Is Islamic banking Islamic?

Tarek El Diwany

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Is Islamic banking Islamic?

By Tarek El Diwany

The contractum trinius was a legal trick used by European merchants in the Middle Ages to allow borrowing at usury, something that the Church fiercely opposed. It was a combination of three separate contracts, each of which was deemed permissible by the Church, but which together yielded a fixed rate of return from the outset.

For example, Person A might invest £100 in Person B for one year. A would then sell back to B the right to any profit over and above say £30, for a fee of £15 to be paid by B. Finally, A would insure himself against any loss of wealth by means of a third contract agreed with B at a cost to A of £5. The result of these three simultaneously agreed contracts was an interest payment of £10 on a loan of £100 made by A to B.

I had read about the contractum trinius some months before first encountering the full documentation behind an Islamic banking murabahah contract. It was the kind of contract that Person A might use in order to finance the purchase of good X from Person B. The bank would intermediate in the transaction by asking A to promise to buy good X from the bank in the event that the bank bought good X from B. With the promise made, the bank knows that if it buys good X from B it can then sell it on to A immediately. The bank would agree that A could pay for good X three months after the bank had delivered it. In return, A would agree to pay the bank a few percent more for good X than the bank had paid to B. The net effect is a fixed rate of financial return for the bank, contractually enforceable from the moment that the bank buys good X from B. Money now for more money later, with good X in between.

The above set of legal devices is nothing other than a trick to circumvent riba, a modern day Islamic contractum trinius. The fact that the text of these contracts is so difficult to come by is one shameful fact of Islamic banking. If so clean, why so secretive? The following is an excerpt from a murabahah contract that was used frequently by two major institutions during the 1990's. The 'Beneficiary' is the client that needs finance, and earlier clauses require that the Beneficiary acts as the agent of the Bank in taking delivery of the goods.

Excerpt from a murabahah contract

Promise to Purchase the Goods

1 The Beneficiary undertakes to purchase the Goods from the Bank immediately after it has taken delivery thereof on behalf of the Bank on the terms specified in this Agreement.

2 The contract of sale of the goods to the Beneficiary shall be concluded by an exchange of telexes or telefax messages as soon as the Beneficiary has taken delivery of the Goods on behalf of the Bank.

3 If, for any reason whatsoever, the Beneficiary shall refuse or fail to take delivery of the Goods or any part thereof or shall refuse or fail to conclude the Sale Contract after taking delivery of the Goods, then the Bank shall have the right to take delivery, or cause delivery to be taken, of the Goods and shall have the right to sell, or to cause the sale of, the Goods (but without obligation on its part to do so) in a manner determined by it in its sole discretion and shall have the right to take whatever steps it deems necessary (including demand from the Guarantor to pay) to recover the difference between the price realized upon sale and the price paid by the Bank plus any other expenses incurred by it in relation to the Goods and/or any damage caused to the Bank as a result of the breach of undertaking by the Beneficiary to take delivery of the Goods or to conclude the contract of sale of the goods. "

We see here that there is even a guarantor used to ensure that the bank does not lose money on the deal in the event that the Beneficiary defaults. So much for profit-sharing. Yet the words 'profit-sharing' are to be heard constantly at all of the conferences. Some of the scholars, if pressed, will talk about moving towards more satisfactory products such as mudaraba. But then everyone goes home and works on another murabahah contract. We are told that Muslims must work within the existing banking system and change it from the inside. But we have been trying this for over forty years and nothing has changed. We are still fixing financial rates of return in advance using the Islamic triple contract.

One head of Islamic Trade Finance admitted to me over lunch not long ago that there is no practical difference between the murabahah business that he does now and the conventional letter of credit business that he used to do in his previous job. Just the labels are different. Then there's the Islamic banking department that uses interest-bearing financial instruments for the purpose of closing some of its deals. When deals are done the funds often go to lubricate the trading operations of large corporations such as BMW and General Motors. Meanwhile, in many countries, small and medium sized Muslim-owned businesses are offered no Islamic finance facilities at all. When they do finally encounter a financing proposal from an Islamic bank, many of these businessmen quickly become cynical because the financing cost is fixed at the outset of the financing agreement.

