Islamic finance is a faith based scheme of the socio-economic system. Guidelines for the modern Islamic financial system are inferred from Islamic jurisprudence (based on Qura’n and Sunnah). Under Islamic law there is a set criterion for issuing a juristic opinion. Accordingly, the foremost important source of law is Qura’n followed by Sunnah, Ijma’a and finally Ijtihad. There are many socio-economic issues directly addressed in The Quran and verdict from Qura’n is final.
If an issue is not discussed in Qura’n or needs further explanation, then Sunnah is consulted to seek guidance. Anything found in Sunnah relating to a prevailing socio-economic issue is accepted as final verdict (if it is not in contradiction with Qura’n). When an issue is neither discussed in Qura’n, nor guidance is available in Sunnah–and there are many issues of modern life which are not directly discussed in these two primary sources of Islamic law–then Ijtihad is applied in the light of core principles laid down by Qura’n and Sunnah.
Throughout the Muslim history, Muslim Clerics have worked on an important aspect of Islamic religion–objectives of Shari’a. This concept is about extracting/inferring goal seeking of religion; as what Islam wants to develop in a human-community. It includes following objectives of Shari’a (Siddiqi, 2010): Hifz ul Emaan: Within the society religious freedom should be ensured, and particularly for Muslims a conducive environment must be developed to practice their faith. Necessary steps must be taken by collective power (government) of people to ensure freedom of Islamic way of living.
Hifz ul Jaan: Second objective of Shari’a is identified by experts in Islamic law is security of life of every individual member within the jurisdiction, irrespective of religious beliefs. Peace and security within the community must be ensured by the government/members.
Hifz ul Maal: Safety and security of wealth of all members of the community is a collective responsibility of members/government. Again establishment of just society is required to achieve this objective. Rule of law and order is required by Islamic law in the society. Islamic finance is required to ensure compliance and help the society in achieving this objective of Shari’a.
Hifz ul Nasal: Protection of Lineage (Nasal) of members of community must be ensured by collective power (government) of the society
Hifz ul Aqal: Security to intellect is required by religion of Islam. One should have independence to think and apply the brain in decision making. Rationality should prevail in the society.
Taking into account objectives of Shari’a, various efforts for reforming Muslim communities around the world were made by Clerics in 20th century after getting liberation from colonial powers and development of modern Islamic finance is one of those efforts.
Modern Islamic Finance is a recent development as a reaction to the prevailing financial system (primarily based upon interest as a charge). According to Abrahamic religions (Judaism, Christianity and Islam) charging of Riba (literally means increase and includes interest and usury) is prohibited (Psalm 15:1,2, 5; Proverbs 28:8; Nehemiah 5:7; Deuteronomy 23:19; Ezekiel 18:8.9 As quoted by Usmani, 1999 and Qura’n 30:391, 4:161, 3:130, 2:275-81).
After liberation from colonial powers in mid of twentieth centuries, Muslims started looking around at socio- political system through Islamic lenses and tested the systems on religious criteria. In economics prevailing dominant system (capitalism) was challenged by Muslim scholars and offered alternatives (Modoodi, 1962; Ibrahim, 2000; Siddiqi, 2010; Usmani, 2002; Qaradawi, 1960; Modoodi, 1962; Rehman & Tug, Siddiqi, 2010; Zaman, 2010; Ayub, 2007).
Major motivational factor in building of modern Islamic financial institutions was elimination of interest, although current operations of the industry covering many other ethical aspects (including Halal businesses, discouraging Gharar and Myser, promoting profit and loss sharing and asset based financing) beyond interest charge. A very brief time line of events in the history of Islamic finance is presented here.
1936-Modoodi, (1962), was the first scholar in subcontinent who criticized the existing practice of interest-based-banking and interest income on deposits with conventional banks declared Haram[page 228].
1949- Objective resolution was passed by National Assembly of Pakistan, declaring Islam as state religion.
1960s-Malaysia started program of Hajj financing (Tabong Haji) in sixties, which was converted to full fledge Islamic banking operations, at later stage.
1 Surah and Verse
1963-First ever practical experience of interest-free-banking was done in Mitghamar, a town of Egypt, which could not last longer. During same period a bank was offering Islamic finance services in Karachi, but author could not find a written source2.
