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Classics

The Bank That Cannot Pursue Its Own Interest

A prohibition on excessive profits and usury, the obligation to give alms to the poor: these are the bases of the economic and financial life of Islam,derived directly from verses in the Koran. In them there is no condemnation of wealth or social difference which are seen to be natural and permitted by God.

The Koran, the holy book of Islam, prohibits all forms of excessive profits usury and risk, and prescribes ritual almsgiving to the poor, the needy, debtors, for paying the ransom of prisoners and for other charitable purposes [9:60]. However, the idea of social justice that is proposed does not in the least contemplate the elimination of social differences which are seen as natural and willed by God. One is dealing, rather, with a model of community, directed by divine principles, in which the more fortunate donate a part of their possessions to the poorer members of society. The morality of the Koran is based, in contrast to the exhortations to choose poverty typical of the Gospel and early Christianity, on a strong sense of ‘just means:’ to distribute all one’s possession is seen as a sinful action on a par with greed [Koran 17:26-27, 29; 25:67].

 

 

In Islam there is no ascetic ideal of forgoing things: penance and fasting are praiseworthy practices as long as they are limited in time, every form of monasticism is rejected; the believer is invited to enjoy what God has granted to him [Koran 4:32; 20:81]; wealth – as long as it is achieved by legal means – is a grace [Koran 16:71]; and in a famous tradition Mohammed is said to have declared ‘when God blesses a man with comfort, he wants to see its marks upon him.’ In other words, luxury in clothes, the use of scents, and all the exterior symbols of prosperity are portrayed as well accepted by God since Islam constitutes a pole that is diametrically opposed to every puritan economic ethic. Starting in the ninth century, Sufism proposed an ideal of life based upon forgoing the world, poverty, and abandonment to God. Faced with the emergence of such a model, specifically at a time when the Islamic world found itself at its economic apogee, there was the birth, above all in the Sunni-Hanaphite context, of a series of textbooks which defended the pre-eminence in the eyes of God of work and every human activity. However, here we are not faced with a work ethic tout court because a hierarchy of occupations was present in which the professions that were seen as noble – in particular that of merchants – had a net prevalence over manual work and certain trades (such as dyers and barbers) associated with an inferior social status. In the Koran both usury [ribâ, 30:39; 3:130; 2:275] and risk [gharar, 2:219; 5:90-91] are given strong censure which is at one and the same time both legal and moral in character. Even taking into account that this was a condemnation at a level of principle behind which was concealed tolerance at the level of fact, in a cultural context in which the fields of ethics, law and economics tended to overlap and interact, this censure had notable consequences for the evolution of contracts, in particular those relating to sale and partnership.

 

 

The first result of an interpretation of the verses in the Koran on usury and risk meant that in contracts involving exchange, services and counter-services, elements of uncertainty must not be present and they must be equal so that each of the parties obtains a benefit that is proportionate, fair and justified in relation to the activity engaged in and to the goal that is aimed at. On the basis of an interpretational lineage which became established in Islamic jurisprudence, pecuniary interests – both in the form of a corresponding and periodic service for the enjoyment of capital and for the delayed repayment of debt – belong to the field of the application of the prohibition of ribâ. From the Islamic point of view, the notion of pre-established interest which does not take into account the real benefit that the debtor obtains from the capital is in itself contradictory. In order to fructify capital, participatory models, therefore, are preferred, by which, on the basis of partnership-based contractual forms, the creditor takes part in the benefits obtained, and the risks borne, by the debtor. These participatory contractual forms, which did not delay but instead fostered the economic development of the medieval Islamic world, are today applied to Islamic banks.

