New Issues in IslamicFinance and Economics:Progress and Challenges

New Issues in IslamicFinance and Economics:Progress and Challenges

Hossein Askari, Zamir Iqbal,and Abbas Mirakhor

John Wiley & Sons (Asia) Pte. Ltd.

Copyright © 2009 by John Wiley & Sons (Asia) Pte. Ltd.Published in 2009 by John Wiley & Sons (Asia) Pte. Ltd.2 Clementi Loop, #02-01, Singapore 129809

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In the Name of Allah, the All Merciful, the All Beneficent

Contents

Acknowledgment ix

Glossary of Arabic Terms xi

1 The Development and Progress of Islamic Finance 1

2 Issues and Challenges 47

3 Islamic Finance and Globalization: Convergence and aBoost for Rapid Growth? 75

4 Globalization and Its Implications for Muslim Countries 111

5 Expanding Financial Frontiers 129

6 Reputational Risk for the Islamic Financial Industry 149

7 The Design of Benchmarks for Asset Pricing 179

8 Qard-ul-Hassan-based Microfinance 197

9 Developing the Theoretical Foundations of Economics in Islam 211

10 Islam and Economic Development 243

11 Taxation and Public Expenditure in Islam 263

12 The Scope of the Social Safety Net in Islam: A Case Study 293

References 327

Index 363

vii

Acknowledgment

We acknowledge the contributions of Dr. Nadeem ul Haque andDr. Kazem Sadr in Chapters 7 and 8 respectively. We are also gratefulto our research assistant, Shahrzad Daneshvar, for her excellent work.

ix

Glossary of Arabic Terms

ahadith Plural of hadith (for meaning, see hadith).ahkam Plural of hukm (for meaning, see hukm).ajr-un-kareem A generous reward.al-adl Justice.al-ghurm bil

ghunmThe principle that one is entitled to a gain only

if one agrees to bear the responsibility for theloss. For example, if someone gives finance tosomeone else, he is only entitled to a share inthe profit resulting from the use of thatfinance if he is also prepared to bear anyresultant loss.

al-kharaj bildaman

The principle in Islamic jurisprudence thatentitlement to return or yield (al-kharaj) isfor the one who bears the liability (daman)for something, say an asset, and one whodoes not bear the liability has no claim to theyield.

al mal Wealth, property.al-mu’minun Those who believe through the heart.amanah Trust.awqaf Plural of waqf (for meaning, see waqf ).ayah A verse of the Qur’an.bay’ Stands for ‘‘sale.’’ It is often used as a prefix in

referring to different sales-based modes ofIslamic finance, such as murabahah, istisna’,and salam.

bay’ al-’ayan Sale of tangible objects such as goods (asopposed to sale of services or rights).

bay’ al-dayn Sale of debt. According to a large majority offuqaha’, debt cannot be sold for money,except at its face value, but can be sold forgoods and services.

bay’ al-kali bilkali

A sale in which both the delivery of the objectof sale and the payment of its price aredelayed. It is similar to a modern forwardsale contract.

xi

xii Glossary of Arabic Terms

bay’ al-’inah The sale of something to someone at a givenprice (usually on credit) and then the purchaseback from the buyer, at the same time, at adifferent price (usually lower but cash). Thiskind of sale and buyback is prohibited becauseit effectively means exchanging a givenamount of money with a different amount ofmoney, which amounts to riba. It can be usedas a subterfuge for riba dealings.

bay’ bithamanajil

A sales contract where payment is made ininstalments after delivery of goods. Sale couldbe for long-term and there is no obligation todisclose profit margins.

bay’ al-mudaf A sales contract in which delivery of both thecommodity and the payment is deferred—forexample forward sales in modern times.Such contracts are not permitted by theShari’ah.

bay’ al-mulamasah

A form of sale prevalent in the days of theProphet (peace be upon him) in which thesales contract was finalized by the simple actof touching the object of sale. The prophet(peace be upon him) prohibited this kind ofsale since the buying party did not have a fairchance of inspection and hence the practiceinvolved gharar.

bay’ al-munabazah

A form of sale prevalent in the days of theProphet (peace be upon him) in which thesales contract was finalized by the simple actof throwing the object of sale towards thebuying party. The prophet (peace be uponhim) prohibited this kind of sale since thebuying party did not have a fair chance ofinspection and hence the practice involvedgharar.

bay’ al-salaf An alternative term for bay’ al-salam.bay’ al-salam A sale in which payment is made in advance by

the buyer and the delivery of the goods isdeferred by the seller.

bay’ al-sifah A sale based on a detailed description of theobject of sale.

