TAKAFUL (Islamic Insurance)

The concept of takaful, or Islamic insurance, where resources

are pooled to help the needy does not contradict Shariah.
The concept is in line with the principles of compensation and
shared responsibilities among the community. It is not a new
concept, in fact it had been practised by the Muhajrin of
Mecca and the Ansar of Medina following the hijra of the
Prophet over 1400 years ago. It is generally accepted by
Muslim Jurists that the operation of conventional insurance
does not conform to the rules and requirements of Shariah.

Conventional insurance involves the elements of uncertainity (Al-gharar) in the contract of

insurance, gambling (Al-maisir) as the consequences of the presence of uncertainty and
interest (Al-riba) in the investment activities of the conventional insurance companies
which contravene the rules of Shariah. Takaful is an alternative form of cover which a
Muslim can avail himself against the risk of loss due to misfortunes.

The insurance providers in year 2001 and beyond should find Takaful sector an exciting
sector of insurance to be in. This presentation focuses on growth potential that exists in
Takaful with great many opportunities for innovative development of unique products,
techniques and systems needed to fill gaps in insurance penetration in many of the
markets around the globe. This paper presents an insight into the size of the current
takaful industry worldwide and sketches the signs of change that may lead to realization of
the potential that exists in this sector.

Overview of takaful

The takaful brand of insurance is a classic example of consumer-driven response to their

needs. For generations, Muslims around the world have grown with a mind set that
insurance (especially life insurance) is taboo because it contravenes some of the Islamic
tenets. Life insurance as sold in conventional way was declared unacceptable in 1903 by
some prominent Islamic scholars in the Arab countries. The search was on for an
acceptable alternative ever since, and not until the 1970's the debate took sufficient
momentum to reach a consensus. In 1985, the Grand Counsel of Islamic scholars in
Makkah, Saudi Arabia, Majma al-Fiqh, approved takaful system as the alternative form of
insurance written in compliance with Islamic Sharia. It is outside the scope of this
presentation to explain how the takaful system works except to say that it is a concept of
protection for the good of society, a concept that was never an issue in Islam in the first
place. The Grand Counsel approved this system as a system of co-operation and mutual
help but the exact method and operation was left to Islamic scholars and insurance
practitioners to resolve, develop and implement.

Takaful industry is still not past its formative years and there are many areas unresolved,
especially in life insurance. The key areas to resolve are the global standardization of
takaful terminology, the development of an acceptable form of life insurance (family
takaful) especially for countries in the Arab regions and a common consensus for a system
to determine profits (or surplus) distributable to participants and shareholders.

The very first Takaful company was established in 1979 - the Islamic Insurance Company
of Sudan. Today there are some 28 registered Takaful companies worldwide writing takaful
directly and 10 more as Islamic windows or marketing agencies placing insurance risk with
conventional and takaful companies. In fact the number of takaful companies is higher as
all insurance companies in Sudan are deemed to operate in accordance with Islamic Sharia
principles. In addition, new takaful companies have been established recently in Sri Lanka
and Tunisia. At least four more Takaful companies are under formation in the Middle East
(viz. Kuwait, UAE and Egypt). Several other Takaful companies are being contemplated in
various countries such as Pakistan, Australia and Lebanon. It is also understood that
interest is shown in Takaful in South Africa, Nigeria, and some of the former states of the
Soviet Union.
Takaful industry in the Middle East is under-developed compared to other markets such as
Malaysia. The more successful companies in the Middle East have grown at 10% p.a.
whereas in Malaysia the rate of growth has been 60% p.a.

A broad estimate of the total Takaful industry in 2000 is approximately US$550m for both
life and non-life business, of which around $193m pertains to Asia Pacific. Malaysia is one
of the largest markets outside the Arab region for Takaful, writing 72% of the non-Arab
takaful business. A geographical spread of takaful business is as follows.

These are estimated figures Takaful % of total

Malaysia $143m 27%
Other Asia Pacific $50m 9%
Europe, USA $6m 1%
Arab Countries $340m 63%
Total $538m 100%

Table 1: Geographical spread of Takaful business - 2000

The growth in Takaful business in Malaysia has been impressive. Starting from a low base
in 1994, the annualized average growth used to be in the order of 92% in Family Takaful
and 34% in General. Since 1998, the growth rate has slowed down to around 30% in
Family Takaful and 17% in General. In Family Takaful the products sold were individual and
group term and savings products, mortgage policies and pension plans. In General takaful
all classes of business were sold.

US$m Family % General % Total %

Takaful Increase Takaful Increase Takaful Increase
1998 55.0 36.6 91.6
1999 70.0 27% 42.7 17% 112.7 23%
2000 93.2 33% 49.8 17% 143.0 27%

Exchange rate RM2.43 to $ (1997 prices)

Table 2: Growth of Takaful in Malaysia

Takaful in Arab Countries

To illustrate the penetration of takaful in the private sector, the following table provides a
picture of business written by companies in the Arab countries excluding NCCI in Saudi
Arabia. This company's business is mainly generated from government sources and its
exclusion from the figures provide a better measure of how takaful companies are doing in
the market place where they compete with conventional insurance companies.

