History, Basic Tenets of Islamic Finance, and Implications (Part 1 of 2)

Historical Basis of Islamic Finance

Islamic finance is based on an economic model during the early Islamic period and related financial tools. The basic tenets of Islamic finance such as the establishment of a central treasury and the generation of income from public property for social welfare were prevalent in ancient Islam. Fair business dealings were promoted in commercial contracts and the accumulation of wealth was kept under check.

The Beginnings with Bayt al Mal and Waqf in the Period of Umar ibn al Khattab

(may Allah, the Exalted, be Pleased with him)

When the second caliph of Islam, Umar ibn al Khattab, may Allah, the Exalted, be pleased with him, succeeded Prophet Muhammad, may peace be upon him, he instituted the Bayt al Mal (central treasury). The goal of the treasury was to distribute charity to promote a compassionate society that protected the vulnerable sections. Another system introduced by him was the public trusteeship system or waqf as a means to generate income from public property (Irfan & Ahmed, 2019). These initiatives indicate the importance of social advancement in financial initiatives in the early Islamic period. During this era, the primary goal was the distribution of wealth to prevent accumulation among a few wealthy people.

Fair Business Dealings and Commercial Contracts in the Period of Imam Abu Haneefah

(may Allah, the Exalted, be Pleased with him)

Later, during the period of Imam Abu Haneefah, may Allah, the Exalted, be pleased with him, contractual principles began to be converted for commercial adoption (Irfan & Ahmed, 2019). As a textile merchant, his principles of fairness formed the core of a legislative framework relying on the principles of Prophet Muhammad, may peace be upon him. Unjust transactions and speculation in commercial dealings were prohibited according to the teachings in the Quran.

The Beginning of a Money System in Ottoman Era

During the Ottoman period, this commercial law gave way to a money economy when gold and silver were replaced by paper notes. A money transfer system was instituted, and the use of credit letters and cheques came into effect (Irfan & Ahmed, 2019). However, during this same period, European money lending became a prominent practice, and Shariah principles were compromised, leading to an interest-based European banking system.

Emergence of Islamic Institutions in the Mid-Twentieth Century

Islamic finance regained attention by muslim-majority nations during the mid-twentieth century. In 1963, Dr Ahmed Elnaggar formed the Mit-Ghamr Savings bank, which did not charge or pay interest, shared profits with depositors, invested in trade and industry, and promoted investment and savings (Irfan & Ahmed, 2019). Consequently, similar institutions were set up in Egypt and Dubai (Dubai Islamic bank). These banks worked on the investor and manager partnership and subsequent profit sharing.

Current Islamic Banking Context — Not the Ideal Islamic Finance System

Later, international banks began adopting Islamic financing practice. For example, Deutsche bank worked extensively on Sukuk (Islamic bonds), which led to other complex investment-banking products and market growth (Irfan & Ahmed, 2019).

When the year 2008 witnessed the global financial crisis, international banks switched to more familiar banking instruments and Islamic financing took a backseat (Irfan & Ahmed, 2019). Growth rates contracted and fewer assets began to be managed by the global Islamic finance industry, leading to only 4% assets managed by the Islamic finance industry.

Islamic banking in the current context is debt-focused and without the benefit of risk-sharing. This structure steers away from an ideal Islamic finance economy based on risk-sharing through instruments such as musharakah (investment partnership) and mudarabah (investment partnership with one the parties acting as the capital manager). The current scenario has led to provision of Shariah-compliant services that give high margins but are debt related. These services are targeted at high net worth individuals (for example, Sukuk or bonds). In the retail segment, customers are offered high-volume and low margin products (for example, takaful or insurance). Another cause of sub-optimal outcomes is the limited adoption of financial technology (Irfan & Ahmed, 2019). The social impact of the present Islamic finance context is also controversial, in that it may or may not have promoted economic growth and equality.

