Guest Editor's Introduction to Thunderbird International Business Review, Special Issue on Islamic Banking, July 1999.
By Clement M. Henry
As a political scientist who has studied the Middle East and North Africa over four decades, I am saddened by the growing polarization between popular Islamist oppositions and incumbent regimes. The Algerian tragedy is the most striking illustration of this trend. Most opposition movements in the Arab-Islamic world have acquired an Islamist veneer, and most governments keep suppressing them while attempting to appropriate their rhetoric of cultural reassertion. Arab societies thus undergo some cosmetics of re-Islamization, but the repressive political orders stay in place. Segments of the middle classes, notably their ethnic, religious, and secularized minorities, are blackmailed into submission for fear of the alternative. American diplomacy makes matters worse. Bombing Iraq, for instance, weakens pro-Western governments, caught between their international commitments and the need to placate domestic public opinion, and radicalizes Islamist oppositions.
The best that a sympathetic academic outsider can do is to attempt to demystify "Islamism" and to examine possible bases of coexistence between the Islamists and their secular Muslim as well as Western counterparts. The term "Islamism" denotes an ideology calling on society fully to conform to the Shari'ah, the divine law of Islam. There is little agreement in the Muslim world, however, on the specifics of an Islamic political and social order. Islamism is a work in progress, expressed in a variety of movements and social projects. One of its most dynamic manifestations is Islamic banking and finance, an area of growing interest to the international business community. Islamic banking has its own distinctive logic but also displays constructive patterns of coexistence with "conventional" Western banking systems. I was accordingly delighted to accept Yahia Zoubir's kind invitation to be the guest editor of this special issue of the Thunderbird International Business Review devoted to the subject. The assignment offered me the opportunity to build on my previous research (Henry 1996) and to acquire valuable new insights from a distinguished set of contributors across much of the world. I thank them for their patience responding via the Internet to my many questions. I also wish to thank our Review Board for its professional opinions and advice. The Board refereed the manuscripts although I take full responsibility for the final editorial decisions. I also also grateful to Mohammed Malley, a PhD candidate in the Government Department of the University of Texas at Austin, for his editorial assistance and to Suzy Howell, of Thunderbird University, for her logistic help and encouragment.
The recent work of Vogel and Hayes (1998) also deserves mention at the outset, because it helped me better to understand the parameters of Islamic finance. The very fact that two Harvard professors have devoted a full length study, published in a mainstream legal publishing outlet, to Islamic finance and banking also gives the subject greater credibility in professional circles inside and outside the Muslim world. Their work demonstrates the strengths and weaknesses but above all the seriousness of the Muslim financial endeavor. Legal innovators and financial engineers are attempting to demonstrate that Islam, properly understood, presents a viable alternative to conventional western financial practices for managing the modern global economy. Some of the more ambitious pioneers of Islamic finance may be looking even further: if Islam offers a viable set of contemporary financial and commercial practices, then may it not after all provide an appropriate basis for political and social order as well? Islamic finance at least brings Islam out of the colonial closet of personal status and family affairs into the public domain. As our contributors amply demonstrate, it has become the most dynamic and innovative area of Islamic jurisprudence. The present volume bears testimony to its promise.
Yet many westernized Muslims as well as other Middle Easterners and international observers still tend to view Islamic "interest-free" banking as a hypocritical exercise in semantics. Through marked-up prices, commissions and other subterfuges, it is often argued, Islamic bankers get their interest but call it something else. Many westernized Muslim scholars furthermore reject the conflation of riba or usury with interest and argue instead that modest fixed rates of interest are in accord with Islamic principles. At the beginning of the century Egypt's revered mufti, Muhammad Abduh, is alleged to have made a fatwah (ruling) to this effect [1], as did a successor, Shaykh Muhammad Sayyid Tantawi, in 1988 (Galloux, below, p). Abduh, however, was operating under the thumb of an informal British protectorate, and Tantawi's initiative also appears to have been politically motivated.
