Mohammad Nejatullah Siddiqi

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[Presented at Harvard University Forum on Islamic Finance,6 April 2002]



It is more than a quarter century now when the practice ofIslamic banking and finance began in earnest. The Dubai Islamic Bank, a private company, as well as the Islamic Development Bank, a symbol of the Muslimpeoplesí endorsement of the idea launched by the Organization of the Islamic Conference (OIC), were both established in 1975. The idea is maturing, the numbers are growing, the market share is increasing. There must be something that sustains it in an environment overwhelmingly dominated by†† conventional finance. What could it be?


Not all Muslims are fully satisfied by the character and performance ofthe existing Islamic financial institutions. Barring the small minority who sees no need for them, most express dissatisfaction either on the ground that they are not Islamic enough or because they are inefficient as compared to their conventional counterparts. But all agree that these deficiencies could be remedied overtime and there is nothing to justify aborting the experiment.There must be some reason for this resilience. What is it?

There had been a widespread fear thatthe dominant interests in the field of money, banking and finance would soon gang up to kill the initiative. They would do so, it was alleged, so that the lucrative markets peopled by Muslims do not slip out of their hands. Nothing of that sort has happened yet, anddoes not appear to be on the cards. On the contrary large vested interests in the continuation of the Islamic financial movement have appeared involving conventional moneymanagers. Why?


Last, but not the least in significance, is the fact that, out of the small number of western professional economists who found time to pay some

serious attention to the phenomenon, most have been very positive about it. In an intellectual environment in which hardly anything originating in the

Muslim world isseen to be bearing some promise and looked at with respect, this calls for some explanation.


It is my intention today to share some thoughts with youin search ofthe answers to the questions posed above. I do not know all the answers. I feel some of the questions call for empirical data not yet available and forfield surveys not conducted till now. Yet thequestions themselves are interesting enough to deserve your attention. Any time and energy spent in search of answers to these questions will be well rewarded as they may indicate the future agenda for research for the nascent scientific discipline of Islamic economics.


Search for a Better System of Finance


There are three contemporary phenomena which, in my opinion, provide clues to what we are looking for. The first is the widespread dissatisfaction with the performance and consequences of the monetary and financial sector all over the world since the end of the world war two, specially since the 1970s. The second is the fact that the Islamic financial movement appeared on the scene as an offshoot of a much broader resurgence among the Muslim peoples. Andthe third factor that could partly explain the above mentioned resilience and hope invoked by the Islamic approach to money, banking and financecouldpossibly be the strong moral overtones accompanying it since its inception.

Let us examine these points one by one.


There is a widely shared perception that there is much more inequality in the distribution of income and wealth today than at any other timein the entire past of mankind. This applies to the distribution within nations as well as between nations. Worse still, inequality is growing and there is nothing on the horizon to indicate a reversal in this trend. It is rightfully regarded as a potential threat to peace and a phenomenon unbecoming of human fraternity.

At least part of the blame for bringing this about is laid on the monetary and financial system as it evolved during the past half century. While a detailed analysis of that system is not possible in the context of our deliberations today, some reference to the main factors is in order.

At the top of the list is the opportunity the current system provides for money to be exchanged for more money, making the moneyed richer. Next in importance is the immense scope for gambling-like speculationprovided by the huge volumes of debt-based securities in a system that permits sales on margin, short selling and other exotic money games. Last but not the least is the philosophy that regards profit maximization as the only legitimate concern of the investmentmanagers to the neglect of all the other ingredients of human weal. Add to these perennial features of capitalism its newfound energy with globalization and deregulation and the consequences should be surprising to no one.


As it stands, the performance of the system is generally regarded to be suboptimal. The monetary and fiscal policies recommended to improvethe systemís efficiency areoften complicated and unconvincing. Some of them may be politically impossible to implement. In this situation any simple and straight forward approach like that of Islamic economics is bound to attract attention.

