New Issues in Islamic Finance and Economics: Progress and Challenges

New Issues in Islamic Finance and Economics: Progress and Challenges

New Issues in Islamic Finance and Economics: Progress and Challenges Hossein Askari, Zamir Iqbal, and Abbas Mirakhor John Wiley & Sons (Asia) Pte. Ltd.

Copyright 2009 by John Wiley & Sons (Asia) Pte. Ltd. Published in 2009 by John Wiley & Sons (Asia) Pte. Ltd. 2 Clementi Loop, #02-01, Singapore 129809 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center. Requests for permission should be addressed to the Publisher, John Wiley & Sons (Asia) Pte. Ltd., 2 Clementi Loop, #02-01, Singapore 129809, tel: 65-6463-2400, fax: 65-6463-4605, e-mail: enquiry@wiley.com. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. Neither the authors nor the publisher are liable for any actions prompted or caused by the information presented in this book. Any views expressed herein are those of the authors and do not represent the views of the organizations they work for. Other Wiley Editorial Offices John Wiley & Sons, 111 River Street, Hoboken, NJ 07030, USA John Wiley & Sons, The Atrium, Southern Gate, Chichester, West Sussex, P019 8SQ, United Kingdom John Wiley & Sons (Canada) Ltd, 5353 Dundas Street West, Suite 400, Toronto, Ontario, M9B 6HB, Canada John Wiley & Sons Australia Ltd, 42 McDougall Street, Milton, Queensland 4064, Australia Wiley-VCH, Boschstrasse 12, D-69469 Weinheim, Germany Library of Congress Cataloging-in-Publication Data ISBN 978-0-470-82293-7 Typeset in 10.5/13pt Palatino by Laserwords Private Limited, Chennai, India. Printed in Singapore by Markono Print Media Pte. Ltd. 10987654321

In the Name of Allah, the All Merciful, the All Beneficent

Contents Acknowledgment Glossary of Arabic Terms ix xi 1 The Development and Progress of Islamic Finance 1 2 Issues and Challenges 47 3 Islamic Finance and Globalization: Convergence and a Boost for Rapid Growth? 75 4 Globalization and Its Implications for Muslim Countries 111 5 Expanding Financial Frontiers 129 6 Reputational Risk for the Islamic Financial Industry 149 7 The Design of Benchmarks for Asset Pricing 179 8 Qard-ul-Hassan-based Microfinance 197 9 Developing the Theoretical Foundations of Economics in Islam 211 10 Islam and Economic Development 243 11 Taxation and Public Expenditure in Islam 263 12 The Scope of the Social Safety Net in Islam: A Case Study 293 References 327 Index 363 vii

Acknowledgment We acknowledge the contributions of Dr. Nadeem ul Haque and Dr. Kazem Sadr in Chapters 7 and 8 respectively. We are also grateful to our research assistant, Shahrzad Daneshvar, for her excellent work. ix

Glossary of Arabic Terms ahadith Plural of hadith (for meaning, see hadith). ahkam Plural of hukm (for meaning, see hukm). ajr-un-kareem A generous reward. al-adl Justice. al-ghurm bil The principle that one is entitled to a gain only ghunm if one agrees to bear the responsibility for the loss. For example, if someone gives finance to someone else, he is only entitled to a share in the profit resulting from the use of that finance if he is also prepared to bear any resultant loss. al-kharaj bil The principle in Islamic jurisprudence that daman entitlement to return or yield (al-kharaj) is for the one who bears the liability (daman) for something, say an asset, and one who does not bear the liability has no claim to the yield. al mal Wealth, property. al-mu minun Those who believe through the heart. amanah Trust. awqaf Plural of waqf (for meaning, see waqf ). ayah A verse of the Qur an. bay Stands for sale. It is often used as a prefix in referring to different sales-based modes of Islamic finance, such as murabahah, istisna, and salam. bay al- ayan Sale of tangible objects such as goods (as opposed to sale of services or rights). bay al-dayn Sale of debt. According to a large majority of fuqaha, debt cannot be sold for money, except at its face value, but can be sold for goods and services. bay al-kali bil A sale in which both the delivery of the object kali of sale and the payment of its price are delayed. It is similar to a modern forward sale contract. xi