In fact "a near unanimity of traditionalist scholars¼ seems certain that modern bank-interest falls within the revealed prohibitions and entails a major sin, tolerable only in the throes of necessity." (Vogel and Hayes, p. 25) And, of greater interest to bankers, so also do substantial segments of Muslim populations. I know of at least one prominent Christian bank in Lebanon that grew out of a strong base in Sidon of Muslim depositors who refused to accept interest. More recently, some well known international banks hesitated to open Islamic finance windows, lest they lose their most lucrative conventional accounts – as they eventually did! (Vogel and Hayes, p. 7) Perhaps the "throes of necessity" are less compelling for affluent private Gulf Arabs than for poorer strata. We simply do not know what proportions of Muslims tolerate interest as a matter of "necessity" in the modern world, or how their attitudes might be changing. Substantial segments avoid banks altogether, and others may be ready to switch from conventional interest-based banking to a viable Islamic alternative. Market research in some countries indicates significant potential for interest-free banking (Kahf below). Other ostensibly progressive, formerly "socialist" countries like Algeria and Syria are remarkable for the substantial amounts of cash that remain outside their respective commercial banking systems [2]. Many other reasons may explain the popular distrust of conventional banking in these countries, but Algeria has cautiously permitted Islamic banking since 1988, even allowing new ones to be established after the outbreak of the Islamist insurrection in 1992.
Many states in the Muslim world, however, distrust and fear Islamic banking, either because of its alleged associations with Islamist oppositions or because of the vested interests of governing elites in existing conventional banking arrangements. Not only militantly secular regimes, like Syria or Iraq, but even Oman and Saudi Arabia "actively discourage" these new commercial banking institutions (Vogel and Hayes, p. 11; Kahf below, note 10). That Saudi Arabia should be so recalcitrant, periodically rejecting applications for banking licenses by Islam’s two principal transnational finance groups, Al-Baraka and Dar al Mal al Islami, is especially ironical in that much of the material and moral encouragement for Islamic banking comes from Saudi Arabia. The Saudi Arabian Monetary Agency (SAMA) did license Al-Rajhi, originally a local money-changing network which redefined itself as an Islamic bank, but it has consistently rejected the requests of the two Islamic banking transnationals despite their impeccable Saudi credentials. Al Baraka’s principal owner and original chief executive officer is Shaykh Saleh Kamel, a self-made Saudi businessman, and the Dar al Mal’s leader is none other Prince Muhammad Al Faysal, son of the late King Faysal.
In fact Islamic finance is a major laboratory for innovation by Islamists, who are determined by definition to remake or modernize contemporary reality by Islamizing it. It is a peculiarly fertile field for innovation precisely because it is somewhat removed from politics and hence from the political extremism associated rightly or wrongly with Islamic "fundamentalism." Inspired by Ahmad al-Najjar’s brief experience in Nasser’s Egypt, the Conference of Islamic States launched the Islamic Development Bank in 1973. Then, beginning in 1975 with the Dubai Islamic Bank, scores of private sector commercial Islamic banks opened for business and competed successfully with conventional banks, first in many Arab and then in other Muslim and even non-Muslim countries. Despite their rapid growth, however, they appear today to be stagnating. Symptomatically the Dubai Islamic Bank required a rescue package in 1998, and a number of other Islamic commercial banks show signs of stumbling. One of their basic problems is that they do not have an adequate arsenal of financial instruments with which to compete with conventional banks. I consequently encouraged financial engineers and innovative legal scholars to contribute to the present volume. Our collection includes studies of possible instruments that could give the Islamic finance movement a second wind.
As Vogel and Hayes have suggested, there are basically two possible scientific approaches to Islamic finance. One is to take the macro approach of Islamic economics and "mine the classical law corpus for fundamental Islamic principles" so as draw conclusions about interest-free economies. The other approach is to take a micro approach more in keeping with the focus of Islamic law or fiqh upon the "concrete individual actions¼ that have prime religious significance." (p. 30) Frank Vogel tactfully dismisses Islamic economics in favor of the second approach since "it is the classical law, with its micro, formal, transaction-based perspective, that most influences the practices of Islamic banking and finance." (p. 31) He further observes that attempts by Islamic economists to reduce fiqh to a few simple rules can turn out to be incorrect as statements about the classical law (pp. 44-45). Consequently mixing the two approaches can lead to confusion. Economists may retort that the findings of the conservative legal scholars ought to be rationalized; indeed, respectful outsiders may be vulnerable to charges of perpetuating an "Orientalist" opposition to Muslim progress. I tried to avoid these pitfalls by selecting a progressive legal scholar, Professor Mohammad Hashim Kamali, as well as economists like Professor Mahmoud A. El-Gamal who display a broad understanding of the legal issues at stake. Most of the contributors, quite explicitly in the case of Zamir Iqbal, steer a middle road between the reverse engineering of the economists and the lawyers bound to legal precedent.
