Chapter 3

The History of Islamic Finance

In This Chapter

arrow Establishing the core concepts of Islamic finance

arrow Developing an alternative to conventional banking

arrow Watching the Islamic banking industry bloom

Islamic finance has been one of the most discussed phenomena in the financial industry in the early 21st century, in part because the global financial crises that rocked investors starting in late 2007 underscored the importance of alternatives to the status quo.

In response to growing demand for alternative investment and banking options among Muslims and non-Muslims alike, many conventional banks, including those in the West, have opened Islamic branches or Islamic windows (which I discuss in Chapter 4). In Muslim countries, full-fledged Islamic financial institutions have emerged to provide viable sharia-compliant financial products ranging from bank accounts and mutual funds to takaful (Islamic insurance) and a form of bonds.

Since the 1970s, when the modern history of the Islamic finance industry began, more than 500 Islamic financial institutions have been established worldwide. (In Chapter 4, I offer details about the current state of the Islamic finance industry as well as projections for future growth.)

remember.epsAlthough the modern system of Islamic finance is young, the true history of Islamic economics dates back about 1,400 years to the time of the Prophet Muhammad (pbuh) and the birth of Islam. (Note: When Muslims refer to the name of a prophet, they follow it with the words peace be upon him or pbuh.)

In this chapter, I divide information into three parts. In the first, I briefly describe key events during the 6th through 12th centuries, when certain core concepts of Islamic law were established. I then point out some developments in the early 20th century that laid the groundwork for what has become the modern Islamic financial industry. I finish with a quick tour of events that have occurred since the 1970s, when the modern industry was born.

Looking Way Back: The Golden Age of Islam

Muslims practiced a version of Islamic finance during the early days of Islam — the period extending from the 6th century through the 12th century. Although the modern Islamic financial industry features products and structures quite different from those used so long ago (largely because the modern industry has to compete with conventional financial instruments), the core concepts are quite similar. In this section, I point out a few of those early concepts and explain how they played out in real-life transactions. I also touch on the decline of this era starting around the 13th century.

remember.epsMy descriptions here are representative of what was occurring during these time periods and are by no means comprehensive. If you choose to read more about the history of Islamic finance, you’ll discover that many concepts and products were developed during these early centuries that resemble those being used in the Islamic finance industry today.

The sixth century: Pioneering venture capital (mudaraba)

In the modern Islamic finance world, mudaraba contracts are used to structure many products, such as bank savings and investment accounts, Islamic bonds (called sukuk, which I discuss in Chapter 13), mutual funds, and Islamic insurance (takaful, which is the focus of the chapters in Part VI). To be clear: Not every Islamic savings account, investment account, bond, or insurance product is based on the mudaraba contract, but you can find products in all these categories that use the mudaraba structure.

remember.epsAs I explain in more detail in later chapters (such as Chapter 10), a mudaraba contract creates a financial partnership in which one party (an investor) gives money to another (a fund manager) for the purpose of investing it in a business or economic activity. The investor puts up all the capital, and the fund manager provides expertise and knowledge to help the activity succeed. Both parties share the profits based on an agreed-upon ratio, but only the investor can lose the initial capital if the activity is a flop.

The basics of mudaraba contracts have existed at least since the sixth century. (In fact, some records from the pre-Islamic period indicate that Arab merchants used similar contracts to support their caravan trade.) History supports this timeline; the Prophet Muhammad (pbuh) was born in the sixth century (some sources say in 570), and records of his life indicate that he participated in mudaraba contracts, acting as the agent for capital that was provided by his wife and others.

Records also indicate that two companions of the Prophet Muhammad (pbuh), Umar and Uthman — who became caliphs (leaders) of Islam after the Prophet’s death — used mudaraba contracts to invest funds belonging to orphans. Merchants (who usually traded between Iraq and the city of Medina, in what is now Saudi Arabia) acted as the fund managers.