 

 

After the Oil Boom

 

 

From the Islamic point of view, the prohibition on interest implies that there cannot be gain without joint-participation in risk. The Islamic banking system thus attempts, in agreement with the dictates of the Koran, to eliminate interest and to replace it with the principle of joint-participation in risk. Islamic banking activity began on a small scale thanks to individual initiatives in the early 1960s. The subsequent growth of the Islamic banking system in the 1970s, following the oil boom, was, instead, fostered and supported by certain Islamic states through changes to their own banking legislation or the passing of ad hoc laws. A practical step towards the creation of an Islamic banking system was the signing in 1974 in Jeddah of an agreement between twenty-seven Islamic states to create an inter-governmental Islamic financial institute with the specific task of promoting development by using Islamic financial instruments. The next year the Islamic Development Bank, (IDB) was came into being.

 

 

Recent studies have listed about three hundred Islamic banks present in over seventy (Islamic and non-Islamic) countries which administer capital amounting to $500 billion. For the most part Islamic banks operate in competition with conventional banks; only in Pakistan, Iran and the Sudan has the entire banking sector been completely Islamised.

 

 

An Islamic bank, like any other bank, has as its objective the mobilisation of savings for the purpose of investment. It is organised as a share-based company whose initial capital is provided by the shareholders. The functions of Islamic banks and other intermediaries are very similar to their conventional counterparts. Islamic economists have demonstrated that there are alternative modalities and instruments to interest rates (whether active or passive) by which to perform such functions. The conformity of Islam to the operations carried out by an Islamic bank is assured by an organ called the Council for Sharia Control, whose principal function is the assessment of the economic activity of an Islamic bank with reference to its consistency with the principles and rules of Islamic law.

 

 

From the point of view of the management of asset capital, an Islamic bank in order to grant credit to its clients uses a certain number of financial products that do not envisage the payment of interest. In the Islamic financial system deposits on demand (current accounts and savings accounts) do not take part in the risks of banking activity. Thus they do not earn anything but are guaranteed. Deposits for investments, on the other hand, take part in risks and as a consequence in profits. The capital that is invested takes the form of joint-participation in profits or losses (Profit and Loss Sharing – PLS) derived from entrepreneurial or financial activities through partnership contracts. The principal contracts are the mudâraba (passive partnership) contract and the mushâraka (active partnership) contract.

 

 

The mudâraba (passive partnership) contract, which is similar to the contract that was used during the medieval period, is signed by the bank that supplies the capital and an agent-manager (the entrepreneur who has requested financing). The profits are divided between the parties according to quotas established at the moment of the signing of the contract. Any financial loss is borne exclusively by the capitalist whereas the agent runs the risk of performing his activity without any reward. Unless there are violations of the contract or failures to comply with it, the agent does not guarantee the repayment of the capital that was entrusted to him nor the generation of profits.

 

 

In the form used by Islamic institutes of credit as regards the raising of capital, savers perform the role of providers of capital and the bank performs the role of the agent. Islamic investment funds can be general or limited to specific projects.

 

 

Differently from the mudâraba contact, the mushâraka (active partnership) contract envisages joint-participation in the management and contribution of capital as well as the division of profits and losses. The profits are divided between the contracting parties in proportions established by the contract whereas the joint-participation in losses takes place on the basis of the quota of capital that is possessed.

 

 

Credit to companies on a participatory basis constitutes a substantial alternative to an interest-paying mortgage whose capital repayment is added to the payment of interest, at a level that is not pre-determined and separated from the success of the company in which the capital has been invested. Vice versa, in the Islamic system the debt of the entrepreneur towards the bank is made up of a sum that varies according to the results of the undertaking. Thus the entrepreneur is said to be more motivated to carry out the project successfully because upon the final profits depend the financial benefits that he obtains from the operation. Of fundamental importance, in addition, is the ability of the customer to convince the bank of the validity of the project for which he requests funding. Thus the financial position of the client and his ability to honour the credit is not central – as is the case with conventional systems – but the practicality and profitability of the project that he submits to the bank is.