These are all signs that something has gone badly wrong in this industry. But I'm not saying that it is all the fault of the people on the inside. The Western academic establishment is at least partly responsible for the way that the Islamic financiers are thinking. For example, because Brealey and Myers have written a standard text on corporate finance, they are probably as big a force in Islamic finance as Judge Taqi Usmani. It is awfully hard to escape from the value judgements that the overwhelming mass of usury-based finance books contain. That's why an educated Muslim in Islamic finance can ask his client a shocking question such as 'what cost of finance are you looking for?' without thinking twice. He's been taught by Brealey and Myers that fixed-rate finance plays a part in any 'good' financing structure and so off he goes in search of a way to do fixed-rate finance Islamically. The possibility that fixed-rate finance may be completely incompatible with Islam in the first place may not even occur.

But there are two other reasons that prevent Islamic banks from giving up on the doubtful fixed rate products and adopting profit and loss sharing instead. The first is that the clients often prefer to take finance on a fixed rate basis. The second, more overwhelming problem, is the nature of the very business process underlying commercial banking itself.

To explain the first reason, let me tell you about a discussion I had with the Chairman of a major construction company in Asia. His company specialized in building toll roads. It had borrowed heavily at fixed interest in the middle of an economic boom. I told the Chairman that we could develop a toll revenue-sharing financing package. We would part-finance the toll road and share the toll receipts. No toll receipts, nothing for us to share. This would be good for his company because if no one used the road, there would be no financing cost. With the interest based alternative, whether the toll road was full or empty, there would still be a financing cost.

But the Chairman felt that 7% interest was a good deal and so our suggestion was not adopted. Probably this was because he knew that the toll road was going to provide profits of 30%, and there's no point paying out 30% in profit share when you can pay out 7% in interest instead, is there?

Well, the economy turned down, fewer motorists than predicted used the toll roads, but the interest still had to be paid. And so the company had to be rescued. The Financial Times commented a few days later that the rescue was required because 'interest costs exceeded toll revenues'. I kept that article because it summarized with a real life example everything that true profit-sharing would have avoided. The moral of the story is that the chairman wants to fix his financing cost because he believes his business is going to be profitable and he wants to keep most of the profit to himself. He's practicing financial leverage like all those un-Islamic textbooks tell him to.

The unfortunate fact is that even if the Chairman had given the go ahead for profit-sharing, no Islamic bank would have offered it to him. This brings me on to the second of the two reasons for the general failure of Islamic banking to provide profit-sharing finance.

Several years ago, a teacher of mine was invited to Kuwait to provide a consulting service of sorts to the executive committee of a large Islamic financial institution. On an early fact-finding tour he encountered the institution's senior Shariah scholar, an elderly man who was partly deaf, paralyzed on one side, and who had little experience of modern banking and finance. The local bankers portrayed this man as a venerated Shariah scholar, but my teacher immediately recognised him as a rubber stamper - shamefully empowered by his employers when he should have been enjoying a quiet retirement. To understand how this situation came to pass, we need only delve into the recent past. During the late 1970s and early 1980s, a small number of international Islamic banking and finance organisations came to prominence. Understandably, they were characterized by a narrow product range and in some cases a lack of credibility. For some of these companies, commercial survival came in t he form of occasional equity injections from a kindly patron and the incentive to improve business efficiency was therefore reduced. Yet it was argued that faults should be tolerated and the financial lifelines maintained in order to shield the new-born industry from a world of harsh competition. The conventional banking system could not be changed overnight, and the road of transition had to be travelled patiently.

As it turns out, patience has been of little use on this particular journey for the simple reason that we have taken the wrong road to begin with. We have arrived at a financial wonderland in which there exists an Islamic equivalent to almost all the major products of the interest-based sector, with quantitative and qualitative features that are frequently indistinguishable from them. Some have explained this situation by arguing that Islamic banking and finance can only function properly within the context of economic and social policies that are themselves Islamic. They propose that governments in the Islamic world should encourage such institutions as Waqf (endowment), mutual associations, and Zakat (the wealth levy), or at least remove the encouragements that presently exist for proscribed activities (the tax deductibility of interest for example). In my view, the most urgent of these tasks is that the Muslim world reforms its monetary system. An Islamic economy cannot be built upon un-Islamic money, and to know why this is so requires a brief digression into monetary history.