The seventh through ninth centuries: Developing commercial instruments

In the centuries immediately following the death of the Prophet Muhammad (pbuh) in 632, Muslim merchants who traded between the Islamic world and East Asia began to use a financial instrument called sakk. (As I explain in Chapter 13, the Arabic word sakk is translated as “certificate” or “written document,” and its plural form is sukuk — the term used for the modern Islamic equivalent of bonds.) The sakk used during the seventh through ninth centuries were certificates of payment obligation that could be exchanged. (Some scholars argue that the sakk concept was later adopted by Europeans to become the modern cheque, or check.)

Here’s how this instrument worked: Merchants didn’t want to carry substantial amounts of currency on a long journey. (The chances of being robbed or losing the money were too great.) Therefore, merchants would give their money to an agent in an economic center such as (in the late eighth century) Baghdad, Iraq. In exchange, the merchant would receive written documents that he would take with him on his journey to, say, China. When he arrived at his destination, he would present the certificates to a representative of the agent and receive the associated currency.

remember.epsThe modern Islamic financial industry uses the concept of the ancient sakk as the basis for Islamic bonds. Modern sukuk are certificates that represent a financial obligation that’s linked directly to the performance of an asset.

According to researchers, governments in major trading cities during this same time period established a banking system called diwan al-jahabidhah that didn’t involve the use of interest. As early as the ninth century, the diwan al-jahabidhah managed deposits and fund transfers (including sakk). These financial centers gave loans to caliphs (leaders of the Islamic empire), high-ranking officers such as ministers, and courthouse officials. They also collected taxes for the government. The people who managed the centers were called jahbadh; they acted as government cashiers, money changers, money collectors, financial clerks, and treasury receivers. Jahbadh were appointed by the governors and responsible for preparing monthly and yearly accounting statements.

The 11th century: Applying the mudaraba concept in Europe

Historians point out that the mudaraba (financial partnership) contract was used in Europe from the 11th century through the 13th century. (Shelomo Dov Goitein, a 20th-century historian, documented the use of mudaraba contracts as far back as the 11th century by studying Cairo Genizaarchives: a vast collection of Jewish manuscripts discovered in a synagogue in Cairo.)

Although earlier Muslim merchants had limited their partnerships to just a few partners, Europeans adapted the mudaraba concept so they could involve many partners in a single contract. In doing so, they were able to channel smaller amounts of capital to support larger enterprises. Even though no sharia restriction exists to limit the number of partners in a mudaraba partnership, the innovation to involve many partners in a single contract seems to have been limited to Europe. No historical evidence demonstrates that Muslim merchants expanded mudaraba contracts to include multiple parties contributing to larger scale projects.

The 13th century: Slowing the progress of Islamic finance

The period between the 6th and 12th centuries is considered the golden age of Islam in the Arabian Peninsula, northern Africa, India, and points beyond. You can think of it as the golden age of the Islamic economy as well. But by the 13th century, that age was in decline for many reasons. Central governments were breaking down, rulers were deviating from Islamic principles, government bureaucracy was thriving, and various religious sects were emerging. As a result, the importance of the Islamic banking system (diwan al-jahabidhah) declined in the 13th century, and many financial centers became mere money changers.

To be clear, Islamic financial instruments were still used in the Islamic empire after the golden age of Islam came to an end and a more secular system took root in Muslim states; the Islamic products were just no longer a central element of financial activity. For example, according to some scholars, multiple mudaraba (financial partnership) contracts were used in Asia in the 15th century to support the shipping industry on the Indian Ocean. Shipping had become very important to traders, but traders couldn’t always afford to buy ships, so a captain and his crew members could enter a mudaraba contract with merchants. The merchants helped the captain and crew purchase a ship, and the captain and crew shared the profits of their trade activities with the merchants.

Historical documents indicate that Islamic contracts such as mudaraba were used as late as the end of the 17th century. But from the 13th century on, the Islamic financial systems that thrived in the golden age of Islam were a shadow of what they had been.

