Elements of Islamic Finance: Interest, Contracts, and Responsibility
The holy month of Ramadan is one during which, besides not eating or drinking from dawn to dusk, Muslims around the world are especially encouraged to do good for their families and their communities. As the holy month ends this week, it is an ideal time to discuss the connection between social finance and Islamic finance.
Islamic finance, by its very nature, is a financial system that highlights the importance of aligning the objectives of businesses with the needs of the community to ensure that the overall well-being of society is not forgotten when pursuing investment opportunities. In his book titled Islamic Finance in the Global Economy, Ibrahim Warde notes that while Islamic banks are a part of the global economy and are thus subjected to the pressures of emphasizing financial performance above all else, the reality is that “since the earliest days, it was clear that Islamic banks should not be driven by profit maximization, but by the provision of socio-economic benefits to their communities” (Warde, 2000).
In an effort to provide a high-level understanding of the linkages between Islamic finance and social finance, let us look at three fundamental principles of Islamic finance and discuss the implications they have on individuals and society as a whole:
1) The prohibition of riba
Perhaps the most well-known feature of Islamic finance is the prohibition of riba, which is defined as “the practice of charging financial interest or a premium in excess of the principal amount of the loan” (Iqbal and Mirakhor, 2007). While the concept of interest is fundamental to Western economic systems, one of the key reasons for its rejection in an Islamic context is because it is seen as a form of economic exploitation, which goes against the principle of social justice. The argument is that interest-based financial products do not allow the risk inherent in a project to be equally shared between the lender and the borrower. For example, if Sam issues an interest-based loan to Bill to start a business, Sam (lender) is set to collect interest payments while Bill (borrower) is exposed to the risks of starting his own business and must invest time and labour to ensure the success of his enterprise. Profit and risk sharing are important concepts in the Islamic model and the appropriate alternative would be for Sam (lender) to invest the money in Bill’s enterprise with the intent of earning a share of the profit as the return on investment. This way, rather than operating as a creditor, Sam becomes an equity investor and shares in the risk of the enterprise, thus aligning his interests with those of Bill.
It’s important to note that the prohibition of charging financial interest is not a novel concept to Islam; rather, it has been mentioned in religious texts and by philosophers that came before Islam. It is noted that Greek philosopher Aristotle viewed money as “a means to facilitate exchange” and believed that “a piece of money cannot beget another piece”; in other words, you can’t make money with money (Warde, 2000).
2) Contracts and the concept of gharar
Gharar is defined as “a situation where either party to a contract has information regarding some element of the subject of the contract, which is withheld from the other party, and/or the subject of contract is something over which neither party has control” (Iqbal and Mirakhor, 2007). In the world of Islamic contracts, any uncertainty between the buyer and/or the seller related to fundamental aspects of a contract (i.e. the quality, quantity, existence, and recoverability of the product) fits under the definition of gharar, therefore making the contract invalid.
With this in mind, financial contracts dealing with speculation, such as credit default swaps (CDS) issued by AIG, are not permissible in the Islamic model. With CDS’, the quality and recoverability of the product (i.e. the loan being insured) was never guaranteed, which ultimately led to the collapse of AIG and became a contributing factor to the global financial crisis which began in 2008. The inherent clarity and predictability of contracts is designed to promote integrity in the financial system, which allows individuals (and, collectively, society) to appropriately manage their risk.
3) Socially responsible investing
While equity investing is a core component of Islamic finance, an individual/institution may only invest in industries and activities that are consistent with Islamic law (known as shariah). While Islamic law is not the “law of the land”, there are already numerous socially responsible investing organizations who have some policies that resemble those outlined by Islamic law. Investing in oppressive governments or in businesses that promote activities such as gambling or pornography is strictly prohibited. From an Islamic perspective, they negatively impact the social fabric of the community and thus while they may generate a positive financial return, the social return is not positive and thus investment must be withheld.
While this is a simple overview of three key elements of Islamic finance, it is clear that the model embodies values which are consistent with social finance through its objective of generating financial returns while emphasizing the need to consider the impact of these returns on the socio-economic status of the community.