Takaful figures estimated, Market figures from Sigma SwissRe & Arig

LIfe General Total Total Takaful Share

US$m
Takaful Takaful Takaful Market of Market
Saudi
1.3 60 61 781 * 8%
Arabia
UAE 1.1 12 13 815 2%
Qatar - 6 6 153 4%
Bahrain - 5 5 134 4%
 Sudan 0.4 27 27 33 83%
Jordan 0.3 6.3 7 141 5%
Total 3.1 116 119 2,057 6%

* Takaful share for Saudi Arabia increases from 8% to 36% if NCCI's premium is included above.

Table 3: Takaful business in the Arab Region - 1999

Takaful business has generally grown at a higher rate than the total insurance business in
each of these countries. Growth rates reflect the increasing market share of Takaful
business over the same period, 1995 to 1999 for these countries:

Reinsurance or Retakaful

Reinsurance of takaful business on Islamic principles has been an area of much debate.
Reinsurance on Islamic principles is known as retakaful. The problem has been one of lack
of retakaful companies in the market. This has left the takaful companies with a dilemma
of having to reinsure on conventional basis, contrary to the customer's preference of
seeking cover on Islamic principles. The Sharia scholars have allowed dispensation to
takaful operators to reinsure on conventional basis so long as there was no retakaful
alternative available. Takaful companies therefore actively promote co-insurance. A
number of large conventional reinsurance companies from Muslim countries take on
retrocession. Still there is a lack of capacity within the Takaful industry worldwide. A
certain proportion of risk is placed with international reinsurance companies that operate
on conventional basis. The retrocession from Takaful companies ranges from some 10% in
the Far East where Takaful companies have relatively smaller commercial risks (so far), to
the Middle East where up to 80% of risk is reinsured on conventional basis.

Market characteristics

The market characteristics of the Arab region are quite different from other regions. The
main differences are in terms of the attitude to risk and lack of insurance awareness. The
level of awareness is very low about financial protection amongst individuals. This is not
the case for Malaysia, Indonesia and Brunei, certainly not to the same extent. This is
illustrated by comparing insurance density and penetration of conventional insurance and
Takaful aggregated.

The average ratio of capital to premiums for many Arab insurers is around 1 whereas the
ratio should be in the region of 2.5 times.

The Middle East and indeed many of the Muslim countries are a mixture of some rich and
some poorer economies. Insurance density and penetration in some of these countries
show the low expenditure in life insurance in Saudi Arabia of $1 per head and UAE of $68.
In comparison, the world average life premium per capita was $235, the UK $2,503, USA
$1,447 and Switzerland $2,914 (highest). The GDP in many of these countries is high,
such as Kuwait, Saudi Arabia and UAE, and yet insurance penetration is not commensurate
with the high GDP. This reflects the indifferent attitude to risk in these countries.

The insurance penetration in the UK was 13.35% (life 10.30%), USA 8.55% (life 4.23%),
and South Africa 16.54% (life 13.92%) the highest. Insurance penetration for the Middle
East is very low at 1.6%.

Traditionally the reasons for low penetration for insurance in the Middle East, particularly in
life insurance, used to be:

• lower disposable incomes, except for the Arabian Gulf countries.

• greater reliance on social welfare provisions
• extended family system
 • attitude to personal risk

Nevertheless many of the classic parameters of old are changing, such as the extended
family system. The pace of change has increased manifold due to urbanisation and
industrialisation and the recent phenomenon of liberalisation and globalisation. Moreover,
populations of many developing Muslim countries are skewed towards younger age groups,
which has put greater pressure on limited resources and employment.

The economic factors have kept insurance low in many of these countries. People may be
aware of insurance needs but cannot afford to buy the required protection. The minority,
who can afford, are either not convinced or are not interested. Poor marketing has been
one of the contributory factors

Company Profiles

The status and type of activities carried out by takaful companies worldwide, is mainly
based on data collected directly from the companies through a questionnaire sent to some
30 companies. All except Takaful USA are continuing to transact business. The position
about Takaful USA is not clear as of March 2001.

The more successful Takaful companies in the Arab region managed a dividend of up to
8%. Nevertheless, they can do much better if the critical mass of business is built up. Lack
of capacity to write different classes of business, low retention, limited product range and
lack of good service have been the impediments of the past and these parameters are fast
changing for the better, especially in Jordan, Bahrain and Qatar. New Takaful companies in
Kuwait and the UAE are expected to add to this improving scenario for Takaful industry.

