Islamic Finance: Origins, Emergence, and Future

by Scott B. Wilson September 18 2007, 23:35

    One of the most raucous political fights of 2006 involved the takeover of the British ports operator P&O by DP World, which if fully effectuated would have ceded the control over six U.S. ports to a firm owned by the government of Dubai.[1] A principle objection to the deal was that it in effect would have rendered control of U.S. commerce and a main facet of national security to a government of Middle Eastern country that potentially had links to international terrorism. After a lengthy showdown between the Congress and President, DP World conceded to sell the firm to an American interest.[2] However, what went almost unnoticed was that this new deal was financed with a sukuk, a bond-like financial instrument that concurrently remains consistent with Shariah law.[3] Such issues are part of an emerging sector in the financial industry known as "Islamic Finance." This article traces a brief history of the origins of Islamic Finance, its emerging competitiveness, and its prospects for the future.


    Islamic Finance is part of a larger unified system known as "Islamic Economics." There is much in common with this system and western economic systems.[4] One overarching difference, however, is that Islam does not distinguish between the secular and the sacred as has been the tradition through much of the Christian West.[5] One author has painted this distinction by characterizing western secular economic systems as being driven by "unbridled profit motive" regulated only by the legislative and democratic processes while an Islamic system recognizes market forces up front but simultaneously requires humanity to submit to "divine authority" and all its commands to correct for the assigned evils emanating from the marketplace.[6]

    Thus, "Islam postulates a unique nexus of contracts among the Creator, man and society on the basis of the Divine Law that directly affects the workings of the various social, political, economic, and financial systems."[7] Thus, the foundation of any Islamic economic system will be consistent with Islamic ideology, which encompasses three tenants[8]:

  1. Unity and Oneness of the Creator;
  2. Mohammed is the last prophet of Allah and was the perfect prototype of a perfect set of rules for living a perfect life in this world;
  3. Return of everything in this world to Allah at the Final Judgment

    Consistent with this ideological framework, Islam posits a unique law, Shariah, which governs both private and public affairs.[9] The sources of Shariah include the Quran and the writings and acts of the Prophet Mohammed, commonly called the Hadith.[10] These laws are comprehensive, governing all aspects of one's life, and ultimate compliance with these rules leads to not only a harmonious life but also a consequential unified human society.[11] It is important to remember that any Islamic economic system seeks consistency with Shariah not as an end in itself, but its ordering is part of a much larger unified whole. Examples of how an Islamic system based on Shariah challenges the western secular model include[12]:

  • Priority in emphasis on Islam's teaching of Justice and Equity as demonstrated by the enforcement of both distributive and commutative justice
  • A spiritual framework that values human relations above material possessions
  • A balance between individual self-interest and the common good
  • Maximum profit and satisfaction are not the sole objectives, which in effect minimizes waste
  • Recognition and protection of private property rights while encouraging reciprocal responsibilities

    One  well-reported feature of Islamic Finance, or rather Shariah, is its abhorrence of interest, or riba. Scholars differ on whether an exact translation exists; however, a suitable definition is that Shariah forbids "the practice of charging financial interest or a premium in excesses of the principle amount of a loan."[13]. The Quran emphasizes the earning of money through trade and commerce rather than the charging of interest.[14] One verse from the Quran, 2:275, specifically distinguishes between the two practices by describing Allah's prohibition against "usury."[15]

    Essentially, the prohibition of riba is a prohibition on debt security, but the system permits other forms of financing, such as risk and profit sharing.[16] Thus, instead of return on capital being determined ex ante through a nominal interest rate, the return naturally occurs ex post on the basis of the economic activity for which the funds were invested.[17] Scholars posit that this system avoids the risks, such as bank runs and periodic financial crisis, inherent in a fractional reserve banking system.[18] However, the element of riba does not alone differentiate Islamic Finance; a valid financial contract also must not contain Gharar (ambiguity or deficiency of information in the contract), Qimar (any elements of gambling), and Myisur (deceptive games of chance).[19]

     All Islamic banks or traditional banks that provide Islamic financial products are required to establish "Shariah Advisory Councils" that serve the dual purpose of advising clients and assuring that the institution remains compliant with the demands of Shariah.[20] Such councils are composed of religious scholars who are experts in Shariah as well as the financial markets.[21] It is in conjunction with these councils that financial institutions have developed tools that while remaining consistent with Shariah also satisfy the institution's shareholders and customers. The Islamic Finance system is complex, but a nonexclusive list of some of its tools includes:

