After exploring the Smithian conception of an ideal economic system, Dr Abbas Mirakhor continues his investigation by looking at the principles of an ideal Islamic financial system, which, as the article shows, differs from the contemporary financial system and, to some extent, the current Islamic financial system.
The ideal Islamic finance points to a full-spectrum of instruments serving a financial sector embedded in an Islamic economy in which the institutional “scaffolding” (rules of behaviour as prescribed by Allah (swt) and operationalized by the Noble Messenger, including rules of market behaviour prescribed by Islam) is fully operational. The essential function of that spectrum would be spreading and al- locating risk among market participants rather than allowing it to concentrate among the borrowing class. Islam pro- poses three sets of risk-sharing instruments:
- mu’amalat risk-sharing instru- ments in the financial sector;
- redistributive risk-sharing instruments through which the economically more able segment of the society utilizes in order to share the risks facing the less able segment of the population; and
- the inheritance rules specified in the Qur’an through which the wealth of a person at the time of passing is distributed among present and future generations of inheritors.
As will be argued here, the second set of instruments is used to redeem the rights of the less able by enabling them to participate in the income and wealth of the more able. These are not instruments of charity, altruism or beneficence. They are instruments of redemption of rights and re-payment of obligations.
The spectrum of ideal Islamic finance instruments would run the gamut between short-term liquid, low-risk financ- ing of trade contracts to long-term financ- ing of real sector investment. The essence of the spectrum is risk sharing. At one end, the spectrum provides financing for the
purchase and sale of what has already been produced in order to allow further production. On the other end, it provides financing for what is intended or planned to be produced. In this spectrum, there does not seem to be room provided for making money out of pure finance where instruments are developed that use real sector activity only as virtual licenses to accommodate what amounts to pure financial transactions. There are duyun and qardh hassan that are non-interest-based debts
but used only to facilitate real sector transactions in terms of consumption
smoothing for those who have experienced liquidity shocks. This is a case when a financier shares liquidity risk with the firms or consumers for whom the risk has materialised or who use non-interest borrowing as
insurance against liquidity shocks. It may be argued plausibly that in a modern complex economy, there is a need for a variety of ready-to-use means of liquidity, and so long as instruments being developed are, in the judgement of Shari’a scholars, permissible where is the harm? Usually, this argument starts with the reasoning that financial instruments that serve short-term, trade-oriented transaction contracts, such as murabaha, are permissible. From there, the argument goes that any instrument with a
connection, no matter how tenuous, to the real sector is also permissible. It is worth noting that transaction con- tracts permissible in Islam and the financial instruments intended to facilitate them are not the same thing. Islamic real sector transactions contracts (uqud) that have reached us are all permissible. However, it is possible that a financial instrument designed to facilitate a given permissible contract may itself be judged non-permissible.
As the proliferation of derivative instruments in the period leading up to the global financial crisis demonstrated, the number of financial instruments that have some relation, even if only nominal, to a real sector transaction is limited only by the imagination of financial engineers. This is the essence of the theory of spanning developed in finance in the late 1960s and early 1970s which led to the design and development of derivatives It is possible that a financial instrument may have weaker risk-sharing characteristics than the Islamic
In this spectrum, there does not seem to be room provided for making money out of pure finance where instruments are developed that use real sector activity only as virtual licenses to accommodate what amounts to pure financial transactions.
transaction contract it intends to serve.
Since Islamic finance is all about risk sharing, then the risk characteristics of a given instrument need
to become paramount in decisions. One reason, inter alia, for the non-permissibility of the contract of Al-Riba is surely due to the fact that this contract transfers all, or at least a major portion, of risk to the borrower. It is possible to imagine instruments that on their face are compatible with the no-riba requirement, but are instruments of risk transfer and, ultimately, of shifting risk to taxpayers. An example would be a sovereign ijarah sukuk based on the assets subject to ijarah but credit-enhanced by other means, say collateral. All costs are taken
into account, such a sukuk may well be more expensive and involve a stronger risk transfer characteristic than a direct sovereign bond. Clearly, a judgement call needs to be made by financiers and financial engineers when they design and develop an instrument in considering its risk-sharing characteristic. This is a call with which fiqh alone should not be overburdened. Financiers and financial engineers should assure the risk-sharing characteristics of instruments they present to fuquha for approval. Fiqh will need to catch up with modern fi- nance as well as with the intricacies of risk and uncertainty.
