1.27 Any successful belief system, whether religious or secular, has seemingly contradictory characteristics: it is malleable enough to adapt to a variety of geographical settings and survive the test of time, yet it must be able to maintain its specificity, or else it would disappear or become fused with competing belief systems; it is idealistic, sometimes even utopian, yet capable of adjusting to human imperfection and making the kinds of compromises that are endemic to political and economic life. With this in mind we can better understand how a system rooted in the Middle Ages could survive, and thrive, in the global economy.
1.28 It should be noted at the outset that Islamic commandments are not as unbending as they would superficially appear. There are mechanisms through which Islam adapted to changing circumstances, and came to accommodate itself with modern economics and finance. The general interest (maslaha) and overriding necessity (darura)—the need to achieve economic welfare and the requirements of a global economy—whether articulated or not, often outweigh theological or legal concerns.
1.29 Also, traditional Islamic injunctions are not framed as simple dichotomies, but along a continuum, thus allowing significant flexibility and pragmatism. In the early Islamic community, an action (either for the community as a whole, or for every single member of it) could be regarded as obligatory (wajib), meritorious (mustahabb), morally neutral (mubah), reprehensible (makruh), or forbidden (haram). Also, most injunctions contain dispensations and exceptions. On the subject of fasting during Ramadan, the sick and the travellers could postpone their fasting, and those for whom it would cause hardship could dispense with it, making up for it instead with a good deed such as feeding a poor person. In finance, this pragmatism has taken the form of ‘purification’ of improper income through charitable donations.
1.30 As Islam expanded, it was brought into contact with different cultures and this made it necessary for Islamic jurisprudence to produce legislation on problems for which there were no clear legal precedents to follow. The principles of Islamic jurisprudence (usul al-fiqh) provide for a set of elaborate rules to interpret the Shari’a. But the existence of such complex rules did not preclude adaptive mechanisms. The principle of talfiq (patching) would for example authorize judges to choose an interpretation from schools of jurisprudence other than their own if it seemed to fit the particular circumstances of the case, see paragraph 2.42.
1.31 Furthermore, there is a central distinction in Islamic law between ‘ibadat and mu’amalat. ‘Ibadat (acts of worship) refer to relations between man and God, such as prayer and fasting, and are immutable, whereas mu’amalat (transactions) which refer to relations between man and man, and are open to evolution and change. (p. 11) Thus, in the realm of mu’amalat, which is of course that of economic and financial dealings, there is considerable room to develop and change the law, albeit within limits and based on principles discussed in the following pages, to facilitate human interaction and promote justice and prosperity.
1.32 More generally, three principles allow for departures from existing norms: local custom (‘urf), the public interest (maslaha), and necessity (darura). The Shari’a can thus be accommodated to societal developments, and allow for innovation, exceptions, and loopholes—provided they are properly justified.
1.33 Assessments of Islamic banks tend to fall into one of two categories: excessive claims or outright dismissal. It has become nearly impossible to have a nuanced or empirically-grounded understanding of Islamic finance, or capture its evolutionary nature: one set of writings presents Islamic finance as a universal panacea that will produce a world of no inflation, no unemployment, no exploitation, and no poverty; the other dismisses Islamic finance as a failure—at best an inconsequential phenomenon and an exercise in semantics, at worst a fraud or a threat to Western civilization.7 Such binary approaches cannot capture the diversity and nuances of Islamic finance.
1.34 When it comes to the main characteristics of the Islamic sector, no two countries are identical. Despite recent strides in harmonization and streamlining there is still a great deal of diversity and pluralism to the Islamic sector. Perceptions of Islamic finance in the West cannot be separated from general perceptions of Islam as a monolithic, unchanging, and somewhat fossilized belief system. In reality, Islamic finance reflects the diversity of a fourteen-hundred-year-old, 1.4 billion strong religion spread over every continent. Islamic financial institutions come in all shapes and forms: banks and non-banks; large and small; specialized and diversified; traditional and innovative; national and multinational; successful and unsuccessful; prudent and reckless; strictly regulated and freewheeling, etc. Some are virtually identical to their conventional counterparts, while others are markedly different. Some are driven solely by religious considerations; others use religion as a way of sidestepping regulation, as a shield against government interference, as a tool for political change, or simply as a marketing ploy.
