Review of Islamic Economics, No.

11, 2002, pp. 63-72

Review Article

Growing Mainstream Relevance of Islamic Finance: A Critical Review of Recent Literature

Humayon A Dar

I. Introduction
Such has been the dearth of literature on modern Islamic banking and finance that any good book on the subject published in the West tends to acquire the status of a treatise. For example, Vogel and Heyes's Islamic Law and Finance (1998)has been in heavy demand; many still talk of Usmani's An Introduction to Islamic Finance (1999) and Mills and Presley's.1 Islamic Banking by Lewis and Algaoud (hereafter LA), published by Edward Elgar zoo^), and Islamic Finance in the Global Economy by Warde, published by Edinburgh University Press (2000) are worthwhile additions to the literature in this field. Unlike LA, who maintain a sympathetic attitude to Islamic banking and finance throughout, Warde appears aggressive and critical. He sets out to challenge the traditional criticism of Islamic finance as an epiphenomenon of Islamic revivalism (see, for example, Kuran, 1995). He questions not only the critics but also the mainstream writings on Islamic finance, which, by and large, are poor in quaility, being neither empirical nor interdisciplinary. H e claims to adopt an empirical, historical, comparative and interdisciplinary approach in

HUMAYON A DAR is a lecturer in Islamic Banking and Finance, Economics Department, Loughborough University.

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an attempt to understand the political economy of Islamic finance. Undoubtedly, this makes the book interesting if controversial reading. This review looks at these two books in the light of mainstream literature on Islamic economics, of which banking and finance is an offshoot. The approach is necessary because analyses done by outside observers tend t o suffer from (and generate) misconceptions in their efforts to understand Islamic banking and finance

11. Intended Messages

The two books have different messages to convey. While LA attempts to introduce Islamic banking in a non-technical way, Warde provides a critical account of the political economy of Islamic finance in a global context. Following the mainstream Islamic argument LA contends that Islamic beliefs and ethics help reduce adverse selection and moral hazard problems in Islamic finance. Warde, on the other hand, rather forcefully suggests that a major source of moral hazard is the religion itself and coins the term 'Islamic moral hazard', defined as unscrupulous behaviour on part of those engaged in Islamic finance, behaviour encouraged by certain features of Islamic finance (Warde, p. I 54). These features include: (i) The assumption of righteous behaviour on the part of employees and customers of Islamic banks. (ii) The use of religion as a shield against scrutiny. (iii) The religious and legal ambiguity that may allow borrowers to escape their obligations with impunity. (iv) Conflicts of interest involving the bank and its customers. Warde contends that these factors have in the past contributed to moral hazard problems in Islamic banking and finance. Specific examples provided in this context are those of the Dubai Islamic Bank, so-called Islamic money management companies in Egypt and Islamic foundations (sort of NGOs established by religious very forceful organizations) in Iran. While the argument may soui~d to many, it will not impress anyone who has a basic familiarity with the socio-economic environments in which Islamic financial institutions operate. The kind of fraudulent behaviour mentioned is not typical of Islamic financial institutions in the countries mentioned.

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In fact, such behaviour is also prevalent in other organizations; it therefore seems unfair to use the term 'Islamic moral hazard', as there is nothing Islamic in this kind of behaviour. Rather, it is a contradiction in terms. Furthermore, Islamic foundations in Iran are not Islamic financial institutions in the sense the term is now widely used in the literature on Islamic economics, banking and finance. Rather, they are welfare organizations set up by Islamic missionaries. It is true that problems of moral hazard and adverse selection have hindered the use of profit loss sharing (PLS) in Islamic finance. Many studies address this issue in some detail.2 But the kind of behaviour that Warde distinguishes as 'Islamic moral hazard' not peculiar to any Islamic context: everywhere rational economic agent will try to exploit the loopholes in a legal and regulatory regime - that is, after all, what professional accountants all over the world do in an acceptable and legitimate way. In Muslim countries where property rights have not been fully developed, informational asymmetries contribute to agency problems. Thus, the lack of well defined property rights, and not the religion, is a major source of moral hazard, which makes it rather unfair to call it 'Islamic moral hazard'. As a matter of fact there is a well-documented awareness of agency problems in share contracts (in conventional as well as in Islamic economic literature) and steps are being taken to reduce informational asymmetries between providers of Islamic financial services and their users. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has already embarked upon formulating accounting, auditing, governance and SharFa standards for Islamic financial institutions (IFIs) - these have in some cases been implemented on a country level. This is a significant development and should help mitigate informational asymmetries (and hence possibility of moral hazard) between IFIs and the users of their services. Warde's message is political: his language is polemical, his analysis is at best political-economic, and the book is full of political examples. Political analysis tends to be selective and Warde is no exception. O n occasions, he furnishes truncated or no evidence in support of otherwise very strong statements. For example, he mentions a survey on customer satisfaction, which revealed dissatisfaction of customers of Albaraka Bank London (Warde, p. 158). But he fails to mention a number of other studies showing that

