Islamic Insurance and Investment

TAKAFUL (Islamic Insurance)
The concept of takaful, or Islamic insurance, where resources are pooled to help the needy does not contradict Shariah. The concept is in line with the principles of compensation and shared responsibilities among the community. It is not a new concept, in fact it had been practised by the Muhajrin of Mecca and the Ansar of Medina following the hijra of the Prophet over 1400 years ago. It is generally accepted by Muslim Jurists that the operation of conventional insurance does not conform to the rules and requirements of Shariah. Conventional insurance involves the elements of uncertainity (Al-gharar) in the contract of insurance, gambling (Al-maisir) as the consequences of the presence of uncertainty and interest (Al-riba) in the investment activities of the conventional insurance companies which contravene the rules of Shariah. Takaful is an alternative form of cover which a Muslim can avail himself against the risk of loss due to misfortunes. The insurance providers in year 2001 and beyond should find Takaful sector an exciting sector of insurance to be in. This presentation focuses on growth potential that exists in Takaful with great many opportunities for innovative development of unique products, techniques and systems needed to fill gaps in insurance penetration in many of the markets around the globe. This paper presents an insight into the size of the current takaful industry worldwide and sketches the signs of change that may lead to realization of the potential that exists in this sector.

Overview of takaful
The takaful brand of insurance is a classic example of consumer-driven response to their needs. For generations, Muslims around the world have grown with a mind set that insurance (especially life insurance) is taboo because it contravenes some of the Islamic tenets. Life insurance as sold in conventional way was declared unacceptable in 1903 by some prominent Islamic scholars in the Arab countries. The search was on for an acceptable alternative ever since, and not until the 1970's the debate took sufficient momentum to reach a consensus. In 1985, the Grand Counsel of Islamic scholars in Makkah, Saudi Arabia, Majma al-Fiqh, approved takaful system as the alternative form of insurance written in compliance with Islamic Sharia. It is outside the scope of this presentation to explain how the takaful system works except to say that it is a concept of protection for the good of society, a concept that was never an issue in Islam in the first place. The Grand Counsel approved this system as a system of co-operation and mutual help but the exact method and operation was left to Islamic scholars and insurance practitioners to resolve, develop and implement. Takaful industry is still not past its formative years and there are many areas unresolved, especially in life insurance. The key areas to resolve are the global standardization of takaful terminology, the development of an acceptable form of life insurance (family takaful) especially for countries in the Arab regions and a common consensus for a system to determine profits (or surplus) distributable to participants and shareholders. The very first Takaful company was established in 1979 - the Islamic Insurance Company of Sudan. Today there are some 28 registered Takaful companies worldwide writing takaful directly and 10 more as Islamic windows or marketing agencies placing insurance risk with conventional and takaful companies. In fact the number of takaful companies is higher as all insurance companies in Sudan are deemed to operate in accordance with Islamic Sharia principles. In addition, new takaful companies have been established recently in Sri Lanka and Tunisia. At least four more Takaful companies are under formation in the Middle East (viz. Kuwait, UAE and Egypt). Several other Takaful companies are being contemplated in various countries such as Pakistan, Australia and Lebanon. It is also understood that interest is shown in Takaful in South Africa, Nigeria, and some of the former states of the Soviet Union.

Takaful industry in the Middle East is under-developed compared to other markets such as Malaysia. The more successful companies in the Middle East have grown at 10% p.a. whereas in Malaysia the rate of growth has been 60% p.a. A broad estimate of the total Takaful industry in 2000 is approximately US$550m for both life and non-life business, of which around $193m pertains to Asia Pacific. Malaysia is one of the largest markets outside the Arab region for Takaful, writing 72% of the non-Arab takaful business. A geographical spread of takaful business is as follows.

These are estimated figures Malaysia Other Asia Pacific Europe, USA Arab Countries Total

Takaful $143m $50m $6m $340m $538m

% of total 27% 9% 1% 63% 100%

Table 1: Geographical spread of Takaful business - 2000 The growth in Takaful business in Malaysia has been impressive. Starting from a low base in 1994, the annualized average growth used to be in the order of 92% in Family Takaful and 34% in General. Since 1998, the growth rate has slowed down to around 30% in Family Takaful and 17% in General. In Family Takaful the products sold were individual and group term and savings products, mortgage policies and pension plans. In General takaful all classes of business were sold.

