A Critical Perspective on the Principles of Islamic Finance Focusing on Sharia Compliance and Arbitrage

By James Garner   Published 25 March, 2016

islamic banking, islamic finance

Abstract

This essay is a comprehensive discussion of the crucial Islamic finance principles written within Sharia law that govern the sector. Riba (prohibition of interest) being the major and most widely known is central to the discussion. However, this essay deals with many other of the major financial principles, for instance Gharar (avoidance of excessive risk), Maisir (avoidance of transactions based on luck or chance) and unjust enrichment.

The essay then analyses and evaluates how many popular and intrinsic Islamic financial products used today remain commercially competitive whilst still abiding by these strict Sharia principles.

This essay also highlights a contemporary issue and idea within Islamic finance, namely that of so-called Sharia Arbitrage. The theory posits that many of the Sharia complaint products available today are not so different from their Western counterparts. Despite the fact that methods that will be highlighted and used to ensure compliance, they do not go far enough to alter the nature of the products themselves.

I. Introduction

Allah has allowed trading and forbidden Riba

This principle is crucial to the development of Islamic finance in the modern world. It emphasises that by no means does the Qur’an or Islamic teachings prohibit trade or profit within finance; rather there are certain principles that Sharia law prohibits, usually due to unfairness.

This essay will discuss the key prohibitions within Islamic finance and how the Islamic financial products abide by these prohibitions. It should be noted at the outset that in referencing ‘Sharia law’ this author is predominantly referring to modern interpretations of Sharia laws that exist within the lived reality of capitalism and the Western financial system that has heavily influenced the Islamic financial sector, rather than traditional and classical interpretations of Sharia law and principles.

The aim of this essay is to evaluate the ways in which these products become Sharia-complaint. This essay also highlights a contemporary issue and idea within Islamic finance, namely that of so-called ‘Sharia Arbitrage’.

This theory posits that many of the Sharia-compliant products available today are not so different from their Western counterparts, and despite the fact many methods will be highlighted ensure compliance, they do not go far enough to alter the nature of the products themselves to become compliant with the classical moral based Sharia principles.

Sharia law is, as noted by Khan J, ‘the law laid down by the Qur’an. . . the holy book of Islam, and the Sunnah’. These different sources create principles by which Muslims should live. Crucially however, it does not form a binding source of law in the sense of legally binding obligations. However, these principles can be contracted for within a financial agreement like any other contractual clause and this is how Islamic financial products have come into fruition.

The Financial Times has recently estimated the size of the Islamic finance industry at $1.1 trillion. This is vast given the industry began just 50 years ago with the establishment of the Mit Ghamr Local Savings Bank in Egypt. The Islamic finance industry is also experiencing incredible growth, with some estimates putting it as high as 20 per cent in 2011 and within the United Arab Emirates at 65 per cent.

II. The History of Islamic Finance

Islamic finance dates back to medieval times when Sharia law would govern financial transactions in the Middle East, principles that incidentally were also found within the European financial systems at the time. Wherever trade occurred between a European and a Middle Eastern nation at the time, they tended to eschew principles of interest in favour of a profit sharing system, for instance within the trading relationships between the Ottoman Empire and the Spanish. However, as Western financial models began to spread around the world, the principle of interest took worldwide precedence over Sharia principles. This trend continued until the 1960s with the establishment of the Mit Ghamr Local Savings Bank in Egypt. From here, smaller Sharia-compliant banks have sprung up across the Arab world, catering for growing demand within the Arab world for Sharia-compliant banking services, sparking a trend of growth that since the late 1990s has seen a rate of 10–15 per cent year on year. The market, although still significantly smaller than the traditional Western model contains both smaller niche ‘totally compliant’ Islamic finance institutions, as well as conventional worldwide banks offering Sharia-compliant services through what Dr Schoon calls ‘Islamic Windows’. However, regardless of the business model, they must all abide by the same Islamic laws to offer similar compliant products to the markets.