Glossary of Arabic Terms xiii

bay’ bi thamanal-’ajil

Another term used for bay’ mu’ajjal.

bay’ mu’ajjal Sale on credit, that is, a sale in which goods aredelivered immediately but payment is deferred.

bay’muzayadah

Sale by auction.

buyu’ Plural of bay’ (for meaning, see bay’).daman Guarantee, security.Dar al-Islam The world (or the abode ) of Islam.darar Damage, harm, injury.darurah Necessity. (Usually used for the ‘‘Doctrine of

Necessity,’’ whereby something otherwiseprohibited becomes temporarily permissible).

dhimmah Liability, responsibility.faqih Jurist who gives rulings on various juristic issues

in the light of the Qur’an and the sunnah.fasad Mischief, troublemaking, corruption.fatwa Religious verdict by fuqaha’.fatawi Plural of fatwa (for meaning see fatwa).fiqh Refers to the whole corpus of Islamic

jurisprudence. In contrast to conventional law,fiqh covers all aspects of life—religious,political, social, commercial, and economic.Fiqh is based primarily on interpretations ofthe Qur’an and the sunnah and secondarily onijma’ (consensus) and ijtihad (individualjudgement) by the fuqaha’. While the Qur’anand the sunnah are immutable, fiqhi verdictsmay change due to changing circumstances.

fiqhi Relating to fiqh.fuqaha’ Plural of faqih (for meaning, see faqih).gharar Literally, it means deception, danger, risk, and

uncertainty. Technically, it means exposingoneself to excessive risk and danger in abusiness transaction as a result of uncertaintyabout the price, the quality and the quantity ofthe countervalue, the date of delivery, theability of either the buyer or the seller to fulfiltheir commitment, or ambiguity in the termsof the deal—thereby, exposing either of thetwo parties to unnecessary risks.

xiv Glossary of Arabic Terms

gharar yasir A little bit of gharar. This is tolerable because itmay be unavoidable.

hadanah The right of custody of a child after the divorce.hadith Saying, deed, or endorsement of the Prophet

Muhammad (peace be upon him) narrated byhis Companions.

Hajj The pilgrimage to Mecca.halal Things or activities permitted by the Shari’ah.Hanafi A school of Islamic jurisprudence named after

Imam Abu Hanifa.Hanbali A school of Islamic jurisprudence named after

Imam Ahmed bin Hanbal.haq A right.haq al-irtifaq Literally, the right of utilization or easement.

Technically, the right to derive free benefitfrom the immovable property of someone else.The right has been recognized by the Shari’ahin the spirit of generosity that members of acommunity should display toward each other.

haram Things or activities prohibited by the Shari’ah.hawalah Literally, it means transfer. Technically, it refers

to an arrangement whereby a debtor transfersthe responsibility for payment of a debt to athird party who owes that debtor a debt. It isalso used for a cheque or draft.

hazar Danger, caution.hibah Gift.hikmah Wisdom.hilah Legal trick or device to avoid the imposition of a

law in a particular case.Hisbah Literally, it means reward or calculation.

Technically, it refers to an institution thatexisted through most of Islamic history forimplementing what is proper and preventingwhat is improper. The main role of al-hisbahwas the regulation and supervision of marketsto ensure proper market conduct by allconcerned.

hiyal Plural of hilah (for meaning, see hilah).hukm Shari’ah ruling having general applicability.’ibadat Duties of man due to God.

