Recent History of Islamic Banking and Finance

(Anderson Graduate School of Management, University of California,

Los Angeles, 7 November 2001)
During the eighteenth, nineteenth and the first half of the twentieth
centuries almost all of the world of Islam was colonized by the European
countries. They managed the economies and finances of these countries
in their own interests and in their own ways. Other than the native elites
who had to get involved, the Muslim masses stayed away from interestbased financial institutions. As the national consciousness grew and
freedom movements promised to bear fruits during the second half of the
last century, the urge to manage their affairs in accordance with their own
values and traditions also emerged in these countries. Indonesia gained
independence in 1945 and Algeria in 1963. In between these two dates,
all Muslim majority countries became independent. The discussion on the
management of their respective economies in order to promote their own
interests had, as an offshoot, brought the Islamic financial movement
into being. While nationalism made them focus on rapid economic
development, religion, the other motivating force in freedom struggle,
made many turn to Islam for guidance.
Theoretical Literature
Early theoretical work on the subject appeared during 1940s through
1960s, in Urdu, Arabic and English. The focus was not banking and
finance in the narrow sense but the economic system as a whole. The
writer would , generally speaking, criticize capitalism and socialism and
proceed to outline a system based on Islamic injunctions relating to
moderation in consumption, helping the poor, encouragement of
economic enterprise, avoidance of waste, justice and fairness, etc. The
poor tax, zakat, and prohibition of interest would be emphasized in this
context. It would be argued that Muslims should not adopt the
conventional system of money, banking and finance blindly. They must
purge it of prohibited interest and modify it to suit the just and poorfriendly economic system of Islam. Some of these writers went beyond
generalities and suggested that the early Islamic contracts provided sound
bases for restructuring banking so that it was free of interest and served
the goals of Islam. The youngest of Islamic countries, Pakistan, made the
commitment to abolish Riba a part of its constitution.

Professional Muslim economists as well as Shariah scholars made

significant contributions to the subject so that by the end of 1960s some
kind of a blueprint of Islamic banking was available. Bankers and
businessmen had also joined the task of evolving a workable model since
efforts were on in several Muslim countries to put the idea into practice.
The political conditions in Arab countries were not favorable for any
initiative at the state level. But private practical initiatives had a greater
chance of mobilizing the monies needed for such a venture in these
countries, as we shall see when tracing the history of the practice of
Islamic banking.
The earliest theoretical model was based on two-tier mudaraba, profit
sharing replacing interest in bank-depositor as well as bank-borrower
relationship. Islamic banks would be financial intermediaries, like
conventional commercial banks, only they would purge interest from all
their operations, relying on partnership and profit-sharing instead. They
could operate demand deposits like their conventional counterparts and
offer other services against fees, like other banks. Banks directly doing
business and entering the real estate market in order to make profits for
their depositors and shareholders( partners ) was not a part of this model.
But practitioners in the Arab world did not see much scope in this
model. Accepting deposits into investment accounts on profit-sharing
basis was all right, but their profitable employment needed direct
involvement in business. Merchant banking was also nearer to the milieu
with which Shariah scholars were familiar. They felt more at home with a
model in which savings were mobilized on profit sharing basis but their
profitable use was based on familiar Islamic contracts of sale and
purchase and leasing, etc.
Murabaha, i.e, cost plus or mark up financing entered into the model of
Islamic banking in the second half of the nineteen-seventies. By this time
practice had revealed the difficulties of applying the mudaraba ( profitsharing) contract in dealing with businessmen in a legal environment that
failed to provide any protection to the financier in this case, unlike the
protection it provided to interest based finance. Adverse selection in an
environment dominated by interest-based institutions was another serious
problem. Other Islamic contracts like salam, istisna and wakala were
also being explored. Shariah scholars, many of them formally advising
Islamic financial institutions, made significant contributions in
developing the model.