US$m 1998 1999 2000

Family % General % Total % Takaful Increase Takaful Increase Takaful Increase 55.0 70.0 93.2 27% 33% 36.6 42.7 49.8 17% 17% 91.6 112.7 143.0 23% 27%

Exchange rate RM2.43 to $ (1997 prices)

Table 2: Growth of Takaful in Malaysia

Takaful in Arab Countries
To illustrate the penetration of takaful in the private sector, the following table provides a picture of business written by companies in the Arab countries excluding NCCI in Saudi Arabia. This company's business is mainly generated from government sources and its exclusion from the figures provide a better measure of how takaful companies are doing in the market place where they compete with conventional insurance companies.
Takaful figures estimated, Market figures from Sigma SwissRe & Arig

US$m Saudi Arabia UAE Qatar Bahrain

LIfe Takaful 1.3 1.1 -

General Takaful 60 12 6 5

Total Takaful 61 13 6 5

Total Market 781 815 153 134

Takaful Share of Market * 8% 2% 4% 4%

Sudan Jordan Total

0.4 0.3 3.1

27 6.3 116

27 7 119

33 141 2,057

83% 5% 6%

* Takaful share for Saudi Arabia increases from 8% to 36% if NCCI's premium is included above.

Table 3: Takaful business in the Arab Region - 1999 Takaful business has generally grown at a higher rate than the total insurance business in each of these countries. Growth rates reflect the increasing market share of Takaful business over the same period, 1995 to 1999 for these countries:

Reinsurance or Retakaful
Reinsurance of takaful business on Islamic principles has been an area of much debate. Reinsurance on Islamic principles is known as retakaful. The problem has been one of lack of retakaful companies in the market. This has left the takaful companies with a dilemma of having to reinsure on conventional basis, contrary to the customer's preference of seeking cover on Islamic principles. The Sharia scholars have allowed dispensation to takaful operators to reinsure on conventional basis so long as there was no retakaful alternative available. Takaful companies therefore actively promote co-insurance. A number of large conventional reinsurance companies from Muslim countries take on retrocession. Still there is a lack of capacity within the Takaful industry worldwide. A certain proportion of risk is placed with international reinsurance companies that operate on conventional basis. The retrocession from Takaful companies ranges from some 10% in the Far East where Takaful companies have relatively smaller commercial risks (so far), to the Middle East where up to 80% of risk is reinsured on conventional basis.

Market characteristics
The market characteristics of the Arab region are quite different from other regions. The main differences are in terms of the attitude to risk and lack of insurance awareness. The level of awareness is very low about financial protection amongst individuals. This is not the case for Malaysia, Indonesia and Brunei, certainly not to the same extent. This is illustrated by comparing insurance density and penetration of conventional insurance and Takaful aggregated. The average ratio of capital to premiums for many Arab insurers is around 1 whereas the ratio should be in the region of 2.5 times. The Middle East and indeed many of the Muslim countries are a mixture of some rich and some poorer economies. Insurance density and penetration in some of these countries show the low expenditure in life insurance in Saudi Arabia of $1 per head and UAE of $68. In comparison, the world average life premium per capita was $235, the UK $2,503, USA $1,447 and Switzerland $2,914 (highest). The GDP in many of these countries is high, such as Kuwait, Saudi Arabia and UAE, and yet insurance penetration is not commensurate with the high GDP. This reflects the indifferent attitude to risk in these countries. The insurance penetration in the UK was 13.35% (life 10.30%), USA 8.55% (life 4.23%), and South Africa 16.54% (life 13.92%) the highest. Insurance penetration for the Middle East is very low at 1.6%. Traditionally the reasons for low penetration for insurance in the Middle East, particularly in life insurance, used to be:

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lower disposable incomes, except for the Arabian Gulf countries. greater reliance on social welfare provisions extended family system

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attitude to personal risk

Nevertheless many of the classic parameters of old are changing, such as the extended family system. The pace of change has increased manifold due to urbanisation and industrialisation and the recent phenomenon of liberalisation and globalisation. Moreover, populations of many developing Muslim countries are skewed towards younger age groups, which has put greater pressure on limited resources and employment. The economic factors have kept insurance low in many of these countries. People may be aware of insurance needs but cannot afford to buy the required protection. The minority, who can afford, are either not convinced or are not interested. Poor marketing has been one of the contributory factors

Company Profiles
The status and type of activities carried out by takaful companies worldwide, is mainly based on data collected directly from the companies through a questionnaire sent to some 30 companies. All except Takaful USA are continuing to transact business. The position about Takaful USA is not clear as of March 2001. The more successful Takaful companies in the Arab region managed a dividend of up to 8%. Nevertheless, they can do much better if the critical mass of business is built up. Lack of capacity to write different classes of business, low retention, limited product range and lack of good service have been the impediments of the past and these parameters are fast changing for the better, especially in Jordan, Bahrain and Qatar. New Takaful companies in Kuwait and the UAE are expected to add to this improving scenario for Takaful industry.