There are four methods of elaborating fiqh and applying it to contemporary circumstances: 1) by ijtihad or new interpretation in light of the Quran and Sunna; 2) by choice (ikhtiyar) among the views already propounded by past scholars and adapted by a variety of possible criteria, including the general welfare, or maslaha, to the present circumstance; 3) by necessity (darura); and 4) by legal artifice (hila, pl. hiyal) or clever uses of law to gain legitimate ends (Vogel, pp. 34-39). Vogel notes that conservative legal scholars prefer to avoid ijtihad wherever they can justify innovations by appeals to precedent; in practice, the method of choice covers ijtihad, notably in contemporary deliberations about options, which are financial instruments critical to any effective future for Islamic finance. In the present volume Professor Kamali, while calling for ijtihad, explicitly adopts the method of choice and the criterion of the general welfare in his legal analysis of these instruments.
Some hiyal also deserve mention. One of the principal instruments of Islamic banking is murabaha, a perfectly legitimate means of financing a sale by charging markups to the current price at a future time. Islam, as the studies in the present volume amply demonstrate, accepts the time value of money but rejects making money from money. The bank financing a murabaha sale must actually buy the merchandise and then advance it to buyer. In practice, however, Islamic banks in Pakistan, Malaysia, and elsewhere have devised artificial murabaha, whereby the creditor immediately releases the merchandise to the buyer without ever really possessing it or even fully identifying it [see Rosly, below]. The Fiqh Academy of the Organization of Islamic States has condemned this practice, yet many Islamic banks engage in such hiyal and perhaps lack the commercial expertise and warehousing capabilities literally to fulfill the conditions of a "real" murabaha. The major portion of outstanding credit extended by Islamic banks takes the form of murabaha but the proportion of it that is artificial is unknown. Any systematic attack on the artifice, however, could place the entire Islamic financial movement in jeopardy. Out of necessity Islamic banks are in need of new financial instruments.
As many of our authors agree, the major impediments to the growth of Islamic banking are its liquidity problems, the limited set of financial instruments, cumbersome transactions, and no ready provisions for risk management (cf. Vogel and Hayes, p. 13). Liquidity is doubly problematic. Most commercial Islamic banks do not have a lender of last resort or a discount window at the central bank, nor may they readily find ways of investing excess liquidity, given the limited number of Islamically acceptable financial instruments. The banks do not find adequate outlets to place funds in intermediate and long-term investments without incurring excessive risks of equity financing. Consequently they are often unable to generate adequate returns for their depositors, many of whom expect the market rates offered by conventional banks. Some Islamic banks have been obliged to pay their depositors out of shareholders’ retained earnings to keep them from shifting their deposits to other banks – clearly an untenable position for banks intent on competing with conventional commercial banks. Yet their bread and butter murabahas may become ever more saddled with cumbersome procedures if they are to retain their Islamic legitimacy.
This journal issue cannot resolve these major problems, but the essays shed light upon them from a variety of disciplinary perspectives. The first four contributions are designed to introduce the reader to the challenges and opportunities Islamic finance currently faces. The next three focus on Islamic commercial banking and point to the urgent need for innovation if these banks are to survive in a world of financial deregulation and vigorous competition from conventional banks. The final five essays break new ground by proposing or evaluating new instruments in light of legal, theoretical, and empirical analysis. The essays are sequenced roughly in order of difficulty for a Western business audience wishing to learn more about Islamic finance. Thus the final essay, by an Islamic financial engineer, presupposes a sophisticated knowledge of modern financial theory as well as Islamic finance and illustrates how critical differences may be bridged. For those of us who may be uncomfortable with the mathematics, the major point is that they can be bridged, at least in the opinion of some financial analysts and legal scholars. Perhaps Islam and conventional financial theory may indeed share common building blocks within their respective edifices of financial instruments. But I am already anticipating the discussion.
