From its advent in seventh century Arabia, Islam spread outward in all directions throughout the Middle East to Asia, Africa as well as Europe. From the seventh to the fourteenth centuries, while Europe faced its Dark Ages, the Islamic civilisation
experienced its Golden Age20, characterised by rising economic strength, advancement in knowledge, technology, and culture. Significant contributions were made in the fields of science, mathematics, economics, law, philosophy and literature amongst others (Warde, 2000).
On the financial front as well, the Islamic world was far ahead of the West, having developed a wide variety of credit institutions by the mid-eighth century. Historical records from the ninth to the eleventh century show evidence of complex quasi-banking activities in tenth century Iraq, an extensive ramified system of proto-banking in
eleventh century Egypt and North Africa as well as widespread use of credit instruments which preceded their conventional counterpart. The latter included the suftaja (bill of exchange/letter of credit), as well as the ruq’as and sukuk (akin to modern-day cheques) 21. Many of the complex financial instruments commonly used and accepted as part of commercial life in the Islamic world were later adopted by the West (Udovitch, 1975). Famous examples include the sakk (singular of sukuk, referring to financial certificate) which is considered to be the root of the French/English word cheque (Warde, 2000; El-Gamal, 2006) and the mudarabah, a profit-and-loss sharing (PLS) financing arrangement developed to support the financial needs of merchants along major trade routes, which later became known as the ‘commenda’ in Europe (Harris, 2009). Although extensively used and discussed in religious and legal
documents in the first two centuries of Islam, the mudarabah reached Europe centuries later with the oldest records found in Northern Italy in the late 11th and 12th centuries (Harris, 2009, see also references within). Other financial practices and similar credit techniques to those developed during the earliest medieval period in the Islamic world also began to appear in the West several centuries later, some as late as the 13th century. Thus, the widespread use of complex financial instruments in the early Islamic world is attested to be at least three to four centuries earlier than anything comparable appearing in medieval Europe (Udovitch, 1975).
20 The Golden Age of Islam is approximated to be between the seventh to the tenth centuries in the
Middle East and eleventh to the fourteenth centuries in Spain and the North African region (Warde, 2000).
21 The ruqa’s (literally notes) were used in short distance and local trade as orders for payments, delivery
and as promissory notes. These complemented sakks (literally a “written documentation of financial liability”) and were used as instructions for transfer or deposit of funds and for payments of a variety of bills. Both operated as close equivalents of modern-day cheques (Udovitch, 1975; Shanmugam and Zahari, 2009; El-Gamal, 2006, p.195, see also references within).
29
Despite this four century head start, the Islamic world did not develop independent banking institutions, of the kind present today. Indeed the developments in the Islamic world preceded the emergence of standalone institutions devoted to banking, the foundations of which were laid in 12th century Europe and then firmly established by 14th century Italian commercial banking houses. From the 14th to the 16th centuries, this European banking model, which operated by converting deposits into credit, became more elaborate and has ever since followed an upward trend in complexity, size and influence, proceeding to the present day complex banking and financial institutions (Udovitch, 1975; Warde, 2000).
Such an institution however did not and could not have developed in the Islamic world. As Udovitch (1975) explains this was due to a number of factors, including the socio- economic structure of Islamic economies and rules governing financial transactions. In the Islamic world, financial services were provided through two institutions: money- changers and merchant bankers, although some of their functions overlapped. The former were a reliable source of international coinage and their evaluation, facilitating the interchangeability of gold and silver coins, used then as currency. In commercial centres such as Alexandria, money-changers occupied their own special bazaars, akin to Wall Street, which served as the nerve centres of financial exchange. Profits were primarily earned in form of a fixed transaction fee for each exchange.
Merchant bankers were involved in a variety of proto-banking activities, from issuing bills of exchange (suftajas), accepting deposits (although no interest was paid on these) to acting as a clearinghouse for payments through extensively using ruqa’s and sukuk as well as money-changing for those with significant involvement in international trade. Despite their extensive banking operations, no individual was exclusively a banker. Instead, all banking activities undertaken by merchant-bankers were an extension of their commercial endeavours, related directly or indirectly to the trade in commodities (Udovitch, 1975). This was an important factor in the development of financial
institutions in the Islamic world. In line with the gharar prohibition, all financial transactions were linked to a real economic activity through either trade of goods, production or investment in commercial ventures. Thus, there was no need for a
standalone financial institution as financial activities were never autonomous but rather always conducted as a subset of commerce (Warde, 2000).
