UAE Laws and Islamic Finance

Laws of the UAE and Islamic Finance

Archive for November 5, 2012

Book Review for “Islamic Finance, Why It Makes Sense” by Daud Vicary Abdullah and Keon Chee

Beirut, Lebanon

Islamic Finance, Why It Makes Sense by Daud Vicary Abdullah and Keon Chee delves into the scintillating history of Islam and the key ideas behind Islamic finance including the belief in divine guidance; the no-interest rule; socially responsible investing; the sharing of risk; and the using of real assets to finance deals.  The authors explore the benevolent objectives of Islamic banking, the roots of the basic principles of Islamic Finance in the Qu’ran, Hadith, and Sunnah, and the explosion of Islamic finance and banking into the modern conventional scene. Abdullah and Chee give a solid and easy to understand explanation of all of the major concepts and modes of financing in Islamic Finance from ijarah to musharakah, debt- versus -equity financing in Islamic finance, the categories of Islamic Finance contracts, Islamic Investment, and the Islamic financial system and its regulation.  The authors explain how to invest and manage investment risk, how funds are constructed using various Islamic finance contracts, what is halal and haram in Islamic investing, and investing with Islamic unit trusts (or mutual funds).  The authors then provide information in regards to the process of screening using Islamic Indexes, the process for purifying earnings and purification of unit trust gains and delve into the different types of Islamic funds including equity, lease (ijarah), and Islamic exchange-traded funds (ETF’s).  They then proceed to strategically discuss the opening of non-bank financial institutions including Takaful, Fund Management, Derivative Instruments, and Money Market Securities as well as the internationalization of Islamic financial infrastructure.

“Islamic finance principles are not only ethical, they are also sensible.  Transparency, risk sharing, interest-free financing, asset-based transactions and the avoidance of undesirable activities – these are hallmark features.” – Abdullah and Chee

The authors, being one Muslim and one non-Muslim with lifetime careers in conventional banking and finance, further provide an insightful and educational comparison with conventional finance, allowing Westerners and those with a conventional finance background to easily grasp the otherwise seemingly difficult and impossible to understand Islamic finance and Arabic terms. For instance, the authors explain the key features of Islamic finance contracts, which are remarkably similar to contracts in common and civil law.  “In Islamic finance contracts, there are at least two parties, there is an offer and acceptance by both parties on the purpose and terms of the contract, the purpose of the contract must not be haram (forbidden) or offensive to Shari’ah, the subject of the contract must change hands upon completion of the contract, the terms of the contract should be achievable, the contracting parties must be aware of the exact quality, quantity, and specifications of the object of the contract in order to eliminate gharar or uncertainty that could lead to a dispute; and the contracting parties should be above 15 years of age and possess a sound mind.”

In a comprehensive manner, the authors give a heart-to-heart explanation of how Islamic Finance is universally applicable and makes sense for everyone.  Abdullah and Chee present various practical and common sense reasons for why non-Muslims and Muslims alike may find resonance with Islamic finance.   For example, the authors state that Islamic finance is widely appealing because it is based on ethical principles that are appreciated by everyone. The authors describe how, ‘From purchasing Islamic mortgages to Islamic funds, more and more non-Muslims today are participating in Islamic finance to satisfy their sense of social responsibility.’

In fact, not only is Islamic finance universally appealing, however, it makes economic sense. To give an example, Abdullah and Chee speak about the recent financial crises and the resilience and stability of Islamic finance.  “The US sub-prime mortgage crisis caused several large international banks to collapse and brought many others to the brink of it.  Yet to our knowledge, no Islamic banks have failed as a result of the mortgage crisis.  One explanation is that Islamic finance requires the use of real assets and prohibits highly speculative financial derivatives.  Such derivatives were a major cause of the mortgage crisis. The focus of asset-based financing puts natural limits on the level of debt, preventing excessive leverage.  A second explanation is that Islamic finance encourages the sharing of risk, such as between banks and consumers.  When investments in a mudharabah (profit-sharing) deposit account, for example, do poorly, the depositors (capital provider) absorb the full loss.  But at the same time, Islamic banks are fully aware that if depositors do not receive ample returns on their investments, they would take their business elsewhere.  This encourages Islamic banks to be conservative in order to minimize losses yet ensure that a reasonable and competitive return is generated.”

The dynamic duo, Abdullah and Chee, cleverly bring up the analogous examples of co-operative societies in the US and UK and the similarity in concept with Islamic finance.  The authors explain that, “Non-Muslims find the co-operative nature of Islamic finance very much aligned to that of conventional co-operative societies.” Similar to Islamic society,  “Such societies consist of persons united voluntarily to meet their common economic, social, and cultural needs through a jointly-owned enterprise.”  In the UK, for instance, ‘members of building co-operatives pool resources to build housing normally using a high proportion of their own labor.’

The authors then rivet the readers by bringing up the example of the original cooperative nature of insurance in the US, which is similar in concept to Islamic insurance or takaful. Abdullah and Chee intelligently remind us that, “In the US, insurance began through a mutual (or co-operative structure).”  Similarly, in takaful or Islamic insurance, the basis is of a cooperative nature. The authors explain that “it is not a sale-and-purchase agreement where one party offers and sells protection, and the other party accepts and buys the service at a certain price.  It is, instead, an arrangement by a group of people who have the desire to protect each other from defined risks and mishaps, by contributing to a pool of money out of their own resources.  Such a practice of mutual help and shared responsibility was laid down by the principle of Aqilah (persons of relationship), which was customary in some tribes at the time of Prophet Muhammad provided contributions to relieve the affected parties.  This principle of Aqilah is the foundation of takaful.”