xii Glossary of Arabic Terms bay al- inah bay bithaman ajil bay al-mudaf bay almulamasah bay almunabazah bay al-salaf bay al-salam bay al-sifah The sale of something to someone at a given price (usually on credit) and then the purchase back from the buyer, at the same time, at a different price (usually lower but cash). This kind of sale and buyback is prohibited because it effectively means exchanging a given amount of money with a different amount of money, which amounts to riba. It can be used as a subterfuge for riba dealings. A sales contract where payment is made in instalments after delivery of goods. Sale could be for long-term and there is no obligation to disclose profit margins. A sales contract in which delivery of both the commodity and the payment is deferred for example forward sales in modern times. Such contracts are not permitted by the Shari ah. A form of sale prevalent in the days of the Prophet (peace be upon him) in which the sales contract was finalized by the simple act of touching the object of sale. The prophet (peace be upon him) prohibited this kind of sale since the buying party did not have a fair chance of inspection and hence the practice involved gharar. A form of sale prevalent in the days of the Prophet (peace be upon him) in which the sales contract was finalized by the simple act of throwing the object of sale towards the buying party. The prophet (peace be upon him) prohibited this kind of sale since the buying party did not have a fair chance of inspection and hence the practice involved gharar. An alternative term for bay al-salam. A sale in which payment is made in advance by the buyer and the delivery of the goods is deferred by the seller. A sale based on a detailed description of the object of sale.

Glossary of Arabic Terms xiii bay bi thaman al- ajil bay mu ajjal bay muzayadah buyu daman Dar al-islam darar darurah dhimmah faqih fasad fatwa fatawi fiqh fiqhi fuqaha gharar Another term used for bay mu ajjal. Sale on credit, that is, a sale in which goods are delivered immediately but payment is deferred. Sale by auction. Plural of bay (for meaning, see bay ). Guarantee, security. The world (or the abode ) of Islam. Damage, harm, injury. Necessity. (Usually used for the Doctrine of Necessity, whereby something otherwise prohibited becomes temporarily permissible). Liability, responsibility. Jurist who gives rulings on various juristic issues in the light of the Qur an and the sunnah. Mischief, troublemaking, corruption. Religious verdict by fuqaha. Plural of fatwa (for meaning see fatwa). Refers to the whole corpus of Islamic jurisprudence. In contrast to conventional law, fiqh covers all aspects of life religious, political, social, commercial, and economic. Fiqh is based primarily on interpretations of the Qur an and the sunnah and secondarily on ijma (consensus) and ijtihad (individual judgement) by the fuqaha. While the Qur an and the sunnah are immutable, fiqhi verdicts may change due to changing circumstances. Relating to fiqh. Plural of faqih (for meaning, see faqih). Literally, it means deception, danger, risk, and uncertainty. Technically, it means exposing oneself to excessive risk and danger in a business transaction as a result of uncertainty about the price, the quality and the quantity of the countervalue, the date of delivery, the ability of either the buyer or the seller to fulfil their commitment, or ambiguity in the terms of the deal thereby, exposing either of the two parties to unnecessary risks.