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Islamic banks in fact provide services on a par with, if not better than, their conventional counterparts.3 Similarly, the discussion of Saudi and Pakistani involvement in the US-led war against the Soviet Union in Afghanistan suggests that Islamic banking played an important role in funnelling aid to the Mujahideen. In the current scenario, this kind of statements deserves explanation and can be potentially misleading. It is true that the book was written and published in a completely different political environment, yet the arguments furnished in the book need substantiation by facts, a lack most evident where it is most needed.

111. Overview of the Books

i. Islamic Banking by Lewis and Algaoud Like most books written on the subject, LA starts with a lengthy introduction to the phenomenon of Islamic banking in the light of Islamic economics and law. There is some repetition of material already available in a few recently published books (mentioned above). That said this is the first book on Islamic banking to provide an accurate account of the historical development of Islamic banking. While most other books refer to Mit Ghamr Savings Bank in Egypt as the first modern experiment with Islamic banking and finance, LA refers to even earlier developments in Malaysia and Pakistan. The authors assume that their readers know very little about Islam. Even some very basic terms are defined, which readers familiar with Islam will find irrelevant. An appealing aspect of the book is that, following on from its very general introduction, it maintains its easy style throughout, and ends with a non-technical discussion on usury, giving the impression that after all Islamic banking is not as difficult or peculiar a practice as many would otherwise think. The middle chapters (especially chapters 4 and 7) provide a useful analysis of financial intermediation and corporate governance. The mainstream issues in these areas are related to Islamic banking in a relaxed style. This feature makes it a good introductory book for those who have only recently become interested in Islamic banking. Those with some basic knowledge of Islam may wish to skip chapter 2, which is a general introduction to Islam and the Islamic law. Similarly, chapter 8 may not be of interest to those whose primary

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concern is with the practical issues in Islamic banking rather than its theological foundations. The analysis of operations of Islamic banking is distinctively different from many previous studies. LA appears to be the first book indicating that the practice of Islamic banking is moving, slowly but gradually, towards its paradigm version based on profit loss sharing (PLS), as suggested by Siddiqui 1983 and Chapra 198 5. It reports that now more than one-third of financing by 199 Islamic banks worldwide is based on PLS, which is in contrast t o the previous disappointingly low figures. O n an individual level, Faisal Islamic Bank of Egypt now invests on PLS basis one-third of its funds, contrary to the previous figure of about 20 percent. Furthermore, direct investment is reported to be emerging as significant financing activity by Islamic banks. For example, Jordan Islamic Bank for, Finance and Investment invests about 40 percent of its funds directly in companies and joint ventures of different types. Another significant contribution of LA is a discussion (chapter 7) of corporate governance with reference to Islamic banking. The discussion is limited to three Bahrain-based banks. The authors note that there are significant governance differences among the three banks. Financial reporting is not uniform across the banks. For example, Bahrain Islamic Bank (BIB) includes Mudaraba investment accounts along with current accounts, contrary to Faisal Islamic Bank of Bahrain (FIBB) that treats them as off-balance sheet entities, owing to the fiduciary nature of these investments. Al-Baraka Islamic Investment Bank (AIIB) takes a middle course by dividing the Mudaraba investment accounts into joint investment accounts (unrestricted PLS accounts) and specific Mudaraba accounts (restricted PLS accounts), treating the former as a balance sheet entity and the latter as an off-balance sheet entity. Given these variations, there was a need t o discuss the need for standardization of accounting, auditing and governance of Islamic banks. This is an important omission, specially as the Accounting and Auditing Organisation for Islamic Financial Institutions based in Bahrain,4 where one of the authors is based. (Warde, [chapter 101, fills this gap by providing an exhaustive discussion of international regulatory framework and its relevance to Islamic banking.)