Credit provided to support the financial needs of merchants, domestic households, agriculture and industry primarily came in the form of credit and prepayment sale contracts as well as profit-and-loss sharing (PLS) arrangements. Credit sales were not only an indispensable source of credit supporting long-distance international trade but also an important source of profit, fully consistent with Islamic law. The sale of an item on credit for a higher than spot price is permitted under Islamic law, as the difference in price is considered a legitimate compensation to the creditor for the absence of capital, the risks involved and the benefit the buyer is able to receive through the use of the goods before full payment is made (Udovtich, 1975; Usmani, 2004; Visser, 2009). This encouraged widespread use of credit sales which explains why the prohibition of riba was observed to a considerable extent at the time, without retarding commercial activities. In keeping with the riba prohibition, investment in trade and industry was based on PLS arrangements, particularly the mudarabah and its variants, which were used as flexible alternatives to the interest-bearing loan contract. Usurious transactions were not the norm and the use of traditional Islamic loan contract i.e. qard hasan (interest-free benevolent loan) was insignificant in commerce (Udovtich, 1975). The relationship between deposit and credit was also very different in the Islamic world. The European bank developed as an intermediary which converted deposits into credit. In the Islamic world, this form of financial intermediation i.e. the conversion of deposits into return-generating loans was not possible as there was a disconnection between deposit and credit functions. In the Islamic world, deposits were held in form of trust. The contract of wadiah (safekeeping) was used which neither involved payment of any fee or compensation either to the depository or the depositor, nor permitted the depository to use the deposited funds. The function of this contract was restricted to safeguarding of money/goods deposited. This ensured that
credit/investment and deposit activities were kept separate and within narrow confines. This was in sharp contrast to the European experience where the depository could not only use the deposited funds for its own commercial endeavours, generating credit, but also paid a premium to the depositors for this privilege. The latter, which developed into a deposit banking system continuing to this day, could clearly not be established in the Islamic world (Udovitch, 1975; Warde, 2000).
In addition to the legal framework and financial structure, the social context was also an important factor. Credit, banking and commercial institutions in the Islamic world were
primarily reliant on a close-knit network of personal and communal relationships. Granting of credit was primarily based on the status and reputation of the parties concerned and was embedded in intricate albeit informally-structured but nonetheless an effective network of personal-social relationships. Merchant banking activities outside of such a network were rare (Udovitch, 1975; Warde, 2000). As Udovitch argues, these exact social-personal relations, which ensured successful and effective functioning of merchant banking and credit activities during the medieval period, were also the factors which confined their elaboration, development and growth into
independent organisational forms. The complexities, unpredictability and slowness of communication between distant geographical locations limited the scale of economic activities at the time to numerous intimate circles, the integration of which into a much larger independent structure was precluded by the reliance on strong social networks. Thus, the socio-economic structure of the medieval Islamic civilisation did not lay down the foundations to construct economic institutions which could exist
independently of the intricate social network on which economic life was based
(Udovitch, 1975). With no individual specialising in banking, a disconnection between deposit and credit functions, and financial relationships predominantly embedded in personal and communal ties, the European style independent deposit banking system could not and did not develop in the medieval Islamic world.
Although not indigenously developed, the European banking model did firmly establish itself in the Islamic world. This was possible due to changes in world economic powers. As Europe exited the Dark Ages, it underwent a huge transformation through the stages of the Renaissance, Reformation, Enlightenment, Industrial Revolution, and
Imperialism. In contrast, the Islamic world began to experience a break from it celebrated past as well as developments in the West, resulting in prolonged period of stagnation followed by decline between the fifteenth and the twentieth centuries (Warde, 2000). By the nineteenth century, a huge gap between the West and the
Muslim world had developed which was followed by most of the Muslim world falling under colonial rule (Iqbal and Molyneux, 2005).
The economic, political and cultural impact of Western ascendency has been of significant importance in shaping the Muslim world. By the late nineteenth century, Western models of economics, law, politics and education were imposed on most Muslim countries which underwent, along with Westernisation, a thorough process of
secularisation. The role of religious scholars was significantly reduced while that of publically elected representatives was enhanced. This period was also critical for the financial sector, as the traditional Islamic financial institutions were replaced by western counterparts. The European interest-based model of commercial banking, which was first transported to most of the Muslim world through trade, became firmly established through colonisation. Muslim countries’ banking sectors thereafter began operating on the conventional interest-based banking model (Warde, 2000; Maali and Napier, 2010).