Signs of Change: Tracing For Takaful Potential

The world population in 1999 is estimated to be around 6 billion as per the Global
Population Project based in the United States. The data on Muslim population is not readily
available. It was estimated by using information contained in a publication entitled Islamic
Beliefs and Teachings from India. Accordingly there may be around 1.5 billion Muslims
making up for 25% of the total world population in 1999. As we look around throughout
the Muslim world it is quite evident that people have not taken to life insurance in the
same way as in most other countries.

The growth of insurance in Muslim countries was examined by looking at the past trends
and taking a conservative view on future growth. This provided a consistent pattern of
slower growth in mature markets and higher growth in many of the developing countries.
Most of the Muslim countries have potential to at least double their insurance volumes.

One of the main reasons for low penetration of insurance in these countries is the under-
development of life insurance. As stated earlier, decades of misunderstandings created a
mind-set amongst Muslims that did not help to develop life insurance to any great extent.
And yet life insurance is so essential in providing the vital protection to the family. The
insurance industry globally was US$ 2.3 trillion in 1999 (up by 7.3% on 1998), with life
insurance 61% of total. The size of the Middle East insurance market was US$ 7.9 billion or
2.4% of world premium, and life insurance 31% of the market. Iran experienced strong
growth at 25.2% for 1999, compared to average for the region of 5.2%. Life insurance in
the region increased by around 3% in 1999 compared to 12.5% in Iran and 5.3% in
Kuwait.

The takaful industry holds the key to unlocking this potential where life insurance can
actually be provided through "family takaful" naturally acceptable to the masses. The
demand for Islamic products is evident from the success of Islamic finance and banking
that has now firmly established itself with a total of more than $7 billion of capital, $4.1
trillion of assets and more than $120 billion of deposits.
The potential takaful volumes were estimated by taking into account the growth inertia
that can be achieved through the introduction of family takaful and the following factors:

A greater awareness of Takaful system is achieved

• More Takaful companies are set up and run professionally

• More global coverage is secured through international companies' network and the
use of modern IT technology
• Sale through banks
• Companies are well capitalized and demonstrate secure haven for the funds
• Retakaful capacity with triple A rating is available

Other factors were also taken into account such as literacy levels in each country and the
take up rates for takaful products as opposed to conventional products.

HOPES FOR THE FUTURE OF ISLAMIC FINANCE

Past Successes

The topic of my talk is challenges to and for Islamic finance: a look into the past, present
and our hopes for the future. For someone like me, it is astonishing to realize how far and
fast Islamic finance has come and how well it has managed to meet the challenges
it faced in just two decades. It is astonishing because when I started my own research in
this field in mid-1970s, there was virtually no analytic works on Islamic banking and
finance that could explain in modern economic and financial analytic language what Islam
expects of a financial system in a modern economy. And, of course, virtually no major
Islamic banks existed at the time.

Based on what was known then, and in the absence of an analytic framework recognizable
by modern economic and financial theory, most western observers and commentators
began to refer to Islamic banking and financial system as a "zero-interest" system, by
which they meant "no return to capital". I recall when the Islamic Revolution of Iran
succeeded and its leaders and economists declared they wished to eliminate from
their economic system, western media, including the BBC and the Wall Street Journal,
commented on the impossibility of such a system referring to the thinking behind it as "
voodoo economics".

By 1983-84, when Iran, Pakistan. and Sudan declared that they would adopt a system-
wide Islamic banking and finance, the challenge was to show that such a system was first
theoretically and analytically a viable financial system; second, it had to be shown that
such a system was empirically workable as a whole and financially viable for each of its
parts, meaning Islamic banks and financial institutions.

The challenge came from western analysts who suggested the folly of adopting such a
system. Here, I summarize their arguments in six propositions:

1. that zero interest meant infinite demand for loanable funds and zero supply;
2. such a system would be incapable of equilibrating demand for and supply of
loanable funds;
3. with zero interest rate there would be no savings;
4. this meant no investment and no growth;
 5. in this system, there could be no monetary policy since no instruments of liquidity
management could exist without a fixed predetermined rate of interest; and,
finally,
6. this all meant that in countries adopting such a system there would be one way
capital flight.

By 1988, this challenge was met when research, using modern analytic financial and
economic theory, showed that:

 A modern financial system can be designed without the need for an ex ante
determined positive nominal fixed interest rate. [In fact, it had been shown by
western researchers that there was no satisfactory theory that could explain the
existence of a positive nominal ex ante interest rate];
 Moreover, it was shown that not assuming a nominal fixed ex ante positive interest
rate, i.e., no debt contract, did not necessarily mean that there would have to be
zero return to capital;
 The basic proposition of Islamic finance was that the return to capital would be
determined ex post, and that the magnitude of return to capital was determined on
the basis of the return to the economic activity in which the funds were employed;
 It was that expected return which determined investment;
 It was also the expected rate of return, and income, which determined savings.
Therefore, there is no justification for assuming that in such a system there would
be no savings and investment;
 It was shown that in such a system there would be positive growth;
 That monetary policy in such a system would function as in the conventional
system, its efficiency depending on the availability of instruments which could be
designed to manage liquidity;
 Finally, it was shown that, in an open-economy macroeconomic model without an
ex ante fixed interest, but with returns to investment determined ex post, there
was no justification to assume that there would be a one-way capital flight.