III. Sharia Products

Procter notes there are four main prohibitions within Islamic finance law, ‘namely, Riba, Maisir, Gharar, and unjust enrichment’. Indeed Riba is the most commonly known prohibition. However the others are also important in terms of establishing a product that complies with Sharia law.

Riba broadly means increase and is known within the Qur’an as an injustice or oppression, but specifically Khorshid notes Riba ‘means usury and interest, and in general any unjustifiable increase in capital for which no compensation is given’. Riba of hadith (or riba al fadl) also exists; this is in effect Riba hidden in sales, for instance, the charging extra for a foreign exchange transaction would also be forbidden as Riba.

Warde points to interest as being a common example, but also the charging of late fees would be a form of exploitation of others. Procter notes that interest is prohibited because ‘money is a medium of exchange; it thus has no independent value and should not be a tradable commodity which is itself capable of being exploited for profit’. It would seem, therefore, that the unfairness associated with a rich man lending money to a poor person and making money simply via exploitation on the basis of him having money to lend, is largely unfair. This unfairness underpins the basis of a great deal of Islamic finance.

El-Gamal notes that of the two forms of Riba, it is Riba-al-nasia, or ‘credit transactions’, ‘where money is exchanged for money with deferment’that is the form of finance by which the Western finance sector has been built’. Procter further notes that very wide scope has been given to what is defined as Riba following a judgement by the Sharia Appellate Bench of the Supreme Court of Pakistan, where it was held that Riba constituted, ‘any additional amount over the principle in a contract of loan or debt’. Therefore, it would be right to assume that particularly in very strict Muslim countries; compliance with certain aspects of Sharia law can be highly onerous. Attempts to formulate a viable and successful financial system have therefore been difficult. This has led to the creation of products whose compliance is arguably a result of so called ‘Sharia Arbitrage’, a point to be discussed later.

Other key prohibitions exist, such as Gharar. Gharar is prohibited given it ‘connotes a transaction based on incomplete information (or deception) and which incorporates an unnecessary degree of risk and/or uncertainty’. Vogel further notes that Gharar:

. . . bar[s] only risks affecting the existence of the object as to which the parties transact rather than just its price. In the hadiths, such risks arise either (1) because of the parties’ lack of knowledge (jahl/ignorance) about that object; (2) because the object does not now exist; or (3) because the object evades the parties’ control.
Rodinson summarises this as ‘any gain that may result from chance, from undetermined causes, is here prohibited’. However, crucially, risk is present within all modern transactions, and to prohibit all risk taking would be to prohibit trade, which as the above seminal quote confirms, was not the aim of Allah. Therefore, Gharar is crucially prohibiting unnecessary risk, or blind risk. This in many respects makes good commercial sense. However, El-Gamal has noted ‘jurists have been more lenient to varying degrees with the prohibition of Gharar since no contract can be totally devoid of uncertainty’and ‘in many cases, Gharar can be eliminated from contracts by carefully stating the object of sale and the price to eliminate unnecessary ambiguities’. Therefore, as Procter notes, Gharar will:

. . . only invalidate a contract if; (i) the risk or uncertainty is significant; (ii) the risk affects the price or the principal objective of the contract; and (iii) the risk cannot be satisfactorily addressed through other available products which are Islamic compliant.

Therefore, this suggests an element of flexibility within the prohibition of Gharar that is not present within Riba. This flexibility has allowed for a greater diversity of Islamic financial products to arise through innovation. Areas such as insurance, originally strictly prohibited, are now allowed through a carefully structured Islamic finance product called a Takaful, which will be explored later.

Contracts based on luck, or effectively a gamble, are also prohibited. These are called Maisir or Qimar. Procter clarifies this by stating, ‘whilst any commercial contract inventively involves a degree of speculation, the prohibition applies to contracts where the outcome depends on luck or chance’, or as Balala notes, essentially any form of speculation. For example, Procter points to a decision by the Court of Cassation in Abu Dhabi that held invalid foreign exchange contracts. Therefore, this would also include the trading of futures and other dealings of a similar nature, important elements of the Western financial system.