Recognizing Developments in Early 20th-Century Thought

The modern Islamic financial industry didn’t just emerge — primed and ready for commercial success — in the 1970s. Rather, a change in economic perspective had to occur within the Muslim community to prepare for the development of the modern industry. In this section, I describe how that change unfolded in the early 20th century and what Islamic scholars envisioned for the future of the financial system.

Writing the future: Muslim economists in the 1900s

For many centuries, Muslims have written and expressed ideas about economics from the Islamic perspective. For example, from the 8th through the 15th centuries, Muslim economists including Ibn Sina (Avicenna) (980–1037), Al-Ghazali (1058–1111), Nasir al-Din al-Tusi (1201–1274), Ibn Khaldun (1332–1406), and Asaad Davani (b. 1444) shared thoughts about division of labor, resource allocation, international trade, and monetary theory. What distinguished 20th-century Muslim economists from their predecessors? In a word: colonialism.

Responding to Western control

The 15th through the early 20th centuries saw (mostly) European countries colonizing much of the world, including Muslim nations. By the end of the 19th century, Europe controlled 60 to 70 percent of the land in the entire world, and colonization continued for several more decades. Every aspect of society, from education to economics, was colonized. Western economic and banking systems were imposed on colonized lands, so capitalism (and its interest-based transactions) took hold.

remember.epsModern conventional banking can be traced back to 17th-century London. Europe’s Industrial Revolution created a need for banks to support the transfer of funds for investments in manufacturing and trade. As the conventional banking system emerged, so did other conventional financial institutions. When conventional finance was forced upon the Muslim world, Muslims basically had two choices:

check.png Accept it by justifying that the interest-based transactions occurring in modern commercial banking weren’t the same as the interest mentioned in (and forbidden by) the Holy Quran (see Chapter 2).

check.png Reject the conventional institutions and develop an alternative, interest-free system.

The majority of Muslims preferred the second choice because it supported their religious principles. But how could they create such institutions while under Western control?

remember.epsMost 20th-century Muslim economists were thinking, speaking, and writing in direct response to this question. They were compelled to discuss alternatives to conventional Western economics because their religious law prohibited the interest-based transactions being practiced in their countries. Islamic scholars in the early and mid-20th century criticized capitalism at the academic level and tried to research and develop an economic system that didn’t rely on interest. Some of the scholars who took on this challenge were Egypt-based Ahmed Al-Najjar, India-based Mohamed Nejatullah Siddiqi, and Pakistan-based Maulana Syed Abul Ala Maududi.

The Muslim economists wrote in English, Arabic, and Urdu, and they criticized not only the Western economic system but also socialism. They wrote of an alternative Islamic economic system that encouraged social justice and resource allocation in an ethical manner, and some scholars discussed early Islamic contracts and how they helped the Muslim economy during the 6th through 12th centuries.

Taking action in the aftermath of colonialism

Throughout the early decades of the 20th century, but especially after World War II, colonialism began to lose its grip; nations that had previously been colonized became independent countries able to manage their own affairs. With this climate of independence came a newfound ability for Muslim nations to move away from Western systems and toward financial institutions that represented the values promoted by Islam.

Therefore, starting in about 1960, the scholarly discussion about how to revolutionize the banking system began to move into more practical applications. Muslim economists were joined by investors and bankers who developed a banking model based on Islamic contracts (see Chapter 6).

remember.epsAn important point to keep in mind: Muslim states at that time showed relatively little interest in developing Islamic banking models, so the banking system reforms occurred because of private institution initiatives, not government leadership.

Developing basic financial models and products

The very basic financial models proposed by Muslim scholars in the 1950s and 1960s were based on early Islamic mudaraba contracts (see “The sixth century: Pioneering venture capital [mudaraba]” earlier in the chapter). Very simply, the idea was that an Islamic bank would act as a financial intermediary by borrowing money from the depositor and using the funds as instruments for investment. The bank and the depositors would share the risks and the profits from such activities.