The ideal benchmark to measure this impact would be to look at the extent to which Islamic banking has met Maqasid al Shariah (Shariah objectives). Further, in light of apparent megatrends such as demographic changes, a socially conscious society and emerging technologies, it may be justified to say that fintech that targets disintermediation would support current banking systems to achieve Shariah objectives (Irfan & Ahmed, 2019). Fintech has the potential to disrupt current banking systems, support emergence and growth of risk-sharing asset classes, and democratize provision of finance.

Mohammed and Amri (2019) elaborate on the widening gap between prevalent Islamic finance practices and the actual Shariah objectives, or Maqasid al Shariah. They propose that considerable work needs to be undertaken to prohibit the transactions that are based on interest, gambling, and speculations. They also recommend that the values of fairness, transparency, trust, and equitable wealth distribution must be implemented.

Wealth as an Essential Aspect of Islamic Finance

Shariah objectives are at the core of an Islamic finance system. The goal of Maqasid al Shariah is to prevent mafsadah (harm and hardship) and promote maslahah (public good and benefit). Five hundred years after the era of the Prophet Muhammad, may peace be upon him, the concept of maslahah and mafsadah was introduced. This was during the time of Imam al-Juwayni. His student, Imam al Ghazali (may Allah, the Exalted be pleased with them), further categorized maslahah into daruriyat or necessities (extremely necessary and their absence causes chaos), hajiyat or complements (facilitators), and tahsiniyat or embellishments (tied to ethical and moral conduct). His framework had further categories for necessities, life, religion, progeny, wealth, and intellect. The work of Imam Ghazali was further studied in recent years by Al Shatibi, Abu Zahra, and Ibn Ashur to include education and justice in his framework (Mohammed & Amri, 2019).

Researchers studied the different views on wealth or mal, which includes intangible and tangible properties, and that which is acquired legally. Wealth must be transferable as financial rights, in circulation, transparent, durable, preservable, and ensure fairness. Wealth must be protected from misappropriation, deceit, extravagance, envy, and destruction (Mohammed & Amri, 2019). Wealth is an important aspect of Islamic finance as it helps to achieve positive results with respect to maslahah or public interest.

The Islamic finance perspective discussed by Mohammed and Amri (2019) consists of three dimensions: “Shariah value proposition” and socio-economic welfare, which are the objectives, and wealth development, which is the means to these ends. Shariah principles promote justice and condemn extravagance, theft, hoarding, avoiding wastage, misappropriation, and injustice. These principles relate to efficient utilization of wealth and ensure trust, circulation, and transparency (Mohammed & Amri, 2019).

• Unjust consumption of wealth is prohibited, and, therefore, riba or interest is prohibited. Mutual consent is a condition for the consumption of wealth by way of lawful business transactions.
• Extravagance is prohibited as it leads to a loss of benefits to people and corruption
• Hoarding and theft of wealth is prohibited as it does not allow circulation of wealth that promotes business activities.
• Monopoly and gambling is also prohibited as it does not allow circulation of wealth and growth of the economy.
• Transparency can be achieved in dealings that involve wealth through the use of proper documentation, pledges and guarantees, and the inclusion of witnesses. This prevents disputes, risk, and harm.
• Justice in the context of wealth refers to prohibition of unjust or wrongful acquisition. Wealth must be acquired by personal effort in the form of compensation, inheritance, or donation.
• An important concept in relation to wealth is Hifz al mal which refers to the resources and property that can be owned. Its rights and benefits are in line with khilafah or stewardship with the key objectives of promoting socio economic justice (Adl) and mutual benevolence (Ihsan).
• Earning and spending of wealth must be directed at socio-economic welfare. Benefits can be realized by spending for the sake of religion such as pilgrimage or to earn good deeds such as charity, helping others, as remuneration for some work, or to preserve honor.

Islamic Finance Technology, Financial Inclusion, and Regulation

The purpose of Islamic financial technology is financial inclusion with innovative solutions and direction for policy makers. In a report by Ernst and Young, released in 2017, the investment in financial technology increased from USD 3 billion to USD 19 billion between 2012 and 2015 (Oseni & Ali, 2019). This report pointed at the disruptive nature of technological financial innovation in global finance.