Procter noted another prohibition, that of unjust enrichment. Namely, ‘a contract which is unfair or which is imposed (e.g. under duress) on a weaker counterparty to his detriment, will not be Sharia-compliant’. Procter identifies late fees as an example, given it exploits a debtor’s weaker position. However, there is another final prohibition in that the object of finance must be Halal, i.e. not Haram (forbidden). This includes products such as pork and alcohol.

Western banks traditionally make money by charging interest on lent money or through a finance transaction with debtors. This constitutes making ‘money on money’and is prohibited as Riba. Therefore, in order to become viable and profitable businesses, Islamic banks found alternative and innovative methods of using depositor’s funds, or providing finance without breaching the four main prohibitions. Procter notes, they do this by taking advantage of the fact Sharia law:

. . . allows profit for labour or for the taking of risk, but not merely for the use of money. . . Sharia-compliant products depend their validity on the sale of assets or the receipt of rent for the use or occupation of property.

Therefore, the products that have arisen are ways that banks have inventively avoided the ’Harams’ within Western banking to create viable and profitable Islamic financial products. These will now be considered.

One of the most widely used products is a Murab¯aha, effectively a finance agreement. Traditionally, Western banks would charge interest at the market rate (i.e. London Interbank Offered Rate, LIBOR) over and above the cost of purchase and this would be charged to the debtor over a fixed period of time along with payment of the cost price, in order to pay off the cost of the product. However, this agreement would be Riba. Instead, an agreement is reached under contract between the bank and the customer. Then the bank purchases the pre-identified product, and ownership is transferred to the bank, a pre-agreed mark-up is placed on the price of the product and it is sold to the customer at a fixed price to be paid back over instalments.

IV. Sharia-Compliance

There are two crucial factors involved within this transaction that are present to ensure Sharia-compliance. Firstly, the fact ownership transfers to the bank prior to being sold to the customer, is crucial. This is because, as Warde notes, it equates to the bank ‘selling the customer the specified good’ as if they were a trader adding a markup on a product. Khan supports this by stating that ‘a Murab¯aha is permissible since the bank has actual ownership of the [product] and so has borne some risk’. Procter affirms that whilst the bank is in ownership of the produce it is exposed to the ‘risks involved in ownership of the asset’, if even for a short while, justifying the mark-up.

Therefore, as noted above, Riba is avoided given the bank can justify the profit or mark-up due to the risk it has exposed itself as well as the labour or service it has provided. The increase in price has not been made purely out of the use of money or the finance agreement. Procter underlines that due to the trading relationship rather than the Western structure of a ‘secured lender/borrower relationship’, there are greater risks, again justifying the mark-up by the bank.

Secondly, there are a number of factors that must be abided by to ensure that the prohibition of Gharar is satisfied and the transaction is ‘certain’. Procter outlines the necessary precautions:

(i) the object of the sale must exist at the time of the transaction,(ii) the seller must have a valid title to, and possession of, that object, (iii) there must be certainty of price.

These exist to ensure Gharar is not present, although it is widely accepted that ‘both actual and constructive possession are sufficient on the part of the bank’to ensure compliance. Therefore, this product is a good example of how Islamic banks can carefully structure a product in order to comply with Sharia law. Often there are only quite subtle differences from Western financial products. This compliance is often aided by the method by which these products achieve Sharia compliance. For instance, it tends to be an interpretation or judgement made as to a products compliance with Sharia law by a mixture of scholars and Sharia advisory boards. These boards often exist as part of a larger bank and it could be argued are therefore subject to a strong conflict of interest, further strengthening the argument of El-Gamal discussed below.

V. Sharia and Western Finance Principles

Warde agrees by observing many parallels exist between a Murab¯aha transaction, and a traditional Western interest based finance agreement. Namely that of due diligence, credit assessments and also the fact the asset is used as collateral. Other parallels can also be drawn, namely, as El-Gamal remarks, the mark-up charged by the bank will often equate to the interest charged by the Western banks in similar finance agreements. Also, Procter notes ‘the bank will usually appoint the customer as its agent for the purpose of selecting, inspecting, ordering, and taking possession of the goods’.