One of the specific needs to meet was financing house purchase on

terms acceptable Islamically. Three models of interest free finance were
developed. The first, which formed the basis of the House Building
Finance Corporation of Pakistan (1980 ),was based on joint ownership
and rent sharing, eventually leading to the home dweller possessing it in
full as he/she purchased the government owned part bit by bit. The
second was a cooperative in which members pooled resources and got
funded in turn, the pooled resources being profitably invested while
waiting. The third method is based on murabaha, the customer paying the
higher deferred price in installments.
In practice small variation were introduced to ensure Shariah
compatibility as well as financial viability.
During 1980s the subject of Islamic banking and finance received broad
based academic and professional attention. A number of Muslim countries
began considering implementation of the idea officially and appointed
expert bodies to work out the details. Several universities started teaching
the subject and encouraged research resulting into hundreds of PhD
dissertations, some of them in the universities in Europe and America.
Numerous seminars and conferences drew attention to the subject in
places as wide apart as Kuala Lumpur, Dhaka, Islamabad, Bahrain,
Jeddah, Cairo, Khartoum, Sokoto ( Nigeria ), Tunis, Geneva, London and
New York. A number of research centers made Islamic economics their
field, paying special attention to money and banking. Some of these
launched academic journals providing forums for exchange of views and
dissemination of information on a world-wide scale.
During the 1990s the model was further developed and refined. The
liabilities side saw frameworks put in place for handling trust funds,
venture capitals, and financial papers based on ijara ( leasing ) salam
( forwards ) and murabaha (mark up ). The special techniques for
launching Shariah compatible mutual funds were also developed in this
period. This involved selecting companies whose shares could be traded
as they did not violate any Shariah norms. This selection was made by
screening out the undesirables. The first norm was that the products in
which the company dealt should not be prohibited ones like alcohol or
pork. The other was that its finances should be free of interest bearing
loans and its revenue free of interest income. Since the condition about
debt finance would eliminate almost all shares traded on the stock
exchange, some scholars allowed a leverage of 30% or less. There could
be other criteria also but these two are the main, common to all existing
Islamic funds. Once the filtering process was complete, managing a

portfolio became a professional job. This is why the phenomenon of

Islamic mutual funds, even though endorsed by a group of Shariah
scholars, owes itself to the initiative of professional players in the field.
As the launching of the Dow Jones Islamic Indexes evidenced, Islamic
finance too needed the modern tools designed to handle the complex web
of financial transactions. The Indexes track Shariah compliant stocks
from around the world.
Advantages of Islamic Banking and Finance
Before we turn to Islamic banking in practice, let us note some of its
features emphasized in the literature.
Justice and fairness to all concerned was the main feature of a model of
financial intermediation whose core was profit-sharing. Interest was
essentially unfair because our environment does not guarantee positive
returns to business enterprise financed with borrowed money capital.
Current practice penalizes entrepreneurship by obliging it to return the
principal even when part of it is lost due to circumstances beyond the
entrepreneurs control. Justice requires that money capital seeking profit
share the risk attached to profit making. A just system of financial
intermediation would contribute to a more equitable distribution of
income and wealth.
Islamic finance will foster greater stability as it synchronizes payment
obligations of the entrepreneur with his or her revenues .This is possible
only when the obligation to pay back the funds acquired from the
financier and pay a profit is related to realization of profits in the project
in which the funds are invested, as it is in the profit-sharing model.
Contrary to this, in the debt-financing model the payment obligations of
the entrepreneur are dated as well as fixed in amount. The same is the
case with the financial intermediaries, their commitment to the depositors
in time and saving accounts is to pay back the sum deposited with interest
added. When a project fails and businessman defaults, the financial
intermediary must also default with ripple effects destabilizing the whole
system. The debt based financial system of capitalism is inherently prone
to recurrent crises. This malaise of the capitalist financial system is well
discussed by Hyman P. Minskey in his book, Stabilizing an Unstable
Economy ( New Haven and London, Yale University Press,1986.)
The linking of depositors entitlements to the actual profitability of the
projects in which their monies are invested through the services of the
financial intermediary, the bank, would almost eliminate the risk of runs

