Islamic Banking - Part 1 (Introduction)

[Armstrong]

Salaamu Alaikum,

 

Before the details of Islamic modes of financing are discussed it seem necessary to provide a brief introduction to the basic principles that govern the whole economic set up in an Islamic way of life.

 

1. Belief in Divine Guidance

 

The foremost belief around which all the Islamic concepts revolve is that the whole universe is created and controlled by One, Allah, the Only True God. He has created man and appointed him as vicegerent (Khalifa) on the earth to fulfil certain objectives through obeying His commands. The commands are not restricted to some modes of worship or so called religious rituals. They, on the contrary, cover a substantial area of every aspect of life. These commands are neither so exhaustive that straiten the human activities within a narrow circle, leaving no role for human intellect to play, nor are they so little or ambiguous that they leave every sphere of life at the mercy of human perception and desire. Far from these extremes, Islam has a balanced approach to govern human life. The obedience from the servants of Allah is required not only in worship but also in their economic activities.

 

2. The basic difference between capitalist and Islamic economy

 

Islam does not deny the market forces and market economy. Even the profit motive is acceptable to a reasonable extent. Private ownership is not totally negated. Yet the basic difference of Islamic economy to the capitalist one is that in secular capitalism, the private ownership or profit motive are given unbridled power to make economic decisions. This attitude has allowed imbalances in society such as:

 

(i) Interest, gambling, speculative transactions tend to concentrate wealth in the hands of the few.

 

(ii) Unhealthy human instincts are exploited to make money through immoral and injurious products/services.

 

(iii) Unbridled profit making creates monopolies, which paralyse the market forces or at least hinder their natural operation. Thus the capitalist economy that claims to based on market forces practically stops the natural process of supply and demand, because these forces can only work in an atmosphere of free competition.

 

Islam after recognising private ownership and profit motive it has put divine restrictions on the economic activities. These restrictions being imposed by Allah Almighty, Whose Knowledge has no limits, cannot be removed by any human authority. The prohibition of Riba (Usury, Interest), gambling, hoarding, dealing in unlawful goods or services, short sales and speculative transactions are some examples of these divine restrictions. All these restrictions combined have a cumulative effect of maintaining balance, distributive justice and equality of opportunities.

 

3. Asset-backed financing

 

One of the most important characteristics of Islamic Financing is that it is an asset backed financing. The capitalist concept of financing is to deal with money and monetary papers only without any real goods/services as an asset backed finance. Islam on the other hand, does not recognise money as a subject matter of trade, except in some exceptional cases. Money has no intrinsic utility; it is only a medium of exchange; each unit of money is 100% equal to another unit of the same denomination, therefore, there is no room for making profit through the exchange of these units inter se. Profit is generated when something having intrinsic value is sold for money or when different currencies are exchanged, one for another. The profit from dealing with money of the same currency or the papers representing them is interest hence prohibited. Financing in Islam is always based on illiquid assets, which creates real assets and inventories.

 

The real and ideal instruments of financing in Shari'ah are musharakah and mudarabah. When a financier contributes money on the basis of these two instruments it is bound to be converted into the assets having intrinsic utility. Profits are generated through the sale of these real assets.

 

Financing in the case of Salam and Istisna also creates real assets. The financier in the case of salam receives real goods and can make profit by selling them in the market. In the case of istisna, financing is affected through manufacturing some real assets, as a reward of which the financier earns profit. Other instruments include murabahah and financial leases the scholars have reshaped these to meet certain cases where none of the other instruments are suitable and subject to terms and conditions.

 

4. Capital and entrepreneur

 

According to the capitalist theory, capital and entrepreneur are two separate factors of production. The former gets interest and the later profit. Interest is a fixed return for providing capital, while profit can be earned only when there is a surplus after distributing the fixed return to land, labour and capital (in the form of rent, wages and interest).

 

Islam on the contrary, does not recognise capital and entrepreneur as two separate factors of production. Every person that contributes capital (in the form of money) to a commercial enterprise assumes risk of loss, therefore is entitled to a share in actual profit. In this manner capital has intrinsic element of entrepreneurships so far as the risk of business is concerned. Therefore, instead of a fixed return of interest it derives profit. The more the profit of the business the higher the return of capital.

 

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Insha Allah Part 2 to come in the near future