This act crucially reduces the transaction to becoming very similar to its Western counterpart as the customer even orders and collects the product. Therefore, the bank only has constructive ownership, exposing itself to only questionable levels of risk.

This demonstrates that despite the subtle differences many similarities remain, even to the point that the bank can appoint the consumer as its agent to carry out a great deal of the labour on its behalf. However, Sharia abidance is crucial, via well drafted rules within the financial product, even if it means effectively jumping through hoops to do so. The Murab¯aha is used to finance the purchase of an asset, but another slightly more controversial product has been developed in order to provide capital on credit to a customer. This is called a Tawarruq and it originally involved as Warde notes, ‘buying a commodity on credit and immediately selling it on to a third person for cash’. Warde notes the modern day equivalent is called an ‘organised Tawarruq’, with the Islamic bank involved throughout the whole transaction. This means:

The bank purchases some commodity from the market, then sells the commodity to the customer on a Murab¯aha basis for deferred payment. Subsequently the bank (as the customer’s agent) sells the [commodity] on the market for immediate cash. As a result the bank will gain Murab¯aha profit and agency fees, and the customer will obtain cash. The [commodity] will not change hands.

Ward submits that the Tawarruq is one of the more controversial products available from Islamic banks, due to the spurious link to the asset by both the bank and the customer. This is underlined by El-Gamal who notes ‘it is only within the Hanbali School that some jurists approved the practice of Tawarruq’. Crucially, however, this product satisfies Sharia law. It does so by ensuring title is transferred from the market, to the bank, then from the bank to the customer, then back to the markets. Even if the bank acts as the customer’s agent to ensure this sequence of events takes place, title nonetheless moves to the appropriate parties to ensure compliance with Sharia law. It mirrors the compliance necessary within the Murab¯aha transaction, whereby the fact title moves ensures there is no Gharar. The product bought and sold must be Halal and, as a fixed price is specified, there is no Riba. It is an innovative way of ensuring the bank can lend capital without breaching the Riba and Gharar prohibitions.

Due to the fact this transaction is for capital rather than an asset, it is frowned upon. Warde notes this is because ‘it can lead to the proliferation of debt’. Due to this, ‘the Accounting and Auditing Organization for Islamic Financial Institutions has stated that Tawarroq is acceptable if it involves four parties (a buyer, a seller, the buyer’s commodity broker, and the seller’s commodity broker)’. Therefore, the many stages clearly emphasise the fact that assets must change hands, and capital is the end result, rather than the bank just using money to make money, as this would be prohibited as Riba.

Another product, the Musharaka, is in effect a joint venture agreement or partnership agreement, whereby the bank will finance an asset or a project and ‘take an equity stake in the business venture’. Warde submits that, ‘partnership finance was at [one time] the most ‘authentic’ form of Islamic finance since it replicated transactions that were common in the early days of Islam’. However, many banks have shunned the widespread use of such an instrument simply due to the very nature of shared risk, such risk that does not exist within many other Islamic products. In order to combat this, many banks have started to guarantee profits, but this contravenes the basic Sharia law of linking risk to reward. Such actions only provide more evidence to critics such as El-Gamal that argue the current system of Islamic finance is nothing more than an interest-based system operating under the guise of profit.

In addition Procter crucially notes, ‘the losses must be borne pro rata to their respective investments but profits may be divided according to agreement’. This clearly demonstrates how the introduction of risk on the part of the bank is crucial in order to avoid Riba, and also to justify the banks profits and comply with Sharia law. The Musharaka generally involves finance from both parties, but the customer will likely give less and their contribution in labour is recognised in the equity share of profit within the agreement.

An innovative form of Musharaka, called a diminishing Musharaka, is commonly used as a method of financing to form a Sharia-compliant mortgage. Procter notes that under this arrangement ‘the financier invests in the customer’s business, on the basis that the customer will progressively buy out the financier’s share over a period’. This can easily be translated into a home buying scheme whereby the business is effectively the house and the financiers share is bought out and the financiers profit ‘effectively represents rental income’.