First, for readers who may be unfamiliar with the controversies over usury, Professors Syed Hussain Ali Jafri and Lawrence S. Margolis give a brief historical overview of how Judaism, Christianity, and Islam confronted the issue. While convinced, unlike the muftis of Egypt, that interest is indeed riba and thus prohibited by the Shari'ah, they are not so confident of a viable alternative in the contemporary world. Zamir Iqbal and Abbas Mirakhor, by contrast, are fully committed to one. They present an overview of the progress of Islamic finance and banking to date and the challenges that lie ahead. Their essay exemplifies a seamless flow of Islamic discourse and contemporary economic theory. An impossible conflation of two distinct intellectual universes, as one outside reader opined, or testimony to revitalized Islamic reflections on the modern economy? Both writers are economists rather than Islamic legal scholars, but they are aware of the tremendous difficulties of marshaling consensus on points of law. If committed to a certain vision of Islam, they are also fully aware of the practical deficiencies of Islamic financial institutions and the fragile dimensions of their national and international markets. Their essay sets the intellectual stage for subsequent discussions of new Islamic financial instruments.
Considerable innovation is already being manifested in international financial markets. Bassel Hamwi and Anthony Aylward document some initiatives taken by the International Finance Corporation, the private sector investment arm of the World Bank, in the areas of leasing and infrastructure finance. The IFC has contributed to the development of Islamic mudaraba funds in Pakistan [further discussed by Jamshed Uppal, below], including the world's first cross-border Islamic leasing fund. Islamic finance also offers great promise for the financing of basic infrastructure, a major priority for the IFC, because such financing can be packaged in Islamically acceptable instruments which mobilize new sources of private capital. Saudi investors, for example, recently joined Chevron and other international investors in a limited recourse financing of a major petrochemical project in Jubeil. The project financing effectively integrates Islamic with Western concepts of investor security (Middle East Economic Digest, 18 September 1998, pp. 36-39).
Rodney Wilson concludes our introductory section with an analysis of Islamic banking and finance in London, which is a major Islamic as well as Western financial center and a principal source of expertise and innovation. Here a small but well placed core of international banks, including Citibank, Dresdner Kleinwort Benson, and ANZ International, offer a range of Islamic services. While mainly concentrated on trade finance, some of them have launched mutual funds - so far, with one exception, denominated in dollars - and experimented, too, with novel modes of project finance. Originally prepared for the Research and Training Institute of the Islamic Development Bank in Jeddah, Professor Wilson's paper also analyzes the potential for the growth of Islamic banking in Britain. The Saudi-based Al-Baraka Group relinquished its license to be a deposit-taking bank in 1993 rather than undergo expensive restructuring to conform to the requirements of the Bank of England. Al-Baraka continues to operate in London as an investment company, but its fate as a commercial deposit-taking bank raises the more general question of the viability of Islamic banks in regulatory contexts which favor conventional banks.
Our second set of essays focuses on this concrete set of institutions, the Islamic banks. Except in Iran, Pakistan, and the Sudan, where all banks were nationalized and Islamized, Islamic banks are predominantly private sector enterprises, and they are a genuinely novel development in Islam, dating back only to the 1960s and acquiring modest market niches in the 1970s and 1980s. Monzer Kahf analyzes their predicaments in the face of financial globalization and competition from more experienced conventional banks which mimic Islamic practices. Without major reforms the Islamic banks seem doomed to remain marginal, even as Islamic financial contracts and practices keep expanding their market shares through other intermediaries. Al-Baraka's experiences in London may have anticipated developments in other countries with preponderantly Muslim populations.