It appears that at present, the energies of financiers and financial engineers are focused on the design and development of instruments to accommodate the low-end of time and risk-return, liquid transactions. Without effort at developing long-term investment instruments with appropriate risk-return characteristics, there is a danger of the emergence of path-depen- dency where the market will continue to see more – albeit in greater variety – of the same. That is more short-term, liquid and safe instruments. This possibility should not be taken lightly. After all, as mentioned earlier, since the early 1970s, finance has been quite familiar with the ‘theory of spanning’. According to this idea, an infinite number of instruments can be “spanned” out of a basic instrument. This is what led to the explosion of derivatives which played an influential role in the re- cent global financial disaster. At one point it was estimated that in 2007, the total financial instruments, mostly derivatives, in the world was 12.5 times larger than the total global GDP. A similar development could be awaiting Islamic finance if the ingenuity of financial engineers and the creative imagination of Shari’a scholars continue to serve the demand-driven appetite for liquid, low-risk, and short-term instruments. In that case, the configuration of Islamic finance would have failed to achieve the hopes and aspirations evoked by the potential of the ideal Islamic financial system.
In this spectrum, there does not seem to be room provided for making money out of pure finance where instruments are developed that use real sector activity only as virtual license to accommodate what amounts to pure financial transactions.
Epistemology of An Ideal Islamic Finance System
The fountainhead of all Islamic thought is the Qur’an. Whatever the theory of Islamic knowledge may be, any epistemology, including that of finance, must find its roots in the Qur’an.
The starting point of this discussion is therefore Verse 275 of Chapter 2 of the Qur’an, particularly the part of the Verse that declares the contract of Al-Bay’ permissible and that of Al-Riba non-permissible. Arguably, these few words can be considered as constituting the organising principle – the fundamental theorem as it were – of the Islamic economy. Most translations of the Qur’an render Al-Bay’ as “commerce” or “trade”. They also translate “Al-Tijarah” as “commerce” or “trade”. Consulting major lexicons of Arabic (such as Lisan Al-Arab, Mufradat Alfaz Al- Qur’an, Lane’s Arabic Lexicon, Al-Tahquiq fi Kalamat Al-Qur’an Karim, among others) reveals that there is a substantive difference between Al-Bay’ and Al-Tijarah. Relying on various verses of the Qur’an (e.g. verse 254: chapter 2; 111:2; 29-30:35; 10-13:61)
these sources suggest that trade contracts (Al-Tijarah) are entered into in the expectation of profit (ribh). On the other hand, Al-Bay’s
contracts are defined as “Mubadi- lah Al-Maal Bi Al-Maal” an exchange of property with the property. In contemporary economics, it would be rendered as the exchange of property rights claim. These sources also suggest a further difference in that those who enter into a contract of exchange expect gains but are cognizant of the
probability of loss (Khisarah).
It is worth noting also that all Islamic contractual forms, except spot exchange, involve time. From an economic point of view, time transactions involve a commitment to do something today in exchange for a promise of a commitment to do something in the future. All transactions involving time are subject to uncertainty and uncertainty involves risk. Risk exists whenever more than one outcome is possible. Consider for example a contract in which a seller commits to deliver a product in the future against payments today. There are a number of risks involved. There is a price risk for both sides of the ex- change; the price may be higher or lower in the future. In that case, the two sides are at risk which they share once they enter into the contract agreement. If the price in the future is higher, the buyer would be better off and the price risk has been shed to the seller. The converse is true if the price is lower. Under uncertainty, the buyer and seller have, through the contract, shared the price risk. There are other risks that the buyer takes including the risks of non-delivery and quality risk. The seller, on the other hand, also faces additional risks including the risk that the price of raw materials may be higher in the future, and transportation and delivery cost risk. This risk may also be lower. Again, these risks have been shared through the contract. The same argument applies to deferred payment contracts.
Second, it may appear that spot exchange or cash sale involves no risk. But price changes post-completion of spot ex-change are unknown. The two sides of a spot exchange share this risk. Moreover, from the time of the classical economists, it is known that specialisation through comparative advantage provides the basis for gains from trade. But in specialising, a producer takes a risk of becoming dependent on other producers specialised in the production of what he needs. Again, through ex-change the two sides to a transaction share the risk of specialisation. Additionally, there are pre-exchange risks of production and transportation that are shared through the exchange. It is clear that the other contracts at the other end of the spectrum of Islamic contracts, i.e. mudharabah and musharakah, are risk-sharing transactions. Therefore, it can be inferred that by man-dating Al-Bay’, Allah (swt) ordained risk-sharing in all exchange activities.
