Limits and Dangers of Shari‘a Arbitrage (2024)

Limits and Dangers of Shari‘a Arbitrage

Mahmoud A.El-Gamal<![if !supportFootnotes]>[1]<![endif]>

INTRODUCTION: THE MARKET FOR SHARI‘A

ARBITRAGE

“Islamic banking and other Islamic financial institutions arerapidly approaching a crossroads,” Sheikh Ahmad bin Mohammad Al Khalifa toldthe opening session of a conference on Islamic Banking and Finance in Manama[in late February, 2004]. “Islamic banks have grown primarily by providingservices to a captive market, people who will only deal with a financialinstitution that strictly adheres to Islamic principles.”<![if !supportFootnotes]>[2]<![endif]>

Islamic finance is fundamentally a prohibition-drivenindustry. Its beginnings can be traced to mid-twentieth-century literature onIslamic economics, which emphasized the presumed equity and stabilityconsequences of adhering to Islamic legal and economic principles. However, thenature of this industry is best exemplified in the titles of some of theearliest and most influential writings on Islamic banking, for instance:

<![if !supportLists]>·<![endif]>Baqir al-Sadr, The Riba-Based Bank in Islam: A treatise onreplacement of Riba, and a study of the various activities of banks in light ofIslamic Jurisprudence (fiqh).<![if !supportFootnotes]>[3]<![endif]>

<![if !supportLists]>·<![endif]>Sami Humud, Evolution of Banking Operations in a Manner that Agrees with IslamicLaw (Shari`a).<![if !supportFootnotes]>[4]<![endif]>

Most other writings on the subject started from afundamental assumption that banking interest is the forbidden riba,and proceeded to propose means of operating “banks without interest.”<![if !supportFootnotes]>[5]<![endif]>Despite repeated questions regarding distinctions between interest and riba, jurists affiliated with orsupportive of the Islamic financial industry have maintained that there is anirrefutable consensus as to what is forbidden and how to avoid it.<![if !supportFootnotes]>[6]<![endif]>

While most Islamic economics writings suggestedthe evolution of a distinctive financial system under Islamic law,<![if !supportFootnotes]>[7]<![endif]>the titles of the two books by al-Sadr and Humud were better predictors of theIslamic finance industry to ensue. Both titles suggested that the startingpoint for Islamic finance is conventional financial practice. The authors reasonedthat to the extent that standard banking operations were based on riba,that riba should be removed from thesystem. Otherwise, the goal and agenda was simple: find the closestapproximation to conventional financial practice that can be deemed to avoidforbidden elements.<![if !supportFootnotes]>[8]<![endif]>Often, this approximation is form-based rather than substance-based.

Ever since the introduction of Western-stylefinance to the Islamic world in the late nineteenth century, large numbers ofMuslims have felt uneasy about the new transactions, which they either believedor suspected to be forbidden under classical Islamic jurisprudence. Inresponse, the twentieth century witnessed a vast literature on Islamiceconomics and finance starting in mid-century, followed by the evolution of anIslamic finance industry later in the century. Many early practitioners ofIslamic finance lamented the large gap between Islamic economic and financerhetoric, which focused on the substance and spirit of Islamic jurisprudence,and the practice of Islamic finance, which focused on its medieval forms.<![if !supportFootnotes]>[9]<![endif]> However, the captive market, of which thegovernor of the BMAspoke in the opening quotation of thissection, had already been established as follows: (1) conventional financialpractice is certainly forbidden, (2) at least in theory, an Islamic financialalternative is available, and (3) even if the industry seems excessively toadhere to forms of Islamic jurisprudence rather than substance, it is nowimpermissible to use conventional finance based on the law of necessity.<![if !supportFootnotes]>[10]<![endif]>

THE NATURE OF SHARI‘A ARBITRAGE

Arbitrage opportunities occur when discrepancies existbetween prices of the same product in different markets. Hence, the arbitrageurcan buy the product in the market within whichit is sold cheaply and sell it in the other, provided that the price differenceexceeds transaction costs. A related type of arbitrage opportunity is calledregulatory arbitrage, wherein the arbitrageur attempts to generate a profitbased on certain financial practices being disallowed (at any price) within thelegal system of one country or region (say, country A) but allowed in others(including, say, country B). In this case, financial professionals and lawyerscooperate to manufacture an analog of the financial product for country A.Often this is accomplished using the product in country B as a building block,and heavily relying on offshore special purpose entities to structuretransactions in a manner acceptable to country A. This type of regulatoryarbitrage played a pivotal role in giving rise to and sustaining thesecuritizationindustry in the 1980s and 1990s.

