back to home pageregister for updatesstudy centre

The following article was published in the Banker Middle East September 2003 edition.

Several years ago, a teacher of mine was invited to Kuwait to provide a consulting service of sorts to the executive committee of a large Islamic financial institution. On an early fact-finding tour he encountered the institution's senior Shari`ah scholar, an elderly man who was partly deaf, paralysed on one side, and who had little experience of modern banking and finance. The local bankers portrayed this man as a venerated Shari`ah scholar, but my teacher immediately recognised him as a rubber stamper - shamefully empowered by his employers when he should have been enjoying a quiet retirement.

To understand how this situation came to pass, we need only delve into the recent past. During the late 1970s and early 1980s, a small number of international Islamic banking and finance organisations came to prominence. Understandably, they were characterised by a narrow product range and in some cases a lack of credibility. For some of these companies, commercial survival came in the form of occasional equity injections from a kindly patron and the incentive to improve business efficiency was therefore reduced. Yet it was argued that faults should be tolerated and the financial lifelines maintained in order to shield the new-born industry from a world of harsh competition. The conventional banking system could not be changed overnight, and the road of transition had to be travelled patiently.

As it turns out, patience has been of little use on this particular journey for the simple reason that we have taken the wrong road to begin with. We have arrived at a financial wonderland in which there exists an Islamic equivalent to almost all the major products of the interest-based sector, with quantitative and qualitative features that are frequently indistinguishable from them. Some have explained this situation by arguing that Islamic banking and finance can only function properly within the context of economic and social policies that are themselves Islamic. They propose that governments in the Islamic world should encourage such institutions as Waqf (endowment), mutual associations, and Zakat (the wealth levy), or at least remove the encouragements that presently exist for proscribed activities (the tax deductibility of interest for example). In my view, the most urgent of these tasks is that the Muslim world reforms its monetary system. An Islamic economy cannot be built upon un-Islamic money, and to know why this is so requires a brief digression into monetary history.

The European goldsmith bankers of the seventeenth century are widely seen as the forefathers of modern banking. These men took deposits of gold coins from customers and issued paper receipts in return. Each receipt promised repayment of the underlying gold upon presentation at the bank, and the goldsmith would often charge a fee for his service of safe-keeping. In due course, the public began to trust paper receipts to the extent that they would use them in payment for goods and services among one another. The goldsmiths' paper receipts had, for all practical purposes, become "money". This development was the key to the goldsmiths' future wealth. They gradually turned to society not as safe-keepers of coins but as lenders of money, and when borrowers came to take their loans they would be given not gold coins but newly printed paper. The goldsmith had obtained the ability to manufacture money out of nothing, and charge society interest for the privilege of borrowing it. Loans would be secured against property or other assets of the borrower; collateral that could be seized and liquidated if the borrower fell into trouble. The financing of poorer members of society therefore became the exception from the earliest days of banking practice.

The reason for the lack of profit-sharing in commercial banking emerges when we imagine an economy in which the banking system creates all of the money supply. Here, if a total of 400 units of paper money have been advanced to borrowers on a profit sharing basis, the maximum that all borrowers will be able to repay is 400. No opportunity exists under these arrangements for the banking system as a whole to make a profit. By charging 10% interest on the other hand, the banks may stipulate that 440 is to be repaid in one year's time, thus making the system commercially viable. Such a stipulation leads directly to what is probably the most disturbing feature of the modern monetary system. If the repayment amount at the end of year one is 440, but there is still only 400 of money in existence, where will the extra 40 come from? The answer is that it has to be created, either under the authority of the state, or by the banking system. Given that most of the modern money supply is created by the banking system, it becomes immediately obvious why repayment of yesterday's debt tends to leave society in even deeper debt today. If the commercial banks create sufficient money to repay yesterday's debt we enjoy a healthy or inflationary economy. If they don't, recession or deflation will eventually arise. The former scenario is adopted as a policy target by almost all modern governments, but leads inevitably to an increase in both debt and money supply in the long term.

At a time when education, health and housing services are suffering financial stress in many countries of the world, an almost embarrassing bias in resource allocation towards the banking sector is encouraged by the interest-based monetary system. In August of 2002, Fortune magazine ranked the top 500 global corporations of 2001 by revenue. Taking one example, 33 of those companies were in the UK, and among them were six banking organisations.These UK banks made $20.62 billion in profit during the year. All of the other UK corporations on the list, when added together, made a loss of $0.97 billion. 37 companies on the Fortune 500 were headquartered in France. Here, the five banks made $7.99 billion profit, and the remaining 32 corporations when added together made a loss of $2.41 billion.