The earliest Islamic banks (which I cover in the following section) did use this basic model but later added other services so they could better compete with conventional banks. For example, conventional banking was attractive because it offered protected products such as fixed-term deposits. Therefore, Islamic scholars explored contracts that allowed Islamic banks to offer competitive, protected investment products.

In the 1970s, they came up with murabaha (cost plus profit) contracts, which enable the sale of goods or assets for an agreed-upon cost and profit margin. The murabaha contract is the basis for crucial Islamic bank instruments, including mortgages. Additional Islamic financial products based on various contract models emerged later in the 1970s. These offerings, some based on salam (advanced payment) and istisna (deferred delivery) contracts, further opened the Islamic banking market. And in the 1980s, more contracts, including ijara (lease or rental), were brought into play to develop even more banking products. (Check out Chapter 6 for more on these Islamic contracts.)

Getting the ball rolling: The Mit Ghamr Savings Bank and Tabung Haji

In the first half of the 20th century, several efforts were made in different regions in the Muslim world (including Pakistan, India, and Malaysia) to establish a functional interest-free banking system. However, the two initiatives I describe here are considered the real forerunners to the modern Islamic banking system.

Mit Ghamr

The Mit Ghamr Savings Bank, established in Egypt in 1963, is considered the first modern Islamic bank on record. The Mit Ghamr district was rural, and its population was quite religious and didn’t want to participate in interest-based banking institutions. The bank incorporated Islamic values with the operating structure of a German savings bank. It offered savings accounts, loan accounts, and zakat accounts that enabled direct investment with community services. (As I explain in Chapter 2, zakat is a giving of alms that’s one of the Five Pillars, or obligations, of Islam.)

In its first year of operation, the bank had 17,560 depositors. By its third year, the number of depositors had grown to 251,152. In mid-1967, for political reasons, the bank was taken over by the Central Bank of Egypt and the National Bank of Egypt as the country moved toward a more socialist structure. This was a setback for the first modern model Islamic bank, but Mit Ghamr undoubtedly helped the Islamic banking concept to develop further.

Pilgrims Saving Corporation/Lembaga Tabung Haji

In the same year that Mit Ghamr Savings Bank was established in Egypt (1963), the Pilgrims Saving Corporation of Malaysia began to incorporate basic Islamic banking concepts. Though not a bank, the corporation’s use of modern Islamic banking principles in its savings project was significant.

As I note in Chapter 2, performing Hajj (pilgrimage) in the holy city of Mecca is one of the five obligations of Muslims. Muslims in Malaysia weren’t happy about needing to save money for Hajj by depositing funds into non-sharia-compliant, interest-based banking institutions. To satisfy the need for a savings option that supported Islamic law, the Pilgrims Saving Corporation developed a savings plan that provided welfare services and protection to the pilgrims and a way to invest in sharia-compliant ways.

Basically, the savings project operated as a bank, collecting deposits from its branches and through designated agents such as local post offices. The project started with 1,281 depositors in 1963 and grew steadily. In 1969, Pilgrims Saving Corporation was incorporated as the Pilgrims Management and Fund Board, and in 1985, the institution’s 65 branches across Malaysia had an estimated combined 867,220 depositors.

In the mid-1990s, the Pilgrims Management and Fund Board was renamed Lembaga Tabung Haji (TH). To this day, the core activities of TH are accepting deposits and providing investment and Hajj management services for Malaysian Muslim pilgrims. You can find out more at www.tabunghaji.gov.my/th/TH/English/coreactivities-investment.html.

Moving into the Modern Industry

Although the Mit Ghamr Savings Bank and Pilgrims Saving Corporation of Malaysia (see the preceding sections) were crucial forerunners to modern Islamic finance, the opening of several Islamic commercial banks in the 1970s truly signaled the emergence of a new global industry. In this section, I explain how and when the Islamic banking industry got its footing, and I touch on subsequent developments that helped shape the industry into its current form.