Signs of Change: Tracing For Takaful Potential
The world population in 1999 is estimated to be around 6 billion as per the Global Population Project based in the United States. The data on Muslim population is not readily available. It was estimated by using information contained in a publication entitled Islamic Beliefs and Teachings from India. Accordingly there may be around 1.5 billion Muslims making up for 25% of the total world population in 1999. As we look around throughout the Muslim world it is quite evident that people have not taken to life insurance in the same way as in most other countries. The growth of insurance in Muslim countries was examined by looking at the past trends and taking a conservative view on future growth. This provided a consistent pattern of slower growth in mature markets and higher growth in many of the developing countries. Most of the Muslim countries have potential to at least double their insurance volumes. One of the main reasons for low penetration of insurance in these countries is the underdevelopment of life insurance. As stated earlier, decades of misunderstandings created a mind-set amongst Muslims that did not help to develop life insurance to any great extent. And yet life insurance is so essential in providing the vital protection to the family. The insurance industry globally was US$ 2.3 trillion in 1999 (up by 7.3% on 1998), with life insurance 61% of total. The size of the Middle East insurance market was US$ 7.9 billion or 2.4% of world premium, and life insurance 31% of the market. Iran experienced strong growth at 25.2% for 1999, compared to average for the region of 5.2%. Life insurance in the region increased by around 3% in 1999 compared to 12.5% in Iran and 5.3% in Kuwait. The takaful industry holds the key to unlocking this potential where life insurance can actually be provided through "family takaful" naturally acceptable to the masses. The demand for Islamic products is evident from the success of Islamic finance and banking that has now firmly established itself with a total of more than $7 billion of capital, $4.1 trillion of assets and more than $120 billion of deposits.

The potential takaful volumes were estimated by taking into account the growth inertia that can be achieved through the introduction of family takaful and the following factors: A greater awareness of Takaful system is achieved

• • • • •

More Takaful companies are set up and run professionally More global coverage is secured through international companies' network and the use of modern IT technology Sale through banks Companies are well capitalized and demonstrate secure haven for the funds Retakaful capacity with triple A rating is available

Other factors were also taken into account such as literacy levels in each country and the take up rates for takaful products as opposed to conventional products.

HOPES FOR THE FUTURE OF ISLAMIC FINANCE

Past Successes
The topic of my talk is challenges to and for Islamic finance: a look into the past, present and our hopes for the future. For someone like me, it is astonishing to realize how far and fast Islamic finance has come and how well it has managed to meet the challenges it faced in just two decades. It is astonishing because when I started my own research in this field in mid-1970s, there was virtually no analytic works on Islamic banking and finance that could explain in modern economic and financial analytic language what Islam expects of a financial system in a modern economy. And, of course, virtually no major Islamic banks existed at the time. Based on what was known then, and in the absence of an analytic framework recognizable by modern economic and financial theory, most western observers and commentators began to refer to Islamic banking and financial system as a "zero-interest" system, by which they meant "no return to capital". I recall when the Islamic Revolution of Iran succeeded and its leaders and economists declared they wished to eliminate from their economic system, western media, including the BBC and the Wall Street Journal, commented on the impossibility of such a system referring to the thinking behind it as " voodoo economics". By 1983-84, when Iran, Pakistan. and Sudan declared that they would adopt a systemwide Islamic banking and finance, the challenge was to show that such a system was first theoretically and analytically a viable financial system; second, it had to be shown that such a system was empirically workable as a whole and financially viable for each of its parts, meaning Islamic banks and financial institutions. The challenge came from western analysts who suggested the folly of adopting such a system. Here, I summarize their arguments in six propositions: 1. 2. 3. 4. that zero interest meant infinite demand for loanable funds and zero supply; such a system would be incapable of equilibrating demand for and supply of loanable funds; with zero interest rate there would be no savings; this meant no investment and no growth;

5. 6.

in this system, there could be no monetary policy since no instruments of liquidity management could exist without a fixed predetermined rate of interest; and, finally, this all meant that in countries adopting such a system there would be one way capital flight.

By 1988, this challenge was met when research, using modern analytic financial and economic theory, showed that:

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A modern financial system can be designed without the need for an ex ante determined positive nominal fixed interest rate. [In fact, it had been shown by western researchers that there was no satisfactory theory that could explain the existence of a positive nominal ex ante interest rate]; Moreover, it was shown that not assuming a nominal fixed ex ante positive interest rate, i.e., no debt contract, did not necessarily mean that there would have to be zero return to capital; The basic proposition of Islamic finance was that the return to capital would be determined ex post, and that the magnitude of return to capital was determined on the basis of the return to the economic activity in which the funds were employed; It was that expected return which determined investment; It was also the expected rate of return, and income, which determined savings. Therefore, there is no justification for assuming that in such a system there would be no savings and investment; It was shown that in such a system there would be positive growth; That monetary policy in such a system would function as in the conventional system, its efficiency depending on the availability of instruments which could be designed to manage liquidity; Finally, it was shown that, in an open-economy macroeconomic model without an ex ante fixed interest, but with returns to investment determined ex post, there was no justification to assume that there would be a one-way capital flight.