Kahf's warning is reinforced by case studies of the Malaysian and Egyptian Islamic banking experiences, presented from very different disciplinary perspectives. Saiful Rosly, a professor of finance at the Islamic University of Malaysia, argues that in his country's dual banking system the small Islamic sector is inevitably at a disadvantage when interest rates either increase or decrease. The problem is structural: an Islamic bank has less flexibility on the asset side than conventional banks, which can instantly pass on interest rate changes to many of their customers. Professor Rosly's analysis may have more general applicability because most private sector Islamic banks operate in dual systems. Malaysia's has been viewed as one of the most promising by advocates of Islamic banking because of special understandings reached between the Islamic banks and the Malaysian Central Bank. The Islamic share of the total market is in fact less than that of Egyptian, Jordanian or various Gulf countries' Islamic sectors of their respective commercial banking markets. Their respective performances in Egypt and Jordan, however, have also been disappointing in the 1990s after initial successes in the early 1980s.
Michel Galloux's study of Egypt is of particular interest because, as a political scientist, he documents the subtle political game that constrains the development of Islamic banking in this country. Not only are conventional banks more flexible than Islamic ones; for the former to co-opt Islamic banking practices may also be a state strategy to contain the Islamic competitors! In other words, complementing Kahf's analysis, Galloux argues that the Islamic banks face increasing political as well as technical challenges as confrontation intensifies between the regime and Islamist opposition forces. Governments also try to contain and control Islamic banking in a number of other Arab countries and Turkey, where Islamic banks also coexist in competition with conventional banks.
Yet the regimes are obliged to tolerate Islamic banks, like other manifestations of Islam, to defend their own legitimacy in the eyes of public opinion. Most governments thus allow some modest spaces for continued experimentation, and international banks enliven the competition with Islamic banks within these spaces. Whether the Islamic ones can take advantage of their opportunities should be of interest to international businesses seeking new sources of funds. The governments of most Muslim countries, despite their fears of Islamic banks, may wish to escape any blame for their failure. In theory it may be possible for Islamic financial institutions to devise new contracts acceptable to Islamic legal authorities which make Islamic finance more competitive in international markets while complementing conventional finance.
The third section of essays discusses possible financial innovations. Like Vogel and Hayes, the contributors to the present volume seek "not to turn Islamic finance into its conventional equivalent" (Vogel and Hayes, p 236) but rather to equip Islamic financiers to compete more effectively with their conventional counterparts. The struggle for competitive advantage does not entail mimicking the adversary’s techniques but rather discovering functional equivalents within one’s own arsenal of legal traditions. Opening our discussion, Professor El-Gamal argues in fact that the central banks of Muslim countries would do better to mimic the practices of their Islamic banks if they intend to regulate the money supply through open market operations.
The issue he raises of Islamic T-Bills is of critical importance not only for monetary policy but also for the Islamic banks, always in need of safe havens for parking their excess liquidity. Familiar with Islamic law as well as modern economics, however, Professor El-Gamal highlights the major constraint on any innovations in Islamic finance. There simply is no consensus as to what is or is not permitted in Islamic jurisprudence. He presents the full spectrum of legal arguments and country practices: "virtually all existing government securities are acceptable to some [Islamic banks] and not to others," depending upon the legal interpretations of their respective Shari'ah boards. He examines three sets of practices, the Malaysian Model, the state models of Pakistan and Iran, and the Arab Islamic Model. However, while the Malaysian Model has accommodated Islamic banks in a dual system of Islamic and conventional banks, it is by no means evident that Malaysian practices would prove Islamically acceptable in Arab countries. There is no generally accepted Islamic formula for a relatively risk-free government security.
Another standard building block of modern conventional finance is the option, a right without obligation to buy or sell something at a future date at a specified price. From Malaysia Professor Mohammad Hashim Kamali presents a provocative legal defense for various sorts of Islamic derivatives based on futures markets for commodities. Much in his argument depends upon the institutional capacity of the market to control the elements of gharar or speculation inherent in a derivatives market. Professor Kamali displays a remarkably sophisticated appreciation of modern finance that is perhaps not yet shared by most "traditional" legal scholars. As the bankers and economists broaden the legal community's understanding of finance, however, interpretations along his lines may crystallize a new consensus concerning Islamic derivatives. Islamic finance could acquire considerable flexibility and develop along lines being suggested by some of our other contributors.