The roots of the problem

The European goldsmith bankers of the seventeenth century are widely seen as the forefathers of modern banking. These men took deposits of gold coins from customers and issued paper receipts in return. Each receipt promised repayment of the underlying gold upon presentation at the bank, and the goldsmith would often charge a fee for his service of safe-keeping. In due course, the public began to trust paper receipts to the extent that they would use them in payment for goods and services among one another. The goldsmiths' paper receipts had, for all practical purposes, become "money". This development was the key to the goldsmiths' future wealth. They gradually turned to society not as safe-keepers of coins but as lenders of money, and when borrowers came to take their loans they would be given not gold coins but newly printed paper. The goldsmith had obtained the ability to manufacture money out of nothing, and charge society interest for the privilege of borrowing it. Loans would be secured against property or other assets of the borrower; collateral that could be seized and liquidated if the borrower fell into trouble. The financing of poorer members of society therefore became the exception from the earliest days of banking practice.

The reason for the lack of profit-sharing in commercial banking emerges when we imagine an economy in which the banking system creates all of the money supply. Here, if a total of 400 units of paper money have been advanced to borrowers on a profit sharing basis, the maximum that all borrowers will be able to repay is 400. No opportunity exists under these arrangements for the banking system as a whole to make a profit. By charging 10% interest on the other hand, the banks may stipulate that 440 is to be repaid in one year's time, thus making the system commercially viable. Such a stipulation leads directly to what is probably the most disturbing feature of the modern monetary system. If the repayment amount at the end of year one is 440, but there is still only 400 of money in existence, where will the extra 40 come from? The answer is that it has to be created, either under the authority of the state, or by the banking system. Given that most of the modern money supply i s created by the banking system, it becomes immediately obvious why repayment of yesterday's debt tends to leave society in even deeper debt today. If the commercial banks create sufficient money to repay yesterday's debt we enjoy a healthy or inflationary economy. If they don't, recession or deflation will eventually arise. The former scenario is adopted as a policy target by almost all modern governments, but leads inevitably to an increase in both debt and money supply in the long term.

At a time when education, health and housing services are suffering financial stress in many countries of the world, an almost embarrassing bias in resource allocation towards the banking sector is encouraged by the interest-based monetary system. In August of 2002, Fortune magazine ranked the top 500 global corporations of 2001 by revenue. Taking one example, 33 of those companies were in the UK, and among them were six banking organisations. These UK banks made $20.62 billion in profit during the year. All of the other UK corporations on the list, when added together, made a loss of $0.97 billion. 37 companies on the Fortune 500 were head-quartered in France. Here, the five banks made $7.99 billion profit, and the remaining 32 corporations when added together made a loss of $2.41 billion.

"The society that witnesses the change to interest-free money will recognize the new system as a pillar of true freedom"

To the letter of the law

Today, Islamic commercial banks indulge in money creation just as much as conventional commercial banks. This single sin is sufficient on its own to conclude that Islamic banking isn't Islamic but, as the earlier example demonstrates, it is a sin that requires interest-based lending in order to make it profitable. Though Islamic bankers may not realize it, the business model of interest-based banking is forced upon them and it is putting true profit sharing beyond their reach.

The crop of 'Islamic' mortgages that are now appearing in the UK are a clear manifestation of the fixed rate mentality that now predominates in Islamic banking. In not one of those mortgages does the bank contract to take capital risk. Even in the so-called Ijara mortgage, in which the bank is held to own the property and rent it to the client, arrangements have been put in place to pass capital risk to the lessee. Thus, if the client is unable to keep up with rental payments and the property is repossessed by the bank, the bank has recourse to the client if it realizes a capital loss when selling the property on the open market.

One Shariah argument used to justify this recourse is that the client has promised to buy the property from the bank at the end of the lease period, and must therefore bear all of the capital risk should he place the bank at a monetary disadvantage by failing to fulfil that promise. This implies that a promise to purchase (given by the client to the bank) can be used to produce the same commercial risks as an actual purchase. No one should underestimate the implication of this legal position. The doors that it opens in a world of sophisticated arbitrageurs will almost certainly lead to the synthesis of many transactions that are presently prohibited by consensus of the Islamic scholars.

The splitting of conventional interest-bearing products into components that can be replaced with 'Islamic' counterparts is an essential skill which the Islamic bankers have perfected in their search for fixed rate returns. At best the combination of such components into one transaction weakens the integrity of the contractual principles involved, and at worst represents a blatant technique for bypassing the Islamic prohibition of usury. For example, while it is unanimously accepted that the giving of gifts, the making of promises and the advancing of interest-free loans are all acceptable in Islam, the combination of these three contracts into one transaction easily produces an interest-bearing loan. Here, Person B promises to give a gift of 10 to Person A if Person A makes an interest-free loan of 100 to Person B.