Establishing the Islamic Development Bank

An important milestone in the history of the Islamic finance industry was the establishment of the Islamic Development Bank (IDB) based in Jeddah, Saudi Arabia. The Conference of Finance Ministers of Muslim Countries issued a declaration in 1973 that such a bank would be established, and it opened for business in 1975. The establishment of the IDB gave the Islamic finance industry its first international presence and paved the way for similar banks to open in other nations.

According to the IDB website (www.isdb.org), the bank’s purpose is

[T]o foster the economic development and social progress of member countries and Muslim communities individually as well as jointly in accordance with the principles of Sharia’a i.e., Islamic Law.

The IDB is still going strong. (As I write these words, I’m just 500 meters away from this towering building.) Currently, 56 countries are IDB members, and its major shareholders are Saudi Arabia, Libya, Iran, Nigeria, Qatar, Egypt, Turkey, United Arab Emirates, and Kuwait.

Opening other Islamic banks

Islamic banking was the first sector of the Islamic finance industry to develop (and, as I show in Chapter 4, it still has a starring role in the industry as a whole). Even before the Islamic Development Bank opened its doors in 1975, a presidential decree established the Nasser Social Bank (NSB) in Egypt in 1972 with the objective of providing social assistance. The bank offered many loans on a profit-sharing basis and assisted students with interest-free loans. NSB is still in operation. Because of its nature as a socialized bank, it can’t be considered a true commercial bank, but it certainly was the first Islamic bank developed at the state level.

In the same time period, oil exploration and development in the Persian Gulf region created many wealthy individuals and governments who wanted to make investments in a sharia-compliant manner. To accommodate this demand, businesspeople initiated the Dubai Islamic Bank, a true Islamic commercial bank, in United Arab Emirates in 1975. Three other commercial banks opened in 1977: Faisal Islamic Bank of Egypt, Faisal Islamic Bank of Sudan, and Kuwait Finance House.

In 1978, the Jordan Islamic Bank joined this collection of Islamic banks, and 1979 saw the establishment of the Bahrain Islamic Bank. Although many additional Islamic banks joined the scene during the 1980s and 1990s, I’ll point out just one additional major player in Islamic finance: Bank Islam Malaysia Berhad, which emerged in Malaysia in 1983.

remember.epsThe growth of the Islamic commercial banking industry jumped substantially when, in 1985, the Islamic Fiqh Academy (which promotes the advanced study of Islam) met in Jeddah, Saudi Arabia, and issued a formal request for state-level support for the development of Islamic banks. The academy also issued a statement that restricted Muslims’ use of conventional banks in areas where Islamic banks exist. For statistics on the current Islamic banking industry, be sure to check out Chapter 4.

Creating additional industry sectors

Today, the commercial Islamic finance industry isn’t populated solely by banks. Although banking came first, it spurred the development of related fields, such as the Islamic capital markets (including the sukuk or Islamic bond industry) and the takaful (Islamic insurance) industry.

Islamic capital markets feature Islamic asset-based securities (both equity funds and sukuk). For the backstory on how these capital markets developed, turn to the opening pages of Chapter 11 and final pages of Chapter 13.

The takaful (and retakaful, or reinsurance) industry emerged for the same reasons Islamic banking developed: because Islamic scholars criticized conventional insurance (like conventional banking) for involving elements that violate sharia. And just as scholarly efforts paved the way for the cultivation of Islamic banks (see the earlier section “Writing the future: Muslim economists in the 1900s”), scholars researched and developed models for Islamic contracts based on principles of mutual assistance, mutual responsibility, and shared risk that would become the foundation for an Islamic insurance industry. The first Islamic insurance company was established in Sudan in 1979. Want to find out more? Turn to the final pages of Chapter 18 for a timeline of takaful-related developments as well as some thoughts about the industry’s growth potential.

Setting accounting and auditing standards with the AAOIFI

Islamic financial institutions differ significantly from their conventional counterparts, so their accounting procedures and auditing processes differ, too. But within the Islamic industry, financial institutions must use universally applied standards or else risk creating confusion and losing investor confidence.