Glossary of Arabic Terms xv

’ibadah Worship.ibahah Permissibility from a Shari’ah point of view.ihsan Beneficence, kindness, virtue.ijarah Leasing. The sale of usufruct of an asset. The

lessor retains the ownership of the asset withall the rights and the responsibilities that gowith ownership.

ijarahmuntahiyyahbil-tamlik

Lease ending in ownership.

ijma’ A consensus (of fuqaha’). Ijma’ is one of thesources of Islamic Law.

ijma’ al-nas General consensus of ‘‘ulama.’’ijma’ sukuti Tacit consensus (of fuqaha’), that is, an opinion

carried without any contest from any knownscholar.

ijma’ qawli Consensus expressed verbally.ijtihad In technical terms, it refers to the endeavor of a

jurist to derive a rule or reach a judgementbased on evidence found in the Islamic sourcesof law, predominantly, the Qur’an and thesunnah.

ikrah hukmi An ‘‘unpleasant ruling.”’illah Reason or characteristic behind a Shari’ah ruling

such that if a particular reason orcharacteristic is found in other instances, thesame ruling will apply.

ilm Knowledge.imama Spiritual and temporal leadership.iman Belief through the heart in addition to oral

profession of faith.infaq Spending. In the literature of Islamic economics,

it usually refers to spending in the way ofAllah (swt).

iqtisad It refers to Islamic approach to economicproblems.

irfaq An act of benevolence or charity for seeking thepleasure of Allah (swt).

irshad Providing moral guidance.israf Extravagance or excessiveness (especially in

expenditure).

xvi Glossary of Arabic Terms

istihsan It refers to the departure from a ruling in aparticular situation in favor of another ruling,which brings about ease. This is done bytaking a lenient view of an act which would beconsidered a ‘‘violation’’ on a stricterinterpretation of the action based on earlierqiyas.

istislah An unprecedented judgement within the overallShari’ah framework though not havingexplicit support from the Qur’an or sunnah.Motivated by broader public interest, istislahis accepted as a source of Islamic Law.

istisna’ (shortform for bay’al-istisna’)

Refers to a contract whereby a manufacturer(contractor) agrees to produce (build) anddeliver a well-described product (or premise)at a given price on a given date in the future.In istisna’ as opposed to salam, the price neednot be paid in advance. It may be paid ininstalments in step with the preferences of theparties or partly at the front end and thebalance later on as agreed.

ithm A sinful act.jahl Ignorance, lack of knowledge. In contracts, it

refers to lack of information on the subject, orthe terms and conditions, of the contract.

jihad Striving to better oneself spiritually. One specificapplication is participation in defense of one’sfaith against aggression.

jizyah A levy on those who prefer to keep their ownfaith in lieu of zakat which all Muslims arerequired to pay.

ju’alah Performing a given task for a prescribed fee in agiven period.

kafalah A contract whereby a person guarantees, ortakes responsibility for, a liability or duty ofanother person.

kafil Guarantor.karahiyyah Dislike, aversion. In Shari’ah terms, something

that is not completely prohibited but isabhorred.

kharaj A levy on land use.

Glossary of Arabic Terms xvii

khilafa Vice-regency.khiyanah Breach of faith, cheating, deception.khiyar Option.khiyar al-’ayb Option to rescind a sales contract if a defect is

discovered in the object of sale.khiyar

al-ru’yahOption to rescind a sales contract after physical

inspection of the object of sale.khiyar al-shart The option to rescind a sales contract based on

certain conditions. One of the parties to a salescontract may stipulate specific conditions,which, if not met, would grant the stipulatingparty the option to rescind the contract.

khula’ A divorce in return for either the husbandforegoing the dower of the wife or a monetarycompensation by the wife to the husband.

khums A 20 percent levy on net annual income.maad The event of ‘‘end-of-time return,’’ indicating the

‘‘day of reckoning,’’ the time when all standbefore their Creator to be judged.

mafasid Plural for mafsadah (for meaning, see mafsadah).mafsadah Anything declared harmful by the Shari’ah or

anything hampering the achievement of themaqasid al-Shari’ah.