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Chapter 8 compares Islamic and Christian attitudes to usury, which seems misplaced after the detailed discussion of corporate governance in the previous chapter. However, there are some interesting observations. The authors note that some of the devices used by early Christians in response to the prohibition of usury by the Church were remarkably similar to the financing instruments used by Islamic banks today. They furnish an interesting example of the Christian distinction between usura and interesse. The former is simply the money paid for the use of money, and was banned by the Medieval Christian laws. The latter refers to the compensation made by a debtor to a creditor for damages caused by the creditor as a result of default in payment of the principal, corresponding to any loss incurred or gain foregone on the creditor's part. This was permissible. However, the unlawfulness of usura and the acceptability of interesse resulted in misuse of the latter, which later resulted in the acceptance of interest in Christianity. The parallel exists in the Islamic law in the form of a distinction between mark-up financing and interest. Although, the mark-up financing is permissible, it is prone to misuse and is potentially a 'back-door for interest to creep in' [LA, p. 1141. Heavy use of mark-up financing may seem innocuous to many, but, when seen in a historical perspective, may be damaging for the Islamic stance on interest. Perhaps, this is why it has already been proclaimed unlawful in Pakistan. The book provides quite a good account of Islamic insurance, an area by and large ignored in other books on Islamic banking and finance. Most of the writers on Islamic insurance originate from Malaysia, creating an impression that Islamic insurance is primarily a Far Eastern phenomenon. LA report, contrary to the common perception, that Saudi Arabia has the largest number of Islamic insurance companies (eleven), followed by Malaysia (with five). Other aspects of Islamic finance are also discussed, albeit briefly. Islamic unit trusts, Islamic investment banking and project finance are examined in chapter 9, with some suggestions for future directions to be taken in this field. Overall the book is a useful reading for researchers as well as students of Islamic economics, banking and f'inance.

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ii. Islamic Finance in the Global Economy by Warde Referring t o many frameworks at a time runs the danger of diluting methodology. Consequently, Warde is simultaneously confusing and intelligent. For example, while discussing the adaptability of Muslim traditions in light of changing circumstances Warde overemphasizes the role of Maslahah (public interest). This emphasis in its own right may seem innocuous but clever mixing of the principles of Maslahah and Darurah (overriding necessity) may prove fatal, especially in Muslim societies dominated by non-Muslim traditions and institutions. This, in effect, amounts to internalizing whatever, right or wrong, happens to enter into Muslim ranks. A clear indication of this is provided in the form of the use of interest by individuals, businesses and governments in Muslim countries, which without doubt lies outside the consensus view on the non-acceptability of interest in any form and guise (pp. 43-44). The book, however, rightly suggests the need for close co-operation between conventional strands of economics and Islamic economics. Although comparison of homo economicus and homo Islamicus is useful (pp. 44-48), mainstream Islamic economists would not accept the suggested causality in theorizing. Like the argument on interest (discussed above), Warde suggests revision of theory in the light of practice, which is the exact opposite of what the purists suggest. The analysis is political-economic with rather more emphasis on politics than economics. For example, chapter I, which is on 'Islamic Finance: Theory and Practice,' discusses Islamic finance in an economic framework in only four pages (pp. 5-9) while the remainder of the chapter (pp. 9-28) by and large deals with political issues facing the contemporary world in general and Islamic finance in particular. The author makes some bold statements which may not be acceptable to mainstream Islamic economists. Similarly, although Warde dedicates one whole chapter to the country-level experiments with Islamic banking and finance (chapter G), his approach is journalistic without proper economic analysis of the Islamisation of banking and economy in the selected countries, namely, Pakistan, Iran, Sudan, Malaysia and Bahrain. An economist reader would note lack of references t o mainstream Islamic economics literature. The author has tended to dismiss it for being inadequately rigorous. Few serious references to

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Islamic economics and its critique include Kuran (who is the most credible critic of Islamic economics), Baqar as-Sadr, and M. Akram Khan. Perhaps Mallat, an expert in Islamic law and by no means an Islamic economist, is the major link between the author and Islamic economics. Warde quotes Baqar as-Sadr through Mallat. Influenced by Mallat, Warde's view of Islamic economics is primarily based on a legal analysis, which is not necessarily held by a majority of Islamic economists. Warde observes some interesting phenomena, especially in the second aggiornamento of Islamic economics. He notes the increasing role of conventional banks in offering Islamic financial products, which have lately been more aggressive than Islamic banks in terms of product innovation and marketing of Islamic financial products. Given the severe competition from conventional banks, Islamic banks need to concentrate on PLS to truly differentiate themselves from their conventional counterparts. Furthermore, they should attempt to achieve the social goals of Islamic economic system, which were emphasized as one of the primary reasons for Islamic banking during the first aggiornamento. However, Islamic banks face a dilemma when competing with conventional banks on the basis of profitability while, at the same time, pursuing the social goals of an Islamic economic system.