Therefore, the system which prohibited a fixed ex ante interest rate and allowed the rate of return to capital to be determined ex post, based on the returns to the economic activity in which the funds were employed, was theoretically viable. In the process of demonstrating the analytic viability of such a system, research also clearly differentiated it from the conventional system. In the conventional system, based on debt contracts, risks and rewards were shared asymmetrically with the debtor carrying the greatest part of the risk, and with governments enforcing the contract. Such a system had a built-in incentive structure that promoted moral hazard and asymmetric information requiring close monitoring whose costs could be managed if monitoring could be delegated to an institution which could act on behalf of the collectivity of depositor/investor: hence the reason for existence of banking institutions. In the late 1970s - early 1980s, it was shown, mostly by Minsky, that such a system was inherently prone to instability because there would always be maturity mismatch between liabilities (short-term deposits) and assets (investment-long-term). Because the nominal values of liabilities were guaranteed, but not the nominal value of assets, when the maturity mismatch became a problem, the banks would go into a liability management mode by offering higher interest rates to attract more deposits. There was always the possibility that this process could not be sustained resulting in erosion in confidence and bank runs. Such a system, therefore, needed a lender of last resort and bankruptcy procedures, restructuring processes, and debt workout procedures to mitigate contagion. During 1950s - 60s. Lloyd Metzler of the University of Chicago had proposed an alternative system in which contracts were based on equity rather than debt, and in which there was no guarantee of nominal values of liability since these were tied to the nominal values of assets. Metzler showed that such a system did not have the instability characteristics of the conventional banking system. In 1985, in his now classic article in the IMF staff papers, Mohsin Khan, showed the affinity of Metzler?s model to Islamic finance. Using

Metzler's basic model, Mohsin Khan demonstrated that this system produces a saddle point and is, therefore, more stable than the conventional system. By early 1990s, it was clear that an Islamic financial system was not only theoretically viable, but had desirable characteristics that rendered it superior to a debt-based conventional system. The phenomenon growth of Islamic finance during the decade of 1990s, demonstrated the empirical and practical viability of the system.

Hopes for the future
The crises we have been witnessing in the international financial system since 1997 have set the stage for Islamic finance to demonstrate its viability as potentially a genuine alternative global financial system. The present international system is deficient in many ways of which the two most important are:

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A debt-based system needs an effective lender of last resort, and the present international financial system does not have one and it is not likely that one will emerge anytime soon: and A debt-based system needs bankruptcy proceedings, debt restructuring, and workout mechanisms and processes which the present international financial system lacks. There are preliminary discussions underway for an international sovereign debt restructuring mechanism to be established, but there are many complications. While such a mechanism, if and when it comes into being, will help reduce the risk of moral hazard and lead to better distribution of risk, it will not address the inherent fundamental fragility of a system largely based on debt contracts.

In the mean time, there are no guarantees that the international financial system has witnessed its last crises with their huge domestic costs that, at times, have threatened the very foundation and fabric of societies. The example of Indonesia is a heartbreaker; it took this country 25 years to reduce poverty by 50 percent, but it took a year of severe financial crisis to wipe out most of this gain. Countries with an otherwise viable economic system have paid dearly for crises generated by a debt structure whose nominal values and maturities were out of line, with the ability of the economic structure to service them. There are many analyses of financial crises and a long list of their causes, but surprisingly little is said about the one underlying common denominator to all of them: debt contracts that are by nature out of sync, and unrelated to, the income flows that the underlying productive and capital assets of these countries can generate to serve them. The jury is still out as to the reasons why Malaysia did not suffer from contagion as much as other crises countries. While capital controls may have played a role, some analysts believe its liability structure and its general reliance on non-debt-creating flows made Malaysia less vulnerable to crisis. While the financial innovations of the 1990s in the conventional system have led to mobilization of financial resources in astronomical proportions, they have also led to the equally impressive growth of debt contracts and instruments. According to the latest reports, there are now US$32 trillion of sovereign and corporate bonds alone. Compare this (plus all other forms of debt, including consumer debt in industrial countries) to the production and capital base of the global economy and one observes an inverted pyramid of huge debt piled upon a narrow production base that is supposed to generate the income flows that are to serve this debt. In short, this growth in debt has nearly severed the relationship between finance and production. Analysts are now worried about a "debt bubble". For each dollar worth of production there are thousands of dollars of debt claims. An Islamic financial system has the potential to redress this serious threat to global financial stability because of its fundamental operating principle of a close link between financial and productive flows and because of its requirement of risk sharing. It is now a serious advice of the IMF to developing countries that they should:

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Avoid debt-creating flows;

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Rely mostly on FDI; If they have to borrow, they should ensure that their debt obligations are not bunched toward the short end of maturities; If they have to borrow, they should ensure that their economy is producing enough primary surplus to meet their debt obligations; Ensure that their sovereign bonds incorporate clauses (majority action clause, engagement clause, initiation clause) that make debt workout and restructuring easier. That is, to make sure that there exists better risk sharing mechanisms to avoid moral hazard: and finally, They should put in place an efficient debt management structure.