A subtly changed Musharaka, can form a Mudaraba, a ‘silent partnership’or ‘profit-sharing partnership’. This product mimics that of a mutual or investment fund. Procter notes the procedure whereby, ‘one or a group of investors (Rab al maal) pool their resources for a given business venture under the management of a fund administrator or manager (Mudareb)’. This is known as a silent partnership as the investor takes a back seat with little to no involvement, as with a Western investment fund. The Mudareb acts much like a fund manager in Western terms and similar to a Western fund, if the initial due diligence proves effective; it is the investor that will bear the full loss.

Another investment vehicle used in the Western world is that of a bond. This is a form of transferable security whereby the issuer owes the purchaser a debt plus interest. This can be issued by a government (e.g. UK Guilt, a government issued liability in sterling issued by the HM Treasury) or by a company as a method of raising capital. Due to the interest element, Muslims are obviously forbidden to invest in or issue such instruments.

However, Islamic finance has found an alternative in a Sukuk. This is effectively a product that, as Procter notes, ‘evidences a share in an underlying asset and the revenues which may be derived from it’. As Khorshid observes the Sukuk is a needed financial innovation for the Islamic world given that the huge liquidity surplus created by oil wealth can be securitised and traded on the secondary market.

This product works by the Islamic bank issuing the Sukuk (certificates) to raise a pool of capital. This is then used to purchase an asset that the subject company wish to use, and it is then leased to the company, representing income (equivalent to interest pegged at LIBOR) for the Sukuk holders. Ultimately, as with a bond the premium is ultimately repaid, and within a Sukuk the assets are ‘sold or transferred back to the primary entity’. Importantly a Sukuk is effectively a securitized asset financial product that can be traded and sold on the secondary market. This factor increases the negotiability of the bonds making them a more valuable and prudent commercial investment, with less risk.

The Sukuk represents legal ownership of an identified asset. Importantly Sharia law considers the many investors within a Sukuk to be ‘co-owners of an asset, although held on trust’, therefore it does not breach the principles of Gharar. Also, because the owner is exposed to any risk associated with the investment subject (asset), there is no Riba, as both the investor and investee are seen as equally exposed to risk. This point is summarised by Warde, ‘In contrast to a real bond, Sukuk holders are the owners of a specific asset and are entitled to receive the profit or usufructs generated by such assets, as well as the proceedings from the sale of the asset’.However, the Sukuk is a controversial Islamic financial product.

Conservative scholars reference the fact the Sukuk requires payment for the time-value of money, as well as a fixed return, both fundamental characteristics of interest. Importantly, the compliance principles of the Sukuk were questioned by Sheik Muhammad Taqi Usmani, President of the Sharia Council of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) published in 2007. Within this paper, Usmani pointed out that in many ways the Sukuk mirrored many characteristics of the conventional interest-bearing bonds, as they do not return to investors more than a fixed percentage of the principal, based on interest rates, while guaranteeing the return of investors’ principal at maturity.

He posited that up to 85% of all issued Sukuks were not Sharia-compliant, sparking a collapse in the Sukuk markets, from US $33.9bn in 2007 to approximately $14.9bn in 2008.75 The fact such high level scholars are questioning the basis of Sharia compliance within such prevalent products certainly adds great strength to the arguments of Sharia arbitrage posited by El-Gamal, a view shared by this author.

Ijara is a form of lease or a sale contract, essentially, the customer and the bank will agree on the asset to be the subject of the Ijara, then the bank will purchase the asset, then as Warde notes, ‘the bank leases an asset to a [customer] in exchange for specified rent. The amounts of payments are known in advance and the asset remains the property of the lessor’. These lease payments essentially give, as El-Gamal argues, ‘the usufruct (the right to use the object) for a specified period of time’and include as Procter observes, ‘the financier’s required margin of profit’.