In their effort to gain approval for such techniques, unscrupulous Islamic bankers may succumb to the temptation of asking questions that elicit the 'correct' answers from their Shariah scholars. Thus the modern scholar must shift some of his focus away from the detailed level of contractual principle and look to the wider impact of what the banker is trying to achieve.

If asked whether it is permitted to pull a string, the scholar must find out whether the string is attached to a gun before giving his Judgement. Such efforts require a high degree of both Shariah and technical knowledge. There is a big difference between defining interest (a Shariah matter) and discovering whether or not a particular Islamic banking contract allows the bank to practice interest (a technical issue).

We should not expect Shariah scholars to fulfil both of these roles.

Replacing artifice with value

In time, an entirely new methodology will be adopted in Islamic banking; one based upon a surplus of money, not upon the artificial shortage that is maintained by the modern commercial banking system. Debt will no longer be the pre-requisite to every major act of spending or investment. The time value of money will no longer dominate our view of how to manage the earth's resources, for the money with which we measure value will no longer bear interest as a condition of its creation. I believe that this change will occur either by force or reason, as the world grows weary of perpetual indebtedness. The society that witnesses the change to interest-free money will recognize the new system as a pillar of true freedom. It will enjoy the release into productive employment of human and physical resources that are presently engaged in the value-subtractive processes of the modern financial economy.

There will of course be much resistance to such a change, and the lobby that presently benefits from the interest-based monetary system will spend heavily in order to protect its future. The payment of money by banking organisations to Shariah scholars must be scrutinized for precisely this reason. If a bank asks 100 scholars whether its latest product is Halal, and 98 of them say "no", should we be suspicious if the bank gives a consulting contract to the two who said "yes"? Would some of the 98 become a little more flexible next time round, if they saw the other two earning large incomes from their work?

These are not the questions of a cynic. They are the questions of one who has read a little history and knows the simplest facts of human nature. A scholar should not have his integrity questioned simply for being in a minority, of course, for his views may be honestly held. What matters is that by promoting those scholars who approve of the products it wants to launch, an Islamic bank is in the fortunate position of being able to choose the rules of the game for itself while telling everybody else that it doesn't make up those rules.

In this battle between truth and falsehood, central banks and supranational institutions cannot lead the necessary reforms because they have always been creatures of the system itself. Over many decades they have proven themselves unwilling to delve into the essential issues of money creation, despite the volumes of research that they undertake on every other nuance of monetary policy. The real tragedy is that the Islamic banking movement, which could have exposed the fraud of modern money creation, has become a laughable effort to Islamize that fraud. The Prophet Muhammad, PBUH, said that "Even though usury be much it leads in the end to utter poverty" [2]. Our Creator does not want His creation to forget that. But we are slipping, slowly, into a world that thinks it knows better.

Islamic finance is not a product to be offered to a niche market. It is a system. It must be promoted and implemented as a system. Where the monetary system is concerned, I am beginning to feel that this is something that cannot be achieved by the private sector alone, Islamic or otherwise. A lead is required from the State since we must redefine the meaning of the words 'legal tender'. We must somehow overturn the monetary system as it is. And that will require us to defeat the monster that faces us.

Some of our scholars have yet to recognize the monster for what it is. They think of the banking system as a necessary part of economic activity. They do not connect the deaths of millions of children in Africa every year with the burden of debt repayments to the banks (the United Nations Development Programme's annual Human Development Reports 1997 - 1999 do show this connection). We need a payment transmission system, a safekeeping service, and investment advisory services. To all these things, yes. To money creation for the sake of profit, no.

Which politician will be brave enough to challenge the wealthy bankers and their friends in the leveraged corporate boardroom? The prize awaiting a successful challenge will be huge. Such a nation will be a light for the world to follow. Imagine no more debt. Imagine all those bankers being released from their unproductive industry (the largest by value on the London Stock exchange) to do something useful instead. Imagine a world free of dominance by a few huge firms, huge and dominant because they have been leveraged with the bankers created money. Imagine what we once had before all of this. A world of small businesses, a world of variety, of individual responsibilities and co-operating communities.