In these circumstances, Islamic finance can provide a viable financial system on a global scale, but there are challenges that have to be met to make it so. Islamic finance has to adopt the best standards of accountability, transparency and efficiency. Fortunately, an architecture of Islamic finance on a global scale is emerging with the establishment of supporting institutions such as:

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The Accounting and Auditing Organization for Islamic Financial Institutions through the efforts of Professor Rifaat Abdel Karim The International Islamic Rating Agency The Islamic Financial Services Board The International Islamic Financial Market, and The Liquidity Management Center.

As this architecture emerges, Islamic finance has to develop its own genuinely Islamic financial instruments. So far, we have been free riding on financial theories and instruments developed within the context of the conventional debt and interest-based system. Unless Islamic finance develops its own genuinely Islamic financial instruments, it cannot achieve the dynamism of a system that provides security, liquidity, and diversity needed for a globally accepted financial system which would be a genuine alternative to the present debt-interest-based international financial system. Unfortunately, there are, at present, nothing in the Muslim world close to resembling large endowment institutions, such as the National Science Foundation, the Ford Foundation, the Rockefeller Foundation, and the like to support research in Islamic banking, finance and economics. There is, therefore, an urgent need for scholarly foundations, institutions, colleges, and universities that can train Islamic financial engineers who are well trained in economic and financial theory and methods, on the one hand, and Islamic Shariah, on the other. My generation was fortunate to have people like Dr. Anas Azzarga and Dr. Kazem Sadr who are equally at ease with Islamic "Fiqh" as with economic theory and method. Trained by their fathers (Sheikh Mustafa Azzarqa and Ayatollah Reza Sadr, ) in "Fiqh" and having earned doctorate degrees in economics from reputable universities in the U.S.A., they were able to help the rest of us in understanding the intricacies of Islamic "Fiqh" as it related to finance. There is now a need to systematize the process of training financial engineers, experts in modern finance who are well versed in the Shariah, to expand the horizon and the menu of available Islamic financial instruments. Islamic finance possesses the basic instruments that can be spanned into a wide, varied, and variegated menu of financial instruments. There is a theory developed in the 1980s referred to as the spanning theory which asserts that if there is one basic financial instrument it can be spanned into an infinite number of instruments. Islamic finance has at least 14 basic instruments and financial experts can span these into a much larger menu to provide greater security, liquidity, and diversity to meet the demand of investors on a global scale. Let me say once again that there is an urgent need for rich endowments to be established solely for the purpose of financially supporting institutions that can train the kind of research scholars and experts mentioned. Let me conclude by mentioning a very important function of Islamic finance that is seldom noted: that is the ability of Islamic finance to provide the vehicle for financial and economic empowerment. Before I do so, let me recommend the works of the Peruvian

economist Hernando de Soto. De Soto's long-time research has been summarized in a recent book titled: "The Mystery of Capital". His basic thesis is that much of the poor in developing countries are in possession of what he calls dead capital. He estimates that the developing and former communist countries possess US$9.3 trillion worth of dead capital. These are physical resources and capital that are not used for any purpose other than to provide physical service to their owners. He suggests that the ability of documenting and using this capital as a productive asset is what distinguishes the rich from the poor. How can Islamic finance help to empower financially those who are in possession of dead capital? Let me give some rudimentary examples: Agricultural Development Bank of Iran through partnerships with farmers helps them to convert their physical possession into assets that can generate additional capital. Also through the Islamic law of of , dead capital is converted into productive asset. A second example is that of the Housing Bank of Iran which through and lease purchase agreements helps people without homes to own one. These homes can then be used to generate additional capital for the owners to undertake other productive activities. Similarly, Islamic finance can be used in other Muslim and developing countries to convert dead capital into income generating assets to financially and economically empower the poor.

