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THE ISLAMIC FINANCIAL SYSTEM:

AN INTRODUCTIONby

Dr. M. Umer Chapra

for the Muslim Almanac

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All major religions, including Hinduism, Judaism, Christianity

and Islam, have prohibited interested. This raises two questions. The

first question is whether an interest-free financial system has ever

been established and how effective it was in mobilizing and utilizing

savings, the primary objective of a financial system. The second

question is that, even if the system was successful then, can it be

workable now when the international financial environment is

significantly different from what prevailed during the heyday of

Muslim civilization.

The answer to the first question is that from the very earlystage in Islamic history, Muslims were able to establish an interest-

free financial system in conformity with the teachings of the

Shariah. The system was based primarily on the profit-and-loss

sharing (PLS) modes ofmudarabah (commenda) and musharakah

(partnership). It worked quite effectively not only during the heyday

of Islamic civilization but also for centuries thereafter. It was able to

mobilize the entire reservoir of monetary resources of the medievalIslamic world for financing agriculture, crafts, manufacturing and

long-distance trade. The system was used not only by Muslims but

also by Jews and Christians to the extent that interest-bearing loans

and other usurious practices were not in common use (Udovitch,

1970, p. 257; see also p. 268)

Bankers were known in early Muslim history as sarrfs or

sayrifah. By the time of the Abbasid caliph al-Muqtadir (295-

320AH/908-932AC), they had started performing most of the basic

functions of modern banks (Fischel, 1992). They had their own

markets, something akin to the Wall Street in New York and the

Lombard Street in London, and fulfilled all the banking needs of

commerce, industry and agriculture within the constraints of the

then-prevailing technological environment (Duri, 1986, p. 898).

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The ability to mobilize financial resources, along with a

combination of several economic and political factors, provided a

great boost to trade which flourished from Morocco and Spain in the

West, to India and China in the East, Central Asia in the North, andAfrica in the South. The extension of Islamic trade influence is

indicated not only by the available historical documents but also by

the Muslim coins of the seventh to the eleventh centuries found

through excavations in countries like Russia, Finland, Sweden,

Norway, the British Isles and Scotland, which were on the outskirts

of the then-Muslim world (Kramers, 1952, p. 100; see also pp. 101-

106).

Due to a number of socio-political and historical circumstances

the Muslim world lost its position of leadership in the economic,

political, educational and technological fields and a number of

Islamic institutions, including the Islamic financial system, got

displaced by Western institutions, some of which are in clear conflict

with Islamic teachings (see Chapra, 2000, pp. 173-252). However,

the independence of Muslim countries from foreign domination

around the middle of the 20th century has led to the revival of Islam

and an effort is being made to reinstate most of the lost institutions,

the Islamic financial system being one of them.

This brings us to the second question of whether Islamic

finance is workable now in an environment which is significantly

different from what prevailed during the heyday of Muslim

civilization. Economies have become more complex and the

financial system cannot be a replica of the past. Therefore, even

though the PLS modes continue to be emphasized, the debt-creating

sales-based modes ofmurabahah,iijarah, (leasing), salamii and

istisnaiiiare currently playing a more important role. This is because

the institutional infrastructure necessary for movement into the PLS

modes has not yet become available. As compared with the PLS

modes, the rate of return in the sales-based modes gets fixed in

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advance. Nevertheless, there is a difference between these modes

and pure lending and borrowing on interest. They are not only asset-

based but also require the financier to share in the risk at least to

some extent.

The impression that one gets from the rapid expansion of the

system so far is that the system has been working successfully and

is capable of handling all the financial needs of both the public and

private sectors. According to a rough estimate there are more than

250 Islamic banks around the word, of which one is even in the U.K.

In addition, a number of conventional banks, including some major

multinational western banks, have opened either branches or

windows to offer Islamic financial services. All these together have

assets close to $500 billion. The prospects for the future are even

brighter because, in spite of the rapid expansion of the system, only

a small part of the potential market has been tapped so far. While in

the 1950s and the 1960s Islamic banking was only an academic

dream, it has now become a reality. It has also attracted the

attention of Western central banks like the Federal Reserve and the

Bank of England, international financial institutions like the IMF and

the World Bank, and prestigious centres of learning like Harvard

University and the London School of Economics.

Nevertheless, the system is still in its infancy. When it comes

of age with the passage of time, it may be able to not only

accelerate development in the Muslim world but also exert a healthy

influence on the international financial system which has been

experiencing a great deal of instability over the last three decades.

It may be difficult to overcome this instability without injecting

greater discipline into the financial system. The prohibition of

interest by the major religions can be helpful in this task. The

assured positive rate of return on deposits and loans that the rate of

interest involves stands in the ways of ensuring such discipline.

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iMurabahah (also called bay muajjal) refers to a sales agreement whereby the sellerpurchases the goods desired by the buyer and sells them at an agreed marked-up price, thepayment being settled within a specified time frame, either in instalments or lump sum. Theseller bears the risk for the goods until they have been delivered to the buyer.

ii Salam refers to a sales agreement whereby full payment is made in advance against anobligation to deliver the specified fungible goods at an agreed future date. This is not the

same as speculative forward sale because full, and not margin, payment is required. Underthis arrangement the seller, say a farmer, may be able to secure the needed financing bymaking an advance sale of only a part of his expected output. This may not get him intodelivery problems in case of a fall in output due to unforeseen circumstances

iii Istishn refers to a sales agreement whereby a manufacturer (contractor) agrees to

produce (build) and deliver a certain good (or premise) at a given price on a givendate in the future. This, like salam, is an exception to the general Shariah ruling whichdoes not allow a person to sell what he does not own and possess. However, unlikesalam the price need not be paid in advance. It may be paid in agreed instalments, orpartly at the front-end and the balance later on as agreed.

References1. Chapra, M. Umer (2000), The Future of Economics: An Islamic Perspective (Leicester: The

Islamic Foundation).

2. Duri A.A. (1986), Baghdad, The Encyclopedia of Islam (Leiden, E.S. Brill), Vol.1, pp.894-909.

3. Fischel, W.J., (1992), Djahbadh, in the Encyclopedia of Islam, Vol. 2, pp.382-3.

4. Kramers, J.H., (1952), Geography and Commerce, in T. Arnold and A. Guillaume (eds.),The Legacy of Islam (London: Oxford University Press).

5. Udovitch, Abraham, (1970), Partnership and Profit in Early Islam (Princeton, N.J.: Princeton

University Press).