). It is not a new system but, rather, part of a system that originated with the first revelation revealed to Prophet Muhammad s.a.w. more than one thousand four hundred years ago. The macro-system governs all aspects of life; including―but not limited to―the social, political and economic systems. The different practices and contracts used in Islamic finance at present originated from the same source. However, it has been expanded and empowered to deal with the complexity of the modern financial system.

The Qur’anic message in finance is obvious and clear, as formulated in the abovementioned verse, which governs the entire Islamic finance system. The broad points are: do not encroach upon the properties of others unjustly by any means; and: all the different mechanisms for acquiring property must be executed with the mutual consent of the parties involved. In addition, the gist of the Qur’anic and Prophetic messages emphasizes the importance of observing certain principles in acquiring and accumulating wealth, which are called the broad principles of the Shari’ah. If these principles are observed, than a resilient and sustainable financial system can be built, and it will provide a prosperous alternative to the existing financial system.

The broad Shari’ah principles are in harmony with key universal values that will bring about benefit to humanity and protect them from harm. The following key elements are the important principles in economic activities:

  1. Prohibition of interest (riba) is the core principle which differentiates Islamic finance from conventional finance. The Qur’an says: “…and Allah has permitted trading and forbidden usury.” [Al-Baqarah 2:275]. The main reason for the prohibition of usury is the injustice which is caused by such practice. In addition, the interest-based system limits economic activities, as the creditor will tend to loan his money for interest without investing it in real economic activity, taking only credit risk for his undertaking.
  2. Prohibition of uncertainties in economic activities. In Islamic commercial law any activities undertaken must be transparent and any uncertainties must be avoided. For instance, in buying and selling activities, the object of sale must be clearly defined, and the seller must own the commodity which he intends to sell. Any ambiguity in such a transaction will render a contract null and void.
  3. Economic activities must have a direct link to the real economy through different contracts available in Islamic law, such as sales-based contracts, lease-based contracts and equity-based contracts. All contracts shall reflect true activities and be guided by several values such as the avoidance of uncertainties in contracts, full transparency and disclosure of the transaction details, avoidance of any element of deceit, etc. The underlying activities will help to boost productivity and promote prosperity of the society at large.
  4. Islam prohibits any immoral activities and considers any income from such activities to be illicit income. This includes any transaction which has the element of gambling, excessive speculation, taking of interest etc. In addition, Islam also prohibits trade involving immoral activities such as pornography, liquor, etc. Excess leveraging that leads to uncertainty is also prohibited.
  5. The principle of no-risks/no-gain emphasizes the necessity of taking some risk in order to realize any gain. Therefore, in any activities of Islamic finance the parties have to bear the risk in order to obtain the return from their activities. Islam does not recognize the charging and taking of interest simply because the gains are obtained without taking any obvious risk regarding the underlying activities. In interest borrowing the borrower guarantees the capital as well as a certain percentage of return to the lender, and in this situation the lender is free from any risk related to the activities undertaken by the borrower. No activity, whether it is sale-based, lease-based or equity-based, is free from risk; therefore, the seller, lessor and partners are entitled to a return from their activities. The nature of contracts, which requires that risk be shared by the contracting parties, exemplifies the principle of fairness and justice in Islamic Finance. For instance the partnership contract (musharakah) specifies that all the parties that share the capital in a particular venture will share the profit in proportion to their capital contributions. On the other hand, if there is any loss, all have to share the loss according to the portion of the capital contributed. This equity-based contract will also help to generate greater economic activities through the principle of profit-and-loss sharing; and the clearly defined risk-and-profit-sharing characteristic serves as an additional built-in mechanism to avoid any disputes and economic uncertainties.
  6. That money is a means for conducting transactions and not a commodity to be traded is another important principle in Islamic economics. Islam recognizes money as a medium of exchange and prohibits the sale of money as a commodity. The Islamic concept of money is such that the value of money is the reflection of the value of the commodity and has no value of its own. Therefore it is not to be traded but to be used as a medium of exchange in order to facilitate the transactions undertaken by the society.
  7. Fiduciary duties and accountability in undertaking Islamic finance activities. All the activities of Islamic Finance are guided and supervised by Shari’ah advisors, whose role is to ensure the compliance of Islamic financial products. In addition, all those who are involved in Islamic finance must ensure that they apply all the decisions of the Shari’ah accordingly.
  8. A fundamental Islamic legal principle is the starting assumption in matters related to transactions that they are permissible unless there is specific evidence to the contrary]. This principle allows innovation in Islamic finance. However, the innovations shall be guided by the other principles articulated in the Qur’an and Sunnah. In the current development of Islamic finance it is important to innovate and ensure that adequate products are offered to the market, for there is an excess of liquidity in the market that raises the need for more innovative products.

All the above principles can be considered as built-in mechanisms to prevent calamities befalling the economy. These principles, even though briefly described in this writing, are highly elaborated in actual practice and will serve as an important shield to the Islamic finance industry.

The abovementioned principles have protected Islamic Finance during the current financial crisis. It has been the least affected by and has emerged largely unscathed from it, which has made it the subject of a certain amount of discussion and review. Islamic finance can be a viable alternative to the current financial system provided that all the principles and the philosophy of Islamic commercial transactions are observed. Certain quarters have called for an examination of Islamic finance as a viable option. A sample of these quotations is as follows:

Robert E. Michael, the Head of Islamic Finance at the New York City Bar, when asked whether Islamic Finance is a viable alternative in the current crisis, responded by saying:

“The answer is clearly yes, but for two mutually exclusive reasons. On the one hand, it is clear that, properly employed, Quranic restrictions would have prevented the excesses of leverage and gambling on derivatives that led to the current collapse; on the other hand, however, those same restrictions would have prevented our Western economies from reaching anywhere near the levels of size and complexity we enjoy that make it possible for such enormous problems to occur.”

The Vatican, as quoted in the L’Osservatore Romano Magazine, says that Islamic Finance may help Western banks in crisis.

The Hong Kong Monetary Authority Chief Executive Joseph Yam expressed similar sentiments when he said:

“Islamic finance encourages business activities and generates legitimate profits and rests on principles of fairness, shared risk and ethical practices. There is much for us all to reflect on when considering how badly things have gone wrong recently in what might be called traditional finance.

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