The mid twentieth century brought about another notable change. With the fall of the British Empire in colonial India and the creation of Pakistan, a separate independent state for South-Asian Muslims, a movement to revive Islamic norms in the economic domain ignited. Contributions from South-Asian scholars, especially the writing of Maulana Mawdudi (1903-1979), which gave rise to the term ‘Islamic Economics’ became of significant influence22. Following Mawdudi’s seminal work, an abundance of literature was produced on Islamic economics, with the largest contributions made by Pakistani scholars23. Driven by the establishment of a separate sovereign state based on religious identity, Pakistan became the pioneer of the Islamisation24 movement (Wilson, 1983; Kuran, 1996; Warde, 2000).
The Islamic economics doctrine which appeared in the postcolonial era, as Kuran (1995, 1996, 2004) has extensively argued, was driven largely by “cultural rather than economic concerns” (Kuran, 1996, p.438). Aimed at re-establishing the importance of religion in the economic domain, it emerged as an instrument to create, protect and strengthen the religious identity of South Asian Muslims which at the time was
considered threatened by western influence. It therefore lacked scientific rigour and was primarily normative. Few contributions in the literature proposed solutions for modern- day economic problems. Instead the focus was firmly placed on establishing an
‘Islamic’ approach towards economics (Kuran, 1996). Two features became dominant 22 Influential figures in the Arab world include Sayyid Qutb and Baqir Al-Sadr (El-Gamal, 2006). 23
Despite Saudi Arabia being the birthplace of Islam and the Arab Peninsula being the centre of the earliest Islamic civilisation, the only serious debate about applying Islamic principles to economics in modern times took place in Pakistan and not the Middle East. Unsurprisingly so, as Pakistan is the world's only country which was founded explicitly for the purpose of providing Muslims a state to govern themselves in accordance with Islamic principles (Wilson, 1983; Kuran, 1996; Warde, 2000).
24 Islamisation refers to the process of desecularising the state including the legal, political and economic
systems to bring these in line with the Islamic principles (Haniffa and Hudaib, 2010).
33
in the literature. First, the prohibition of riba, translated within narrow confines as a ban on interest, which took centre stage and second, the emphasis on social justice in Islam, which translated into socio-economic development being one of the primary goals of an Islamic financial system (Chapra, 1985).
With the ban on interest taken as the central precept, the challenge was to Islamicize the existing interest-based banking system. However, without examples of modern-style banking institutions in the Sunnah (Prophetic tradition) and Islamic history, religious scholars trying to create an indigenous, ‘authentic’ brand of Islamic economics, and particularly banking, struggled to reconcile legal sources with demands of the modern world. Scholarly efforts within the realm of fiqh (jurisprudence) expanded. An
unprecedented level of ijtihad25 (juristic inference) was undertaken to devise a financial system which would be consistent with both religious principles and the modern
economy (Warde, 2000). Scholars relied on qiyas (analogical reasoning) through reference to legal precedents26. Documents of classical fiqh were searched for contractual arrangements which could be used either directly or in modified form as alternatives to modern-day conventional financial products (El-Gamal, 2006). The classical texts provided abundant examples of trade and investment contracts; the former comprising of a variety of sale contracts including mark-up and credit sale, leasing as well as other trade-based contracts and the latter consisting of PLS arrangements including the mudarabah and its variants (including musharakah). Majority of scholars promoted the idea that interest was to be replaced by PLS
mechanisms, creating alternative bank–business and depositor–bank relationships based on equity partnerships rather than the usual borrower-lender relationship in
conventional banking (Warde, 2000; Ayub, 2007).
With no indigenous Islamic precedent, Islamic economists at the time took the existing conventional commercial banks as the blueprint for an ‘Islamic’ version of the banking institution, leaving the structure of the bank in terms of its role and nature of
25
Recall from chapter 2, ijtihad refers to independent reasoning undertaken by Islamic jurists to establish new legal rules. It is used to address contemporary issues for which an explicit directive from the Quran and the sunnah cannot be found (Ayub, 2007).
26
In premodern times, jurists/religious scholars used a variety of different legal tools to derive new laws including istislah (benefit analysis) and istihsan (public interest). In modern times, however, scholars have primarily focused on the rule ‘ijtihad through qiyas’ i.e. drawing juristic inferences solely on the basis of analogical reasoning through reference to legal precedents (El-Gamal, 2006).
34
assets/liabilities intact. Although unintentional, this as will be shown below, became one of the fundamental contributors in the divergence between the theoretical model and the practice of Islamic banks (see sections 3.4.2 and 3.6). To appreciate the
discrepancies between theory and the practice of Islamic banking it is important first to understand the theoretical model of Islamic banking and the developmental phases the industry underwent. These are presented in the following two sections.