makrooh Abominable. In Shari’ah terms, something that isnot completely prohibited but is abhorred.

mal Asset, property.Maliki A school of Islamic jurisprudence named after

Imam Malik.manfa’ ah Usufruct. Benefit flowing from a durable

commodity or asset.maqasid al-

Shari’ahThe basic objectives of the Shari’ah. These are

protection of faith, life, progeny, property,and reason.

masalih Plural of maslahah (for meaning, see maslahah).masalih

mursalahPublic interest as determined in the light of the

rules of the Shari’ah.maslahah Literally, it means benefit. Technically, it refers

to any action taken to protect any one of thefive basic objectives of the Shari’ah, that is,protection of faith, life, progeny, property,and reason.

xviii Glossary of Arabic Terms

maysir Literally, it refers to an ancient Arabian game ofchance with arrows used for stakes ofslaughtered animals. Technically, gambling orany game of chance.

milkiyyah Ownership.mu’ amalat Relationships or contracts among human beings

as against ’ibadat which define the relationshipbetween God and His creatures.

mudarabah A contract between two parties—a capital owneror financier (rabb al-mal) and an investmentmanager (mudarib). Profit is distributedbetween the two parties in accordance withthe ratio upon which they agree at the time ofthe contract. Financial loss is borne only bythe financier. The investment manager’s losslies in not getting any reward for his services.

mudarib An investment manager in a mudarabahcontract.

muhtasib Ombudsperson.mujtahid A religious scholar qualified to give

Shari’ah rulings.mukhatarah Risk.muqaradah Carries the same meaning as mudarabah.murabahah Sale at a specified profit margin. This term,

however, is now used to refer to a saleagreement whereby the seller purchases thegoods desired by the buyer and sells them atan agreed marked-up price, the payment beingsettled within an agreed time frame, either ininstalments or as a lump sum. The seller bearsthe risk for the goods until they have beendelivered to the buyer. Murabahah is alsoreferred to as bay’ mu’ajjal.

musharakah Partnership. A musharakah contract is similar toa mudarabah contract, the difference beingthat in the former both the partnersparticipate in the management and theprovision of capital and share in the profit andloss. Profits are distributed between thepartners in accordance with the ratios initiallyset, whereas loss is distributed in proportionto each one’s share in the capital.

Glossary of Arabic Terms xix

muzara’ah A contract whereby one party agrees to till theland owned by the other party for an agreedshare in the produce of the land.

nafaqah Allowance.nafaqat Plural of nafaqah, (for meaning, see nafaqah).nafs The inner, primordial self.Najash In reference to a sales contract, it means

contriving with the seller and bidding a higherprice, not with an intention to buy but simplyto fetch a higher price from other potentialbuyers.

nas Text from the Qur’an or sunnah.nisab With reference to Zakah, the limit of wealth that

marks the beginning of the imposition ofZakah liability. Wealth below this limit isexempt.

niyyah Intention.nubuwwah Prophethood.qabd Possession.qadar Provision of exact measure by the Creator of

what His creation needs, individually andcollectively, for the life on this plane ofexistence.

qadi Judge.qard-ul-hassan

(short formqard)

A loan extended without interest or any othercompensation from the borrower. The lenderexpects a reward only from God.

qasada The term refers to the concept of ‘‘the goldenmean.’’

qimar Gambling.qirad See mudarabah.qiyas Derivation and application of a rule or law on

the analogy of another rule or law if the basis(’illah) of the two is the same. It is one of thesecondary sources of Islamic Law.

qur’an (alsowritten asal-qur’an)

The Holy Book of Muslims, consisting of therevelations made by God to the ProphetMuhammad (peace be upon him). The Qur’anlays down the fundamentals of the Islamicfaith, including beliefs and all aspects of theIslamic way of life.

xx Glossary of Arabic Terms

qurud hasanah Plural of qard ul-hassan (for meaning, see qardul-hassan).

rabb al-mal Capital owner (financier) in amudarabah contract.