Shari‘aarbitrageis a particular form of regulatory arbitrage,wherein a captive market of pious Muslims voluntarily chooses not to usecertain financial products. Lawyers, in partnership with bankers and jurists,strive to provide them a reengineered version of those products. Conventionalfinancial productsare usedas building blocks for the reengineered Islamic productsapproved by jurists. For instance, a specialpurpose vehiclemay be created by a conventional bank. The SPVmay receive a credit line from the mother bank(whether or not it is a wholly owned subsidiary thereof), but deal with its“Islamic finance” customers in terms of reengineered nominate contracts (e.g.,under the name of murabaha-financing).Thus, the Islamic customer is separated from the interest-bearing loan by theSPV and juristic focus on the contract in which the customer is a party. Thisapproach will become obvious in light of the example of HSBC’s auto-financing shari‘a boardpronouncements cited in the following section.

Murabaha(cost-plus) financing is one of the oldest andmost commonly used means of Islamic finance. The full technical name of thiscontract is “a credit sale with mark-up to one who ordered the initialpurchase” (al-murabaha lil-amirb-il-shira’ ma‘a bay‘bi-thaman ‘ajil). Sami Humudenvisioned one of the earliest manifestationsof this transaction as a substitute for bank loans in his above-cited book(which was based on his Ph.D. dissertation). Over the years, a number ofadditional alterations have been added to make the contract as close to aninterest-based loan as possible. For instance, a customer’s promise to buy theproperty from the bank at the mark-up credit price was made binding by jurists,once the bank buys the property to finance its ultimate purchase by thecustomer.<![if !supportFootnotes]>[11]<![endif]>Further pronouncements allowed the bank to appoint the customer as its buyingagent – to negotiate the price and purchase the property on its behalf, andthen as its selling agent – to sell the property to himself:

If in cases of genuine need, the financier appoints the clienthis agent to purchase the commodity on his behalf, his different capacities(i.e. as agent and as ultimate purchaser) should be clearly distinguished. Asan agent, he is a trustee. . . .

After he purchases the commodity in his capacity as agent, hemust inform the financier that, in fulfilling his obligation as his agent, hehas taken delivery of the purchased commodity and now he extends his offer topurchase it from him. When, in response to this offer, the financier conveyshis acceptance to this offer, the sale will be deemed to be complete, and therisk of the property will be passed on to the client as purchaser. At this pointhe will become a debtor. . . . <![if !supportFootnotes]>[12]<![endif]>

In the eyes of M. Taqi Usmani, a highly respected juristwho is frequently retained by Islamic financial institutions worldwide, theformalistic invocation of the buying agent’s possessions of trust(amana), which keeps liability (daman) with the bank until the final sale,justifies the distinction between the bank’s legitimate return on murabahafinancing and the forbidden interest the bankwould earn on a conventional secured lending operation. This distinctionbetween possessions of trust and guarantee is indeed central to the formativeclassical jurisprudence. However, that classical distinction becomes obsoletein light of the contemporary conventional financial practice of securedlending, wherein the bank puts a lien on the financed property. Indeed, whenthe Office of the Comptroller of the Currency was asked to write an approvingletter of understanding regarding murabahafinancing in the United States, it reasoned as follows:

[OCC #867, 1999:] . . . lending takes many forms . . . murabahafinancing proposals are functionally equivalentto, or a logical outgrowth of secured real estate lending and inventory andequipment financing, activities that are part of the business of banking.<![if !supportFootnotes]>[13]<![endif]>