Third, it appears that the reason for the prohibition of the contract of Al-Riba is the fact that opportunities for risk sharing are non-existent in this contract. It may be argued that the creditor does take the
risk – the risk of default. But it is not risk-taking per se that makes a transaction permissible. A gambler takes a
risk as well but gambling is haram. Instead, what seems to matter is providing the opportunity for risk sharing. Al-Riba is a contract of risk transfer. As Keynes emphasised in his writing, if interest rates did not exist, the financier would have to share in all the risks that the entrepreneur faces in producing, marketing and selling a product. But by decoupling his future gains, by loaning money today for more money in the future, the financier transfers all risks to the entrepreneur. Fourth, it is clear that by declaring the contract of Al-Riba non-permissible, the Qur’an intends for humans to shift their focus to risk-sharing contracts of exchange. It appears – and Allah knows best –
that it can be inferred from the above discussion that there are two types of contracts involving time:
- contracts over time (or on spot) involving trade in which there is expectation of gain (ribh); and
- contracts over time involving exchange in which there is expectation of gain or loss (Khisarah).
The latter must refer also to contracts of investment with an uncertain out- come in terms of gain or loss. This, of course, does not mean that mudharabah and musharakah could not be used for longer-term trade in expectations of profits to be shared and for long-term investment as was the case for centuries in the Muslim world as well as in Europe in the Middle Ages. Borrowed from Muslims and known as commenda in Western Europe, mud- harabah became quite popular as means of financing long-term trade and investment It has been suggested that the commenda was of the highest importance and contributed greatly to the fast growth of trade and investment which led to economic change and growth in Europe. The com- menda’s contribution to the
industrial development of Ruhr Valley in Germany and in building railroads in Europe was particularly impressive. Therefore, what needs emphasis is that Al-Bay’ covers long-term investment contracts that allow the growth of employment and income and the expansion of the economy. The focus of Al-Tijarah and all its financing instruments is the
trade of commodities already produced. In effect, Islam meets the financing needs of trade as well as the requirements of resource allocation, investment, production, employment, income creation, and risk management.
Given the above, major economic implications follow. First, as the definition of Al-Bay’ indicates, it is a contract of exchange of property. This means that the parties to the
exchange must have property rights over the subject of the contract prior to the exchange. Second, parties must have the freedom not only to produce what they wish but be able to contract with whom they wish to exchange. Third, parties must have the
freedom to contract. Fourth, there must be means of enforcing contracts. Fifth, the exchange requires a place for the parties to complete their transactions, meaning a market. Sixth, markets need rules of behaviour to ensure an orderly and efficient operation. Seventh, the contract of ex-change requires trust among the parties as to commitments to perform according to the terms and conditions of exchange. Eighth, there must be rules governing the distribution of proceeds. Ninth, there must be redistributive rules and mechanisms to correct for the pattern of distribution emerging out of market performance. These are rules that govern the redemption of the rights of those who are not parties to the contract directly but who have acquired rights in the proceeds because, one way or another, they or their properties have contributed to the production of what is the subject of exchange. These implications are discussed below.
It is worth noting that transaction contracts permissible in Islam and the financial instruments intended to facilitate them are not the same thing. Islamic real sector transactions contracts )u: udZthat have reached us are all permissible. However, it is possible that a financial instrument designed to facilitate a given permissible contract may itself be ©udged nonj permissible.
Property Rights
Briefly, the principles of property rights in Islam include:
- Allah (swt) has created all property and He is the ultimate owner;
- resources created by Allah (swt) are at the disposal of all humans to empower them to perform duties prescribed by the Creator;
- while the ultimate ownership is preserved for the Creator, humans are al- lowed to combine their physical and intellectual abilities with the created resources to produce means of sustenance for themselves and others;
- the right of access to resources belongs to all of mankind;
- humans can claim property rights over what is produced through their own labour or transfers through gift giving, exchange, contracts, inheritance or redemption of rights in the produced of property rights, Islam imposes strict limits on the freedom of disposing of property; there is no absolute freedom for the owner to dispose of property as there are rules against extravagance, waste, destruction of property or its use in prohibited transactions;
- property rights must not lead to accumulation of wealth as the latter is considered the lifeblood of the society which must constantly circulate to create investment, employment, income and economic growth opportunities; and
- once the principles governing property rights are observed, particularly the rule of sharing, the owner’s right to the remaining property, cleansed of others’ rights, is inviolate.
