What Would A Muslim Say:

Conversations, Questions, and Answers About Islam

How Modern Scholars Deal with Financing and Investing

Emphasizing Premodern Forms

Because of the political and social upheavals in the Muslim world due to colonialism and losing power and prestige on the world stage, there has been an Islamic revival aimed at reclaiming this lost heritage. Islamist movements start with the rejection of Western advances, whether in the social or the legal sector; then they strive to achieve “Islamic” states, “Islamic” social science, “Islamic” economics, and “Islamic” finance. The problem is that these labels are often distinctions without any substantial differences. Because of this mindset, Islamist thinkers and advocates read classical (premodern) jurisprudence without critique, seeking to emulate past rulings that are not applicable or representative or current financial realities.[1]

Here is an example of how the Islamic Finance industry frames the issue and then solves it with various premodern contract forms, retaining the Arabic names but edited to mimic conventional financing:

Central to Islamic economics and finance is the fact that money itself has no intrinsic value. As a matter of faith, a Muslim cannot lend money to, or receive money from someone and expect to benefit through any increase, such as interest (commonly referred to as riba) is not allowed. To make money from money is strictly forbidden, wealth can only be generated through legitimate trade and investment in assets.

Musharakah, murabaha and ijarah contract types form the basis of a variety of Shari’ah compliant alternatives to conventional interest-based financing solutions. The basic premise of Islamic finance lies in the need to eliminate both interest (Riba) and uncertainty (Gharar) in all business and financial transactions. In brief, the following are key types of Islamic contracts applied today.

Musharakah –contracts of partnership. Islamic scholars have preferred … musharakah as the ideal forms of permissible contract that comply with the rules and objectives of the Shari’ah. The basic reasoning is that these contracts pool resources and expertise as well as spread the inherent risk in a project among the various parties involved.

Murabaha– a term often referred to as ‘cost-plus financing’ and in its simplest form, this contract involves the sale of goods on a deferred basis. The goods are delivered immediately and the price to be paid for the item includes a mutually agreed margin of profit payable to the seller. In this contract, the Shari’ah requires a financier to first procure the goods and then sell it on to the actual buyer at a mutually agreed mark-up as the financier’s profit, and in that process the financier must also disclose to the buyer the market cost price (true cost) of the goods procured.

Ijarah– a term used for a leasing contract in Islamic law where a specified asset required by a party may be purchased by a financier and then leased by the financier to the party for an agreed rental and for an agreed period. The way lease rentals are calculated and the fact that the leased asset continues to be owned by the financier throughout the lease period, the rentals is not equated with receiving interest.[2]

While this exposition is very admirable in theory, the sad reality is that Islamic financing firms are not as attached to asset-based exchanges as the customers are led to believe. Classical contract forms are used as superficially legitimate means toward illegitimate ends. For example, in order to extend credit or provide liquidity for its big business customers, Islamic banks and financiers use a transaction called tawarruq that involves two spot sales and one credit sale of some commodity to hide the sale of credit. Therefore, if a customer wants to borrow $10,000 at 5% interest, and the bank agrees to lend him the money at that rate, the bank would buy $10,000 worth of platinum from a dealer, sell to the customer on a credit basis for $10,500 to be paid later, and then sell the platinum on behalf of the customer back to the dealer, thus generating the desired result.[3] Although traditional rules of currency exchange strictly ensures that an interest-bearing loan cannot be synthesized out of what seems like trade on the surface, recent developments in jurisprudence have allowed trade-based financing to replicate loans. This does little to protect individuals or corporations from borrowing or lending excessively, and it divests the Islamic financer of any economic significance or moral high ground vis a vis conventional financing.