 

 

A Limited Use Because of the Risks

 

 

Islamic economists stress the socio-economic importance of methods based upon joint-participation in profits and losses. However their use by Islamic banks is still rather limited because of the risks that are involved and the costs of the management of such projects. The incidence of non-participatory methods is greater.

 

 

Not all the activities of Islamic banks can be placed within the realm of the participatory system. The modalities of non-participatory financing are based upon contracts of sale or the renting of real estate and services. In this case the remuneration rate is established beforehand and is incorporated into the purchase price or the rent. In this way the financing is less risky than participation in the form of shares or financing along PLS lines. The fact that the remuneration rate is established beforehand may make these contractual forms similar to loans based on interest.

 

 

Islamic economists stress a number of differences. First of all, they argue that non-participatory contracts implemented by Islamic banks do not involve the provision of loans but, rather, are based upon transactions whose subjects are real estate or services. Secondly, they observe that a price is established for the property or service provided and not interest. Once it has been established, the price cannot be changed where the payment is delayed because of unforeseen circumstances. On the one hand, this defends the customers but, on the other, it can create problems as regards the liquidity of the bank in the case of deliberate delays in repayment.

 

 

Islamic banks use certain typologies of contracts of sale as forms of financing, in particular: bay‘ mu’ajjal (sale by payments in stages) contracts and bay‘ al-murâbaha contracts (sale with mark-ups); leasing, both at the level of operations (ijâra) and through financing; istisnâ‘ (production contract), that is to say a contract by which one of the parties orders another to produce and provide a good with a delivery date and pre-established prices; and the salam, a contract of sale where the payment is prior to the delivery of goods or services which takes place at a future date that has already been established. The most recent of the Islamic financial services are the sukûk, which are similar to bonds and in conformity with the dictates of the Koran. These are experiencing an exponential growth. Issued for the first time in 1990 on a small scale, by 2006 they accounted for 199 bonds of a value of $27.17 billion. By 2007 they numbered 206 and had a value of $47 billion and in the first quarter of 2008 44 of these bonds were issued with a value of $2.3 billion [1].

 

 

The prospects for growth over the next five years of Islamic finance envisage a 15% annual growth rate, double that of traditional finance. To this important growth rate is added the fact that over the next five years the Islamic banking system should be regulated in a uniform way throughout the euro area, thereby creating a new channel in the relations between Islamic and Western financial institutions.

 

 


 

[1] 'Finanza, le banche islamiche non conoscono la crisi', il Sole24ore, in <http://www.ilsole24ore.com/art/SoleOnLine4/Mondo/2009/01/finanza-islamica.shtml?uuid=1d6602d8-dfec-11dd-9949-bocfdoc5e1df&DocRulesView=Libero>, 2009-01-11

 

 

Bibliography

 

 

Maxime Rodinson, Islam et capitalisme (Pantheon Books, New York, 1973).

 

 

Biancamaria Scarcia Amoretti (ed.), Profilo dell’economia islamica (Centro Culturale al-Farabi, Palermo, 1988).

 

 

Gian Maria Piccinelli, Banche islamiche in contesto non islamico. Materiali e strumenti giuridici (I.P.O. “C.A. Nallino”, Roma, 1996).

 

 

Rodney Wilson, Economics, Ethics and Religion: Jewish, Christian and Muslim Economic Thought (MacMillan, London, 1997).

 

 

Ersilia Francesca, Teoria e pratica del commercio nell’Islam medievale (Università degli Studi di Roma “Tor Vergata” - IPO “C.A. Nallino”, Roma, 2002).

 

 

Clement M. Henry and Rodney Wilson, The Politics of Islamic Finance (Edinburgh University Press, Edinburgh, 2004).

 

 

Munawar Iqbal and Ausaf Ahmad, Islamic Finance and Economic Development (Palgrave MacMillan, New York, 2005).

 

 

Marco Mauri and Rony Hamaui, Economia e finanza islamica. Quando i mercati incontrano il mondo del Profeta (Il Mulino, Bologna, 2009).

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