It is through its rules of property rights that Islam envisions economic growth and poverty alleviation in human societies. The latter is accomplished through the discharge of the obligation of sharing, derived from the property rights principles which envision the economically less able as the silent partners of the more able. In effect, the more able are trustee agents in using resources created by Allah (swt) on behalf of themselves and the less able. In contrast to the property rights principles of the conventional system, in Islam property rights are not means of exclusion but of inclusion of the less able in the in- come and wealth of the more able as a matter of rights that must be redeemed. In the conventional system, the rich help the poor as a demonstration of sympathy, benevolence and charity. In Islam, the more able are required to share the consequences of the materialisation of idiosyncratic risks – illness, bankruptcy, disability, accidents and adverse socio-economic conditions
for those who are unable to provide for themselves. Those who are more able to diversify away a good portion of their own idiosyncratic risks using risk-sharing instruments of Islamic finance. The economically well-off are commanded to share the
risks of those who are economically unable to use the instruments of Islamic finance. It can be argued plausibly that unemployment, misery, poverty and destitution in any society are prima facie evidence of a violation of property rights
rules of Islam and/or non-implementation of Islamic instruments of risk sharing. In Islam, the risks that would face future generations are shared by the present generation through the rules of inheritance. These rules break up the accumulated wealth as it passes from one generation to another to enable sharing risks of a larger number of people.
Contracts and Trust
Basically, a contract is an enforceable agreement. Its essence is commitment. Islam anchors all socio-political-economic relations on contracts. The fabric of the Shari’a itself is contractual in its conceptualisation, content and application. Its very foundation is the primordial covenant be- tween the Creator and humans (see verses 172-173: 7). In an unambiguous verse (152:6), the Qur’an urges the believers to fulfil the covenant of Allah. This is ex- tended to the terms and conditions of all contracts through another clear verse (1:5) in which believers are ordered to be faithful to their contracts. They are ordered to protect faithfulness to their covenants and what has been placed in trust with them as a shepherd protects sheep (8:32; also 34:17; 172:2; 91-92:16). Thus, believers do not treat obligations of contracts lightly; they will take on contractual obligations only if they intend fully to fulfil them. Hence, their commitments are credible. Contracts are means of coming to terms with future risks and uncertainty. They allocate risks by providing for future contingencies and set obligations for each party and each state in the future as well as remedies for breach of contracts. Generally, there are four motives for entering into a contract: sharing of risk, transfer of risk, alignment of incentives, or minimising transaction costs. Mudharabah, musharakah, and the purchase of equity shares are examples of risk sharing. Enter- ing into an insurance contract is an example of transferring risks for a fee to those who can better bear them. Risk shifting occurs when the risks of a transaction or a contract between two parties are shifted to a third party. This concept was discussed by economists Michael Jensen and William Meckling in 1976 in the context of corporate managers resorting to debt finance in- stead of issuing additional equity, thus shifting the risk of debt burden to other stakeholders. To align incentives, one party (usually the principle) enters into a contract with another (an agent) through which incentives are created for the latter to take actions that serve their joint-surplus maximisation objective. Contracts that are designed to reduce transaction costs are usually aimed at establishing stable, long-term relationships between parties in order to avoid ex-ante information, search and sorting costs as well as ex-post bargaining costs.
There is an organic relationship be- tween contract and trust. Without the latter, contracts become difficult to negotiate and conclude and costly to monitor and enforce. When and where trust is weak, complicated and costly, administrative devices are needed to enforce contracts. Problems are exacerbated when, in addition to a lack of trust, property rights are poorly defined and protected. Under these circumstances, it becomes difficult to specify clearly the terms of a contract since transaction costs – that is search and information costs, bargaining and decision costs, contract negotiations and enforcement costs – are high. Consequently, there is less trade, fewer market participants, less long-term investment, lower productivity and slower economic growth. Weakness of trust creates the problem of lack of credible commitment which arises when parties to an exchange cannot commit themselves or do not trust that others can commit themselves to performing contractual obligations. Empirical research has shown that where the problem of lack of commitment exists and is significant, it leads to disruption in economic, political and social interaction among people. Long-term contracting will not be possible and parties to exchange opt for spot market or very short-term transactions. Considering these issues, one can appreciate the strong emphasis that the Qur’an [as well as the Messenger (saw)] has placed on trust, (see 27: 8 and 57:4) and on the need to fulfil terms and conditions of contracts, covenants, and promises one makes. These rules solve the problem of credible commitment and trust, thus facilitating long-term contracts. To illustrate the importance of trust, consider the role of complete contracts in the neo-classical theory of competitive equilibrium. A complete contract fully specifies all future contingencies relevant to the exchange. In the real world,
a vast majority of contracts are incomplete. This requirement, therefore, is considered too stringent and unrealistic. Not only does ignorance about all future contingencies make writing complete contracts impossible, but
even if all future contingencies are known, it would be nearly impossible to write a contract that can accommodate them all. However, if the parties to a contract trust each other, they can agree to enter into a simple contract and commit to revising its terms and conditions as contingencies arise.