Today, Islamic commercial banks indulge in money creation just as much as conventional commercial banks. This single sin is sufficient on its own to conclude that Islamic banking isn't Islamic but, as the earlier example demonstrates, it is a sin that requires interest-based lending in order to make it profitable. Though Islamic bankers may not realise it, the business model of interest-based banking is forced upon them and it is putting true profit sharing beyond their reach. The crop of 'Islamic' mortgages that are now appearing in the UK are a clear manifestation of the fixed rate mentality that now predominates in Islamic banking. In not one of those mortgages does the bank contract to take capital risk. Even in the so-called Ijara mortgage, in which the bank is held to own the property and rent it to the client, arrangements have been put in place to pass capital risk to the lessee. Thus, if the client is unable to keep up with rental payments and the property is repossessed by the bank, the bank has recourse to the client if it realises a capital loss when selling the property on the open market.

One Shari`ah argument used to justify this recourse is that the client has promised to buy the property from the bank at the end of the lease period, and must therefore bear all of the capital risk should he place the bank at a monetary disadvantage by failing to fulfil that promise. This implies that a promise to purchase (given by the client to the bank) can be used to produce the same commercial risks as an actual purchase. No one should underestimate the implication of this legal position. The doors that it opens in a world of sophisticated arbitrageurs will almost certainly lead to the synthesis of many transactions that are presently prohibited by consensus of the Islamic scholars [1].

The splitting of conventional interest-bearing products into components that can be replaced with 'Islamic' counterparts is an essential skill which theIslamic bankers have perfected in their search for fixed rate returns. At best the combination of such components into one transaction weakens the integrity of the contractual principles involved, and at worst represents a blatant technique for bypassing the Islamic prohibition of usury. For example, while it is unanimously accepted that the giving of gifts, the making of promises and the advancing of interest-free loans are all acceptable in Islam, the combination of these three contracts into one transaction easily produces an interest-bearing loan. Here, Person B promises to give a gift of 10 to Person A if Person A makes an interest-free loan of 100 to Person B. In their effort to gain approval for such techniques, unscrupulous Islamic bankers may succumb to the temptation of asking questions that elicit the 'correct' answers from their Shari`ah scholars. Thus the modern scholar must shift some of his focus away from the detailed level of contractual principle and look to the wider impact of what the banker is trying to achieve. If asked whether it is permitted to pull a string, the scholar must find out whether the string is attached to a gun before giving his judgement. Such efforts require a high degree of both Shari`ah and technical knowledge. There is a big difference between defining interest (a Shari`ah matter) and discovering whether or not a particular Islamic banking contract allows the bank to practice interest (a technical issue). We should not expect Shari`ah scholars to fulfil both of these roles.

In time, a fresh start will be made in Islamic banking practice. An entirely new methodology will be adopted, one based upon a surplus of money, not upon the artificial shortage that is maintained by the modern commercial banking system. Debt will no longer be the pre-requisite to every major act of spending or investment. The time value of money will no longer dominate our view of how to manage the earth's resources, for the money with which we measure value will no longer bear interest as a condition of its creation. I believe that this change will occur either by force of reason, or by force of circumstance as the world grows weary of perpetual indebtedness. The society that witnesses the change to interest-free money will recognise the new system as a pillar of true freedom. It will enjoy the release into productive employment of substantial human and physical resources, those that are presently engaged in the value-subtractive processes of the modern financial economy.

There will of course be much resistance to such a change, and the lobby that presently benefits from the interest-based monetary system will spend heavily in order to protect its future. The payment of money by banking organisations to Shari`ah scholars must be scrutinised for precisely this reason. If a bank asks 100 scholars whether its latest product is Halal, and 98 of them say "no", should we be suspicious if the bank gives a consulting contract to the two who said "yes"? Would some of the 98 become a little more flexible next time round, if they saw the other two earning large incomes from their work?

These are not the questions of a cynic. They are the questions of one who has read a little history and knows the simplest facts of human nature. A scholar should not have his integrity questioned simply for being in a minority, of course, for his views may be honestly held. What matters is that by promoting those scholars who approve of the products it wants to launch, an Islamic banking department is in the fortunate position of being able to choose the rules of the game for itself while telling everybody else that it doesn't make up those rules.

In this battle between truth and falsehood, central banks and supranational institutions cannot lead the necessary reforms because they have always been creatures of the system itself. Over many decades they have proven themselves unwilling to delve into the essential issues of money creation, despite the volumes of research that they undertake on every other nuance of monetary policy. The real tragedy is that the Islamic banking movement, which could have exposed the fraud of modern money creation, has become a laughable effort to Islamise that fraud. The Prophet Muhammad, PBUH, said that "Even though usury be much it leads in the end to utter poverty" [2]. Our Creator does not want His creation to forget that. But we are slipping, slowly, into a world that thinks it knows better.

[1] Payoffs that replicate an exchange of both sale countervalues at a forward date are an example of such synthesis
[2] Hadith Al Tirmidhi, narrated by Abdullah Ibn Mas'ud. Ibn Majah, Bayhaqi transmitted it in Shu'ab Al Iman and also transmitted by Ahmad.

Editorial, 2003