1973-Mile stone in the history of Islamic banking was the conference of finance ministers of Organization of Islamic Cooperation (OIC) in 1973, where establishment of Islamic Development Bank was agreed.
1973-In Pakistan it is recognized constitutionally that interest free banking would be the banking of the economy (CoP, Articles 2, 31, 37, 227),
1975-Islamic development bank established and also Dubai Islamic bank started operation. 1979-After revolution, Iran started shifting whole of its economy on interest free operations and major steps taken in 1980s.
1980-However first ever genuine effort was made by Council of Islamic Ideology (CII)-Pakistan in 1980, in the form of a report on “elimination of interest from the economy” and suggested transition and implementation of Islamic banking at operational level.
1984-Interest free banking in Sudan-1984
1985-Pakistan started efforts initially by converting specialized financial institutions (e.g. HBFC, ICP) from conventional to Islamic and transformed total banking system on interest-free-system in 1985 (The Presidential Order # 14).
However this optimism failed very badly, primarily, due to non-conduciveness of socio-economic and political environment including lack of human resources, expert in Islamic banking (Khan & Bhatti, 2006) and operations of banking industry continued on conventional system, under the umbrella of profit and loss sharing.
1991-This hypocrisy was not acceptable to practicing Muslims of Pakistan and they took the matter to federal Shari’a court. Apex court issued order, declaring the existing practice (of banking) Haram (prohibited), and ordered the government to take drastic measures for implementation of interest free banking as agreed in constitution of Pakistan (FSC-1991).
1991- AAOIFI was established in to issue guidelines for Islamic financial institutions (IFIs) in the area of business, accounting, auditing and corporate governance. (By Nov 2016, 54 Shari’a standards 27 accounting standards, 7 governance standards and 2 codes of ethics were issued for the guidance of Islamic finance industry).
2 Mr. Alvi A Rahim, Ex chairman CBR, told the author personally.
1999-After receiving the order of the Federal Shari’a court, government of Pakistan analyzed its strengths and weaknesses and once again lack of trained human resources hindered the state from converting conventional system into Islamic. Government of Pakistan responded through two pronged strategies.
First; a commission was set up under the able chairmanship of Raja Zafar-ul- Haq to analyze whether interest free system is workable (in fact to re-invent the wheel, as same job had been done by CII in 1980). Second; government went into appeal against the federal Shari’a court decision in Shari’a appellate bench of supreme court of Pakistan (perhaps to get some time in implementation of decision).
It is interesting to note there were above 60 appeals, against the decision of federal Shari’a court, in Supreme Court of Pakistan, which were heard by honorable court as a single case3. Government failed on both fronts. Commission recommended the applicability of interest free system, and in 1999, Supreme Court issued a detailed decision favoring application of interest free economy (SCP-1999).
2000-By early 2000, state bank of Pakistan (SBP) adopted a different strategy, for promotion of Islamic banking, as parallel to conventional banking. Islamic banking department (IBD) was set up in SBP to guide, facilitate and regulate Islamic banking stream.
2002-Given the binding to execute order of Higher courts, and failure of successive governments in development of Shari’a compliant economic system, in 2002, government of Pakistan filed a review petition in the Supreme Court and case was remanded to Federal Shari’a court to revisit, which is pending to-date.
2002-International Islamic Financial Market-IIFM was established in Bahrain (By Nov 2016, IIFM has issued 9 standards)
2002-International Financial Services Board-IFSB was established in Malaysia (By Nov 2016, 18 standards)
3-Principles of Islamic Finance
Islamic finance is based on Shari’a (Islamic law). Ulema (Clerics in Islamic law) have identified objectives of Shari’a including safety of faith, Life, property, next generation and intellect (Hifz ul Eemaan, Jan, Maal, Nasal and Aqal) [Siddiqi, 2010]. Every design of community institutions should at least ensure conformity with objectives of Shari’a, if not enhance performance on these 3 [This shows the deep roots and resistance level displayed by promoters of conventional financing in Pakistan] fronts. Based on these objectives of Shari’a following principles of Islamic finance have been documented.
a. Prohibition of Riba
First is prohibition of interest and usury in financial dealings. In Qura’n four sets of verses have been identified dealing with the charging of Riba (Al-Qura’n, 30:39, 4:161, 3:130, & 2:275-281). Several Hadiths (traditions of Prophet Muhammad PBUH) clearing the meanings of Riba in various transactions have been reported (English translation by Khan, 1989). Furthermore resolutions of council of Islamic Fiqh Academy, Jeddah, are very much qualifying the status of Ijma’a (consensus) on the issue of Riba.
