The trajectory of the mainstream Islamic financial services sector, as we understand, has never been smooth. The maiden experiments in Islamic banking and finance perhaps started with the birth of institutions like the Dubai Islamic Bank and the Islamic Development Bank in the mid-1970s. A new breed of scholars, known as Islamic economists, dominated all discourse related to this emerging discipline called Islamic finance. Conventional finance was rightly condemned as unethical and unacceptable due to the presence of riba, gharar, maysir, ghubn and such other elements. Scholars would spend endless hours subjecting each and every financial product and service in the banking and insurance sectors to the tests of Shariah norms and identifying the Islamic alternative. In terms of models of banking and insurance there were early breakthroughs in the form of two-tier-mudarabah and (non-profit) mutual-cooperation as the basis of Islamization respectively. Studies were reported that would prove and celebrate the superiority (in terms of efficiency and robustness) of these ethical models over their conventional counterparts.

Take one step forward, beyond the line that divides the permissible-prohibited space, and you are in Islamic terrain. You have the best of both the worlds.

The Switch

Development of financial products and services followed. A new breed of professionals was fast appearing on the scene. Many of them had spent years in conventional banking and were apparently eager to move over (and get rid of the feeling of guilt). Also, the infant Islamic banking and insurance industry needed such professionals who knew what banking and insurance was all about. There was a perfect match. The marriage would be successful, everyone hoped. Soon, the first offspring of this marriage, murabaha was on the table. Some would call it bai-muajjal and others, bai-bithaman-ajil. The conventional-turned-Islamic banker was happy, since it was familiar territory. Take one step forward, beyond the line that divides the permissible-prohibited space, and you are in Islamic terrain. You have the best of both the worlds. The popularity of the offspring took many scholars by surprise. Some were still in a celebratory mode. Islamic banking had arrived. Not everyone was enthused, however.  A section among the scholars favored its outright rejection as they did not see any element of risk-taking by the financier (bank). And how can you make the promise of the client (to buy from the bank, once the latter purchases it from the vendor) binding on him, they asked? Classical Shariah scholarship did make promises non-binding after all. They spoke about replacing such spurious products with qard-hasanah but were quickly countered by the professionals. Wasn’t it their sacred duty to maximize the wealth of the shareholders, given the for-profit nature of the company? How could they ever achieve their goal using non-profit modes like qard? 

What’s Our Benchmark?

The second offspring – ijara or leasing – had better acceptance. But wait a minute. Isn’t classical ijara all about operating and not financial lease? But then, how can you expect a bank (forget the Islamic part for a moment) to engage in rent-a-car or rent-a-cart business, just as you shouldn’t expect it to act like a seller in a murabaha and be exposed to all kinds of risks related to ownership. And why should rental of the asset be determined by its productivity or usage, when the cost of funds was to be determined by LIBOR (London Interbank Offer Rate)? After all, the (Islamic) bank was simply concerned with predetermined cash flows without anything to do with the asset. Did the (Islamic) bankers make their case? The answer was perhaps a strong negative. Those questioning the use of LIBOR were tossed a question – what is wrong if I as a seller of halal meat price my product in such a way that I am as profitable as my neighboring seller of haram meat? What is wrong if I use his price as a benchmark for setting my price? Well-argued and logical perhaps, but I felt we were still missing the bigger picture. Shouldn’t a seller in the Islamic market take into account many other considerations, such as, a consumer’s surplus and welfare, affordability and needs, and what-have-you? Certainly, mimicking the seller of haram meat was not the best of the ideas, even when the exercise was itself halal.

Mimicking the seller of haram meat was not the best of the ideas, even when the exercise was itself halal.

Incentivized by Profits

In the field of insurance, mutuality did not have many takers and it had quickly given way to for-profit considerations. The takaful operator companies appeared on the scene. Some iterations in the model of non-profit member-based cooperative would now make the company a mudarib/ wakeel entrusted with management of the corpus of contributions (or of the entire operation) entitled to profit share. Even a share in underwriting surplus would be made permissible later on grounds of incentivizing efficiency. It was a win-win for all. The conventional insurance- turned- takaful professionals were once again in familiar territory.

Come 1990s, attention quickly turned to Islamic investments and capital markets. How does one invest Islamically? You become a part-owner of a company if you buy a share (this is what classical scholarship prescribed). And none of the companies out there were free from interest (riba) on both sides of their balance sheets. The one-third rule came as a savior. To me, one-third meant a lot. But the scholars said otherwise. If a haram element in a portfolio or a combination was less than one-third, it was insignificant and could be tolerated. This show of tolerance was inexplicable. There was this concern about providing the faithful with an avenue for halal investment. ‘Isn’t the presence of riba or haram elements the mother of all concerns?’, I asked myself. Screens ruled the scene. The market was flooded with Islamic funds. The Islamic capital market was born. 