1.35 A quick look at the leading Islamic institutions reveals the heterogeneity of the industry.8 Large government-owned Iranian banks, that are subject to sanctions and have few interactions with non-Iranian Islamic banks, hold the top spots. Then (p. 12) there are Gulf Cooperation Council (GCC) banks, themselves a heterogeneous group, including some of the earliest Islamic banks such as Kuwait Finance House and Dubai Islamic Bank, and more recent ones, such as Abu Dhabi Islamic Bank and Saudi Arabia’s Al-Rajhi. The majority of GCC banks have a domestic focus, though another of the largest banks, Bahrain-based, Saudi-owned Al-Baraka group, had from the beginning a transnational focus. The top ranks of Islamic banks also include Malaysian banks, such as BIMB, which until recently had little contact with GCC banks. The largest Islamic institutions by assets also include Western-based institutions, such as the UK-controlled, but Dubai-based, HSBC Amanah.
1.36 Examples abound of how deeply embedded Islamic financial institutions are in their political, institutional, and cultural framework. Saudi Arabia was founded as a ‘fundamentalist’ Islamic state, in the sense that its society and institutions were based on a strict and ‘purist’ interpretation of Islam. Paradoxically, this has made the issue of Islamic banking and finance politically sensitive. The reason is that by the time Islamic banks came into existence, Saudi Arabia was a wealthy state—to a large extent a rentier economy, living off its oil production and the substantial revenues from its foreign investment and interest income. Its economy was thus heavily dependent, directly and indirectly, on interest. Although Saudi Arabia played a central role in creating and promoting the Islamic finance industry, it did not initially encourage the growth of Islamic institutions at home. It is only in recent years, mostly due to consumer and corporate demand, that Islamic finance came to play a growing role in the national economy—making Saudi Arabia one of the latecomers in the Islamic sector.
1.37 In Egypt, the story of Islamic finance is equally complicated: in the late 1970s the government promoted Islamic banks as part of its new alliance with Saudi Arabia and as a counterweight to leftwing and Nasserite opposition. Yet a disastrous experiment (the collapse of Islamic Money Management Companies [IMMCs], companies that were not linked to the emerging Islamic banking sector) suddenly cast suspicions on the entire Islamic sector. Political fears of the Muslim Brotherhood also led the government of Hosni Mubarak to stifle the growth of Islamic banks. In Turkey in the 1980s, a secular but cash-strapped government allowed the creation of Islamic banks though they were not allowed to use the word Islam in their name, or to refer explicitly to their Islamic character. Initially called Special Finance Houses, they are now known as Participation Banks. In Jordan, the policy toward Islamic banks has reflected the accommodative policy toward Islamic groups in general. In Malaysia and Indonesia, Islamic finance has reflected the more syncretic brand of Islam, the developmental nature of government policies, as well as a variety of domestic considerations.
1.38 The United Kingdom, home to more than 2 million Muslims, has repeatedly announced its intention of becoming a global hub of Islamic finance. The reasons (p. 13) are political (the integration of an often disenfranchised community) and economic (attracting foreign investment to the UK). A number of tax and regulatory changes have been undertaken to fulfil that goal. Especially notable is the introduction of a new sukuk regime similar to that for conventional securitizations, adding sukuk to the London Stock Exchange, and the issuance by the British government of sovereign sukuk. Singapore, another country where Muslims are only a small minority (about 14 per cent of the population) has also announced its intention of becoming a hub of Islamic finance. In recent years, countries as diverse as Australia, France, Ireland, and South Korea have altered their legislation to become more hospitable to Islamic finance, in particular on sukuk issuance.
1.39 The first Islamic banks appeared in the Arab world. First was the Dubai Islamic Bank in 1975. The following years saw the creation of Islamic banks in Kuwait, Jordan, Bahrain, Egypt, and the Sudan. Then Islamic banks started appearing all over the world. Significant differences appeared across countries in the importance, status, and characteristics of Islamic financial institutions. Their role in national economies ranges from essential to insignificant. Their ‘special character’ may or may not be recognized by regulators. In some countries, they are strongly encouraged by the authorities; in others they are barely tolerated. Domestic factors and the diversity of national circumstances (including of course the impact of indigenous forms of Islam) have inevitably added to differences across countries.9
1.40 Even those countries that fully Islamicized their financial systems—Pakistan, Iran, the Sudan—did so under different religious, political, economic, and cultural circumstances. In most cases, Islamicization did not occur in a carefully thought out application of Islamic principles and jurisprudence, but in an ad hoc manner and under the pressure of events. As a result, paradoxes abound, and the evolution of Islamic finance often runs counter to common perceptions and stereotypes.