Therefore, the system which prohibited a fixed ex ante interest rate and allowed the rate
of return to capital to be determined ex post, based on the returns to the economic activity
in which the funds were employed, was theoretically viable.

In the process of demonstrating the analytic viability of such a system, research also
clearly differentiated it from the conventional system. In the conventional system, based
on debt contracts, risks and rewards were shared asymmetrically with the debtor carrying
the greatest part of the risk, and with governments enforcing the contract. Such a system
had a built-in incentive structure that promoted moral hazard and asymmetric information
requiring close monitoring whose costs could be managed if monitoring could be delegated
to an institution which could act on behalf of the collectivity of depositor/investor: hence
the reason for existence of banking institutions.

In the late 1970s - early 1980s, it was shown, mostly by Minsky, that such a system was
inherently prone to instability because there would always be maturity mismatch between
liabilities (short-term deposits) and assets (investment-long-term). Because the nominal
values of liabilities were guaranteed, but not the nominal value of assets, when the
maturity mismatch became a problem, the banks would go into a liability management
mode by offering higher interest rates to attract more deposits. There was always the
possibility that this process could not be sustained resulting in erosion in confidence and
bank runs. Such a system, therefore, needed a lender of last resort and bankruptcy
procedures, restructuring processes, and debt workout procedures to mitigate contagion.

During 1950s - 60s. Lloyd Metzler of the University of Chicago had proposed an alternative
system in which contracts were based on equity rather than debt, and in which there was
no guarantee of nominal values of liability since these were tied to the nominal values of
assets. Metzler showed that such a system did not have the instability characteristics of
the conventional banking system. In 1985, in his now classic article in the IMF staff
papers, Mohsin Khan, showed the affinity of Metzler?s model to Islamic finance. Using
Metzler's basic model, Mohsin Khan demonstrated that this system produces a saddle point
and is, therefore, more stable than the conventional system.

By early 1990s, it was clear that an Islamic financial system was not only theoretically
viable, but had desirable characteristics that rendered it superior to a debt-based
conventional system. The phenomenon growth of Islamic finance during the decade of
1990s, demonstrated the empirical and practical viability of the system.

Hopes for the future

The crises we have been witnessing in the international financial system since 1997 have
set the stage for Islamic finance to demonstrate its viability as potentially a genuine
alternative global financial system. The present international system is deficient in many
ways of which the two most important are:

 A debt-based system needs an effective lender of last resort, and the present
international financial system does not have one and it is not likely that one will
emerge anytime soon: and
 A debt-based system needs bankruptcy proceedings, debt restructuring, and
workout mechanisms and processes which the present international financial
system lacks. There are preliminary discussions underway for an international
sovereign debt restructuring mechanism to be established, but there are
many complications. While such a mechanism, if and when it comes into being, will
help reduce the risk of moral hazard and lead to better distribution of risk, it will
not address the inherent fundamental fragility of a system largely based on debt
contracts.

In the mean time, there are no guarantees that the international financial system has
witnessed its last crises with their huge domestic costs that, at times, have threatened the
very foundation and fabric of societies. The example of Indonesia is a heartbreaker; it took
this country 25 years to reduce poverty by 50 percent, but it took a year of severe
financial crisis to wipe out most of this gain. Countries with an otherwise viable economic
system have paid dearly for crises generated by a debt structure whose nominal values
and maturities were out of line, with the ability of the economic structure to service them.

There are many analyses of financial crises and a long list of their causes, but surprisingly
little is said about the one underlying common denominator to all of them: debt contracts
that are by nature out of sync, and unrelated to, the income flows that the underlying
productive and capital assets of these countries can generate to serve them. The jury is
still out as to the reasons why Malaysia did not suffer from contagion as much as other
crises countries. While capital controls may have played a role, some analysts believe its
liability structure and its general reliance on non-debt-creating flows made Malaysia less
vulnerable to crisis.

While the financial innovations of the 1990s in the conventional system have led to
mobilization of financial resources in astronomical proportions, they have also led to the
equally impressive growth of debt contracts and instruments. According to the latest
reports, there are now US$32 trillion of sovereign and corporate bonds alone. Compare
this (plus all other forms of debt, including consumer debt in industrial countries) to the
production and capital base of the global economy and one observes an inverted pyramid
of huge debt piled upon a narrow production base that is supposed to generate the income
flows that are to serve this debt. In short, this growth in debt has nearly severed the
relationship between finance and production. Analysts are now worried about a "debt
bubble". For each dollar worth of production there are thousands of dollars of debt claims.
An Islamic financial system has the potential to redress this serious threat to global
financial stability because of its fundamental operating principle of a close link between
financial and productive flows and because of its requirement of risk sharing.
It is now a serious advice of the IMF to developing countries that they should:

 Avoid debt-creating flows;

  Rely mostly on FDI;
 If they have to borrow, they should ensure that their debt obligations are not
bunched toward the short end of maturities;
 If they have to borrow, they should ensure that their economy is producing enough
primary surplus to meet their debt obligations;
 Ensure that their sovereign bonds incorporate clauses (majority action clause,
engagement clause, initiation clause) that make debt workout and restructuring
easier. That is, to make sure that there exists better risk sharing mechanisms to
avoid moral hazard: and finally,
 They should put in place an efficient debt management structure.