riba Literally, it means increase, addition or growth.Technically, it refers to the ‘‘premium’’ thatmust be paid by the borrower to the lenderalong with the principal amount as acondition for the loan or an extension in itsmaturity. Interest, as commonly understoodtoday, is regarded by a predominant majorityof fuqaha’ to be equivalent to riba.

riba al-fadl Riba pertaining to trade contracts. It refers to theexchange of different quantities or qualities ofthe same commodity. As defined by theShari’ah, there are particular commodities forwhich such exchanges are not allowed.Different schools of fiqh apply this prohibitionto different commodities.

riba al-nasa’ Riba pertaining to loan contracts.sadaqah An act of charity.sadaqat Plural of sadaqah (for meaning, see sadaqah).sadaqah jariyah An act of charity with perennial benefits.sadd al-zara’i Prohibition of a deed which, if permitted, may

lead to another prohibited deed.salaf The short form of bay’ al-salaf.salah A verbal noun referring to the best course of

action in accordance with the behavioral rulesof Islam.

salam The short form of bay’ al-salam.sarf Currency exchange.Shaf’i A school of Islamic jurisprudence named after

Imam Shaf’i.Shari’ah Refers to the corpus of Islamic law based on

Divine guidance, as given by the Qur’an andthe sunnah, and embodies all aspects of theIslamic faith, including beliefs and practices.

sharikat tawzifal-amwal

A partnership with assigned property delegation.

shirakah Partnership. Technically, it is equivalent tomusharakah.

Glossary of Arabic Terms xxi

shuf’ah Right of preemption.shura Islamic institution of consultation in the process

of decision-making.subhanahu

wa-ta’alaDeviotional phrase appearing after the mention

of Allah’ meaning ‘‘glorious and exatted isHe.’’ Often abbreviated to swt.

sukuk al-ijarah(short formsukuk)

A negotiable financial instrument issued on thebasis of an asset to be leased. The investorsprovide funds to a lessor (say an Islamic bank).The lessor acquires an asset (either existing orto be created in future) and leases it out if it isnot already leased out. Sukuk al-ijarah areissued by the lessor in favour of the investors,who become owners of the leased asset inproportion to their investment. These sukukentitle the holders to collect rental paymentsfrom the lessee directly. Sukuk can also bemade tradable in the stock exchange.

sukuk al-salam A negotiable instrument issued on the basis of asalam contract. A salam sale creates an in-kinddebt payable on a future date. Sukuk al-salamrepresent common shares in that debt. Tradingsalam debt for money is controversial amongIslamic scholars.

sunnah The sunnah is the second most important sourceof the Islamic faith after the Qur’an and refersto the Prophet’s (peace be upon him) exampleas indicated by his practice of the faith. Theonly way to know the sunnah is through thecollection of ahadith, which consist of reportsabout the sayings, deeds, and endorsements ofthe Prophet (peace be upon him).

surah A chapter of Qur’an.swt Abbreviation of subhanahu wa-tasla.ta’am Eatables.ta’awun Cooperation (for good).tabarru’at Actions or contracts, the purpose of which is not

commercial but is seeking the pleasure ofAllah (swt).

tabdhir Unreasonable (impermissible) and wastefulexpenditure.

xxii Glossary of Arabic Terms

tafseer Interpretation of the Qur’an.takaful An alternative to the contemporary insurance

contract. A group of persons agree to share acertain risk (for example, damage by fire) bycollecting a specified sum from each. In thecase of loss to any of the group, the loss is metfrom the collected funds.

takhrij Deducing rules of fiqh from existing and variedsources, that is, from various schools ofthought.

tamwil Financing.tandid Liquidation.taqwa Ever-present consciousness of the presence of

Allah (swt).tawakkul Trust in God for results after one has undertaken

all necessary effort. It is one of the importantvalues for Muslims. After making all necessaryefforts, a Muslim believes that the results arein the hand of God.

tawarruq Reverse Murabaha. Buying an item on credit ona deferred payment basis and thenimmediately reselling it for cash at discountedprice to a third party.

tawhid Belief in the unity of God, both in terms of theperson as well as in His attributes.