  • Musharakah: This word literally means, "sharing", and int he business context it means a joint enterprise in which all partners share in the profits and losses.[22] This entity naturally developed out of the riba prohibition, and proponents argue that it is more equitable than the interest model.[23] For instance, in the interest model, if the debtor suffers a loss, a fixed rate of interest is still payable to the creditor which results in an "injustice."[24] Likewise, if a debtor succeeds in his venture, then the creditor only receives the fixed interest rate payment instead of a more proportional sum of the profits.[25]
  • Murabahah: This is financing on a cost-plus basis usually through the form of a sale.[26] For instance lacks the capital to do so. He approaches a bank or financier for assistance, which instead of lending him the funds at interest, the two parties form an agreement whereby the financier purchases the product at its "acquisition cost."[27] Then in accordance with the agreement, the financier transfers the product to the entrepreneur at its acquisition cost plus a certain amount above in the form of profit.[28 The entrepreneur thereby agrees to make installment payments to the financier for the balance of the account. This financial tool remains consistent with Shariah and avoids the use of riba on the ground that the bank actually owns the product and has thereby taken on considerable risk in case the entrepreneur backs out, so the profit is justifiable because it is earned.[29] Likewise, if the entrepreneur defaults, he is only responsible for the balance of the account attributable to the acquisition cost, not for any additional fees or interest.[30] Two allowable exceptions under Shariah to a murabahah include a salam (similar to a futures contract for specific goods that require payment up front and a fixed delivery date) and a istisna (a future contract for something that requires manufacturing).[31]
  • Ijarah: A leasing arrangement to be distinguished from a murabahah in that instead of the sale of a tangible asset, an ijarah is the sale of the right to use an asset for a specific period of time.[32] There are several slight differences between this and a conventional lease such as the lease begins on the date of acquisition instead of the date the contract was signed, the lessee is not responsible for the value of the asset in case of its destruction because the bank is required to take out insurance, and the lessee is not bound to purchase the asset at the completion of the contract.[33]
  • Mudarabah: Contract similar to a venture capital transaction whereby a financier agrees to provide capital to an entrepreneur in exchange for a percentage of future profits.[34] The entrepreneur provides only his labor and expertise in investing in real economic activities, while the financier agrees to bear the full loss of a failure.[35]
  • Hawala: An informal debt transfer system that operates exclusively using the honor system without any formal legal system.[36] The system works through a network of interconnected brokers. For example, if I owe a debt to person X in Cairo but I am currently in Damascus, I can approach a hawala broker and pay my debt to him. The broker in turn calls another broker in Cairo who agrees to settle the debt at a later time for a small commission. The advantage of this system is that it avoids hassles such as national currency manipulation, regulatory regimes, and taxation. More pointedly, because of its informal nature, it does not leave a paper trail.[37]

     Above are some of the main contracts and financial tools that compose the emerging Islamic Finance sector. Each developed as a way to remain compliant with Shariah while permitting the flourishing of a functioning economy. Along with understanding what the basic tools of Islamic Finance are, it is also helpful to know of it history, rapid emergence, and prospective future success in the United States and world financial markets.


Emergence & Future

     A sketch of the modern history of Islamic Finance would begin sometime in the 19th Century in predominantly Islamic countries then under colonial rule.[38] During this period, especially during the early decades, the indigent peoples gradually lost touch with their traditional practices and heritage.[39] The colonial powers offered new systems and symbols of modern success that led to the de-emphasis of traditional Islamic teachings that informed one's total worldview.[40]

     Following the demise of the colonial period, "Muslims began to re-discover their identities and manifested the desire to regain the lost values in all aspects of life, especially concerning the economic system."[41] Most notably in Egypt, opposition grew to the presence of the interest-based Barclays Bank, which was established for the purpose of raising capital for the construction of the Suez Canal.[42] Similar opposition arose in India at the turn of the century where a minority of Muslims established Shariah compliant interest-free loans.[43] Joining this low level opposition was a group of intellectuals and scholars that by 1953 developed a formal Islamic banking system.[44]

     As the 20th Century advanced, the Middle East as a whole, but especially the petroleum-rich nations, grew in influence. Increased capital flows resulting from the growing demand for petroleum exports created the need for an integrated financial and banking system. Likewise, in Islamic countries outside the Middle East, such as Malaysia, efforts were made to develop an interest free financial system to assist Muslims performing the Pilgrimage.[45] By the 1970s, the high oil revenues created an incentive for the creation of Shariah compliant investment and financial products. In 1975, the Islamic Development Bank was established, which provided developmental finance in accord with Shariah. This bank and other financial systems used the financial contracts listed above, such as Murabahah, for the placement of the Islamic banks' funds.[47] The countries Iran, Pakistan, and Sudan, at least officially, converted their entire banking systems to an interest-free basis.[48]