There are many intricate essential conditions in order for an Ijara to achieve Sharia compliance. First, the bank or ‘leasing agency, must own the leased object for the duration of the lease’. This is important as it means that a leasing arrangement is in place with the customer paying for use of the asset, rather than the bank effectively offering a loan to the customer to purchase the asset, obtain title and then pay the bank back over time with interest added on the loan. This also ensures the object is certain, and therefore there is no Gharar. This is a subtle difference that ensures the key principles of Islamic finance are not broken. Secondly, as title belongs to the bank, so do the risks and duties associated with owning an asset e.g. maintenance. Thirdly, as Procter notes, ‘payments under an Ijara can only continue whilst the customer has the use of the asset. Consequently, if the asset is lost, stolen, or destroyed, then the obligation to pay rent must terminate’.This and the second noted condition, similar to a Murab¯aha transaction, justify the profit margin charged by the bank. This is because as previously noted, and highlighted by Procter, ‘the lessor cannot pass the entire risk of the asset to the lessee’ as this would mean money would have been made devoid of risk, as this would be borne by the lessee, therefore the bank in making a profit would be charging Riba to make this profit. Another key element is that the bank cannot, as Procter notes, ‘stipulate for an increased payment as a result of late payment of the rent. This would amount to Riba, and would hence be prohibited’, this would consequently also amount to unjust enrichment, another prohibited act again supported by Procter. Finally, the lease cannot finance an asset that is used for a haram purpose.

VI. Sharia Arbitrage

As it may be clear from the products noted above, many involve a subtle adaptation of a Western principle in order to comply with Sharia law. It is certainly interesting to note how far these products break from contemporary Western principles of finance in order to become acceptable to the Sharia Supervisory Boards that warrant their compliance and use. The answer posited by a number of commentators is in fact not far enough. For example, El-Gamal a prevalent author within the subject of Islamic finance posits the existence of what he calls Sharia Arbitrage:

. . . whereby legal devices are used, often employing special purpose vehicles to restructure interest-bearing debt, collecting interest in the form of rent or price mark-up. Designing such instruments and their certification as ‘interest free’ constitutes the bulk of Islamic finance.

This is a strong accusation, effectively suggesting that the Sharia-compliant products are simply remodelled Western banking products, with different notions of how interest is charged under an Islamic name. This is not such an outlandish suggestion given a key principle of finance and indeed making profit from money itself.

Remodelling a product that has proven effective to make money in order to become compliant with religious principles seems a purely sensible notion. After all, El-Gamal argues that Sharia Arbitrage is demand driven, and traditional financial models are simply repackaged to meet this demand. He asserts that this Sharia Arbitrage has enabled ‘juristic efforts to re-characterize modern financial transactions, rather than legal stratagems to circumvent prohibitions’. El-Gamal goes further to note that this act of ‘arbitrage’ to achieve compliance breaks from the spirit of the law, looking to achieve legal compliance Sharia law and ignoring why the principles existed in the first place. In effect these modern day products, despite their compliance status, play against the moral foundations of Sharia law.

This point is supported by Kamala given his comments on the importance of the Sharia Supervisory Boards within these Islamic banks, approving what he calls ‘interest-bearing products’. These are then ‘marketed and passed as Islamic’ by the banks, legitimised by the decision of the Sharia Supervisory Board. Kamala highlights the vital importance the boards play in the marketing and legitimization of these products. Crucially, he notes that ‘in effect the activities of Islamic banks promising interest free banking are described by a number of observers as merely a fiction’. Further, Useem sums up this arbitrage situation by describing modern day Islamic products, such as the Murab¯aha, as looking ‘a lot like interest, and some argue [they are] simply a thinly veiled version of it’. Further, Khan observes that due to the view of a Murab¯aha being simply ‘disguised interest. . . the Pakistani Federal Shariat Court and the Shariat Appellate Bench of the Supreme Court ruled against the existing system of Islamic Banking in 1991 and 2002’.

Perhaps the fact that the mark-up or the lease payment of products, so clearly and unashamedly replicates the interest rates of the market (e.g. LIBOR), is proof enough that the Islamic products are not so different after all. El-Gamal points to the innovative diminishing Musharaka, effectively an Islamic mortgage as an example of a simple replication or re-packaging of a conventional Western financial instrument, given the payment schedule replicates a mortgage schedule payment plan with equivalent rates of interest built into the Musharaka’s lease payments.