In these circumstances, Islamic finance can provide a viable financial system on a global
scale, but there are challenges that have to be met to make it so. Islamic finance has to
adopt the best standards of accountability, transparency and efficiency. Fortunately, an
architecture of Islamic finance on a global scale is emerging with the establishment of
supporting institutions such as:

 The Accounting and Auditing Organization for Islamic Financial Institutions through
the efforts of Professor Rifaat Abdel Karim
 The International Islamic Rating Agency
 The Islamic Financial Services Board
 The International Islamic Financial Market, and
 The Liquidity Management Center.

As this architecture emerges, Islamic finance has to develop its own genuinely Islamic
financial instruments. So far, we have been free riding on financial theories and
instruments developed within the context of the conventional debt and interest-based
system. Unless Islamic finance develops its own genuinely Islamic financial instruments, it
cannot achieve the dynamism of a system that provides security, liquidity, and diversity
needed for a globally accepted financial system which would be a genuine alternative to
the present debt-interest-based international financial system.

Unfortunately, there are, at present, nothing in the Muslim world close to resembling large
endowment institutions, such as the National Science Foundation, the Ford Foundation, the
Rockefeller Foundation, and the like to support research in Islamic banking, finance and
economics. There is, therefore, an urgent need for scholarly foundations, institutions,
colleges, and universities that can train Islamic financial engineers who are well trained in
economic and financial theory and methods, on the one hand, and Islamic Shariah, on the
other. My generation was fortunate to have people like Dr. Anas Azzarga and Dr. Kazem
Sadr who are equally at ease with Islamic "Fiqh" as with economic theory and method.
Trained by their fathers (Sheikh Mustafa Azzarqa and Ayatollah Reza Sadr, )
in "Fiqh" and having earned doctorate degrees in economics from reputable universities in
the U.S.A., they were able to help the rest of us in understanding the intricacies of Islamic
"Fiqh" as it related to finance. There is now a need to systematize the process of training
financial engineers, experts in modern finance who are well versed in the Shariah, to
expand the horizon and the menu of available Islamic financial instruments.

Islamic finance possesses the basic instruments that can be spanned into a wide, varied,
and variegated menu of financial instruments. There is a theory developed in the 1980s
referred to as the spanning theory which asserts that if there is one basic financial
instrument it can be spanned into an infinite number of instruments. Islamic finance has at
least 14 basic instruments and financial experts can span these into a much larger menu
to provide greater security, liquidity, and diversity to meet the demand of investors on a
global scale. Let me say once again that there is an urgent need for rich endowments to be
established solely for the purpose of financially supporting institutions that can train the
kind of research scholars and experts mentioned.

Let me conclude by mentioning a very important function of Islamic finance that is seldom
noted: that is the ability of Islamic finance to provide the vehicle for financial and
economic empowerment. Before I do so, let me recommend the works of the Peruvian
economist Hernando de Soto. De Soto's long-time research has been summarized in a
recent book titled: "The Mystery of Capital". His basic thesis is that much of the poor in
developing countries are in possession of what he calls dead capital. He estimates that the
developing and former communist countries possess US$9.3 trillion worth of dead capital.
These are physical resources and capital that are not used for any purpose other than to
provide physical service to their owners. He suggests that the ability of documenting and
using this capital as a productive asset is what distinguishes the rich from the poor. How
can Islamic finance help to empower financially those who are in possession of dead
capital? Let me give some rudimentary examples:

Agricultural Development Bank of Iran through partnerships with farmers helps

them to convert their physical possession into assets that can generate additional capital.
Also through the Islamic law of of , dead capital is converted into productive
asset. A second example is that of the Housing Bank of Iran which through and
lease purchase agreements helps people without homes to own one. These homes can
then be used to generate additional capital for the owners to undertake other productive
activities. Similarly, Islamic finance can be used in other Muslim and developing countries
to convert dead capital into income generating assets to financially and economically
empower the poor.

ECONOMICS & ETHICS - the quest for equity &

justice

The mass anti-globalisation protests which have paralysed gatherings

of G7/G8 leaders have highlighted a serious unease with the operations
of unfettered markets. For many, the present arrangement leads to
perpetuation of gross global inequity, and rampant globalisation is seen
as making things worse. Similar sentiments underlie the protest
against policies of the International Monetary Fund and the World
Bank. These are seen to be pushing what has come to be called the
“Washington Consensus” of policy prescriptions designed to institutionalise unfettered
markets across the developing world. Unregulated markets are now seen as the primary
mechanism generating inequity on a global scale.