The manifold increase in GNPs and the general uplift in standards of living in most if not all parts of the world, matches uneasily with, if it isnot altogether negated by, the colossal rise in levels of anxiety caused by the increased instability of the system accompanied by volatile exchange rates and, in some cases,collapsing currency values, and frequent job losses. These undesirable consequences and the, at the best, mixed performancemakes thinking people look around for alternatives.


Attractive Features of the Islamic Approach


Islamic resurgence in the twentieth century assumed proportions nobody could afford to ignore. Whether one leaned towards a possible clash of civilizations or hoped that interfaith dialogue would help usher in a happy age of coexistence in the global village, Islam was there as a major factor on the world scene. And the Islamicfinancial movement happens to be one of the uniquefeatures of twentieth century Islam. The fact that its rise coincided with the Muslim countriesícoming out of colonial rule speaks volumes about its place in the Muslim psyche. It is as much an expression of their distinct identity as any other symbol of independence, but there is a distinctionno other symbol shares with it: It is meant for all. As Islam permeates deeper in contemporary Muslim societies,by accommodating what is new but useful and shedding what accompanied it for long but was not essential, the significance of an Islamic approach to such amundaneaffair as finance dawns on all concerned. After all it was a moral approach to mundane affairs that was the essence of the Prophetís mission. Anyone who takes Islam seriouslycan hardly ignorethe moral approach to money, banking and finance represented by this new phenomenon. That makes every Muslim a stakeholder in this venture. The same feature makes outsiders give a greater weight to the enterprise than its current size or volume would call for.


A return to ethics and morality is on the cards. Disillusionment with an amoral approach to economics and exasperation at the excesses of secular-materialistic-hegemonic policies of politicians has created a new environment. The Ďend of historyí triumphalist phase is over. People, including the intellectuals, are willing to listen. Is a moral approach to economic activity possible? Is it possible to define distributive justice in terms which take into account not only the immediate and the actual, which is often affected by things transient and insignificant, but also in terms of things essential and durable which relate to the core of the human situation? Is it desirable to manage money, banking and finance in total indifference to such problems as poverty, unemployment and increasing levels of anxiety? The fact that the Islamic financial movementclaims to be based not on a fine stroke of human ingenuity but on divine guidanceand prophetic insights makes it disarmingly simple. Alone in an age marked by its scepticism and uncertainties, theIslamic financial movement commits itself to a sacred text. To do so in matters economic leaves many gasping for their breath. But the fact that the text is not the handiwork of victors in a war or champions of a particular class, the fact that it is supra-human, introduces anattraction no other school of thought can muster. For, whatever the difficulties faced in drawing guidance from a text revealed in the seventh century for life in the twentyfirst century, it could notpossibly be seen promoting the interest of one group of people at the cost of the interest of others. The universal nature of the teachings of Islam relevant for finance, be it prohibition of Riba (interest) and Maysir (gambling) or the obligatory share of the poor in the wealth of the rich (Zakat), could hardly be doubted .

But did the movementreally demonstrate in practice its ability to fulfil the promise of a moral handling of money, banking and finance that it bears by virtue of its being rooted in religion? That, of course is a different question, one which needs some researchbefore it can be answered. The point I wish to make at this stage is, the very promise raises hopes no other approachhas been able to raise.


Islamic Finance in Practice


Raising hopes in a desparate situation can take you along part of the way but not all the way. What could sustain Islamic banking and finance till now can hardly be expectedto guarantee its continued progress in the future. It is one thing to capture a large chunk of the market in your home base, i.e. the Persian Gulf region, it is a different task to attract customers in the global market place. So, where do we go from here?


Comparative Advantage


Pursue your comparative advantage, seems to be the right answer. I would list it as the following.


Islamic finance forges a closer link between real economic activity that creates value and financial activity that facilitates it.

††† Islamic finance does not allow creating new risks to profit thereby.

††† Islamic finance is global and cosmopolitan.Having committed itself to a text accessable to all and Prophetic precedents availableeasily, Islamic finance is open to any innovations that are in congruence with its fundamentals. It is not a closed system. It has no regional, ethnic or class affiliations.