What is Financial Technology?

The term financial technology refers to all technological applications related to transactions of financial services from negotiation, documentation, execution, to closing and dispute resolution. It is also important to acknowledge the role of the different financial institutions involved in the ecosystem, including not just financial institutions, but also start-ups, government, regulators, technological companies, infrastructure companies, users, consumers, incubators, investors, and accelerators. Finally, it is important to understand how Shariah principles can be applied for further development in the field (Oseni & Ali, 2019).

Financial Technology and Shariah-Compliant Communities

Experts propose that financial technology will promote greater inclusion as opposed to exclusion of a segment of the society from financial services (Oseni & Ali, 2019). However, the role and impact of Shariah-compliant financial services needs to be studied further.

How an Islamic Finance System can Improve Communities

Financial technology and Shariah-compliant financing cover common ground in terms of community benefit. Several other similarities exist, such as crowdfunding as an innovation in fintech, which is similar to donation, an interest-free form of financing from the Islamic finance perspective. Therefore, it may be possible to streamline Islamic finance in a way that it benefits the society at large (Oseni & Ali, 2019). Financial technology in Islamic finance is predicted to address the problems of hunger, poverty, health, education, and climate change. It may leverage the development of sustainable cities and protect forests and oceans.

Application of Shariah Principles to Financial Technology

Innovative financial services from the Shariah perspective may relate to smart contracts, e-commerce, crowdfunding, and the ability to “self-execute, self-maintain, and self-enforce” Islamic finance agreements. These services may reduce uncertainty in resolution of disputes (Oseni & Ali, 2019).

At present, the existing financial technology applications may be divided into three categories, which may be streamlined to apply Shariah principles for greater benefit. These categories are payment, clearing, and settlement, such as the use of digital currency, distributed ledger technology, and contactless payments (Oseni & Ali, 2019). The second category is lending, deposit, and capital raising, which comprises crowdfunding, peer-to-peer lending, and marketplace lending. Market provisioning is the third category which consists of smart contracts, digital identity, Big Data, and e-aggregators.

Challenges Faced in Applying Shariah Principles to Financial Technology

Novel technologies also fall under the investment management category which includes applications such as electronic trading and robo-advisor. Still other areas need greater attention in the area of Islamic financial service, which is online dispute resolution (ODR). Certain financial technologies such as smart contracts may improve operational efficiency (Oseni & Ali, 2019). To be able to apply Islamic financial perspective to solve these problems, the principle of Fiqh al-muamalat (Islamic jurisprudence related to dealing or transactions) is applied, which allows innovations unless explicitly prohibited, and the problems surrounding contractual uncertainty which may need to be addressed to promote contractual validity.

Therefore, the key challenge in including Shariah compliance in the current fintech landscape is to identify when to apply innovation, when formal contracts do not comply with requirements, and what modifications would allow access to innovative Shariah-compliant technology (Oseni & Ali, 2019). Other pertinent Islamic principles that may be applied include fiqhi tools (jurisprudence tools), hiyal (legislative trickery), maslahah (interest of the public), markharij (Islamically-compliant legal solutions), dhara‘i (blocking the means of evil).

Implications of Islamic Fintech on the Staff, Customers, Investors, and Public

The use of Islamic finance technology has resulted in a reduction in data monitoring costs, enhanced risk management, and promoted the use of Mudarabah and Musharakah. Investing in technology means that larger Islamic banks will thrive, and smaller banks may form cooperative partnerships with software companies to remain competitive (Wilson, 2019).