Perhaps the best example of this ‘Sharia Arbitrage’ by the Islamic banks, in search of innovative ways of developing products that will be granted Sharia compliance, is that of Takaful, a compliant form of insurance. It is operated ‘on the basis of shared responsibility, brotherhood, solidarity and mutual cooperation or assistance, which provides for mutual financial security and assistance to safeguard participants against defined risk’. The main method of arranging a Takaful is via a cooperative whereby, ‘a group of subscribers contribute to a pool of funds. Whenever one of the members makes a legitimate claim, they draw money out of the pool’. Hassan explains the contributions are placed into two accounts, one following the model of the Mudaraba (the bank and investors share profits99) and the other treated as a charitable donation to the principle of Tabarra, with payments made to assist members when necessary.

As this is effectively a form of insurance, it makes it perhaps the most controversial modern Islamic financial product. One reason being the tendency of traditional Western insurance companies to invest premiums into investment bearing bonds and financial instruments. Another is the fact that the Western sense of insurance would be forbidden as Gharar, as essentially, it as a gamble by the issuer over whether a payment will or will not be made. This is affirmed by Khorshid when he notes:

The prohibition of Gharar in Islamic law has been the major argument put forward against the validity of insurance. Those who argue that insurance cannot be accepted under Islamic law, argue that uncertainty is a prominent feature of insurance.

This uncertainty relates to the fact that repayment may never occur, and if a claim is made, what the reward will be is also uncertain as that is measured based on the incident (that is in-itself an uncertainty). Importantly, Khorshid goes on to observe:

Insurance manifestly involves uncertainty, and this uncertainty is equivalent to the element of Gharar, expressly prohibited in sales contracts in Islamic law. Thus [strictly] insurance in Islamic law cannot be permissible.

However, Korshid clarifies how the Takaful can become complaint by noting ‘that Gharar is not rejected in the same manner as Riba’. However, this exception seems remarkably convenient in order to create another market in which Islamic banking can compete with the Western world and in this author’s opinion, it seems like another example of what El-Gamal has labelled ‘Sharia Arbitrage’. However, on the other hand, insurance is in essence a modern public necessity, meaning that an Islamic compliant alternative was always needed in order to provide Muslims with the similar benefits enjoyed by those following the traditional Western financial principles. Therefore, although the Takaful morally breaks from the rules underpinning Sharia law it was a necessary innovation that certainly provides a strong example of ‘Sharia arbitrage’ in practice.

VII. Sharia Arbitrage – A Paradox?

Another issue surrounding the use of these products and the extent of their compliance lies within the aims and justifications of Islamic finance. Khan points to a statement by the Islamic Research and Training Institute of the Islamic Development Bank that highlights the aims of Islamic finance:

The most important feature of Islamic Banking is that it promotes risk sharing between the provider of funds. . . and both the financial intermediary (the bank) and the user of funds. . . in conventional banking the risk is all borne by the entrepreneur.

This clearly shows that Profit Loss Sharing (PLS herein) schemes should be central to a system of Islamic banking. However, instead of engaging in the more Sharia-compliant PLS arrangements such as the Murab¯aha, Kamala notes, most Islamic banks are opting for the mark-up products (such as the Murahaba) whereby the principle of shared risk is avoided on the most part or minimised, and the markup, principally based on market rates of interest, is marketed as an approved product. This is supported by Khan who notes that in a ‘typical Islamic bank, [non-PLS forms] dominate the assets portfolio’. Khan claims also that often Islamic finance products are barely risk sharing and even often ‘use current market interest rates as pricing benchmarks’.