Failure to defeat the monster means a never ending necessity for growth. A world awash in the dust of riba, ruled by the 'Money Power', paying perpetual interest on an unrepayable debt.

Oh, I know they'll say I'm being extreme; it's just that these other fellows have all been saying it too.

"The Bank hath benefit of interest on all moneys which it creates out of nothing". Statement of William Paterson, first Director of the Bank of England, upon receiving the Charter of the Bank in 1694: quoted in Tragedy and Hope, Carroll Quigley, MacMillan New York (1966)

The unlimited emission of bank paper has banished all specie .... Private fortunes, in the present state of our circulation, are at the mercy of those self-created money lenders, and are prostrated by the floods of nominal money with which their avarice deluges us.

Thomas Jefferson in a letter to John Wayles Eppes on June 1813, Jefferson, Writings (1984) New York: Literary Classics of the United States

And I sincerely believe with you, that banking establishments are more dangerous than standing armies; and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale Thomas Jefferson in a letter to John Taylor 28 May 1816, Writings (1984) New York: Literary Classics of the United States

The distress and alarm which pervaded and agitated the whole country when the Bank of the United States waged war upon the people in order to compel them to submit to its demands cannot yet be forgotten. The ruthless and unsparing temper with which whole cities and communities were oppressed, individuals impoverished and ruined, and a scene of cheerful prosperity suddenly changed into one of gloom and despondency ought to be indelibly impressed on the memory of the people of the United States. If such was its power in time of peace, what would it have been in a season of war, with an enemy at your doors? No nation but the free men of the United States could have come out victorious from such a contest; yet, if you had not conquered, the government would have passed from the hands of the many to the few, and this organized money power, from its secret conclave, would have dictated the choice of your highest officials and compelled you to make peace or war, as best suited their own wishes. President Andrew Jackson, Address to the American people, 4 March 1837, recorded in Richardson's Messages, volume 4, p. 1532

The government should create issue and circulate all the currency and credit needed to satisfy the spending power of the government and the buying power of the consumers. The privilege of creating and issuing money is not only the supreme prerogative of government, but it is the government's greatest creative opportunity. By the adoption of these principles, the long-felt want for a uniform medium will be satisfied. The taxpayers will be saved immense sums of interest, discounts and exchanges ... money will cease to be the master and become the servant of humanity. Democracy will rise superior to the money power. President Abraham Lincoln, Senate Document 23 1865

I am afraid that the ordinary citizen will not like to be told that the banks or the Bank of England can create and destroy money. Post-war Banking Policy, p. 93 (1928) William Heinemann, by Reginald McKenna, Chancellor of the Exchequer of Great Britain, later Chairman of Midland Bank

In the abstract it is absurd and monstrous for society to pay the commercial banking system interest for multiplying several fold the quantity of the medium of exchange when a) a public agency could do it all at negligible cost, b) there is no sense in having it done at all, since the effect is merely to raise the price level, and c) important evils result, notably the frightful instability of the whole economic system. Saturday Review of Literature, p. 732 (1927), Frank Knight

By allowing private mints to spring up, Parliament has fundamentally and perhaps irretrievably betrayed democracy. Before the War it was customary even in the works of apparently respectable economists to find absolutely dishonest hair-splitting distinctions between the invisible money so created and paper notes. The latter were really money and the former was not! In fact the reader can always tell in such standard works on the subject when he is approaching the fishy part of the business. The essential fact, the creation of new money, becomes obscured in a cloud of anticipatory justification and special pleading. The Role of Money (1933), Frederick Soddy, Nobel Laureate in Chemistry

Despite the accusations of neo-imperialism leveled at the IMF and the World Bank, in the same way that a country's domestic banking system is carried out with apparently scrupulous honesty, the financial conduct of the IMF and World Bank appears above reproach. If a nation borrows, it must repay. Naturally! What other conclusion can there be? The true injustice of the IMF and World Bank only become apparent when the fraudulent nature of these 'loans' is understood, and how they relate to the debt-based banking system ... It is an injustice amounting to international slavery and extortion; it is an aggressive injustice, involving the subjugation of whole nations and their sovereign peoples, operated on a scale that exceeds the total of all the more obvious efforts at dominance by individual nations indulging in warfare over the centuries. The Grip of Death (1998), Michael Rowbotham

Tarek El Diwany - Author of 'The Problem With Interest' which is now available in second edition paperback at


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