xiv Glossary of Arabic Terms gharar yasir hadanah hadith Hajj halal Hanafi Hanbali haq haq al-irtifaq haram hawalah hazar hibah hikmah hilah Hisbah hiyal hukm ibadat A little bit of gharar. This is tolerable because it may be unavoidable. The right of custody of a child after the divorce. Saying, deed, or endorsement of the Prophet Muhammad (peace be upon him) narrated by his Companions. The pilgrimage to Mecca. Things or activities permitted by the Shari ah. A school of Islamic jurisprudence named after Imam Abu Hanifa. A school of Islamic jurisprudence named after Imam Ahmed bin Hanbal. Aright. Literally, the right of utilization or easement. Technically, the right to derive free benefit from the immovable property of someone else. The right has been recognized by the Shari ah in the spirit of generosity that members of a community should display toward each other. Things or activities prohibited by the Shari ah. Literally, it means transfer. Technically, it refers to an arrangement whereby a debtor transfers the responsibility for payment of a debt to a third party who owes that debtor a debt. It is also used for a cheque or draft. Danger, caution. Gift. Wisdom. Legal trick or device to avoid the imposition of a law in a particular case. Literally, it means reward or calculation. Technically, it refers to an institution that existed through most of Islamic history for implementing what is proper and preventing what is improper. The main role of al-hisbah was the regulation and supervision of markets to ensure proper market conduct by all concerned. Plural of hilah (for meaning, see hilah). Shari ah ruling having general applicability. Duties of man due to God.

Glossary of Arabic Terms xv ibadah ibahah ihsan ijarah ijarah muntahiyyah bil-tamlik ijma ijma al-nas ijma sukuti ijma qawli ijtihad ikrah hukmi illah ilm imama iman infaq iqtisad irfaq irshad israf Worship. Permissibility from a Shari ah point of view. Beneficence, kindness, virtue. Leasing. The sale of usufruct of an asset. The lessor retains the ownership of the asset with all the rights and the responsibilities that go with ownership. Lease ending in ownership. A consensus (of fuqaha ). Ijma is one of the sources of Islamic Law. General consensus of ulama. Tacit consensus (of fuqaha ), that is, an opinion carried without any contest from any known scholar. Consensus expressed verbally. In technical terms, it refers to the endeavor of a jurist to derive a rule or reach a judgement based on evidence found in the Islamic sources of law, predominantly, the Qur an and the sunnah. An unpleasant ruling. Reason or characteristic behind a Shari ah ruling such that if a particular reason or characteristic is found in other instances, the same ruling will apply. Knowledge. Spiritual and temporal leadership. Belief through the heart in addition to oral profession of faith. Spending. In the literature of Islamic economics, it usually refers to spending in the way of Allah (swt). It refers to Islamic approach to economic problems. An act of benevolence or charity for seeking the pleasure of Allah (swt). Providing moral guidance. Extravagance or excessiveness (especially in expenditure).

xvi Glossary of Arabic Terms istihsan istislah istisna (short form for bay al-istisna ) ithm jahl jihad jizyah ju alah kafalah kafil karahiyyah kharaj It refers to the departure from a ruling in a particular situation in favor of another ruling, which brings about ease. This is done by taking a lenient view of an act which would be considered a violation on a stricter interpretation of the action based on earlier qiyas. An unprecedented judgement within the overall Shari ah framework though not having explicit support from the Qur an or sunnah. Motivated by broader public interest, istislah is accepted as a source of Islamic Law. Refers to a contract whereby a manufacturer (contractor) agrees to produce (build) and deliver a well-described product (or premise) at a given price on a given date in the future. In istisna as opposed to salam, the price need not be paid in advance. It may be paid in instalments in step with the preferences of the parties or partly at the front end and the balance later on as agreed. Asinfulact. Ignorance, lack of knowledge. In contracts, it refers to lack of information on the subject, or the terms and conditions, of the contract. Striving to better oneself spiritually. One specific application is participation in defense of one s faith against aggression. A levy on those who prefer to keep their own faith in lieu of zakat which all Muslims are required to pay. Performing a given task for a prescribed fee in a given period. A contract whereby a person guarantees, or takes responsibility for, a liability or duty of another person. Guarantor. Dislike, aversion. In Shari ah terms, something that is not completely prohibited but is abhorred. Alevyonlanduse.