IV. Conclusions
Islamic banking and finance, like Islam itself, tends to be one of the most misunderstood phenomena of present times. In some cases the practitioners of Islamic finance have themselves to blame for this confusion. In other instances, the misunderstanding is based on lack of adequate information available on the practice of Islamic finance. For example, one source of confusion is the rather elitist practice of Islamic finance in the Middle East. Many IFIs by and large ignore the socio-economic objectives of Islamic finance. Although ordinary Muslims (and many scholars) perceive Islamic finance as a key to economic development by providing long-term funding to businesses that would otherwise have no or limited access to finance, IFIs have been involved in short term financing mainly in trade and commerce. However, the trend has recently begun to change: any sweeping

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generalization about Islamic finance is likely t o be misleading, if not downright wrong. To sum up, of the two books, an economist would like LA more than Warde, although the latter is more interesting and full of real world examples. This is because an economist would feel uncomfortable drawing conclusions from disparate examples from various countries, without a proper empirical analysis. As suggested in the Introduction, there is a need to understand Islamic banking and finance in the light of Islamic economics. This is exactly what LA does and, hence, should be an economist's preferred choice.

I.
2.

3. 4.

For a review of these books, see Dar 2001. See, for example, Dar, Harvey and Presley 1999; Dar and Presley 2000; and Aggarwal and Yousef 2000. See Al-Fadhly 1998. In January 2002, the Bahrain Monetary Agency, the central bank, promulgated a new set of prudential regulations for Islamic banks. These regulations were prepared with the help of AAOIFI, and aim at reducing informational asymmetries by requiring IFIs to report all their financing activities according to AAOIFI standards.

Aggarwal, R.K. and Yousef, T. (2000) 'Islamic Banks and Investment Financing', Journal of Money, Credit and Banking, 32 ( I ) , (February), pp. 93-120. Al-Fadhly, M. (1998) 'Financial Performance of Islamic Banking in Kuwait'. Unpublished Ph.D dissertation: Department of Economics, Loughborough University. Chapra, M.U. (1985) Towards a Just Monetary System. Leicester: The Islamic Foundation. Dar, H.A., Harvey, D.I., and Presley, J.R. (1999) 'Size, Profitability, and Agency in Profit and Loss Sharing in Islamic Banking and Finance', Proceedings of the Second Harvard University Forum on Islamic Finance. Cambridge, M. A.: Harvard University. Dar, H.A. and Presley, J.R. (2000) 'Lack of Profit Loss Sharing in Islamic Banking: Management and Control Imbalances', International Journal of Islamic Financial Services, 2 (2), (July-September), pp. 3-18. Dar, H.A. (2001) 'Islamic Economics, Banking and Finance: A Critical Review of Recent Literature', The Muslim World Book Review, 2 1 (3), (April-June), pp. 3-16.

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Kuran, T. (1995) 'Islamic Economics and the Islamic Subeconomy', Journal o f Economics Perspectives, q (4),pp. I 5 5-73. Lewis, M.K. and Algaoud, L.M.
(2001)

Islamic Banking. Cheltenham: Edward Elgar.

Mills, P. and Presley, J.R. (1999) Islamic Finance: Theory and Practice. Basingstoke: Macmillan. Siddiqui, M.N. (1983) Issues i n Islamic Baking. Leicester: The Islamic Foundation. Usmani, M.T. (1999) A n Introduction t o Islamic Finance. Karachi: Idaratul Ma'arif. Vogel, F.E and Hayes, S.L. (1998) Islamic L a w and Finance: Risk, Religion and Return. The Hague: Kluwer Law International. Warde, I. (2000) Islamic Finance i n the Global Economy. Edinburgh: Edinburgh University Press.