1.41 Three main models can be identified, one associated with the GCC countries (I shall refer to it as the Arab model), the second with Malaysia, and the third with Iran. The Arab ijtihad was primarily driven by the surpluses generated by the oil boom of the mid-to-late 1970s whereas the Malaysian effort was driven by the developmental imperative, combined with domestic political factors, principally the promotion of the (Muslim) Malay majority. In other words, the Gulf countries, flush with oil money, were concerned with asset management while Malaysia focused on generating financing for the economy and transforming the country from agricultural backwater to industrializing nation. As for Islamic Republic of Iran, it announced the Islamicization of the entire banking system in 1983, shortly after the 1979 revolution overthrew the pro-Western regime of the Shah, (p. 14) in the midst of the Iran−Iraq war (1980–88) during which all Gulf countries sided with Iraq, and while being subjected to a harsh sanctions regime led by the United States.
1.42 Islamic financial systems also differ based on their degree of centralization. The Arab model evolved in a decentralized, haphazard fashion while the Malaysian and Iranian models were generally based on directive, top-down, approaches. In the first case, the Shari’a guidance model was fragmented. Banks could do whatever their Shari’a Board allowed them to do, and some were even not subject to central bank supervision. Thus the Kuwait Finance House was initially placed under the authority of the Ministry of Finance. In contrast, Malaysia sought consistency by creating a Shari’a Board within its Central Bank, whose decisions would supersede those of individual Shari’a Boards. The merits of a centralized Shari’a supervision has increasingly been recognized, and newcomers to Islamic finance have tended to adopt such a model. As for Iran, a theocracy based on Shia Islam and led by a Supreme Leader (velayet e-faqih), financial regulations tend to reflect government priorities.
1.43 The Iranian model evolved in relative seclusion, reflecting domestic concerns and priorities. A basic feature of the system is the imposition of the profit rates on lending as an inflation control measure by the Central Bank. In addition, options and future contracts, controversial in much of the Islamic world are commonly used for crude oil and petrochemicals trading at the Iranian Oil Bourse and the Iran Mercantile Exchange. As for the Arab and Malaysian models, they were both part of the global banking system, although there was little interaction until 2001 between the two models. The Malaysian model of Islamic finance was more innovative and forward-looking, though religiously controversial. Certain Malaysian practices were not deemed acceptable to Shari’a Boards in more conservative Arab states, in particular the widespread use of bay’al-dayn (trading of debt). Malaysia’s posture could be explained in terms of its broader political economy.
1.44 Mahathir Mohammed, Malaysia’s long-serving prime minister (1981–2003), sought to harness Islam to his goal of economic growth. His approach to Islamic finance was highly pragmatic. Rather than using what was historically acceptable as a starting point, he challenged the Malaysian ‘ulama’ to an ijtihad designed to generate new ideas. Religion, rather than being an obstacle to change, was to be an engine of growth and modernization and a tool to promote financial innovation. An Islamic financial system that could offer a growing array of sophisticated financial services was part and parcel of the effort to turn Kuala Lumpur into a leading regional, if not international, financial centre.
1.45 The Malaysian model came into its own in the 1990s. The dual banking logic, as well as other Malaysian innovations such as Islamic insurance (takaful), had also taken root. Another singular characteristic of the Malaysian system is that Islamic (p. 15) products were geared to Muslims as well as to non-Muslims. Muslims would have the opportunity to invest according to their religious beliefs, while non-Muslims, especially the Chinese minority which controls most of the country’s wealth, would have an extension of choice in money management. The message of Malaysian leaders was that industrialization and productivity were fully compatible with piety, and that welfare in this world was fully compatible with salvation in the next.
1.46 Scholars in the Arab world considered their Malaysian counterparts too lax in their religious interpretations. As a result, Arab and Malaysian Islamic banks evolved along separate paths, and had minimal interaction until 2001. The Joint Comprehensive Plan of Action (JCPOA) signed on 14 July 2015 by Iran and the P5+1 (the five permanent members of the United Nations Security Council—United States, Russia, United Kingdom, China, France—plus Germany) held the promise of a greater integration of Iranian banks in the global Islamic system. Indeed, in exchange for nuclear concessions, it was intended that the sanctions regime that had isolated Iran for decades would be progressively lifted. Significantly, in 2017, The Iranian Central Bank was elected to chair the IFSB, the standard-setting Kuala Lumpur-based organization that sets international standards and guidelines for banking governance, liquidity risk management, and capital requirements. However, given the withdrawal by President Donald Trump from the JCPOA and the rising tensions between the GCC and Iran, significant uncertainties remain.