Technology is likely to have several implications on the working of financial systems in an economy and the nature of their human resources:

• Technological disruption may require Islamic banks to employ more IT professionals
• Routine clerical tasks may have to be eliminated
• Process automation will require enhancing the skill set of existing employees
• Islamic banks may choose to train expatriates
• Independent wealth managers may be preferred in the future
• Disruption may be a threat to equity financing
• Shariah alternatives may be offered at low costs
• Contractual monitoring may have to be delegated to Shariah audit managers
• The release of new products may require Shariah-board approval
• Data management technology may support existing Islamic financial systems

Islamic fintech will benefit the customers, investors, and general public in several ways. Customer empowerment is a positive outcome of Islamic fintech. They will acquire more knowledge about financial products, one of the motivations being religious inclination (Wilson, 2019). There may be a need to understand customer requirements and map them to financial priorities of the institution for informed decision-making.

Islamic finance technology also empowers investors by promoting efficient decision-making. It enables the availability of information about securities market, facilitates online brokerage, enforces use of technology to find out if certain investments are halal (permissible) or haram (impermissible), monitors performance of their investment portfolios, facilitates research, improves its quality through the inclusion of fund managers and Shariah board members, and allows the tracking of passive funds. In spite of several benefits from implementation of Islamic finance, it may create unintended complexities. Advocates of Islamic finance fear that it may also lead to financial exclusion as opposed to inclusion (Wilson, 2019).

References

Irfan, H. & Ahmed, D. (2019). Fintech: the Opportunity for Islamic Finance. In Fintech in Islamic Finance — Theory and Practice. (pp. 19–32). Routledge. https://www.researchgate.net/publication/334448354_Fintech_in_Islamic_Finance_Theory_and_Practice

Mohammed, M.O. & Amri, M. C. (2019). Fintech in Islamic Finance. In Fintech in Islamic Finance — Theory and Practice. (pp. 93–112). Routledge. https://www.researchgate.net/publication/334448354_Fintech_in_Islamic_Finance_Theory_and_Practice

Oseni, U. & Ali, S.N. (2019). Fintech in Islamic Finance. In Fintech in Islamic Finance — Theory and Practice. (pp. 3–16). Routledge. https://www.researchgate.net/publication/334448354_Fintech_in_Islamic_Finance_Theory_and_Practice

Wilson, R. (2019). Implications of Technological Advance for Financial Intermediation in Islamic Finanec. In Fintech in Islamic Finance — Theory and Practice. (pp. 33–46). Routledge. https://www.researchgate.net/publication/334448354_Fintech_in_Islamic_Finance_Theory_and_Practice

Non-English Terms Used

Adl — justice

Allah — the One and Only God in Islam

Bayt al Maal — public treasury

Dhara‘i (Sadd al dhariyah)- blocking the means of evil

Fiqh al-muamalat — Islamic jurisprudence related to dealing or transactions

Fiqhi — pertaining to jurisprudence

Halal — permissible

Haram — impermissible

Imam Abu Haneefah — One of the four righteous imams in Islam who founded the Hanafi school of thought

Imam Abu Zahra — Egyptian jurist of the Islamic Hanafi school of thought (1898–1974 C.E.)

Imam Ibn Ashur — Islamic scholar and reformer of education and jurisprudence (1879–1973 C. E.)

Imam al Ghazali — Influential Islamic philosopher, theologian, and jurist from Iran (1056–1111 C. E.)

Khilafah — stewardship

Mafsadah — harm and hardship

Makharij — search for solutions to apply Islamic law

Mal — wealth

Maslahah — public good and benefit

Maqasid al Shariah — Shariah objectives

Mudarabah — investment partnership with one the parties acting as the capital manager

Musharakah — joint partnership where two or more parties share labor and capital in a business where all partners share profit in a specific ratio

Prophet Muhammad — the last prophet of Islam (may peace be upon him)

Shariah — traditional islamic law

Umar ibn al Khattab — One of the four rightly guided caliphs in Islam (may Allah, the Exalted, be pleased with them all) who succeeded Prophet Muhammad (may peace be upon him)

Quran — the book of Allah, the Exalted, revealed to His last prophet, Muhammad, may peace be upon him