Thus, the task of shari‘a arbitrageis accomplished: a conventional bank (in thiscase the United Bank of Kuwait, which later stopped itsManzil USA program but continued its similar Manzil UK program), can use itsregular funds to finance the purchase of a home in an “Islamic” manner, throughmurabaha(or ijara) financing.Regulators are successfully convinced that this is an acceptable form ofsecured lending, while customers are convinced that it is done Islamically.Indeed, the shari‘a boards of various Islamic homefinance providers in the United States explicitly warn customers that due tostate and federal regulations, their mortgage documents may include the terms“mortgage,” “loan,” “interest,” “borrower,” “note,” etc. However, they areassured that such language is used only because regulators require it.Moreover, customers are told that they will receive form 1098 (mortgageinterest statement), which they can use to deduct the “markup” or “rent” componentthat was listed as interest. As a consequence, most potential customers ignorethe industry and – depending on their initial preference and conviction –either continue to use conventional finance, or continue to avoid all forms oforganized finance (of which they see Islamic finance as a thinly disguisedvariety). However, two groups of clients allow the industry to continue its modus operandi: (1) a critical mass ofcaptive clients who attach sacred authority to the pronouncements of Islamicbanks’ shari‘a boards, and (2) a group of clients who participate in themarket hoping that it will eventually outgrow its current (shari‘a arbitrage) mode of operation.

MECHANICS OF SHARI‘A ARBITRAGE

Shari‘aarbitragerelies on two main tools to achieve itsobjective: (1) dual characterization of a financial dealing, one for juristsand one for regulators, as discussed in the previous section, and (2) theaddition of one or more degrees of separation between Islamic finance clientsand the underlying conventional financial products. The latter is oftenachieved by inspecting each part of a complex transaction in isolation, ratherthan studying the entire transaction. The one degree of separation principlewas – perhaps unwittingly – best described by HSBCwhen it launched its home finance program inthe UAE. The following are excerptsfrom the Frequently Asked Questions (FAQ) circular that was published in theIslamic finance section of www.zawya.com on February 3, 2003:

Question: How can aconventional (interest-based) bank offer a shari‘acompliant financial service?

Answer: Islamic law (shari‘a) does not require that theseller of a product be Muslim, or that its other services be shari‘a compliant as well. This is theconsidered opinion of our Shari‘aSupervisory Committee. Conventional banks charge and pay interest, andthe HSBCGroup, ofwhich we are a part, is a conventional bank. But we are also a customer-driveninstitution, and we provide shari‘acompliant products to serve a genuine financial need among Muslims. Of course,our shari‘a compliant products areavailable for Muslims and non-Muslims alike.

Question: Since HSBCis an interest-based bank, what would be anacceptable source of funding for HSBC MEFCO? Are you going to mix conventionaland shari‘a compliant funds?

Answer: The shari‘a (Islamic law) does not requirethat the seller of a product be Muslim or that his/her own income be halal (permitted). We will therefore,initially use funds from conventional sources to finance Amana Vehicle Finance.Muslims may be understandably concerned about mixing conventional funds with shari‘a compliant funds. It isimportant, however, to understand where the two can and cannot meet accordingto Islamic law (shari‘a). To open anaccount or invest money, funds must be segregated from interest-based funds sothat returns are halal (permitted).To buy something or obtain financing, however, funds do not have to be from a halal source. The relationship with theseller must be in line with the shari‘a—theseller’s relationship with other parties, however, is not the purchaser’sresponsibility. This is the opinion of HSBC’s Shari‘a Supervisory Committee.

Question: How do youcalculate the price of Amana Vehicle Finance? Are the payments similar to aconventional vehicle loan? If so, is this acceptable under the shari‘a (Islamic law)?

Answer: HSBCMEFCO determines the rates on Amana VehicleFinance using a fixed payment scheme that is competitive with conventionalvehicle loans. According to the shari‘a,the profit rate in a Murabahatransaction can be set at any value agreedbetween the buyer and seller. Also under Murabahafinancing, HSBC MEFCO is acting as a vehicle seller and not a moneylender.There is no particular reason why a vehicle financed Islamically should be anymore or less expensive than a vehicle financed using a conventional vehicleloan. The criterion for acceptability by the shari‘a is that the transaction be compliant with shari‘a, regardless of the price of thegood or how that price is determined.

The idea of making an impermissible transactionpermissible through degrees of separation is not new. In fact, it underliesmany of the juristic stratagems (hiyal) for circumventing prohibitions.Consider for instance the progression of juristic opinions on various lendingpractices:

• A lends B $100 today, with B to repay $105 in one year. All jurists are unanimous that this practice is a form of the forbidden riba.