‘ulama’ Scholars.Ummah The nation of Muslims.’urf Established usage, custom. ’Urf is one of the

sources of Islamic law as long as it does notcontradict the basic sources, the Qur’an andsunnah.

ushr Referring to the law of Zakah, it means a rate of10 percent leviable on certain types of wealth,output, or income.

usul Principles, basics.wa’d A time-bound promise to deliver on terms

contracted.

Glossary of Arabic Terms xxiii

wadi’ ah A contract whereby a person leaves valuableswith someone for safekeeping. The keeper cancharge a fee, even though Islamic cultureencourages this service to be provided fornothing, or to recover only the costs ofsafekeeping without any profit.

wa’id Warning.wakalah Contract of agency. In this contract, one person

appoints someone else to perform a certaintask on his behalf, usually for a fixed fee.

waqf Appropriation or tying up a property inperpetuity for specific purposes. No propertyrights can be exercised over the corpus. Onlythe usufruct is applied towards the objectives(usually charitable) of the waqf.

Zahiri A school of Islamic jurisprudence.Zakah The amount payable by a Muslim, on his net

worth, as a part of his religious obligations,mainly for the benefit of the poor and theneedy. It is an obligatory duty on every adultMuslim who owns more than a thresholdwealth.

zanni Based on conjecture.zulm Injustice, encroaching upon the rights of anyone

else.

Source: Islamic Research and Training Institute (IRTI), Jeddah,Saudi Arabia.

CHAPTER 1The Development and Progress

of Islamic Finance

I slamic finance has emerged on the international financial landscapein a relatively short time. From a humble beginning in the 1960s,

the concept was put into practice in the 1970s when the first commer-cial Islamic bank, Dubai Islamic Bank, was launched, followed by theestablishment of the Jeddah-based multilateral development institu-tion, the Islamic Development Bank, in 1975. Since then, the Islamicfinancial industry has enjoyed consistently high growth (10–15 per-cent annually) and continues to grow rapidly. There are now morethan 300 institutions in more than 65 countries engaged in some formof Islamic finance, and, according to some conservative estimates,total assets classified as Islamic exceed US$600 billion.

Islamic finance is a relatively new term which denotes engagingin financial and business transactions according to the principles ofIslamic Law—Shari’ah.1 The most critical and distinguishing featureof such a system is the prohibition of riba, which includes the paymentand receipt of interest as understood in today’s financial markets.The most significant implication of this prohibition is the removalof pure ‘‘debt-based’’ contracts from the financial transactions. Inmodern history, interest in conducting Shari’ah-compliant businessrose with the first sign of expansion of conventional ‘‘interest-based’’commercial banking into the Arab and Muslim world. As earlyas the late nineteenth century, a formal critique and opposition tothe element of ‘‘interest’’ started in Egypt when Barclays Bank wasestablished in Cairo to raise funds for the construction of the SuezCanal. Further, a formal opposition to the institution of ‘‘interest’’ canbe found as early as 1903 when the payment of interest on post officesaving funds was declared contrary to Islamic values and, therefore,illegal by Shari’ah scholars in Egypt.

During the first half of the twentieth century, there were severalattempts to highlight the differences between the emerging conven-

1

2 New Issues in Islamic Finance and Economics

tional financial system and the areas where it conflicted with Islamicvalues. By the 1950s and 1960s, several Muslim countries began togain freedom from years of colonialism, and with this newly foundfreedom there were attempts to rediscover Islamic values and heritage.By 1953, Islamic economists had offered the first description of aninterest-free bank. By the start of the 1960s, there was substantialdemand for Shari’ah-compliant banking, resulting in the establish-ment of the Mit Ghamr Local Savings Bank in Egypt in 1963 bythe noted social activist Ahmad-al-Najjar. It is worth noting thatDr. Najjar chose not to label this institution as an ‘‘Islamic bank’’but promoted it as a social welfare institution.2 Unfortunately, thisexperiment lasted for only four years. In the same year, there wereparallel efforts in Malaysia to develop a saving scheme for Muslimsto perform Pilgrimage.