Glossary of Arabic Terms xvii khilafa khiyanah khiyar khiyar al- ayb khiyar al-ru yah khiyar al-shart khula khums maad mafasid mafsadah makrooh mal Maliki manfa ah maqasid al- Shari ah masalih masalih mursalah maslahah Vice-regency. Breach of faith, cheating, deception. Option. Option to rescind a sales contract if a defect is discovered in the object of sale. Option to rescind a sales contract after physical inspection of the object of sale. The option to rescind a sales contract based on certain conditions. One of the parties to a sales contract may stipulate specific conditions, which, if not met, would grant the stipulating party the option to rescind the contract. A divorce in return for either the husband foregoing the dower of the wife or a monetary compensation by the wife to the husband. A 20 percent levy on net annual income. The event of end-of-time return, indicating the day of reckoning, the time when all stand before their Creator to be judged. Plural for mafsadah (for meaning, see mafsadah). Anything declared harmful by the Shari ah or anything hampering the achievement of the maqasid al-shari ah. Abominable. In Shari ah terms, something that is not completely prohibited but is abhorred. Asset, property. A school of Islamic jurisprudence named after Imam Malik. Usufruct. Benefit flowing from a durable commodity or asset. The basic objectives of the Shari ah. Theseare protection of faith, life, progeny, property, and reason. Plural of maslahah (for meaning, see maslahah). Public interest as determined in the light of the rules of the Shari ah. Literally, it means benefit. Technically, it refers to any action taken to protect any one of the five basic objectives of the Shari ah, thatis, protection of faith, life, progeny, property, and reason.

xviii Glossary of Arabic Terms maysir milkiyyah mu amalat mudarabah mudarib muhtasib mujtahid mukhatarah muqaradah murabahah musharakah Literally, it refers to an ancient Arabian game of chance with arrows used for stakes of slaughtered animals. Technically, gambling or any game of chance. Ownership. Relationships or contracts among human beings as against ibadat which define the relationship between God and His creatures. A contract between two parties a capital owner or financier (rabb al-mal) and an investment manager (mudarib). Profit is distributed between the two parties in accordance with the ratio upon which they agree at the time of the contract. Financial loss is borne only by the financier. The investment manager s loss lies in not getting any reward for his services. An investment manager in a mudarabah contract. Ombudsperson. A religious scholar qualified to give Shari ah rulings. Risk. Carriesthesamemeaningasmudarabah. Sale at a specified profit margin. This term, however, is now used to refer to a sale agreement whereby the seller purchases the goods desired by the buyer and sells them at an agreed marked-up price, the payment being settled within an agreed time frame, either in instalments or as a lump sum. The seller bears the risk for the goods until they have been delivered to the buyer. Murabahah is also referred to as bay mu ajjal. Partnership. A musharakah contract is similar to a mudarabah contract, the difference being that in the former both the partners participate in the management and the provision of capital and share in the profit and loss. Profits are distributed between the partners in accordance with the ratios initially set, whereas loss is distributed in proportion to each one s share in the capital.

Glossary of Arabic Terms xix muzara ah nafaqah nafaqat nafs Najash nas nisab niyyah nubuwwah qabd qadar qadi qard-ul-hassan (short form qard) qasada qimar qirad qiyas qur an (also written as al-qur an) A contract whereby one party agrees to till the land owned by the other party for an agreed share in the produce of the land. Allowance. Plural of nafaqah, (for meaning, see nafaqah). The inner, primordial self. In reference to a sales contract, it means contriving with the seller and bidding a higher price, not with an intention to buy but simply to fetch a higher price from other potential buyers. Text from the Qur an or sunnah. With reference to Zakah, the limit of wealth that marks the beginning of the imposition of Zakah liability. Wealth below this limit is exempt. Intention. Prophethood. Possession. Provision of exact measure by the Creator of what His creation needs, individually and collectively, for the life on this plane of existence. Judge. A loan extended without interest or any other compensation from the borrower. The lender expects a reward only from God. The term refers to the concept of the golden mean. Gambling. See mudarabah. Derivation and application of a rule or law on the analogy of another rule or law if the basis ( illah) of the two is the same. It is one of the secondary sources of Islamic Law. The Holy Book of Muslims, consisting of the revelations made by God to the Prophet Muhammad (peace be upon him). The Qur an lays down the fundamentals of the Islamic faith, including beliefs and all aspects of the Islamic way of life.