ECONOMICS & ETHICS - the quest for equity & justice
The mass anti-globalisation protests which have paralysed gatherings of G7/G8 leaders have highlighted a serious unease with the operations of unfettered markets. For many, the present arrangement leads to perpetuation of gross global inequity, and rampant globalisation is seen as making things worse. Similar sentiments underlie the protest against policies of the International Monetary Fund and the World Bank. These are seen to be pushing what has come to be called the “Washington Consensus” of policy prescriptions designed to institutionalise unfettered markets across the developing world. Unregulated markets are now seen as the primary mechanism generating inequity on a global scale. At another level, the saga of Huntingdon Life Sciences (HLS) in the UK has become a landmark issue. The company, a leading user of live animals for experiments, fell foul of the Animal Rights lobby. Mounting a sustained campaign of mass protests, this powerful lobby was able to cut off all sources of bank finance to the company. HLS had to move its operational headquarters from the UK to the USA and rely on funding from non-banking sources. This was a dramatic illustration of banks bowing to pressure from the provider of their funds – the depositors. Not long a go the Bank of Scotland was also forced to withdraw from a deal with the US televangelist Pat Robertson because of the latter’s controversial views. The embarrassing about turn was forced on the bank by its shareholders and depositors. In the UK unease is mounting about the Private Finance Initiatives (PFI) which seem to have delivered a pitiful level of public service at enormous cost to taxpayers. Again unfettered market principles are seen as not suitable for all purposes. These developments provide an illustration of a major shift in public perceptions about how economies and businesses operate. At one level unregulated markets are seen as perpetuating inequity. An urgent need is seen to challenge the prevailing dogma about free markets and introduce regulatory regimes to safeguard the public interest. On another front, the freedom of financial intermediaries to provide funding for operations without taking into account the wishes of the providers of the funds is being seriously questioned. These developments provide an interesting parallel with the ideals of Islamic economics and finance. The quest for equity and justice has been central to the thinking of Muslim

economists. Indeed, most protest movements in Muslim societies have their anchor in the spirit of social equity and justice. At the same time Muslims are deeply concerned about the ways of financing businesses to ensure that ethical considerations are paramount. In this spirit, Muslim economists have argued for tempering the market mechanism with regulations designed to embody the public interest. According to them, in designing all policy, the primary consideration should be justice and equity rather than laissez faire market operations. Muslim jurists have argued the case for limits on land ownership and strict application of inheritance laws to avoid concentration of wealth. Some radical Muslim jurists have also argued that land is a communal resource and ownership is confined to period of active use rather than perpetual. Again, mineral and other natural resources are regarded as communal property. In Muslim societies, the injunction of Zakat provides a vital mechanism for addressing social welfare issues. All Muslims are required to give away at least two and a half percent of their income to the poor and the needy as Zakat. As the principle is well established in Muslim societies, Muslim economists have argued for its institutionalisation with even higher levels of giving. A social welfare state is thus not alien to Muslim thinking at all. As for national borrowing, Muslims are expected to have risk-sharing contracts rather than fixed rate loans. Translated into practice this would imply that lenders to Muslim countries would need to be convinced of the viability of the projects financed as their return would depend on the success of these ventures. This would have a mitigating effect on spurious debt build ups and repayment crisis as has become common. Thus in theory Muslim societies should have a much more equitable ethos than they do at present. This discrepancy is there for a variety of reasons, but developments in banking and finance show that a slow evolution reflecting this basic ethos is taking place. In the area of banking and finance, Muslims share common concerns, about the use of funds by financial intermediaries, with the growing body of ethical investors. The best way to appreciate this is to look at the growth of Ethical funds and investments. Basically, these try to incorporate the desire of the providers of the funds to have a say in the use of their monies. Thus, some funds do not invest in companies which deal in tobacco, alcohol, or military hardware. Others, only invest in corporations which incorporate environmental sustainability criteria in their operations. This is in sharp contrast to the traditional banking model whereby the providers of funds were expected to limit their concerns to the security of their investment rather than the use of the funds. It was little wonder that ethical investment notions were met with cynicism and ridicule when they were mooted in the early seventies. However, they did reflect a public desire and slowly but surely the movement has grown. Islamic finance has a similar rationale. Indeed in some respects it goes further, being concerned not just with what kind of activities are being financed but also with the way in which they are funded. Thus Muslims are encouraged to invest in “permissible” (Halal) activities, via “permissible” means. That means that while Islamic financial institutions will not invest in corporations dealing with forbidden items like alcohol and gambling, neither will they deal with organisations involved in riba, or usury, transactions. Indeed, the lending of money for a predetermined return (riba) is expressly prohibited in the Qur’an. Many Muslim jurists consider any form of interest as riba (usury) and thus do not allow dealing with or investing in banks per se. In practice this is less dramatic than it sounds. Muslims still make everyday transactions like investing their surplus funds, house-buying, and taking out loans and working capital for their businesses etc. For investment purposes Islamic financial institutions employ