The establishment of the Dubai Islamic Bank by some tradersin 1974 is considered to be one of the earliest private initiativesin the United Arab Emirates. The 1970s witnessed a rise in theprice of oil, leading to rising oil revenues and financial assets inseveral oil-rich Muslim countries, especially in the Middle East. Theoil revenues of the 1970s, sometimes referred to as ‘‘petrodollars,’’offered strong incentives for creating suitable investment outlets forMuslims wanting to comply with the Shari’ah. Interest-free or Islamicbanking, which was only a conceptual idea by the early 1970s, wasgiven a strong business foundation. Both domestic and internationalbankers, including some of the leading conventional banks in theworld, exploited this business opportunity.

In 1975, the Islamic Development Bank (IDB) was established,along the lines of other regional development institutions, with theobjective of promoting economic development in Muslim countriesas well as offering development finance according to the rules ofthe Shari’ah. Since its inception, the IDB has played a key role inexpanding Islamic modes of financing and in undertaking valuableresearch in the area of Islamic economics, finance, and banking. The1980s proved to be the beginning of a trend of rapid growth andexpansion for the emerging Islamic financial services industry. Themajor developments of the 1980s included the continuation of seri-ous research on the conceptual and theoretical level, constitutionalprotection in three Muslim countries, and the involvement of con-ventional bankers in offering Shari’ah-compliant services. The IslamicRepublics of Iran, Pakistan, and Sudan announced that they wouldtransform their overall financial systems to make them compliant with

The Development and Progress of Islamic Finance 3

the Shari’ah. Other countries, such as Malaysia and Bahrain, startedIslamic banking within the framework of their existing systems. TheInternational Monetary Fund (IMF) initiated research into under-standing the macroeconomic implications of an economic systemoperating without the basis of interest. Similar research was conductedto understand the issues of profit–loss sharing contracts and thefinancial stability of a system based on the sharing of profit and loss.

During the early stages of Islamic financial market growth in the1980s, Islamic banks faced a dearth of quality investment opportu-nities. This created business opportunities for conventional Westernbanks to act as intermediaries to deploy Islamic banks’ funds accord-ing to the guidelines given by the Islamic banks. Western banksrealized the importance of the emerging Islamic financial marketsand started to offer Islamic products through ‘‘Islamic windows’’in an attempt to attract clients directly, without having an Islamicbank as intermediary. The number of conventional banks offeringIslamic windows grew, and several leading conventional banks, suchas the Hong Kong and Shanghai Banking Corporation (HSBC) andCitibank, began to pursue this market aggressively.

By the early 1990s, the market had gained enough momentum toattract the attention of public policymakers and of institutions inter-ested in introducing innovative products. Citibank is one of the firstWestern banks to have established a separate Islamic bank—CitiIslamic Investment Bank (Bahrain) in 1996. HSBC has a well-established network of banks in the Muslim world. With the objectiveof promoting Islamic asset securitization and private equity and bank-ing in OECD countries, HSBC Global Islamic Finance (GIF) waslaunched in 1998. With the growth of Islamic products and services,the need for regulation and standards increased, resulting in the estab-lishment of a self-regulatory agency—the Accounting and AuditingOrganization for Islamic Financial Institutions (AAOIFI)—in Bahrainwhich has played an important role in promoting growth.

1.1 R E C E N T D E V E L O P M E N T S

By the late 1990s and early 2000s, Islamic finance began to catchattention at international level and more and more countries beganto embrace the concept that a system without interest (debt) isworkable. This recognition can be attributed to two major factors.First, during its history of more than 30 years, no major Islamicbank failed; on the contrary, these banks proved to be as efficient

4 New Issues in Islamic Finance and Economics

and profitable as their conventional counterparts. There were cases ofbank failures but those failures were caused by, and attributed to, badgovernance and lack of risk management. In none of the failed bankswas the issue of Islamic financial products or the design of financialintermediation questioned. This success of 30 years gave confidenceand trust to customers and removed the doubts of skeptics. Second,the advancement of financial theory, in both conventional and Islamicliterature, in the area of portfolio theory and the understanding offinancial intermediation has been supportive. Such advancement intheory showed that a system without interest can be designed, and,under certain conditions, such systems may prove to exhibit morestability than the conventional system.3