xx Glossary of Arabic Terms qurud hasanah rabb al-mal riba riba al-fadl riba al-nasa sadaqah sadaqat sadaqah jariyah sadd al-zara i salaf salah salam sarf Shaf i Shari ah sharikat tawzif al-amwal shirakah Plural of qard ul-hassan (for meaning, see qard ul-hassan). Capital owner (financier) in a mudarabah contract. Literally, it means increase, addition or growth. Technically, it refers to the premium that must be paid by the borrower to the lender along with the principal amount as a condition for the loan or an extension in its maturity. Interest, as commonly understood today, is regarded by a predominant majority of fuqaha to be equivalent to riba. Riba pertaining to trade contracts. It refers to the exchange of different quantities or qualities of the same commodity. As defined by the Shari ah, there are particular commodities for which such exchanges are not allowed. Different schools of fiqh apply this prohibition to different commodities. Riba pertaining to loan contracts. An act of charity. Plural of sadaqah (for meaning, see sadaqah). An act of charity with perennial benefits. Prohibition of a deed which, if permitted, may lead to another prohibited deed. The short form of bay al-salaf. A verbal noun referring to the best course of action in accordance with the behavioral rules of Islam. The short form of bay al-salam. Currency exchange. A school of Islamic jurisprudence named after Imam Shaf i. Refers to the corpus of Islamic law based on Divine guidance, as given by the Qur an and the sunnah, and embodies all aspects of the Islamic faith, including beliefs and practices. A partnership with assigned property delegation. Partnership. Technically, it is equivalent to musharakah.

Glossary of Arabic Terms xxi shuf ah shura subhanahu wa-ta ala sukuk al-ijarah (short form sukuk) sukuk al-salam sunnah surah swt ta am ta awun tabarru at tabdhir Right of preemption. Islamic institution of consultation in the process of decision-making. Deviotional phrase appearing after the mention of Allah meaning glorious and exatted is He. Often abbreviated to swt. A negotiable financial instrument issued on the basis of an asset to be leased. The investors provide funds to a lessor (say an Islamic bank). The lessor acquires an asset (either existing or to be created in future) and leases it out if it is not already leased out. Sukuk al-ijarah are issued by the lessor in favour of the investors, who become owners of the leased asset in proportion to their investment. These sukuk entitle the holders to collect rental payments from the lessee directly. Sukuk canalsobe made tradable in the stock exchange. A negotiable instrument issued on the basis of a salam contract. A salam sale creates an in-kind debt payable on a future date. Sukuk al-salam represent common shares in that debt. Trading salam debt for money is controversial among Islamic scholars. The sunnah is the second most important source of the Islamic faith after the Qur an and refers to the Prophet s (peace be upon him) example as indicated by his practice of the faith. The only way to know the sunnah is through the collection of ahadith, which consist of reports about the sayings, deeds, and endorsements of the Prophet (peace be upon him). A chapter of Qur an. Abbreviation of subhanahu wa-tasla. Eatables. Cooperation (for good). Actions or contracts, the purpose of which is not commercial but is seeking the pleasure of Allah (swt). Unreasonable (impermissible) and wasteful expenditure.