criteria similar to those used by the ethical investment funds. The big difference comes in the way they structure lending transactions, both for personal finance and business purposes. In simple terms, lenders enter into risk-sharing contracts with borrowers; return is based on the outcome of the venture or investment, rather than a predetermined rate. The principle of risk-sharing can have far reaching implications. For risks to be shared, borrowers have to be willing to provide much more information about their situation than normal banks would seek for lending against collateral or guarantees. It will include confirmation that the funds are to be deployed in permissible activities, as well as transparency in reporting financial information about the progress of the business or project for which the money has been borrowed. Several modes of financing have been developed. The primary tenet of Islamic financial intermediation is that there should be a sharing of risk between the lender and the borrower. Thus the two prominent instruments are Mudharaba and Musharaka. The Musharaka is very similar to a partnership sharing profits and losses. Under a Mudharaba, however, the provider of capital and labour share the rewards, but losses are borne by the provider of capital only as the provider of labour is already deemed to have contributed his share. There are also two additional instruments utilised by Islamic bankers. These are Murabaha and Ijara. The Murabaha is a simple cost plus transaction and is not accepted as a genuine Islamic banking instrument by many Muslim jurists. Ijara transactions work in a similar way to leasing. Present day Islamic financial institutions also invariably have a Shari’a (Islamic Law) Supervisory Board of Advisors. This is usually a body of qualified Muslim jurists well versed in commercial transactions. All new transactions and structuring of deals are vetted by these Boards for compliance with Islamic Law. Over the last three decades Islamic banking and finance has grown manifold in Muslim communities and countries. In Malaysia, about five percent of all banking transactions are conducted by Islamic Financial Institutions. This is set to rise to ten percent by 2005. Pakistan’s Finance Minister has also announced plans for a similar phasing in of Islamic financial intermediation. Similar moves are afoot in most Muslim countries. Malaysian and Middle Eastern corporations have also begun to raise long and medium term finance by issuing Shari’a compliant bonds. There are plans for launching of primary and secondary debt and equity markets in Shar’ia compliant financial instruments. In other parts of the Muslim world Islamic equity investment funds have also mushroomed. Very much like ethical funds, these restrict their portfolios to approved corporations, based on criteria devised by their Shar’ia Supervisory Boards. An increasing number of Muslim investors are channelling their savings through these funds. There is also a Dow Jones Islamic Index which acts as a benchmark for the performance of some of these funds. In the UK and USA Muslim communities have started to experiment with saving and housing finance products which meet the stipulations of the Shari’a (Islamic Law). In the USA, the Islamic housing finance company Lariba, has had its funding augmented by Freddy Mac, the leading mainstream provider of housing funds. In the UK I-Hilal and Parsoli have started to market Shari’a compliant ISA (Individual Savings Account) products. Indeed, a recent survey by business information company, Datamonitor, concludes “the market for Islamic (Shari’a-compliant) finance in the UK is set to grow hugely. A huge gap exists for Shari’a compliant equity and mortgage products. Muslims have historically been underserved by UK financial institutions, but this is set to change.” The closest situation to a possible scenario in the UK is the Malaysian example. There, a full range of banking products are available to customers from Bank Islam Malaysia Bhd or the “Islamic Banking” counters of all the major banks. The set up is fully regulated by the Central Bank of Malaysia and Islamic finance instruments seem to co-exist with traditional banking products without any problems. If such products are launched in the UK, then the Malaysian model would be ideal as it provides a precedent for a small Islamic banking sector harmoniously co-existing with a much larger traditional banking sector. In fact, two years ago, in a seminar hosted by the Islamic Foundation in Leicester, Eddy Gorge the

Governor of the Bank of England and Ahmed Mohammed Don the former Governor of the Bank Negara Malaysia (Central Bank of Malaysia) had and exchange of views on this very subject. The growth and public appreciation of Islamic financial institutions, just as with the ethical investment movement in developed economies, will in time help ‘persuade’ the big financial players to pay far more heed to their customers’ views in deciding where and how they invest their depositors’ money. In the process it will become easier for social and ethical criteria, like equity considerations, to be incorporated into financial intermediation. The incremental growth of Islamic financial institutions also shows how Muslim societies will begin to incorporate the spirit justice and equity. Emerging from the colonial interlude, Muslim societies have begun to reflect on the basic precepts of their economic organisation. Understandably, there are a host of external and internal realities which impinge upon the way these societies are organised. However, as the move towards more representative societies gathers pace, the underlying thrust of the Islamic quest for equity and justice is likely to manifest itself in developments in Muslim societies over time. In these endeavours Muslims will be in good company. Together with the growing protest against the growth of global inequity, the quest for ethical financial intermediation, will provide platforms for like minded players from across faith and ideological boundaries to come together.