At another level, the saga of Huntingdon Life Sciences (HLS) in the UK has become a
landmark issue. The company, a leading user of live animals for experiments, fell foul of
the Animal Rights lobby. Mounting a sustained campaign of mass protests, this powerful
lobby was able to cut off all sources of bank finance to the company. HLS had to move its
operational headquarters from the UK to the USA and rely on funding from non-banking
sources. This was a dramatic illustration of banks bowing to pressure from the provider of
their funds – the depositors. Not long a go the Bank of Scotland was also forced to
withdraw from a deal with the US televangelist Pat Robertson because of the latter’s
controversial views. The embarrassing about turn was forced on the bank by its
shareholders and depositors.

In the UK unease is mounting about the Private Finance Initiatives (PFI) which seem to
have delivered a pitiful level of public service at enormous cost to taxpayers. Again
unfettered market principles are seen as not suitable for all purposes.

These developments provide an illustration of a major shift in public perceptions about how
economies and businesses operate. At one level unregulated markets are seen as
perpetuating inequity. An urgent need is seen to challenge the prevailing dogma about free
markets and introduce regulatory regimes to safeguard the public interest. On another
front, the freedom of financial intermediaries to provide funding for operations without
taking into account the wishes of the providers of the funds is being seriously questioned.

These developments provide an interesting parallel with the ideals of Islamic economics
and finance. The quest for equity and justice has been central to the thinking of Muslim
economists. Indeed, most protest movements in Muslim societies have their anchor in the
spirit of social equity and justice. At the same time Muslims are deeply concerned about
the ways of financing businesses to ensure that ethical considerations are paramount.

In this spirit, Muslim economists have argued for tempering the market mechanism with
regulations designed to embody the public interest. According to them, in designing all
policy, the primary consideration should be justice and equity rather than laissez faire
market operations.

Muslim jurists have argued the case for limits on land ownership and strict application of
inheritance laws to avoid concentration of wealth. Some radical Muslim jurists have also
argued that land is a communal resource and ownership is confined to period of active use
rather than perpetual. Again, mineral and other natural resources are regarded as
communal property.

In Muslim societies, the injunction of Zakat provides a vital mechanism for addressing
social welfare issues. All Muslims are required to give away at least two and a half percent
of their income to the poor and the needy as Zakat. As the principle is well established in
Muslim societies, Muslim economists have argued for its institutionalisation with even
higher levels of giving. A social welfare state is thus not alien to Muslim thinking at all.

As for national borrowing, Muslims are expected to have risk-sharing contracts rather than
fixed rate loans. Translated into practice this would imply that lenders to Muslim countries
would need to be convinced of the viability of the projects financed as their return would
depend on the success of these ventures. This would have a mitigating effect on spurious
debt build ups and repayment crisis as has become common.

Thus in theory Muslim societies should have a much more equitable ethos than they do at
present. This discrepancy is there for a variety of reasons, but developments in banking
and finance show that a slow evolution reflecting this basic ethos is taking place.

In the area of banking and finance, Muslims share common concerns, about the use of
funds by financial intermediaries, with the growing body of ethical investors.

The best way to appreciate this is to look at the growth of Ethical funds and investments.
Basically, these try to incorporate the desire of the providers of the funds to have a say in
the use of their monies. Thus, some funds do not invest in companies which deal in
tobacco, alcohol, or military hardware. Others, only invest in corporations which
incorporate environmental sustainability criteria in their operations.

This is in sharp contrast to the traditional banking model whereby the providers of funds
were expected to limit their concerns to the security of their investment rather than the
use of the funds. It was little wonder that ethical investment notions were met with
cynicism and ridicule when they were mooted in the early seventies. However, they did
reflect a public desire and slowly but surely the movement has grown.

Islamic finance has a similar rationale. Indeed in some respects it goes further, being
concerned not just with what kind of activities are being financed but also with the way in
which they are funded. Thus Muslims are encouraged to invest in “permissible” (Halal)
activities, via “permissible” means.

That means that while Islamic financial institutions will not invest in corporations dealing
with forbidden items like alcohol and gambling, neither will they deal with organisations
involved in riba, or usury, transactions. Indeed, the lending of money for a predetermined
return (riba) is expressly prohibited in the Qur’an. Many Muslim jurists consider any form
of interest as riba (usury) and thus do not allow dealing with or investing in banks per se.

In practice this is less dramatic than it sounds. Muslims still make everyday transactions
like investing their surplus funds, house-buying, and taking out loans and working capital
for their businesses etc. For investment purposes Islamic financial institutions employ
criteria similar to those used by the ethical investment funds. The big difference comes in
the way they structure lending transactions, both for personal finance and business
purposes. In simple terms, lenders enter into risk-sharing contracts with borrowers; return
is based on the outcome of the venture or investment, rather than a predetermined rate.