For that reason, the establishment of the independent, international Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in 1990 was another milestone in the history of Islamic finance. The development of accounting and auditing standards for the Islamic financial industry eased interaction and communication among Islamic financial institutions, which opened doors to new collaboration opportunities. The standards also set the bar regarding the governance of Islamic financial institutions, their ethical practices, and sharia compliance.

remember.epsThe role of the AAOIFI (www.aaoifi.com) in the Islamic finance industry is similar to that of the Financial Accounting Standards Board, which establishes generally accepted accounting principles (GAAP) for conventional finance in the United States. (In Chapter 14, I explain how AAOIFI standards influence financial reporting in the Islamic finance industry.)

The AAOIFI started in Algiers, Algeria, with an agreement among participating Islamic financial instructions. In 1991, the AAOIFI was registered in Bahrain. Approximately 200 institutional members (including central banks and other financial institutions) representing 45 countries support the organization as of this writing. To date, institutions in Bahrain, Dubai, Jordan, Lebanon, Qatar, Sudan, and Syria have adopted AAOIFI standards. In addition, these standards have influenced financial guidelines in countries such as Australia, Malaysia, Pakistan, and South Africa.

Using Islamic banking concepts in the West

International recognition of the Islamic finance industry increased when prominent Western banks began to offer Islamic banking services. Citibank was the first Western bank to do so; in 1996, it established the Citi Islamic Investment Bank in Bahrain. Other Western banks followed suit, including HSBC (which opened HSBC Amanah) and Standard Chartered (which opened Standard Chartered Saadiq). In addition, some Western banks took the route of opening Islamic windows: separate, sharia-compliant units operating inside the conventional banks.

The first Islamic commercial bank established outside the Muslim world was the Islamic Bank of Britain, which opened in 2004. Since the 1990s, the United Kingdom had been home to multiple Islamic finance operations. At the beginning of the 21st century, the British government embraced the importance of the Islamic finance system and announced its intention to make the United Kingdom the hub of Islamic finance in Europe. The Islamic Bank of Britain was a crucial step toward this goal.

Introducing international Islamic indexes

In 1999, the Dow Jones Index introduced the Dow Jones Islamic Market Index (DJIMI), which helped the Islamic finance industry gain international recognition and trust. Associating Islamic funds with one of the leading capital market financial institutions made potential investors (both Muslim and non-Muslim) more comfortable with this new kind of investment product.

remember.epsBecause Islamic investment funds must screen equities for sharia compliance (a detailed process that I outline in Chapter 12), indexes such as the DJIMI (which conduct their own screening) serve a special purpose. For Islamic equity fund managers, these indexes may reduce the need for independent confirmation of sharia compliance, which means fewer hours (and dollars) devoted to screening research. In other words, if the Islamic scholars governing an equity fund agree in principle with the screening procedures employed by the indexer, the fund may use that indexer’s research when making decisions about which companies’ stocks to include in the fund mix. I explain the importance of Islamic indexes in Chapter 12, where I also profile the Dow Jones Islamic indexes and some other key indexes.

Setting up the Islamic Financial Services Board

The Islamic Financial Services Board (IFSB) started in 2002 in Kuala Lumpur, Malaysia, as an international standard-setting body for Islamic financial institutions. The IFSB promotes transparency and prudence by adopting standards according to sharia principles.

remember.epsThe IFSB wasn’t designed to compete with the AAOIFI. Although the AAOIFI sets best practices for handling the financial reporting requirements of Islamic financial institutions, IFSB standards are mainly concerned with the identification, management, and disclosure of risk related to Islamic financial products. The agencies are similar in their goals of encouraging transparency and good governance within Islamic financial institutions.

The IFSB coordinates its efforts with the Bank for International Settlements (BIS), an international financial organization based in Geneva, Switzerland, that serves as the central bank of banks.

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