The Status of the Stock Exchange
Asif Iftikhar ([email protected]) An important question which Muslim economists face in these times is the status of the stock exchange. Is trading on the stock exchange haram? Is it really gambling as some people say? The stock exchange is a market place where shares are bought and sold. By buying the shares of a company, you, in fact, share in the business. Therefore, if there is nothing against Islam in the nature of the business, there is nothing wrong in being the shareholder of that business or in getting dividends on those shares. Similarly, if you sell the shares at any point of time owing to some reason and get capital gains thereby, the transaction and the profit are not wrong from the Islamic point of view. There are however situations when the activity in the stock exchange is clearly against good sense and the norms of ethics. There are certain transactions which are or can be detrimental to the interests of either party by causing damage or deception. Therefore, though the Shari‘ah has not prohibited these transactions as such and though, in most cases, they can’t really be termed as gambling, they are clearly against the spirit of Islam when they result in or are likely to result in damage or deception. That is why there is a principle of Islamic jurists that any transaction which causes or might cause darar or gharar (damage or deception) to either party should be prohibited by law. Where the law of the land does not deal with such transactions, it is up to the individual to decide whether or not the transaction will or may cause damage or deception to the other party. In case he is certain of such damage or deception, he should certainly avoid undertaking the transaction. Even in the case where there is a sufficient probability of darar or gharar, it is best to avoid the transaction as a Muslim knows that he will be held accountable on the Day of Judgement if his actions deceive someone or cause him damage. Furthermore, at the macro level such transactions can be detrimental to the economy when trading moves beyond mere buying and selling, that is when the buyer and the seller do not remain a buyer and a seller but become a

‘bear’ or a ‘bull’. Ideally, the market price of a share should be related to the performance of the company. But the speculators (euphemistically called investors) manipulate the prices by artificially stimulating the demand and the supply of shares. Forward contracts are made and further contracts are derived (financial derivatives) on that basis. The result is that the whole market activity is based on speculation rather than being based on entrepreneurship. The share price of a company doing perfectly well suddenly falls and that of a company in trouble suddenly rises. A person earns millions and loses millions in a day in this game. Obviously, such fluctuations have a negative impact on the economy, which is usually borne by the not-so-affluent sections of the society. One of the worst cases of such speculation was when on Oct. 19, 1987 -- now known as the Black Monday -- Wall Street crashed owing to the panic that had spread among the investors. Billions are lost in a day in such crashes. Since shares are sometimes bought and sold even before they have been actually bought and sold and, quite frequently, are bought primarily on the basis of borrowed capital (as in the case of the famous Australian investor Alan Bond), stakes are high and the slightest fear can start a chain reaction, which may result in a major catastrophe. The reason for such timorousness is nothing except that the whole economic activity in these exchanges is based on speculation and interest based borrowing rather than on entrepreneurship and equity participation. When such a large area of economic activity is based on speculation and interest based borrowing, the spirit of entrepreneurship suffers and moral corruption pervades the society. Economic activity should be based on entrepreneurship, hard work, creativity, moral principles and concern for others, whereas speculation is often detrimental to these values. An individual should also keep in mind the effect of his personal decisions on the whole society, and as its responsible member and as a good Muslim try to be part of the solution instead of being part of the problem. It has been seen that involvement in speculation often leads to greed and avarice, which come in the way of ethics and concern for society1, whereas a Muslim prefers sticking to nobler values even if they afford him less material benefit. Even in the absence of specific Divine injunctions or enacted laws, a Muslim should ask his own self whether his involvement in such activities is leading him away from God and inclining him towards the violation of moral values and ethics. And this is a question which an individual must answer himself. The rule here is sal nafsak (ask your soul). A Muslim’s life should marked by love of God, fear of His wrath, charity and concern for others. Losing these values for material benefit is a trade that a good Muslim never likes to make.2

1.

The following words of a famous economist bear witness to this reality: ‘For at least another hundred years, we must pretend to ourselves and to everyone that fair is foul and foul is fair, for foul is useful and fair is not. Avarice and usury and precaution must be our gods for a little longer still.’ (Keynes, Economic Possibilities for Our Grandchildren) 2. It must also be remembered that in consideration of the way Allah Almighty revealed His laws through the Prophet (sws) and the way the Prophet (sws) implemented them, the State or an individual, in the desire to implement and

follow Divine laws, should not hasten so much that an unnatural burden is put on one who is trying for his or her spiritual development. The approach of moving gradually towards the target is consistent with the spirit of Islam. Shari‘ah is not difficult. It is not the purpose of Shari‘ah to make life unnecessarily difficult for a person. Its purpose is to purify his or her soul. One should not try to make following the Shari‘ah unnecessarily difficult, especially in areas which it does not directly touch upon and in areas where there is a certainty or risk that not using the allowances given by the Shari‘ah or those that common sense points out will result in such burden as would result in greater evil than the one that is to be rooted out.