As the science of financial engineering developed, its application inIslamic finance also led to innovation. The first wave of innovationcame in the form of Islamic funds where portfolios of commodities,equities, Islamic leases, and other Islamic products were established.In the case of equities, special screening and filters were developed tocomply with Shari’ah, and research showed that application of suchscreens or filters does not impact on the benefit of diversification. Theother significant breakthrough came in the form of sukuk (Islamicbonds), where pools of Shari’ah-compliant financial instruments aresecuritized in the form of a fixed-income security. The issuers ofsukuk include both sovereign and corporate entities, and the successof sukuk is evident by the high growth this market has enjoyed. Sukukhave also proved to be a bridge between Islamic and conventionalmarkets and have led to the gradual development of capital markets,as discussed in the following section. As demand for infrastructureincreased in the region, innovative structures to finance infrastructureprojects were introduced. The years 2006 and 2007 proved to bethe most active for the project finance market in the Middle East,attracting Western banks and law firms to structure Islamic tranchesfor major energy, infrastructure, and real estate projects.

Another noticeable development is the awareness of Islamic financein non-Muslim countries and acceptance of Islamic products at majorfinancial centers in the West. Leading Western financial intermedi-aries were engaged in Islamic transactions from the early stages,and the majority of the deals were done discretely; but by the mid-2000s, competition increased and both Islamic and conventionalfinancial institutions began to position themselves aggressively tocapture market share. Islamic finance gained attention in academiccircles as well. Many well-regarded academic institutions—including

The Development and Progress of Islamic Finance 5

Harvard University (United States), Durham University (United King-dom), and Loughborough University (United Kingdom)—organizedseminars and conferences, and offered degree programs and cer-tifications. During this decade, major publishing houses, such asEuromoney, John Wiley, and Edward Elgar, began to commissioncommercial and academic books on the subject.

More recently, there has been another wave of interest in Islamicfinance. Similar to the surge of 1970s, the recent surge has been stim-ulated by increased oil revenues in the Middle East. Whereas duringthe 1970s interest in Islamic finance was limited to the high-net-worth class, current growth is the result of demand by much widergroups, including small investors and retail consumers. Several coun-tries where Islamic finance was dormant are experiencing a suddensurge in demand for Shari’ah-compliant products. One example isSaudi Arabia, where, for a long time, there was skepticism of Islamicfinance and no encouragement for its growth, but it has suddenly seenincreasing public pressure to embrace Islamic finance. For example,Saudi Arabia’s largest bank, National Commercial Bank, has con-verted its entire branch network to Shari’ah principles. Saudi Arabiahas also issued three new licenses for takaful (Islamic insurance)companies.4

Both Bahrain and Malaysia have taken an active role in the devel-opment of Islamic finance and made serious efforts to establish worldclass financial centers to promote Islamic finance. The governmentof Malaysia has developed this industry, using a phased approachand this can be used as a roadmap for others who are interested indeveloping this sector.5 The Islamic Banking Act was enacted in 1983,which led to the establishment of the first Islamic Bank—Bank IslamMalaysia Berhard—in the same year Shari’ah-compatible investmentcertificates were introduced to supplement the liquidity needs of theIslamic banking sector. In the second phase, three conventional bankswere allowed to open Islamic windows. In January 1994, Bank NegaraMalaysia established the Islamic Interbank Money Market to allowIslamic institutions to adjust their portfolios according to their short-term financing needs. In the third phase, some conventional banks,with a sufficient critical mass of Islamic customers, transitioned tofull-fledged Islamic banks in the late 1990s. Finally, the governmentbegan to promote development of Islamic capital markets, Islamicinsurance businesses, and other supporting institutions.

There is no formal or systematic source of statistics on Islamicfinance but several estimates are often quoted by different commercial