It may be argued that some of these advantages need state sponsorship to be pursued effectively. That is true, but before we take up the issue of state sponsorship let us note that the real source of srength for Islamic finance has always been private initiative. Once a framework for proper exercise of property rights and management of economic enterprise was in place, individuals were left free to organize business the way they liked. When someone felt any need for clarification of a given text, or found oneself in a situation in which no available text offered guidance, in his or her view, he or she approached the Prophet who gave a ruling. When the Prophet was no more, people turned to those who had been close to him. As time passedscholars collected these rulings and developed a whole body of jurisprudence on their basis. Rules relating to finance are also a part of the corpus so developed. But the remarkable thing is that there is nothing Ďofficialí about this corpus. It was and remains till date the work of certain individuals endorsed by other individuals, however large their numbers. Those actually involved in financial dealings followed the ruling of their choice as dictated by their conscience and their circumustances. As long as they operated within the framework defined by the texts they enjoyed a great amount of flexibility in their operations. The statedid not legislate Islamic commercial law, hence the state could not enforce any particular rulings. The state came into picture when a dispute between trading parties brought them to a court of law, and the court took into consideration the particular rulings shared by the parties which were, therefore,supposed to be the basis of their interaction.


The Islamic State and the Financial Markets


I am not claiming that the early Islamicstate left the financial markets alone, unsupervised and unregulated. Far from it. Like the market as a whole, whose supervision and regulation dates back to the Prophetístime, financial markets too were monitored and regulated to ensure they operated within the framework of the divine guidance mentioned above. The rich literature on Hisbah (market regulation ) bears witness to that. What I mean to say is that just as the Islamic state never took over the markets in general, it never took over the financial markets. Though the societyísmoney, the payment mechanism, soon came to be managed by the statein the same manner that itensured proper weights and measures, financial practices relating to investment, intermediation, exchange of currencies, transfer of funds, securitization, etc. were all developed in the open market by those engaged in the art.


I narrate this familier story to point out the vast scope Islamic finance , by its very nature, provides for individual initiatives, innovations and experimentation. It is not a matter of a given list of dos and doníts being handed down to all concerned. It rather is a great quest for justice, balance and felicity in our economic and financial lifein which God gave us some broad, eternal and universal guidanc. His Prophet led us further by applyingthat guidence to the concrete situation of seventh century Arabia. It is always a challenge for the faithful to act in accordance with divine guidance.Those who came after the first generation of Muslims enrichedour heritage by deriving more elaborate rules from the divine texts and the Prophetic traditions applicable to a variety of lands and peoples. Of course, they lacked theProphetic immunity from error. Today in circumustances entirely different, but armed by centuries of history, we arefacing that challenge again. The challenge lies not in conforming to a given set of rules but in realising the objectives ofthe Shariah, for which the current generation of Muslims would have to do for themselves what the earlier generation had done in their time and place.


It is in the nature of the arts that the artist alone knows the details of the job. The art of business enterprise or financial management is no exception. The scholar can help. But he should not aspire to take over the art doing itself. That may kill the art or stifle it. He should rather be at hand to advise and look for any possible guidance the past may have to offer.

Happily, the story of modern Islamic finance in the private sector is not very different. The best of all the worlds will be for the practitioners of Islamic banking and finance to internalize the Islamic values and proceed to do their job. They should turn to Shariah scholars for advice when needed. But it is too much to ask them for blueprints for doing things with whichthey are not the least familier. It is not onlythe scholarís jobbut also the job of the business and financial community amongst Muslims to forge ahead with the distinct Islamic vision of finance in practice and bear witness to it through their activity in the open market.


Need for Restructuring Islamic Financial Markets


Let me explain this with the help of some examples. I select Murabaha (cost plus) financing and Mudaraba (financing by sharing the outcome).