Zamir Iqbal exercises his financial engineering skills upon existing types of Islamically acceptable contracts in efforts to securitize assets and deepen markets in Islamic derivatives. Like Vogel and Hayes, he finds the mudaraba to be a convenient vehicle for securitizing leases and other assets. He also reworks bay al-salam and istisna' contracts into elaborate instruments for commodity swaps, which he illustrates with an oil futures example that has interesting ramifications. To the extent that an Islamic oil futures market could be developed, it would contribute alongside the conventional futures market to greater price stability in the international petroleum industry. Stability would benefit Muslim and non-Muslim producers and consumers alike. Were the proposed instruments to prove acceptable to Muslim legal authorities, Islamic finance would be better equipped to manage risks as well as cope with its perennial liquidity problems.
While these, like other instruments currently being devised by financial engineers, are abstract templates, real financial markets developed sufficiently in Pakistan in the 1990s to test certain kinds of Islamic securities. Professor Uppal empirically demonstrates that the Pakistani mudarabas, which pool leases and securitize them, indeed developed risk and return profiles that more closely resembled those of equity than of debt securities. Were Pakistan fully to Islamize its financial system by abolishing debt securities, the cost of capital to borrowers would increase but so also would the returns to depositors, possibly mobilizing additional savings.
Finally, if Professor Muhammad-Shahid Ebrahim's propositions eventually prove acceptable to Islamic authorities, Islamic finance could devise functional equivalents for virtually any instrument that conventional financial engineers might conceive. While limiting his discussion to project finance, his method has more general reach. It could, for instance, be applied to the creation of Islamic treasury bills. As Professor El-Gamal has warned, however, Islamic legal authorities have not attained any consensus on these matters.
Indeed, Islamic finance remains at a crossroads. It has acquired acceptance and respectability in many countries and in conventional as well as Islamic institutions. Yet the heavy transaction costs of financial innovations may discourage further development. Transaction costs are high for lack of effective national and transnational institutions. Viewed in political perspective, the dilemmas of Islamic finance converge with those of political Islam. Financial institutions remain weak and fragmented in such critical areas as accounting practices and legal supervision. Experts attempt to devise accounting standards and to codify legal rulings, but the results seem neither unambiguous nor generally accepted. Yet the challenge of devising the institutions needed to resolve the technical problems of Islamic finance is even more daunting, because it requires an improbable degree of political coordination among Muslim states. Financial Islamists have perhaps hoped by stealth to build up Islamic economies that might advance a broader political agenda. Conversely, moderate political Islamists may have hoped to lessen tensions with their respective governments by pressing for less controversial economic reform. But increasing polarization is tending to isolate the moderates and to politicize Islamic finance. Just as more effective institutions are needed to consolidate and expand Islamic financial markets, international and local politics conspire to diminish any collective capacity to build them.
Paradoxically, however, Islamic finance may well flourish in the new millennium under the impact of financial globalization. As Monzer Kahf provocatively suggests, the conventional international financial system seems to be reinvigorating Islamic finance, even as Islamic banks, like other traditional commercial banks, decline in importance. The dominant Anglo-Saxon model of capitalism pushes for the same transparency and accountability that Islamic finance requires for its profit-sharing and other forms of financing to be successful. Financial institutions based in London, New York, and Washington, moreover, are taking the lead in promoting new Islamic forms of investment. As many of our contributors demonstrate, there are natural affinities between conventional and Islamic investment banking. The curious prospect arises of international financial markets driving the development of institutions for standardized accounting and legal rulings which have so far eluded the Islamic financial community and Muslim governments. Markets might then empower Islamic financial institutions and perhaps contribute, too, to a softening of the political polarization between Muslim governments and their political oppositions.
References
Clement M. Henry, The Mediterranean Debt Crescent: Money and Power in Algeria, Egypt, Morocco, Tunisia, and Turkey, University Press of Florida, 1996.
Sami Hassan Homoud, Islamic Banking, London: Arabian Information, 1986.
Frank E Vogel and Samuel L. Hayes, III, Islamic Law and Finance: Religion, Risk, and Return, The Hague: Kluwer Law Intl, 1998.
Endnotes