on the bank insofar as the investment accounts are concerned. A report or

rumor that the bank investments are not doing well will not prompt a rush
of withdrawals from investment accounts as depositors could get only
what is actually salvageable. Waiting till the situation improves would be
a more rational option.
Islamic finance is more efficient as it allocates investable fund on the
basis of expected value productivity of projects rather than on the
criterion of creditworthiness of those who own the projects, as is the case
in debt based finance. There is no guaranty that the most promising
projects seeking finance will come from the most wealthy. As
Schumpeter has shown the most innovative may be empty handed. But
debt finance would not serve these. It would prefer those who, on the
basis of other assets owned by them,
would be able to pay back the sum borrowed, interest added, even when
the project being financed failed to create additional wealth.
Last but not the least, Islamic finance will be less prone to inflation and
less vulnerable to gambling-like speculation, both of these being currently
fueled by the presence of huge quantities of debt instruments in the
market. Debt instruments function as money substitutes while equitybased financial instruments do not. And speculators find it much easier to
manipulate debt instruments than those based on profit-sharing.
It is true that these advantages belong to a system whose core is profitsharing. But even murabaha (cost plus or mark up ) financing keeps the
system far less vulnerable to inflation and gambling-like speculation than
the conventional debt based arrangements. Murabaha is firmly linked
with exchange of real goods and services. It is a price, to be paid later. It
is essentially different from money given as a loan which may or may not
be linked to production or exchange of real goods and services. An
Islamic system of finance in which profit-sharing and mark up financing
both exist side by side would still retain the advantages noted above.
Islamic Banking Practice: Early Initiatives
A number of interest free saving and loan societies are reported to have
been established in the Indian subcontinent during 1940s. But efforts to
arrange finance for business enterprises seem to have started later. One
pioneering but short lived experiment was that in Mit Ghamr in the Nile

valley in Egypt in 1963. Same year saw the establishment of Tabung Haji
in Malaysia. Money being saved for meeting the cost of the pilgrimage to
Makkah is profitably invested by this organization which is still working.
The Phillipine Amanah Bank was also established during the same period
to enable Muslims to meet some of their financial needs without
involving interest. An interest free bank in Karachi, Pakistan was
established by some individuals around the same time but it did not
survive for long.
Islamic Banking Practice In The Private Corporate Sector
The Dubai Islamic Bank was established in 1975 under a special law
allowing it to engage in business enterprise while accepting deposits into
checking accounts, which were guaranteed, as well as into investment
accounts which were to receive a share in the profit accruing due to their
use in business by the bank. Within the next ten years, i.e. by 1985, 27
more banks were established in the same manner in the Gulf countries,
Egypt, Sudan, etc. Many more were to follow all over the Muslim world.
Also by 1985, over 50 conventional banks, some of them located at
money centers like London, were offering Islamic financial products.
This was followed by up by some of the major conventional banks
establishing Islamic branches dealing exclusively in Islamic products.
Citi-Islamic in Bahrain and Grindlays in Karachi were followed by the
National Commercial Bank in Saudi Arabia establishing over 50 Islamic
branches by 1990s.
Islamic investment companies and Islamic insurance companies also
appeared in the late 1970s and grew in number. Later, in 1990s, a number
of Islamic mutual funds appeared, many of them being managed by
reputed western firms.
By the year 2000, there were 200 Islamic financial institutions with
over US$ 8 billions in capital, over $100 billions in deposits, managing
assets worth more than $ 160 billions. About 40% of these are in the
Persian Gulf and the Middle East, another 40% in south and south-east
Asia, the remaining equally divided between Africa on the one hand and
Europe and the Americas on the other hand. Two thirds of these
institutions are very small, with assets less than 100 million US dollars.
Two Islamic banks operated in Europe for some years. Islamic Bank of
Denmark was converted into an investment company and Al Barakah
London had to stop deposit taking. As the Bank of England explained, a
deposit taking institution had to guarantee its repayment in full in order to
qualify for a banking license. As of now, western societies are served
either by Islamic mutual funds or by grass roots initiatives at the

community level financing the purchase of houses and other consumer

durables.
Islamic Banking at the State Level
Pakistan Islamized banking between 1979 and 1985 through a series of
Ordinances issued by the Federal government and a number of circulars
issued by the State Bank of Pakistan, the countrys central bank. Even
though profit sharing replaced interest as the basis of time deposits and
saving accounts, the actual rates paid are not market determined as all
major banks were nationalized during the previous regime. On the assets
side mark up became the main basis of bank finance for business. Some
financial products based on profit-sharing were launched but their role in
the market is minimal. Government finances remain conventional,
burdened with huge interest based foreign and domestic debts.
Private initiative played little role in the Islamization process and the
market hardly got a chance to throw up Shariah compatible financial
instruments . The whole process was conducted with some speed by the
bureaucracy under orders from the top. Even the recommendation of the
Islamic Ideology Council to make a start from the assets side was not
heeded.
Iran passed its usury free banking laws in 1983. All banks are
nationalized. In accordance with the school of Islamic law followed in
Iran, depositors may get rewards on their savings provided they are not
committed in advance. Financing of domestic and external trade is done
on mark up basis. But sharing modes do play a significant role in
financing agriculture and industry. Interest free loans are available for the
poor to meet such needs as housing, their source being the state.
Sudan launched Islamic banking in 1984 whose coverage was later
extended to the entire financial sector in 1989. Sharing based modes of
finance are used in agriculture and industry and the government is
considering sharing based investment certificates to be sold to public, the
funds so mobilized to be used in developmental projects. The poor state
of the economy stands in the way of the market playing any significant
role in the process. But the recent phenomenon of oil as an increasing
source of public revenue is likely to make a difference.