Markets
A major reason for contracts of exchange is that the parties to the contract wish to improve upon their own pre-con- tract welfare. For this to happen, parties must have the freedom to contract. This, in turn, implies freedom to produce which calls for clear and well-protected property rights to permit production and sale. To freely and conveniently exchange, the parties need a place to do so, i.e., a market. To operate efficiently, markets need rules of behaviour and clear unambiguous rule enforcement mechanisms to reduce uncertainty in transactions. Markets also need a free flow of information. To reinforce the efficiency of market operations, trust has to be established among participants, transaction costs need to be minimised, and rules established to internalise externalities of two-party transactions. Andrew Sheng, in his 2009 publication, “From Asian to
Global Financial Crisis”, suggests that: “Successful markets all share three key attributes: the protection of property rights, the lowering of transaction costs and the high transparency”. To achieve these attributes, preconditions and infrastructures are needed including:
- freedom of market participants to enter and exit the market, to set their own objectives within the prescribed rules, to employ ways and means of their own choosing to achieve their goals, and to choose whomever they wish as their exchange partner;
- an infrastructure for participants to ac- cess, organise and use information;
- institutions that permit coordination of market activities;
- institutions to regulate and supervise the behaviour of market participants; and (v)legal and administrative institutions to enforce contracts at reasonable costs.
Both the Qur’an and Sunnah place considerable emphasis on the rules of behaviour. Once instated in Medinah, as the spiritual and temporal authority, the Messenger (saw) exerted considerable energy in operationalising and implementing the property rights rules, the institutions of the market, the rules of exchange and contracts as well as rules governing production, consumption, distribution and redistribution. He also implemented rules regarding the fiscal operations of the newly formed state as well as governance rules. Specifically regarding markets, before the advent of Islam, trade had been the most important economic activity in the Arabian Peninsula. A number of dynamic and thriving markets had developed throughout the area. Upon arrival in Medinah, the Messenger of Allah organised a market for Muslims structured and governed by rules prescribed by the Qur’an, and implemented a number of policies to encourage the expansion of trade and strengthen the market. Unlike the already existing market in Medinah, and elsewhere in Arabia, the Prophet prohibited the imposition of taxes on individual merchants as well as on transactions. He also implemented policies to encourage trade among Muslims and non-Muslims by creating incentives for non-Muslim merchants in and out of Medinah. For example, travelling non-Muslim merchants were considered guests of the Muslims and their merchandise was
guaranteed by the Prophet against (non-market) losses. The market was the only authorised place of trade. Its construction and maintenance were
made a duty of the State. As long as space was available in the existing one, no other markets were constructed. The Prophet designated a protective area around the market. No other construction or facility was allowed in the protective area. While trade was permitted in the area surrounding the market in case of overcrowding, the location of each merchant was assigned on a first-come, first-served basis but only for the duration of the trading.
After the conquest of Mecca, rules governing the market and the behaviour of participants were institutionalised and generalised to all markets in Arabia. These rules included, inter alia, no restriction on inter-regional or international trade, in- cluding no taxation on entering into or ex- isting out of markets and on imports and exports; free movement of inputs and out- puts between markets and regions; no barrier to entry to or exit from the market; information regarding prices, quantities and qualities were to be known with full transparency; every contract had to fully specify the property being exchanged, the rights and obligations of each party to the contract and all other terms and conditions; the state and its legal apparatus guaranteed contract enforcement; hoarding of com- modities were prohibited as were price controls; no seller or buyer was permitted to harm the interests of other market par- ticipants; for example, no third party could interrupt negotiations between two parties in order to influence the outcome in favour of one or the other party; short changing,
i.e. not giving full weights and measure, was prohibited; sellers and buyers were given the right of annulment depending on circumstances. These rights protected consumers against the moral hazard of incomplete, faulty or fraudulent information. Interference with supply before the market entrance was prohibited as it would harm the interests of the original seller and the final buyer. These and other rules – such as trust and trustworthiness as well as faithfulness to the terms and conditions of contracts – reduced substantially transaction costs and protected market participants against risks of transactions.