The principle of risk-sharing can have far reaching implications. For risks to be shared,
borrowers have to be willing to provide much more information about their situation than
normal banks would seek for lending against collateral or guarantees. It will include
confirmation that the funds are to be deployed in permissible activities, as well as
transparency in reporting financial information about the progress of the business or
project for which the money has been borrowed.

Several modes of financing have been developed. The primary tenet of Islamic financial
intermediation is that there should be a sharing of risk between the lender and the
borrower. Thus the two prominent instruments are Mudharaba and Musharaka. The
Musharaka is very similar to a partnership sharing profits and losses. Under a Mudharaba,
however, the provider of capital and labour share the rewards, but losses are borne by the
provider of capital only as the provider of labour is already deemed to have contributed his
share. There are also two additional instruments utilised by Islamic bankers. These are
Murabaha and Ijara. The Murabaha is a simple cost plus transaction and is not accepted as
a genuine Islamic banking instrument by many Muslim jurists. Ijara transactions work in a
similar way to leasing.

Present day Islamic financial institutions also invariably have a Shari’a (Islamic Law)
Supervisory Board of Advisors. This is usually a body of qualified Muslim jurists well versed
in commercial transactions. All new transactions and structuring of deals are vetted by
these Boards for compliance with Islamic Law.

Over the last three decades Islamic banking and finance has grown manifold in Muslim
communities and countries. In Malaysia, about five percent of all banking transactions are
conducted by Islamic Financial Institutions. This is set to rise to ten percent by 2005.
Pakistan’s Finance Minister has also announced plans for a similar phasing in of Islamic
financial intermediation. Similar moves are afoot in most Muslim countries. Malaysian and
Middle Eastern corporations have also begun to raise long and medium term finance by
issuing Shari’a compliant bonds. There are plans for launching of primary and secondary
debt and equity markets in Shar’ia compliant financial instruments.

In other parts of the Muslim world Islamic equity investment funds have also mushroomed.
Very much like ethical funds, these restrict their portfolios to approved corporations, based
on criteria devised by their Shar’ia Supervisory Boards. An increasing number of Muslim
investors are channelling their savings through these funds. There is also a Dow Jones
Islamic Index which acts as a benchmark for the performance of some of these funds.

In the UK and USA Muslim communities have started to experiment with saving and
housing finance products which meet the stipulations of the Shari’a (Islamic Law). In the
USA, the Islamic housing finance company Lariba, has had its funding augmented by
Freddy Mac, the leading mainstream provider of housing funds. In the UK I-Hilal and
Parsoli have started to market Shari’a compliant ISA (Individual Savings Account)
products. Indeed, a recent survey by business information company, Datamonitor,
concludes “the market for Islamic (Shari’a-compliant) finance in the UK is set to grow
hugely. A huge gap exists for Shari’a compliant equity and mortgage products. Muslims
have historically been underserved by UK financial institutions, but this is set to change.”

The closest situation to a possible scenario in the UK is the Malaysian example. There, a
full range of banking products are available to customers from Bank Islam Malaysia Bhd or
the “Islamic Banking” counters of all the major banks. The set up is fully regulated by the
Central Bank of Malaysia and Islamic finance instruments seem to co-exist with traditional
banking products without any problems. If such products are launched in the UK, then the
Malaysian model would be ideal as it provides a precedent for a small Islamic banking
sector harmoniously co-existing with a much larger traditional banking sector. In fact, two
years ago, in a seminar hosted by the Islamic Foundation in Leicester, Eddy Gorge the
Governor of the Bank of England and Ahmed Mohammed Don the former Governor of the
Bank Negara Malaysia (Central Bank of Malaysia) had and exchange of views on this very
subject.

The growth and public appreciation of Islamic financial institutions, just as with the ethical
investment movement in developed economies, will in time help ‘persuade’ the big
financial players to pay far more heed to their customers’ views in deciding where and how
they invest their depositors’ money. In the process it will become easier for social and
ethical criteria, like equity considerations, to be incorporated into financial intermediation.

The incremental growth of Islamic financial institutions also shows how Muslim societies
will begin to incorporate the spirit justice and equity. Emerging from the colonial interlude,
Muslim societies have begun to reflect on the basic precepts of their economic
organisation. Understandably, there are a host of external and internal realities which
impinge upon the way these societies are organised. However, as the move towards more
representative societies gathers pace, the underlying thrust of the Islamic quest for equity
and justice is likely to manifest itself in developments in Muslim societies over time.

In these endeavours Muslims will be in good company. Together with the growing protest
against the growth of global inequity, the quest for ethical financial intermediation, will
provide platforms for like minded players from across faith and ideological boundaries to
come together.