xxii Glossary of Arabic Terms tafseer takaful takhrij tamwil tandid taqwa tawakkul tawarruq tawhid ulama Ummah urf ushr usul wa d Interpretation of the Qur an. An alternative to the contemporary insurance contract. A group of persons agree to share a certain risk (for example, damage by fire) by collecting a specified sum from each. In the case of loss to any of the group, the loss is met from the collected funds. Deducing rules of fiqh from existing and varied sources, that is, from various schools of thought. Financing. Liquidation. Ever-present consciousness of the presence of Allah (swt). Trust in God for results after one has undertaken all necessary effort. It is one of the important values for Muslims. After making all necessary efforts, a Muslim believes that the results are in the hand of God. Reverse Murabaha. Buying an item on credit on a deferred payment basis and then immediately reselling it for cash at discounted price to a third party. Belief in the unity of God, both in terms of the person as well as in His attributes. Scholars. The nation of Muslims. Established usage, custom. Urf is one of the sources of Islamic law as long as it does not contradict the basic sources, the Qur an and sunnah. Referring to the law of Zakah, itmeansarateof 10 percent leviable on certain types of wealth, output, or income. Principles, basics. A time-bound promise to deliver on terms contracted.

Glossary of Arabic Terms xxiii wadi ah wa id wakalah waqf Zahiri Zakah zanni zulm A contract whereby a person leaves valuables with someone for safekeeping. The keeper can charge a fee, even though Islamic culture encourages this service to be provided for nothing, or to recover only the costs of safekeeping without any profit. Warning. Contract of agency. In this contract, one person appoints someone else to perform a certain task on his behalf, usually for a fixed fee. Appropriation or tying up a property in perpetuity for specific purposes. No property rights can be exercised over the corpus. Only the usufruct is applied towards the objectives (usually charitable) of the waqf. A school of Islamic jurisprudence. The amount payable by a Muslim, on his net worth, as a part of his religious obligations, mainly for the benefit of the poor and the needy. It is an obligatory duty on every adult Muslim who owns more than a threshold wealth. Based on conjecture. Injustice, encroaching upon the rights of anyone else. Source: Islamic Research and Training Institute (IRTI), Jeddah, Saudi Arabia.

CHAPTER 1 The Development and Progress of Islamic Finance Islamic finance has emerged on the international financial landscape in a relatively short time. From a humble beginning in the 1960s, the concept was put into practice in the 1970s when the first commercial Islamic bank, Dubai Islamic Bank, was launched, followed by the establishment of the Jeddah-based multilateral development institution, the Islamic Development Bank, in 1975. Since then, the Islamic financial industry has enjoyed consistently high growth (10 15 percent annually) and continues to grow rapidly. There are now more than 300 institutions in more than 65 countries engaged in some form of Islamic finance, and, according to some conservative estimates, total assets classified as Islamic exceed US$600 billion. Islamic finance is a relatively new term which denotes engaging in financial and business transactions according to the principles of Islamic Law Shari ah. 1 The most critical and distinguishing feature of such a system is the prohibition of riba, which includes the payment and receipt of interest as understood in today s financial markets. The most significant implication of this prohibition is the removal of pure debt-based contracts from the financial transactions. In modern history, interest in conducting Shari ah-compliant business rose with the first sign of expansion of conventional interest-based commercial banking into the Arab and Muslim world. As early as the late nineteenth century, a formal critique and opposition to the element of interest started in Egypt when Barclays Bank was established in Cairo to raise funds for the construction of the Suez Canal. Further, a formal opposition to the institution of interest can be found as early as 1903 when the payment of interest on post office saving funds was declared contrary to Islamic values and, therefore, illegal by Shari ah scholars in Egypt. During the first half of the twentieth century, there were several attempts to highlight the differences between the emerging conven- 1