Also there are several Ulema (clerics) who declared both usury and commercial interest Haram (Unlawful) (e.g. see SCP-1999; Usmani, 2002; Qaradawi, 1960; Modoodi, 1962; Rehman & Tug, Siddiqi, 2010; Zaman, 2010; Ayub, 2007). Implication of this principle of Islamic finance is discouraging time value of money in its conventional banking sense. Under Islamic financial system money is mere a medium of exchange and not a factor of production independently.
Human labor is required in addition to money to earn a return, hence there is no fixed return for capital, however capitalist can participate in business under profit and loss sharing with or without participation in management of an entity (Shari’a standard # 12).
b. Avoidance of Gharar
Second principle of Islamic finance is avoidance of Gharar (absolute uncertainty) in a business transaction (Ayub, 2007, p 57; Mansoori, 2007, p 179; Ghazi, 2010, p 237). Ayub, (2007) defines “Gharar refers to entering into a contract in absolute risk or uncertainty about the ultimate result of the contract and the nature and/or quality and specifications of the subject matter or the rights and obligations of the parties [p 75]. Mansoori, (2007), documented that Gharar contains [certain] characteristics such as risk, hazard, speculation, uncertain outcome, and unknown future benefits.
c. Prohibition of Myser & Qimar
Third principle of Islamic finance is avoidance of Myser (speculation) or any game of chance (Ghazi, 2010). Ayub, (2007), documented that Maisir refers to easily available wealth or acquisition of wealth by chance, whether or not it deprives the other’s right. Qimar (similar to Myser) means the game of chance; one gains at the cost of other(s) right [p 62]. Myser is prohibited by Holy Qura’n [ 2: 219 and 5: 90] as well as in Hdiths (Khan 1989, p 92)
d. Promotion of Musharaka
Fourth principle is profit and loss sharing. As per this principle capitalist demanding profit on capital should also participate in loss as well (Usmani, 2002, p 87; Ghazi, 2010, p 386; Khan, 2007, p 307 & Shari’a standard # 12).
According to a famous Hadith (saying of the Holy Prophet Muhammad PBUH) “sale transaction of something which is not in your possession is not lawful, nor is the profit arising from something which does not involve liability” (English translation by Khan, 1989). According to this principle an investor can earn return on his investment subject to risk of loss, hence concept of risk free return is disappeared under Islamic financial system.
Mudaraba is partnership between capital and skill. Under this concept entrepreneur and capitalist join hands where by one party (Mudarib) provides skills to develop business and other party (Rab ul Maal) provides required money and both share profit of the business. In case of loss, monetary loss is borne by capitalist while manager loose reward for his skill.
f. Halal Operations
Fifth principle of Islamic finance is financing for only Halal (permitted) businesses. According to Qaradawi, (1960) “Nothing is Haram except what is prohibited by a sound and explicit Nas [Verse of Qura’n and/or an authentic Sunnah] from the law-Giver Allah SWT”. Ulema (Clerics) have made the list of prohibited businesses in which investment for Muslims (including Islamic financial institutions) is prohibited. Activities such as liquor, pork, pornography, adultery, dance clubs, conventional banking, insurance etc. are unlawful, hence earning return through investment in any of these activities is not allowed under Islamic financial system (KMI-30).
To conclude Islamic financial system ensures justice between savers and investors. By demolishing risk free return and promotion of profit and loss sharing, justice is ensured for both parties i.e. capital supplier as well as capital user. As a model of modern commercial banking, initially capital is supplied by depositors and later on by bank to business community. Under Islamic financial system bank can invest in businesses to earn variable return based on actual results of activities and share profit earned with depositors based on agreed sharing formula. Hence it is ensured to distribute the actual outcome and none is to bear risk alone and none is to earn with zero risk.