Khan also, perhaps rather controversially, points to a possible conflict of interest between the large sums of money paid to the members of the Sharia Advisory Boards and the credibility an authorisation from these boards brings. This conflict of interest can be likened to the vast sums of money paid to the Credit Rating Agencies in the West and the independent ratings they are meant to provide. It certainly could be argued that a conflict does indeed exist between a financial system seeking to comply with principles of risk sharing and fairness, and a system seeking to become profitable and in competition with the West. Perhaps then, it is this conflict that has led to the possibility of ‘Sharia Arbitrage’ and the creation of some products that are not so different to their Western counterparts. Ultimately, Khan finds that ‘Islamic Banking and Finance is virtually indistinguishable from conventional banking and finance. What makes it Islamic is Sharia Arbitrage’. However, the level of possible arbitrage differs among many products, with many products arguably providing a better system than Western counterparts. For example, the PLS schemes within Islamic finance, where ownership is shared in an asset/venture with a bank and profits are based on the success of the venture, seem a fair method of investment with joint risk and quite different from Western alternatives such as a bond or a loan.

In the opinion of this author the notion of Sharia Arbitrage is well founded. It is likely how the Islamic banking world has managed to become a realistic alternative to Western banking. Trust has been established by largely ‘repackaging’ familiar products.

Indeed, the growth of Islamic finance has been so acute, perhaps mostly due to the fact models of profitable banking methods were available within the Western banking world only to be tweaked to become Sharia-compliant. Whether this is moral, to be marketing products as being effectively unique that are in fact a loose copy is another question. However, in reality for totally unique products to have arisen through the development of Islamic finance, given the relatively short period in which Islamic finance has been available may be an unrealistic expectation.

Nevertheless, unique Sharia-compliant products have certainly arisen which suggests over time the ‘copy-cat’ effect may well diminish reducing the impact of Sharia arbitrage, despite the possibility of there being some truth behind the argument of ‘Sharia Arbitrage’, this essay has demonstrated how some of the most important Islamic financial products have been modelled, perhaps creatively or with a genuine desire to provide a complaint service, in order to be granted Sharia compliance, avoiding the many crucial principles inherent within the rules of Sharia financial law.

VIII. Conclusion and the Future of Islamic Finance

It is clear from the arguments posited by this essay that Islamic financial principles are in essence cleverly repackaged traditional Western financial products, effectively charging interest in ways that ensures the product is Sharia-compliant. Over the years since the founding of the Mit Gamil Savings Bank in Egypt in 1963, the´Islamic financial products on offer have evolved from the purest kinds of Sharia-compliant products (i.e. Musharaka) to products based on a ‘mark-up’ system. This evolution has meant Islamic finance products have eschewed risk and profits from a partnership investment in favour of more regulated and risk free methods of leveraged finance. Clearly this evolution has resulted in an Islamic financial system containing products that are neither pure Sharia-compliant or mirror images of Western products. However, this author would argue that finding this middle ground may not be such a bad thing given the fact Western financial products have themselves been imitated and honed over hundreds of years, from the first Florentine bankers of the 14th century. This has made them both effective and prime candidates for imitation, and it is this refinement and development that will become part of the Islamic financial sector for the next few hundred years. What is also clear since the 2008 financial crisis is a worldwide shift in global capital.

Western banks are now required to increase their capital buffers and ensure more capital is held on their balance sheets, ultimately reducing the available capital for loans and shrinking the Western financial sector in the process. Meanwhile, Islamic nations, many rich from vast oil reserves, are the new hubs seeking investment and capital, all of which will be governed by the principles of Islamic Finance going forward. This global shift could not have occurred without a solid foundation of principles and products that are the basis of Islamic finance today.

About the Author
James Garner

James studied Law (LLB) at the University of Nottingham before moving to the University of Leeds to study an LLM in International Banking and Finance Law.

He is currently in his first year of a training contract at international law firm Pinsent Masons LLP due to qualify in September 2017.

This article was first published in the Leeds Journal of Law & Criminology.

Article picture: A Jordan Islamic Bank branch in Amman.

Coming Soon on iPad

Video Choice

of the Week

Lincoln’s Code: The Puzzling History of the Laws of War. John Fabian Witt, Allen H. Duffy Class of 1960 Professor of Law, Inaugural Lecture.

Tip: Suggest a video!

Ask Jeeves UK