2 New Issues in Islamic Finance and Economics tional financial system and the areas where it conflicted with Islamic values. By the 1950s and 1960s, several Muslim countries began to gain freedom from years of colonialism, and with this newly found freedom there were attempts to rediscover Islamic values and heritage. By 1953, Islamic economists had offered the first description of an interest-free bank. By the start of the 1960s, there was substantial demand for Shari ah-compliant banking, resulting in the establishment of the Mit Ghamr Local Savings Bank in Egypt in 1963 by the noted social activist Ahmad-al-Najjar. It is worth noting that Dr. Najjar chose not to label this institution as an Islamic bank but promoted it as a social welfare institution. 2 Unfortunately, this experiment lasted for only four years. In the same year, there were parallel efforts in Malaysia to develop a saving scheme for Muslims to perform Pilgrimage. The establishment of the Dubai Islamic Bank by some traders in 1974 is considered to be one of the earliest private initiatives in the United Arab Emirates. The 1970s witnessed a rise in the price of oil, leading to rising oil revenues and financial assets in several oil-rich Muslim countries, especially in the Middle East. The oil revenues of the 1970s, sometimes referred to as petrodollars, offered strong incentives for creating suitable investment outlets for Muslims wanting to comply with the Shari ah. Interest-free or Islamic banking, which was only a conceptual idea by the early 1970s, was given a strong business foundation. Both domestic and international bankers, including some of the leading conventional banks in the world, exploited this business opportunity. In 1975, the Islamic Development Bank (IDB) was established, along the lines of other regional development institutions, with the objective of promoting economic development in Muslim countries as well as offering development finance according to the rules of the Shari ah. Since its inception, the IDB has played a key role in expanding Islamic modes of financing and in undertaking valuable research in the area of Islamic economics, finance, and banking. The 1980s proved to be the beginning of a trend of rapid growth and expansion for the emerging Islamic financial services industry. The major developments of the 1980s included the continuation of serious research on the conceptual and theoretical level, constitutional protection in three Muslim countries, and the involvement of conventional bankers in offering Shari ah-compliant services. The Islamic Republics of Iran, Pakistan, and Sudan announced that they would transform their overall financial systems to make them compliant with

The Development and Progress of Islamic Finance 3 the Shari ah. Other countries, such as Malaysia and Bahrain, started Islamic banking within the framework of their existing systems. The International Monetary Fund (IMF) initiated research into understanding the macroeconomic implications of an economic system operating without the basis of interest. Similar research was conducted to understand the issues of profit loss sharing contracts and the financial stability of a system based on the sharing of profit and loss. During the early stages of Islamic financial market growth in the 1980s, Islamic banks faced a dearth of quality investment opportunities. This created business opportunities for conventional Western banks to act as intermediaries to deploy Islamic banks funds according to the guidelines given by the Islamic banks. Western banks realized the importance of the emerging Islamic financial markets and started to offer Islamic products through Islamic windows in an attempt to attract clients directly, without having an Islamic bank as intermediary. The number of conventional banks offering Islamic windows grew, and several leading conventional banks, such as the Hong Kong and Shanghai Banking Corporation (HSBC) and Citibank, began to pursue this market aggressively. By the early 1990s, the market had gained enough momentum to attract the attention of public policymakers and of institutions interested in introducing innovative products. Citibank is one of the first Western banks to have established a separate Islamic bank Citi Islamic Investment Bank (Bahrain) in 1996. HSBC has a wellestablished network of banks in the Muslim world. With the objective of promoting Islamic asset securitization and private equity and banking in OECD countries, HSBC Global Islamic Finance (GIF) was launched in 1998. With the growth of Islamic products and services, the need for regulation and standards increased, resulting in the establishment of a self-regulatory agency the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in Bahrain which has played an important role in promoting growth. 1.1 RECENT DEVELOPMENTS By the late 1990s and early 2000s, Islamic finance began to catch attention at international level and more and more countries began to embrace the concept that a system without interest (debt) is workable. This recognition can be attributed to two major factors. First, during its history of more than 30 years, no major Islamic bank failed; on the contrary, these banks proved to be as efficient