     By the 1990s countries such as Bahrain and Malaysia began to promote Islamic banking in conjunction with the conventional system.[49] Products such as Islamic insurance and equity funds were developed, and both the Dow Jones and FTSE created indices that specifically listed Shariah compliant securities.[50] A regulatory body, the Islamic Financial Services Board, is established.[51] Culminating at the turn of the 21st Century, the Islamic financial system encompassed products such as: banking, mortgages, equity funds, fixed income, insurance, project finance, private equity, and even derivatives.[52] The ratings agency Standard & Poor's recently valued these interests at around $400 billion.[53] At growth rates of 15% over the past three years, Islamic finance as an emerging sector is expected to expand further especially with the rapidly increasing demand for petroleum exports, which brings fresh infusions of "petro-dollars."[54]

     The Islamic Finance sector includes exclusively Islamic banks such as Saudi Arabia's Al-Rajhi Bank, which claims to be the world's largest Islamic financial institution.[55] More significantly however, a large number of conventional banking institutions such as Citibank, HSBC, and UBS all provide Shariah compliant financial products throughout both Islamic and non-Islamic regions. One example is HSBC, which on its website advertises a wide array of both personal and business financial products.[56] Customers are also able to search the biographies of the three sheikhs that compose HSBC's "Central Shariah Committee."[57]

     A recent article described the widening advertising campaigned for Islamic financial products that various financial institutions are promoting in Malaysia.[58] Marketing for these products is becoming savvier as institutions emphasize the competitiveness of their products while remaining consistent with Shariah principles.[59] Markedly, some of the financial institutions are attempting to broaden their market to customers less concerned with compliance with Shariah than earning a competitive return.[60] In fact, some of the advertising is being aimed squarely at non-Muslims or others less concerned with the foundational mission of the products.[61] Perhaps these institutions through savvy marketing techniques are attempting to create a popular trend in an alternative financial market that is appealing to nominally religious customers more concerned with personal wealth and image. Other banks are responding with promises of steadfast devotion to Shariah: "One Bank Muamalat ad shows goldfish jumping from an overcrowded, dirty brown bowl in to a clean one. 'Free the national from the murkiness of interest payments,' sys the slogan with the ad."[62]

     What are the prospects for this emerging financial sector called Islamic Finance? Will it meet the same dismal fate ushered in by political pressure as that of DP World in its ports deal? Or will Islamic Finance continue to expand and perhaps significantly compete with the conventional western financial system? No doubt the differences in approach and the underlying philosophical and religious underpinnings of Shariah-compliant products will raise questions about the legitimacy of certain features currently present in the western system such as the fractional-reserve banking system, the credit markets, and the problems associated with an excessive debt burden. Perhaps critics could point to the current financial crisis in the United Kingdom where the governmental had to bailout the British bank Northern Rock, after thousands of its customers removed their deposits in fear of the looming worldwide mortgage meltdown. Several legal and sociological factors may either prevent or contribute to the expansion of Islamic Finance in the U.S. and throughout the world.

     As far as the world is concerned, one beacon of hope and perhaps an ideal model of an Islamic financial center is Dubai. Some of the world's largest financial institutions, investors, and even western business schools are all flocking to this region to get a piece of the growing pie.[63] Although not having the largest economy in the Gulf region, Dubai is marketing itself as the "one-stop shop" offering financial products ranging from insurance and stocks to sulak bonds.[64] Such a system openly flourishes in the predominately Islamic Middle East; what about in the United States?

     There are several factors that may lead to the success or failure of such a system in the U.S. First, it should be noted that the conventional financial system currently allows for some Islamic financial products as long s the sponsoring institutions remain compliant with various regulatory agencies as well as state and federal laws. However, since the declaration of the "War on Terror", certain elements of Islamic Finance have come under increased scrutiny. One example of this arises from suspicions that Islamic financial institutions are used to launder and funnel money to international terrorist organizations. As of 2005, a total of 140 individuals have been arrested an over $25 million seized by the Department of Homeland Security on alleged violations of the Patriot Act for using hawala, or more specifically for participating in "unlicensed informal money transfer systems."[65 Could the same governmental crackdown come against other Islamic financial products upon the allegation of "terror financing?"

     As far as private American citizens are concerned, Islamic Finance may be in more welcoming waters than those flowing from the public authorities. As noted above, Islamic financial institution as well as conventional banks offering like products are attempting to expand to the greater non-Muslim market base. In Malaysia for instance, the bank Al Rajhi partnered for the ad campaign that appeals to broad religious values with the slogan, "Truth. Honor. Respect. Just Values."[66] There are least two reasons why such an approach may be successful in the United States.

     First, Islamic Finance and its underlying religious worldview can bring a sense of confidence to an investor that his assets are being responsibly cared for: "some people in the  West have begun to find the idea attractive. It gives the provider of money a strong incentive to be sure he is doing something sensible with it."[67] Thus instead of the oftentimes flimsy security that one has of investing in a system that is almost exclusive governed by sheer positive laws or utilitarian force, with Islamic Finance one is investing in a  system that naturally governs through conscience and obedience to a Higher calling.