Malaysia had its first officially sponsored Islamic bank in 1983. All
other banks also offer Islamic financial products. Overall supervision
vests in the countrys central bank, Bank Negara Malaysia, which has a
board of Shariah scholars to advise it. Malaysian Islamic financial system
allows sale of debt instruments based on receivables from sale of real
goods and services and those based on leasing. The government issues
bonds (Malaysian Government Investment Certificates, MGICs) to be
redeemed at par but carrying coupons conferring financial benefits that
vary. Malaysia has an active Islamic money market trading in assets
based securities.
Indonesias Bank Muamalat, established 1994 under state patronage, has
about 400 branches all over the country. Its financial operations follow
the Malaysian model. There are other smaller Islamic banks too, e.g. the
Shariah Bank.
Turkey does not practice Islamic banking at the state level, but several
Islamic banks were launched under special licenses in late eighties-early
nineties. They are still functioning, along with other non-bank Islamic
financial institutions.
The Islamic Development Bank
The Organization of Islamic Conference ( OIC ) took several steps
culminating in the establishment of a bank of Islamic countries which
would serve the entire Muslim ummah ( community of the faithful ).
Share capital, initially fixed at US dollars two billion was supplied by
member countries the largest coming from Saudi Arabia, Kuwait, Libya ,
United Arab Emirates and Iran. It started operations in 1975 with head
quarters at Jeddah, Saudi Arabia. Clause one of its charter states that it
was to foster economic development and social progress of member
countries and Muslim communities individually as well as jointly in
accordance with the principles of shariah. In compliance, the IDB does
not deal with interest.
By the year 2000 the Islamic Development Bank ( IDB ) had financed
inter-Islamic trade to the tune of over 8 billion US dollars mostly using
the mark up technique. It also gives loans, taking only service charges
according to actual administrative expenditures. But it does try to
promote sharing based modes of financing. It is also managing an
investment portfolio in which individual Islamic banks place their surplus
liquidity. Even though it can not, and does not aspire to, serve as a lender
of last resort for all Islamic banks, it is trying to help them solve their

liquidity problems. It fosters technical cooperation between member

countries and has established or sponsored a number of institutions for
this purpose. The Islamic Chamber of Commerce and the Islamic
Foundation for Science, Technology and Development are two of these. It
is also distributing scholarships for higher learning and technical
education to Muslim students in countries in which Muslims are in a
minority.
In order to fulfill its mission, the IDB has established the Islamic
Research and Training Institute (IRTI). It conducts in house research,
sponsors external research, publishes a research journal, conducts training
courses, organizes seminars and conferences and maintains a data base on
Islamic countries economies, etc.
The Islamic Development Bank interacts with all regional and
international financial institutions like the International Monetary Fund
(IMF), the World Bank, the Asian Development Bank, etc.
Islamic Banking and Finance as Part of the International Community
The IMF issued its first study on Islamic banking in 1987. Since then
more than a dozen research papers have come from that forum on
important aspects of Islamic finance. IMF has reported no problems in
dealing with member countries committed to Islamic banking. On the
other hand Islamic financial institutions too never faced any problems
dealing with regional
and international financial institutions. The Accounting and Auditing
Organization for Islamic Financial Institutions (AAOIFI) is in contact
with the standards committee of the Bank of International Settlements
based at Basel, Switzerland.
All Islamic financial institutions operate within the system supervised
by their respective central banks and other relevant authorities. They are
neither working in isolation nor engaged in creating a separate space of
their own. They are inspired by a vision of financial arrangements more
conducive to justice and development for all, especially the poor and the
weak. This is a goal hopefully cherished by all.