We consider Murabaha to be superior to debt financing on a number of grounds. We also consider that its inclusion in the toolbox of Islamic financial instruments makes that box really capable of handling all financial situations. We claim that it serves to keep the financial market in sync with the market for real goods and services, thus making it less vulnerable to gambling like speculation. Demonstrating these and possibly other vurtues require Murabaha to be practiced in real earnest, i.e. as a means of financing the acquisition of means ofproduction and needed goods by people who are expected to be able to pay for them, but after sometime. It would be a caricature of Islamic finance if, instead, Murabaha is used as a trick to do what conventional finance is doing, i.e. lending on the basis of interest. It is only the practitioner who can ensure that Murabaha does not degenerate to that level.

Since financial intermediation does not involve selling goods and services directly, it would be more appropriate to get financial intermedieries involved in Murabaha business indirectly, as I will explain later. The same applies to other forms of business like Salam (payment now for delivery of agricultural goods in future), Istisnaí( prepaid orders for manufactures ), leasing, etc. A financial institution is not fully equipped to handle these businesses directly. It is often reluctantfully to expose its capital to the risks involved in direct businesses. As aresult it tries to make the transactions as risk free as possible. It does not care if this means, on the average and in the long run, settling down for a lower rate of return.


Now imagine a whole range of businesses doing Murabaha, Salam, Istisna and leasing. These businesses would know the risks they are taking. They would also be able to diversify theiractivities as a means of reducing risk. Perhaps they are already specialising in handling different market segments in terms of the commodities involved. Thesebusinesses would need financing. This financing couldcome from Islamic financial institutions. This way there would be a buffer between the changing circumustances of real businesses and those handling only finance. It will thus relieve the Islamic financial institutions from the need to reduce risk by making their contracts look like payment of less money now in exchange of more money to be received in future. The fact that their stake will be not in indivdual deals based on one of the contracts mentioned above but in a large basket of deals will make a crucial difference. In its own interest, the business being financed will have reduced the risk of loss by diversification and other methods. The financial institution will have the added opportunity of diversification byoffering its funds to a variety of businesses.


What would be the basis for the Islamic financial institutionsí financing of Murabaha companies, Leasing companies, etc.? In my opinion the most appropriate form will be Mudaraba or profit sharing. Islamic banks accepting peopleís savings in their investment accounts on the basis of Mudaraba would be giving that money out onthe basis of Mudaraba. This conforms to the earliest form of financial intermediation discussed in Islamic jurisprudence, al mudarib yudarib ( One taking other personís money on the basis of Mudaraba giving that money to yet another person on Mudaraba ). The risks involved will be financial risks which financial intermediaries have learnt, and continue learning, how to handle. Business risks will become the concerns of business houses closer to those who buy and sell, even produce and import/export, or build and lease, hire and sublet, etc.Therewill be no need to twist and turn a trade deal to make it serve the purposes of a financial intermediery.


One might need to encourage establishinga whole range of companies: Murabaha companies, Salam/Istisna companies , Leasing companies, etc. so that finance is channeled from Islamic banks to those actually engaged in production of wealth. Whether it is the building and construction sector or agriculture, manufacturing industries or the transport and communication sector, foregin trade or domestic commerceor the governmentís infrastructure building activities, ways can be found to meet their financial needs through these companies, without recourse to interest based lending and borrowing.

This vision, which involves separating purely financial transactions from business transactions, has two advantages in comparison to what we actually observe today in the Islamic financial markets. Firstly, it would comprise a mixture of sharing based modes with trade based modes of financing that result in creating fixed payment obligations or debts , unlike the current situation dominated by trade based modes. Secondly, it will enable Islamic financial institutions to do needed long term financing, a field from which they are presently shying away. With the exception of istisnawhich can be a basis of long term financing, all other trade based modes of finacing,e.g. Murabaha, leasing and salam, are suitable only for short term financing. Given this change they could rightfully demonstrate how their activities avoidcontributing to the instability of the system, something we accuse interest based institutions of doing. By doing this the system will enjoy the unique feature of sharing based intermediation: syncronization between revenues and payment obligations, and still retainthe flexibility which the presence of very low risk modes of financing impart to a system. A strong presence of sharing based modes of financing will give credibility to the claim of Islamic financial systemís being more just than the conventional system.