     Second, while Muslims are a minority group in the U.S., there is potential growth for Islamic Finance in America's large non-Muslim religious population. There are many large traditional religious groups in America, such as Christians and Jews, whose members are seeking to live out their lives with a worldview consistent with their religion. However, this has often proved to be difficult when it comes to investing or conducting oneself in the marketplace because so many business entities operate or invest in ways contrary to these traditional religious worldviews. There could be growth in Islamic Finance with non-Muslim customers who not only seek a modest return on investment but more importantly, desire a higher satisfaction that their funds are being used in a morally responsible way. For instance, many Catholics and Evangelical Christians would welcome the opportunity to invest in a financial enterprise such as Islamic Finance that is not involved with operations that violate their religious worldview by sponsoring pornography, providing non-spousal partner employee benefits, or promoting abortion rights.

     Lastly, there are two reasons why Islamic Finance may steadily grow and expand across the world in the years to come. First, both domestic and immigrant Islamic populations are widely exceeding their replacement rates while much of the secular West, with the notable exception of the United States, is barely able to keep itself within replacement levels.[68 Second, as the demand for oil grows and the supply likewise declines, this will create increased influence and "petro-dollar" revenues for Islamic nations that insist on investing exclusively through the Islamic financial system.


     Islamic Finance is a subset of a larger concept called Islamic Economics that seeks to conform all of one's life to the tenets of Islamic ideology. This system has developed from under colonial rule and expanded to compete with some of the largest western financial institutions. The prospects for success of this emerging sector in the U.S. will depend on public enforcement of its laws as well as its reception by the American public. However, the prospects for Islamic Finance worldwide with diversified holdings are positive both because of growing Muslim populations as well as increased demand for petroleum exports from Middle Eastern countries.

[1] Calling the Faithful, THE ECONOMIST, Dec. 9, 2006, at 86, available at

[2] Id.

[3] Id.

[4] Zamir Iqbal & Abbas Mirakhor, AN INTRODUCTION TO ISLAMIC FINANCE: THEORY AND PRACTICE 1-2, (John Wile & Sons 2007).

[5] Id. at 2.

[6] Muhammad Taqi Usmani, AN INTRODUCTION TO ISLAMIC FINANCE xiv, (Kluwer Law International 2002).

[7] Iqbal & Mirakhor, supra note 4, at 2.

[8] Id. at 4-5.

[9] Id. at 12-13.

[10] Id. at 15.

[11] Id. at 12.

[12] 17.

[13] Id. at 54

[14] Id. at 55.

[15] Id.

[16] Id. at 17.

[17] Id. at 18.

[18] Id. at 20.

[19] Id. at 53.

[20] Id. at 115; See also Wikipedia, Islamic Banking, (last visited Sept. 18, 2007).

[21] Id.

[22] Usmani, supra note 6, at 1.

[23] Id.

[24] Id.

[25] Id.

[26] J. Michael Taylor, Islamic Banking: The Feasibility of Establishing an Islamic Bank in the United States, 40 AM. BUS. L.J. 385, 395 (2003).

[27] Id.

[28] Id.

[29] Id.

[30] Id.

[31] Usmani, supra note 6, at 83-89.

[32] Iqbal & Mirakhor, supra note 4, at 84.

[33] Taylor, supra note 26, at 396.

[34] Iqbal & Mirakhor, supra note 4, at 103.

[35] Id.

[36] Id. at 108.

[37] Id.

[38] Iqbal & Mirakhor, supra note 4 at 23.

[39] Id.

[40] Id.

[41] Id.

[42] Id.

[43] Id.

[44] Id. at 24.

[45] Id.

[46] Id. at 25.

[47] Id.

[48] Id.

[49] Id.

[50] Id. at 26.

[51] Id.

[52] Calling, supra note 1 at 86.

[53] Id.

[54] Id.

[55] Tom Wright & Yayu Yuniar, Islamic Finance Widens Pitch, WALL ST. J., Sept. 5, 2007, at B3, available at

[56] HSBC Bank, (last visited Sept. 16, 2007).

[57] Id.

[58] Wright & Yuniar, supra note 55, at B3.

[59] Id.

[60] Id.

[61] Id.

[62] Id.

[63] A Bouquet of Desert Flowers, THE ECONOMIST, Sept. 15, 2007, at 14, available at

[64] Id.

[65] Walid Al-Saqaf, Bush Team Launches New 'Hawala' Crackdown, WALL ST. J., May 24, 2005, available at

[66] Wright & Yuniar, supra note 55, at B3.

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