4 New Issues in Islamic Finance and Economics and profitable as their conventional counterparts. There were cases of bank failures but those failures were caused by, and attributed to, bad governance and lack of risk management. In none of the failed banks was the issue of Islamic financial products or the design of financial intermediation questioned. This success of 30 years gave confidence and trust to customers and removed the doubts of skeptics. Second, the advancement of financial theory, in both conventional and Islamic literature, in the area of portfolio theory and the understanding of financial intermediation has been supportive. Such advancement in theory showed that a system without interest can be designed, and, under certain conditions, such systems may prove to exhibit more stability than the conventional system. 3 As the science of financial engineering developed, its application in Islamic finance also led to innovation. The first wave of innovation came in the form of Islamic funds where portfolios of commodities, equities, Islamic leases, and other Islamic products were established. In the case of equities, special screening and filters were developed to comply with Shari ah, and research showed that application of such screens or filters does not impact on the benefit of diversification. The other significant breakthrough came in the form of sukuk (Islamic bonds), where pools of Shari ah-compliant financial instruments are securitized in the form of a fixed-income security. The issuers of sukuk include both sovereign and corporate entities, and the success of sukuk is evident by the high growth this market has enjoyed. Sukuk have also proved to be a bridge between Islamic and conventional markets and have led to the gradual development of capital markets, as discussed in the following section. As demand for infrastructure increased in the region, innovative structures to finance infrastructure projects were introduced. The years 2006 and 2007 proved to be the most active for the project finance market in the Middle East, attracting Western banks and law firms to structure Islamic tranches for major energy, infrastructure, and real estate projects. Another noticeable development is the awareness of Islamic finance in non-muslim countries and acceptance of Islamic products at major financial centers in the West. Leading Western financial intermediaries were engaged in Islamic transactions from the early stages, and the majority of the deals were done discretely; but by the mid- 2000s, competition increased and both Islamic and conventional financial institutions began to position themselves aggressively to capture market share. Islamic finance gained attention in academic circles as well. Many well-regarded academic institutions including

The Development and Progress of Islamic Finance 5 Harvard University (United States), Durham University (United Kingdom), and Loughborough University (United Kingdom) organized seminars and conferences, and offered degree programs and certifications. During this decade, major publishing houses, such as Euromoney, John Wiley, and Edward Elgar, began to commission commercial and academic books on the subject. More recently, there has been another wave of interest in Islamic finance. Similar to the surge of 1970s, the recent surge has been stimulated by increased oil revenues in the Middle East. Whereas during the 1970s interest in Islamic finance was limited to the high-networth class, current growth is the result of demand by much wider groups, including small investors and retail consumers. Several countries where Islamic finance was dormant are experiencing a sudden surge in demand for Shari ah-compliant products. One example is Saudi Arabia, where, for a long time, there was skepticism of Islamic finance and no encouragement for its growth, but it has suddenly seen increasing public pressure to embrace Islamic finance. For example, Saudi Arabia s largest bank, National Commercial Bank, has converted its entire branch network to Shari ah principles. Saudi Arabia has also issued three new licenses for takaful (Islamic insurance) companies. 4 Both Bahrain and Malaysia have taken an active role in the development of Islamic finance and made serious efforts to establish world class financial centers to promote Islamic finance. The government of Malaysia has developed this industry, using a phased approach and this can be used as a roadmap for others who are interested in developing this sector. 5 The Islamic Banking Act was enacted in 1983, which led to the establishment of the first Islamic Bank Bank Islam Malaysia Berhard in the same year Shari ah-compatible investment certificates were introduced to supplement the liquidity needs of the Islamic banking sector. In the second phase, three conventional banks were allowed to open Islamic windows. In January 1994, Bank Negara Malaysia established the Islamic Interbank Money Market to allow Islamic institutions to adjust their portfolios according to their shortterm financing needs. In the third phase, some conventional banks, with a sufficient critical mass of Islamic customers, transitioned to full-fledged Islamic banks in the late 1990s. Finally, the government began to promote development of Islamic capital markets, Islamic insurance businesses, and other supporting institutions. There is no formal or systematic source of statistics on Islamic finance but several estimates are often quoted by different commercial