Isn’t the presence of riba or haram elements the mother of all concerns?

Redefining Riba

This is the time when my personal learning journey into this field began. In 1996, when I attended an international conference in Dubai on the subject, I could feel the excitement flowing through my veins. I took extensive notes in every single session I attended. The presentations were varied and covered a range of topics – the notion of commercial displacement risk (unfortunately, there was no talk of any empirical evidence in its support, yet it formed the basis of the proposed capital adequacy for Islamic banks), Islamic financing of infrastructure projects (the KL international airport as well as the LRT projects), Ijara Funds and what-have-you. The Shariah session was devoted to the issue of Bai-al-Inah, addressed by a Malaysian and a Bahraini scholar. The debate was lively. I got the impression that there were two distinct schools of Islamic finance. One of these was clearly bent on developing the Islamic financial system around inah. The other was determined not to permit this. I quietly prayed and wished that the former school rooted in falsehood would perish in due course. As a student of finance, I always knew Repo (repurchase) to be an interest rate. And here I was being told that Repo could be the basis of Islamic finance! Truth was going to prevail, after all. 

Alas, I did not anticipate the impending invasion of tawarruq. It was to come from the very same people who appeared to be solid protagonists of a riba-free system by ruling out inah completely. This so-called permissible mechanism would simply expand the equation, increasing the number of players from two to three or more, but yield the same result – X amount of money sold now for a repayment of X+Y amount of money after a time period. The definition of riba as I understood all these years seemed to have been altered permanently. The new Islamic finance leaders would brook no further discussion in the matter. Suddenly, any mention of riba had become unfashionable.

The definition of riba as I understood all these years seemed to have been altered permanently.

Creative Engineering

With my doctoral thesis on pricing and informational efficiency of Stock Markets, I was naturally attracted to Islamic Funds, investments, and capital markets. The markets were crowded with Funds. It matured further with the emergence of sukuk – the Islamic financial instruments (not everyone was comfortable with the term – Islamic bonds). The asset ijara sukuk seemed like the perfect Islamic answer to financial engineering taking place in the conventional domain. But lo and behold, more improvisations followed. You can still have up to 49 percent of murabaha debt (that is non-tradable) in an overall portfolio against which tradable sukuk could be issued. The onset of a sukuk boom was inevitable. Then still more innovation and creativity followed in the form of “assured” returns on the sukuk. The sponsors could benefit from the upside – returns over and above the floor and lend and effectively guarantee the same. The boom was gathering more and more strength. It was as if the law firms were out to write the final epitaph for Islamic finance with all the fine prints in sukuk prospectuses that could never be subjected to Shariah scrutiny by ordinary mortals. Personally, for me the proverbial last straw that broke the camel’s back was a session on sukuk where I found myself struggling to explain to my students how and why ABC company would sell its assets to ABC-X (name plate company created for the issuance purpose only) and take them back on lease. It was a class in economics and not on legal tricks. I had to talk sense and the participants were not naïve. The question raised by them was simple. How can I sell something to myself and take it back on lease from myself, and still claim that this is permitted in Shariah!

How can I sell something to myself and take it back on lease from myself, and still claim that this is permitted in Shariah!

A red flag by an eminent scholar against the “assured” and “guaranteed” returns on sukuk did cause some flutter in the market. Though the issuers were believed to have tasted blood and were not going to stop, something strange was round the corner. A crisis in the conventional financial system was brewing and having its impact on the Islamic space. The boom in the sukuk market was losing its steam. And finally, it petered out.

A Silver Lining?

During these years, many were fast getting disillusioned with the entire discipline and the sector. It was like a point of no return for them. Islamic finance was no longer “Islamic” to them. A few fatwas even claimed that Islamic banking was haram!  The global financial crisis however, had put some oxygen back into Islamic economic scholarship. Some scholars got busy with the theory that the global financial crisis was due to the presence of complexity (gharar) and that an Islamic economy would be more insulated from such crises. Some were quick to point out how indigenous experiments like Islamic financial cooperatives (Baitul Maal wat Tamweel) in Indonesia offering Islamic microfinance to the poor were by and large, unaffected by the crisis. The microfinance sector was already in the news with the Nobel Prize going to Dr Yunus and Grameen, and there was talk of a perfect marriage between microfinance and Islamic finance. The new sub-sector called Islamic microfinance had started getting a lot of traction. It was the perfect area of inquiry and engagement for me.

(Continued, click here for Part II of this series)

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