The authors proceed to explain that, ‘Islamic scholar Ibrahim al-Tahawi defined the goals of an Islamic economic system as sufficiency and peace, which can come about by eradicating hunger and fear from society and by ensuring that every individual’s basic needs are fulfilled.  His list of such needs includes food, shelter, medical services, education and ‘all that is regarded necessary according to the custom of the society.’   Dr. M. Umer Chapra states that, “Besides organizing social security, the state maintains stability in the value of money, harmonizes international economic relations, and creates the conditions favourable for full employment and a high rate of growth.”

Actually, these compassionate goals are universal and similar to the humane ambitions found in other religions and schools of thought.  In reality, Islamic finance strikes the cords of justice, equality, and peace, which already exist in the moral mind-set of many people around the world, regardless of their ethnicity, gender, or religious affiliation and hence the popularity of and curiosity about such modes of financing among Muslims and non-Muslims alike.

In order to emphasize this point, the authors vividly bring up the point that, ‘Fortunately, the very large majority of people who follow religion of any sort are peace-loving, tolerant, and law-abiding.’  Therefore, Islamic finance is appealing to anyone who follows any religion, as many similar principles can be found throughout the worlds’ major religions, especially in Christianity and Judaism.  The authors frankly point out that, “More than half of the world is either Christian or Muslim.”

The authors re-iterate the fact that riba was originally banned in other religions aside from and prior to Islam.  The authors explain that riba was prohibited in both Judaism and Christianity long before Islam and that the Qu’ran is just re-stating what the two previous holy books have already mentioned.  In fact, many of the economic principles in Islam can be traced back through the Holy Books to the messages expounded by Jesus and Moses.  Islamic banking is therefore a form of Holy Book Banking, encompassing principles found in Judaism, Christianity, and Islam.

Furthermore, the authors explain that similar to the ideas found in Judaism, Christianity, and Islam, ‘philosophers such as Aristotle (384-322 BCE), who preceded Christ, considered interest an unnatural income because the lender gains without performing any work.’ Aristotle believed that money cannot beget money similar to Islamic belief and ideas found in all of the holy books.

The authors cleverly reveal that, ‘According to Aristotle, there are three ways of seeking profit in business: (1) Through natural trade, that is, through the exchange of essential commodities in daily transactions, such as the exchange of clothing with food; (2) Through the exchange of essential commodities for money, such as the exchange of dollars for food.  This form of trading is practiced in modern society; and (3) Through unnatural trade where money is treated as a commodity that can be traded (rather than as a means of exchange).  The profit realized from such a trade is classified as riba.’

The authors show how the wisdom of the famous Western philosophers including Aristotle actually shines through the lense of Islamic finance.

The authors clarify that, “Islam encourages businesses to increase their wealth through trade, and not from lending and borrowing…Besides its religious restriction, riba is considered unfair and exploitative.  For instance: The earning of interest from a borrower means that the borrower’s money is being taken without providing anything in return.  Not only does this make the borrower worse off, it does not bring about mutual co-operation and goodwill between lender and borrower.  The lender, on the other hand, is earning money without working for it or bearing any risk.  This is unjust.  A party to a financial contract is entitled to returns only if it will bear risk.  Interest-based financing tends to increase the wealth gap between rich and poor. Conventional banks usually require collateral, in the form of assets, for business loans.  This leads them to focus their lending to established businesses and borrowers who can offer collateral.  Smaller businesses with no or few assets to pledge as collateral are either charged high interest or denied financing.  In the long run, large businesses get larger while small businesses, often owned by families, are disadvantaged and likely to suffer closure as a result. “  The authors conceptualize the basic premise of Islamic finance that, “In the end, trade should be conducted between people in a transparent, mutually-beneficial manner so that no party is ever unjustly rewarded or unjustly penalized.”

The authors use a quotation by Mufti Muhammad Taqi Usmani to succinctly portray the difference between the capitalist and Divine economy: “The basic difference between the capitalist and Islamic economy is that in secular capitalism, the profit motive or private ownership is given unbridled power to make economic decisions. Their liberty is not controlled by any divine injunction. If there are some restrictions, they are imposed by human beings and are always subject to change through democratic legislation, which accepts no authority of any super-human power … This is exactly what Islam does.  After recognizing private ownership, profit motive and market forces, Islam has put certain divine restrictions on the economic activities.  These restrictions being imposed by Allah Almighty, Whose knowledge has no limits, cannot be removed by any human authority.”

I highly recommend this book for anyone seeking to quench their curious thirst about Islamic finance, its origin and the principles behind it, and whom wish to receive a thorough overview of Islamic modes of financing, debt- versus- equity financing, Islamic contracts, takaful, Islamic investment, and the Islamic financial system and its regulation.

“Given the severe negative effects of past financial crises in the conventional system, adopting Islamic finance to some extent makes economic sense.” – Abdullah and Chee

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