• B sells a stapler to A, for the cash price of $100. A turns around and sells the stapler to B for a credit price of $105 payable in one year. This practice is called “same item sale-resale” (bay‘al-‘ina). Some jurists (e.g., the Hanbalis) forbade it based on prophetic traditions, while others (e.g., the Malikis) forbade it based on the principle of “prevention of stratagems to achieve illegal ends through legal means” (sadd al-dhara‘i). However, some others (e.g., the Hanafi jurist Abu Yusuf and al-Shafi‘i) allowed the contract, ruling on each of the two separate valid sales separately. Provided that the second sale is not stipulated in the first, they reasoned, one cannot forbid the practice based on speculation about the contracting parties’ unobservable intentions.<![if !supportFootnotes]>[14]<![endif]>

• C sells a stapler to A, for the cash price of $100. A sells the stapler to B for the credit price of $105 payable in one year. B sells the stapler to C for the cash price of $100. This practice is called tawarruq(literally, monetization – of the stapler in this example). Abu Hanifacontemplated this contract as a variation on the previous one, with a third party serving as an intermediary to avoid the prohibition (muhallil). While he forbade the simple ‘ina (without a third party), he was more accommodative of tawarruq. Most jurists considered tawarruq invalid, defective, or reprehensible. However, there were two reports on ibn Hanbal’s opinion on this contract,<![if !supportFootnotes]>[15]<![endif]> thus allowing a faction of the Hanbalischool to approve the contract, which is quickly replacing murabahaas the favorite mode of financing in GCC countries.

• C sells a stapler to A, for the cash price of $100. A sells the stapler to B for the credit price of $105 payable in one year. B sells the stapler to D for the cash price of $100. D sells the stapler to C for the cash price of $100. Now, we have added two intermediary entities (C and D) between lender (A, in all examples) and borrower (B). Contracts with larger numbers of intermediaries do not have explicit names in classical jurisprudence, and were not discussed in their writings.

It is easy to see how we can keep adding degreesof separation until eventually it would become impossible for any jurists,however strict, to prohibit the practice as merely a trick to subvert thesubstance of Islamic law (avoidance of interest-bearing loans from A to B)while adhering to its medieval juristic forms. When bankers wish to practicetheir standard lending practices, but cater to the captive clientele of Islamicfinance, they need at least one degree of separation. Since multiple degrees ofseparation typically add transactional costs (legal fees, sales taxes, etc.),bankers prefer to keep the number of degrees of separation to a bare minimum.Often, one degree of separation is sufficient.

In this regard, it is worthwhile to examine thedegrees of separation most recently utilized in Islamic finance:

• For issuances of bond-alternatives(usually called sukuk, which is an Arabic word for bonds or certificates, albeit different from the more conventional term for bonds, sanadat), governments and corporations have recently opted for a variation on ‘ina, which also incorporates lease-financing in a manner very reminiscent of the decade-old leveraged buy-out methodologies of conventional finance:

• A special purpose vehicle(SPV) is created for the sole purpose of issuing the sukuk.
• SVP sells certificates/bonds (sukuk) and receives proceeds.
• SPVuses the proceeds to buy land, equipment, etc., from the government or a corporation wishing to issue bond-alternatives.
• SPVleases land, equipment, etc., back to the government or corporation, collecting interest-only or principal plus interest in the form of rent, which is passed through to sukuk holders.
• At lease-end, SPVsells the land, equipment, etc., back to the government (or as in one variation for Qatar sukuk, gives it back as gift, if the principal was fully paid along with interest as part of rental payments).

In thispractice, there is one intermediary entity (SPV) and one intermediaryproperty (land, equipment, etc.) to distinguish the sukukfrom conventional bonds. The actual legaldifference (e.g., how much real ownership sukuk-holdershave through the SPV) may not be revealed until we observe the first round oflawsuits associated with those sukukissuances. In the meantime, the “benchmark” argument discussed above iscommonly invoked, to list the “rate of return” sukuk pay in terms of market interest rates (e.g., LIBOR) plus theappropriate risk spread (e.g., 45 basis points above LIBOR for the June 2004issuance of $250 million Bahrainsukukrated A- by Standard and Poors).<![if !supportFootnotes]>[16]<![endif]>

• For retail financing, GCC banks are increasingly moving toward tawarruqfinancing, which also employs one intermediary entity (C in our previous example) as well as some product (usually an easily tradeable commodity such as metals or grains) as degrees of separation for the interest-bearing loan.