The Status of the Stock Exchange

Asif Iftikhar (info@studying-islam.org)

An important question which Muslim economists face in these times is the

status of the stock exchange. Is trading on the stock exchange haram? Is it
really gambling as some people say?
The stock exchange is a market place where shares are bought and sold. By
buying the shares of a company, you, in fact, share in the business. Therefore,
if there is nothing against Islam in the nature of the business, there is nothing
wrong in being the shareholder of that business or in getting dividends on
those shares. Similarly, if you sell the shares at any point of time owing to
some reason and get capital gains thereby, the transaction and the profit are
not wrong from the Islamic point of view.
There are however situations when the activity in the stock exchange is
clearly against good sense and the norms of ethics. There are certain
transactions which are or can be detrimental to the interests of either party by
causing damage or deception. Therefore, though the Shari‘ah has not
prohibited these transactions as such and though, in most cases, they can’t
really be termed as gambling, they are clearly against the spirit of Islam when
they result in or are likely to result in damage or deception. That is why there
is a principle of Islamic jurists that any transaction which causes or might
cause darar or gharar (damage or deception) to either party should be
prohibited by law. Where the law of the land does not deal with such
transactions, it is up to the individual to decide whether or not the transaction
will or may cause damage or deception to the other party. In case he is certain
of such damage or deception, he should certainly avoid undertaking the
transaction. Even in the case where there is a sufficient probability of darar or
gharar, it is best to avoid the transaction as a Muslim knows that he will be
held accountable on the Day of Judgement if his actions deceive someone or
cause him damage.
Furthermore, at the macro level such transactions can be detrimental to the
economy when trading moves beyond mere buying and selling, that is when
the buyer and the seller do not remain a buyer and a seller but become a
‘bear’ or a ‘bull’.
Ideally, the market price of a share should be related to the performance of
the company. But the speculators (euphemistically called investors) manipulate
the prices by artificially stimulating the demand and the supply of shares.
Forward contracts are made and further contracts are derived (financial
derivatives) on that basis. The result is that the whole market activity is based
on speculation rather than being based on entrepreneurship. The share price
of a company doing perfectly well suddenly falls and that of a company in
trouble suddenly rises. A person earns millions and loses millions in a day in
this game. Obviously, such fluctuations have a negative impact on the
economy, which is usually borne by the not-so-affluent sections of the society.
One of the worst cases of such speculation was when on Oct. 19, 1987 -- now
known as the Black Monday -- Wall Street crashed owing to the panic that had
spread among the investors. Billions are lost in a day in such crashes. Since
shares are sometimes bought and sold even before they have been actually
bought and sold and, quite frequently, are bought primarily on the basis of
borrowed capital (as in the case of the famous Australian investor Alan Bond),
stakes are high and the slightest fear can start a chain reaction, which may
result in a major catastrophe. The reason for such timorousness is nothing
except that the whole economic activity in these exchanges is based on
speculation and interest based borrowing rather than on entrepreneurship and
equity participation. When such a large area of economic activity is based on
speculation and interest based borrowing, the spirit of entrepreneurship suffers
and moral corruption pervades the society.
Economic activity should be based on entrepreneurship, hard work,
creativity, moral principles and concern for others, whereas speculation is often
detrimental to these values. An individual should also keep in mind the effect
of his personal decisions on the whole society, and as its responsible member
and as a good Muslim try to be part of the solution instead of being part of the
problem.
It has been seen that involvement in speculation often leads to greed and
avarice, which come in the way of ethics and concern for society1, whereas a
Muslim prefers sticking to nobler values even if they afford him less material
benefit. Even in the absence of specific Divine injunctions or enacted laws, a
Muslim should ask his own self whether his involvement in such activities is
leading him away from God and inclining him towards the violation of moral
values and ethics. And this is a question which an individual must answer
himself. The rule here is sal nafsak (ask your soul). A Muslim’s life should
marked by love of God, fear of His wrath, charity and concern for others.
Losing these values for material benefit is a trade that a good Muslim never
likes to make.2

1.
The following words of a famous economist bear witness to this reality: ‘For
at least another hundred years, we must pretend to ourselves and to everyone
that fair is foul and foul is fair, for foul is useful and fair is not. Avarice and
usury and precaution must be our gods for a little longer still.’ (Keynes,
Economic Possibilities for Our Grandchildren)
2.
It must also be remembered that in consideration of the way Allah Almighty
revealed His laws through the Prophet (sws) and the way the Prophet (sws)
implemented them, the State or an individual, in the desire to implement and
follow Divine laws, should not hasten so much that an unnatural burden is put
on one who is trying for his or her spiritual development. The approach of
moving gradually towards the target is consistent with the spirit of Islam.
Shari‘ah is not difficult. It is not the purpose of Shari‘ah to make life
unnecessarily difficult for a person. Its purpose is to purify his or her soul. One
should not try to make following the Shari‘ah unnecessarily difficult, especially
in areas which it does not directly touch upon and in areas where there is a
certainty or risk that not using the allowances given by the Shari‘ah or those
that common sense points out will result in such burden as would result in
greater evil than the one that is to be rooted out.