The islamic financial system

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Dr. M. Umer Chapra

for the Muslim Almanac

All major religions, including Hinduism, Judaism, Christianity and Islam, have prohibited interested. This raises two questions. The first question is whether an interest-free financial system has ever been established and how effective it was in mobilizing and utilizing savings, the primary objective of a financial system. The second question is that, even if the system was successful then, can it be workable now when the international financial environment is significantly different from what prevailed during the heyday of Muslim civilization.

The answer to the first question is that from the very early stage in Islamic history, Muslims were able to establish an interest-free financial system in conformity with the teachings of the Shari‘ah. The system was based primarily on the profit-and-loss sharing (PLS) modes of mudarabah (commenda) and musharakah (partnership). It worked quite effectively not only during the heyday of Islamic civilization but also for centuries thereafter. It was able to mobilize the “entire reservoir of monetary resources of the medieval Islamic world” for financing agriculture, crafts, manufacturing and long-distance trade. The system was used not only by Muslims but also by Jews and Christians to the extent that interest-bearing loans and other usurious practices were not in common use (Udovitch, 1970, p. 257; see also p. 268)

Bankers were known in early Muslim history as sarrāfs or sayārifah. By the time of the Abbasid caliph al-Muqtadir (295-320AH/908-932AC), they had started performing most of the basic functions of modern banks (Fischel, 1992). They had their own markets, something akin to the Wall Street in New York and the Lombard Street in London, and fulfilled all the banking needs of commerce, industry and agriculture within the constraints of the then-prevailing technological environment (Duri, 1986, p. 898).

The ability to mobilize financial resources, along with a combination of several economic and political factors, provided a great boost to trade which flourished from Morocco and Spain in the West, to India and China in the East, Central Asia in the North, and Africa in the South. The extension of Islamic trade influence is indicated not only by the available historical documents but also by the Muslim coins of the seventh to the eleventh centuries found through excavations in countries like Russia, Finland, Sweden, Norway, the British Isles and Scotland, which were on the outskirts of the then-Muslim world (Kramers, 1952, p. 100; see also pp. 101-106).

Due to a number of socio-political and historical circumstances the Muslim world lost its position of leadership in the economic, political, educational and technological fields and a number of Islamic institutions, including the Islamic financial system, got displaced by Western institutions, some of which are in clear conflict with Islamic teachings (see Chapra, 2000, pp. 173-252). However, the independence of Muslim countries from foreign domination around the middle of the 20th century has led to the revival of Islam and an effort is being made to reinstate most of the lost institutions, the Islamic financial system being one of them.

This brings us to the second question of whether Islamic finance is workable now in an environment which is significantly different from what prevailed during the heyday of Muslim civilization. Economies have become more complex and the financial system cannot be a replica of the past. Therefore, even though the PLS modes continue to be emphasized, the debt-creating sales-based modes of murabahah,i ijarah, (leasing), salamii and istisnaiii are currently playing a more important role. This is because the institutional infrastructure necessary for movement into the PLS modes has not yet become available. As compared with the PLS modes, the rate of return in the sales-based modes gets fixed in advance. Nevertheless, there is a difference between these modes and pure lending and borrowing on interest. They are not only asset-based but also require the financier to share in the risk at least to some extent.

The impression that one gets from the rapid expansion of the system so far is that the system has been working successfully and is capable of handling all the financial needs of both the public and private sectors. According to a rough estimate there are more than 250 Islamic banks around the word, of which one is even in the U.K. In addition, a number of conventional banks, including some major multinational western banks, have opened either branches or windows to offer Islamic financial services. All these together have assets close to $500 billion. The prospects for the future are even brighter because, in spite of the rapid expansion of the system, only a small part of the potential market has been tapped so far. While in the 1950s and the 1960s Islamic banking was only an academic dream, it has now become a reality. It has also attracted the attention of Western central banks like the Federal Reserve and the Bank of England, international financial institutions like the IMF and the World Bank, and prestigious centres of learning like Harvard University and the London School of Economics.

Nevertheless, the system is still in its infancy. When it comes of age with the passage of time, it may be able to not only accelerate development in the Muslim world but also exert a healthy influence on the international financial system which has been experiencing a great deal of instability over the last three decades. It may be difficult to overcome this instability without injecting greater discipline into the financial system. The prohibition of interest by the major religions can be helpful in this task. The assured positive rate of return on deposits and loans that the rate of interest involves stands in the ways of ensuring such discipline.

Prohibition of interest will make the investment depositors as well as the bankers share in the risks of banking business. The depositors will, therefore, tend to take a serious interest in the affairs of the bank and demand greater transparency and more effective management. The bankers will also be under pressure to evaluate the loan applications more rigorously than what they tend to do when they do not have to participate in the risk. Even the debt-creating Islamic modes of finance, which are linked to the purchase and sale of real goods and services, will help make credit expand in step with the growth of the real economy. The excessive expansion of credit, particularly that for speculation in the stock, foreign exchange and commodity markets which accentuates instability in the financial system, will thus be substantially reduced.
Dr. M. Umer Chapra

Formerly Senior Economic Advisor

to the Saudi Arabian Monetary Agency, Riyadh

now Research Advisor to the

Islamic Research & Training Institute

of the Islamic Development Bank, Jeddah


i Murabahah (also called bay‘ mu’ajjal) refers to a sales agreement whereby the seller purchases the goods desired by the buyer and sells them at an agreed marked-up price, the payment being settled within a specified time frame, either in instalments or lump sum. The seller bears the risk for the goods until they have been delivered to the buyer.

ii Salam refers to a sales agreement whereby full payment is made in advance against an obligation to deliver the specified fungible goods at an agreed future date. This is not the same as speculative forward sale because full, and not margin, payment is required. Under this arrangement the seller, say a farmer, may be able to secure the needed financing by making an advance sale of only a part of his expected output. This may not get him into delivery problems in case of a fall in output due to unforeseen circumstances

iii Istishnā‘ refers to a sales agreement whereby a manufacturer (contractor) agrees to produce (build) and deliver a certain good (or premise) at a given price on a given date in the future. This, like salam, is an exception to the general Shari‘ah ruling which does not allow a person to sell what he does not own and possess. However, unlike salam the price need not be paid in advance. It may be paid in agreed instalments, or partly at the front-end and the balance later on as agreed.

  1. Chapra, M. Umer (2000), The Future of Economics: An Islamic Perspective (Leicester: The Islamic Foundation).

  2. Duri A.A. (1986), “Baghdad”, The Encyclopedia of Islam (Leiden, E.S. Brill), Vol.1, pp.894-909.

  3. Fischel, W.J., (1992), “Djahbadh,” in the Encyclopedia of Islam, Vol. 2, pp.382-3.

  4. Kramers, J.H., (1952), “Geography and Commerce”, in T. Arnold and A. Guillaume (eds.), The Legacy of Islam (London: Oxford University Press).

  5. Udovitch, Abraham, (1970), Partnership and Profit in Early Islam (Princeton, N.J.: Princeton University Press).

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