Above I have summarized the comparative advantage of Islamic banking and finance in three things: It keeps the financial sector in sync with the real sector, it is less vulnerable to gambling like speculation, and it is†† cosmopolitan and universal. The first two features contribute towards greater stability, among other things. The third makes it far moresuited to the global village than the curent system suspected of being partial to the developed countries of the west.The claim to impartiality and cosmopolitanism will be credible in sofaras the system is perceived to be rooted in divine guidance. I think a restructuring of the Islamic financial markets along the lines suggested above will go a long way in enabling that market to demonstrate thesedistinctive features and thereby attract more adherents.


Much of this restructuring can be accomplished in the private corporate sector. To the best of my knowledge some of it is already under way in the form of new subsidiaries and syndicates. But it can take the Islamic financial movement a long way ahead if the state in Muslim countries shows awareness of the Islamic approach to economic life in general and to money, banking and finance in particular. The moral approach to worldly wealth, to what Alfred Marshall called the ordinary business of life, is not unique to Islam. All religions are supposed to share it. Even in the so called materialist western society the common man can not possibly be amoral, not to say immoral. The problem lies with economics as a scientefic descipline which refuses to admit ethics and morality. It is not possible to elaborate on this point in this paper. It is noted here to underline the need for Islamic economicsin an Islamic societywhich wants to Islamize its financial markets. The major failure of capitalism noted above, that it promoted inequality between nations and within nations, can not be remediedmerely by introducing Islamic finance. It requires behavioral changes on part of all economic agents, the individual consumer and producer as well as the state.


The suitability of the Islamic finance for the global village and its superiority over conventional finace does not lie in the opportunities it might offer for the moneyed people to make more money through investment. Rather it lies in its promise to ensure that good returns to investments shall be accompanied by promotion of the good of the socity as a whole. A combination of efficiency with morally better end results requires that institutional changes be accompanied by moral regeneration.


Need for Fundamental Research


The role of the state in pursuing the comparative advantages of Islamic financedoes not lieonly in removing legal hurdles in the way of Islamic financial practices and enacting laws enabling the adoption ofsuch practices. It does not end with the setting up of proper regulatorymechanisms and reform of the central bank. Ratherthe Islamic state should aspire to project the moral approach to economics and finance on world forums as well as in its domestic policies. That , I think , is not a call for implementing a given set of dos and doníts. Such a set defined in todayís terms does notexist. No individual or state has the wherewithalls of defining it alone in isolation with the rest of humanity. The formulation of a just and equitable set of economic and financial arrangements for the global village of the twentyfirst century should be a joint human enterprise in whichMuslims, individuals as well as states, should vigorously participate. A beginning has already been made by the launching of the twin projects of Islamic economics and Islamic finance. The need of the hour is to redirectmore resources to these projects so that theyattract more and more people.


Above I have noted the positive response the idea has received from some of the faculty members in western universities. But so far our reach to western academia has been very limited. To reach more people we need scholarships, research grants and endowed chairs for Islamic economics/Islamic finance in the leading universities .There is a good case for the Islamic financial institutions taking a lead in this respect.


In line with the three bases of our comparative advantage, relating to real-financial linkage, reducing speculation and focusing on the interests of mankind in general, researchers should give priority to the relevant contemporary practices and think of alternative ways of doing things expressive of these advantages. Alsoour practitioners should eschew methods fostering money games with no links to goods and services, speculation based on risks enginered by the speculator, and those serving one section of people at the cost of others. It is in the nature of financial systems that no community can have one in isolation with the rest of the world. Just as we can not ensure an unpolluted environment for ourselves unless we try to clean it for every one, we can not have a just and equitable financial system for the Muslim peoples of the world unless we take others too onboard. That requires as much doing as thinking and persuading. Let that be our end note for the day!