While it is true that the customer accounts of Islamic banks continue to be structured in terms of “investment accounts” on a profit-and-loss-sharing basis, it is equally true that murabaha and other debt-financing forms form the majority of the assets of Islamic banks.[4] Where is the Islamic ethics behind this economics? Where is the substantive spirit of Islamic Law? The finance technologies used in the Islamic finance industry are structured first and foremost to segregate potential borrowers or lenders from interest-bearing loans. This form of “Sharia arbitrage” constitutes multiple trades, or special purpose vehicles, and similar transactions that are suspiciously similar to the “layering” tools used by money launderers and criminal financiers.[5] Not only does this make Islamic financing more susceptible to abuse, it adds cost to regulation and to the borrower, which all lead to the result of a less-efficient alternative to conventional straightforward secured loans.

Adherence to Analogy

Most contemporary Muslim jurists deemed conventional mortgage loans equivalent to prohibited riba based on the understanding that the home buyer (mortgagor) borrows a specific sum of money (cash loan) from the bank or financer and pays a larger sum at a later date. However, classical loan contracts (qard) stipulate that ownership of the loaned sum should be transferred to the borrower. Since “conditions contrary to a contract’s nature (e.g., sale for a fixed period, or wherein the buyer ’s use of his property is restricted)” invalidate a contract, any restriction on how the borrower must use the loaned money in effect cancels the concept of ownership and therefore the contract. Therefore, it is invalid to characterize a conventional mortgage as a premodern qard.[6]

Instead, since a lien is defined as “a qualified right of property which a creditor has in or over specific property of his debtor, as security for the debt or charge or for performance of some act,”[7] a lien can be seen as a new form of ownership right previously unknown in classical, premodern business law. If this is the legal definition and reality, jurists historically could have viewed the mortgagee’s lien on property as a form of partial co-ownership for the mortgage period (until the debt is fully paid). Thus, conventional mortgages could have been characterized in terms of diminishing partnership between mortgagor and mortgagee. This initial misclassification caused Islamic financing to go down the path it is on now. We can imagine case studies that follow the letter of the prohibition against riba but do not prevent any substantive abuses under the surface.

Consider this case of exploitation: a seller is not allowed to trade a kilo of gold for two, but he can trade one nonfungible item (e.g., a diamond) for two of those items, each of which is of equal value to the original. A seller could even legally sell a diamond worth $10,000 today for a deferred price of $20,000 later. Like the tawarruq example, the buyer may have no interest in the diamond and sell it for the spot price of $10,000 cash and therefore, the seller could collect 100% profit in single transaction that avoids riba in form (though obviously not in substance). This showcases how the prohibition of riba cannot be related to interest per se, since interest can be hidden in sales (as critics of murabaha and tawarruq claim). Moreover, riba can be made exorbitant while avoiding the formalistic rules of riba.[8]

Consider a Muslim customer who wishes to finance a home purchase through lease financing. If the housing market in question happens to be experiencing a speculative bubble, that fact should become clear to the customer by comparing the “rent” he would have to pay his Islamic bank (which is bench-marked to mortgage market interest rates) to the actual market rent of the property. If mortgage payments are excessively high relative to rent, that is generally an indication that the customer is about to borrow an excessive amount of money relative to the long-term value of the property serving as collateral. If instead the financier marks the interest rate to market lease rates, then this would prevent the individual from engaging in excessive borrowing to purchase that property. In the process, the customer is also assured that the implicit interest rate he pays is marked to the market-determined time value of the property serving as security for the debt.

However, if these considerations are ignored, as is the case in many Islamic financing who benchmark their interest rates to local mortgage rates (rather than comparable lease rates), the Islamic bank would merely allow the customer to become “house-poor” or bankrupt in an “Islamic” manner. This partial adherence to classical contract forms would result in a shameful abuse of religion and finance.[9]

[1] (El-Gamal 2006, 31)

[2] (IIBI n.d.)

[3] (El-Gamal 2006, 62-69)

[4] (El-Gamal 2006, 18)

[5] (El-Gamal 2006, 23)

[6] (El-Gamal 2006, 42)

[7] (Dictionary n.d.)

[8] (Usmani 1998, 39)

[9] (El-Gamal 2006, 57)

How Modern Scholars Deal with Financing and Investing
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