DYNAMICS OF SHARI‘AARBITRAGE

It is interesting to note that many Islamic financialinstitutions could and may have in fact easily practiced tawarruqunder the guise of murabaha. This iseasy to understand: in the four cases considered in the previous section, it iseasy to obtain shari‘a boardapproval of part of the tawarruq transaction as a murabahaone: “Islamic financial institution will buy commodity from C and sell it to Aon credit and at a markup,” ignoring the fact that A will turn around and sellthe commodity back to C for its cash price (less transaction fees). In fact,for the shari‘a board regulatingIslamic financial institution B, one may argue that the first two steps of tawarruq constitute the only part of thetransaction that matters, since it is the only part in which B is involved (thethird leg of the tawarruq transactionis between A and C).

Thus, since the preponderance of murabahafinancing made it easy to gain shari‘a boardacceptability, and since tawarruqis not as widely accepted outside of a subsetof the Hanbalischool, it was easier for bankers to structuretransactions (including ones with the intent of providing liquidityrather than actual trade financing) as murabahas. As more competition joinedthe market, including multinational financial behemoths such as Citibank, HSBC, etc., profit margins becamenarrower, and further innovations were introduced in murabaha practice to minimize costs (e.g. appointing the customeras agent, etc.). Finally, it became clear that murabaha transactions are more costly than tawarruq, especially if the customer’s intent was not in fact topurchase an automobile or a house, but merely to get liquidity for whateverpurpose. In fact, it is sometimes cheaper to use tawarruq (in trading a commodity such as metals), even if thecustomer in fact wanted liquidity to finance the purchase of property such asreal estate (given that the bank’s initial purchase of that property may resultin additional sales taxes, registration fees, etc.).<![if !supportFootnotes]>[17]<![endif]>

However, practicing tawarruqunder the guise of murabaha, by keepingthe three legs of the transaction separate, results in additional costsrelative to treating the entire operation as a single transaction, especiallyone wherein the bank can serve as agent for the other two parties. Thus, ascompetition drove profit margins down, banks had to resort to tawarruq (despite its less thanuniversal acceptability) for two economic reasons: (1) to gain better access toborrowers who simply need cash, student loans, etc., that do not easily lendthemselves to murabaha, and (2) toprovide more efficient credit facilities through tawarruq to others who would have previously obtained them through murabahas, the objects of which theywould immediately sell for cash.

This illustrates a general feature of shari‘a arbitrage.The existence of a captive market initially makes it possible to implement eventhe most inefficient replications of conventional financial productsthroughdegrees of separation. Profit margins in the early stages of shari‘a arbitrage are sufficiently largeto cover legal and jurist costs, as well as other transaction costs associatedwith the less efficient product. However, as competition increases, industryparticipants need to seek new markets and market segments, and also to enhanceefficiency by cutting transactions costs wherever possible. In this manner, anindustry built on shari‘a arbitragesows the seeds of its own downfall.

DANGERS OF SHARI‘AARBITRAGE

The dynamics of shari‘aarbitrage, as analyzed in the previoussection, identify two main dangers that are inherent in an industry built onthat mode of operation. One of those dangers is religious, and the other issecular. The religious danger lies in the fact that the industry thusconfigured is destined to move away, rather than toward, strict adherence toIslamic jurisprudence.

Capitalization on arbitrage opportunitiesnecessarily requires the payment of various transactions costs. In Islamicfinance, those transactions costs are incurred due to conducting otherwiseunnecessary transactions (e.g., in tawarruq, lending through three sales), as wellas the additional legal and jurist fees required to structure a product andcertify it. Although it is perhaps not sufficient, the profitability of shari‘a arbitrageis certainly necessary to get bankers andlawyers involved in Islamic finance.

To the extent that classical Islamic jurisprudenceis generally understood by contemporary jurists to forbid conventionalfinancial practice, movement toward strict adherence to Islamic principlesrequires movement away from conventional finance. To the extent thatprofitability is tied to efficiency of the Islamized analogues of conventionalfinancial practices, the profit motive dictates movement toward conventionalfinancial practice, and thus away from strict adherence to Islamic principlesas understood by contemporary jurists who are active in this industry.

Indeed, this is precisely the root of frustrationsfor early players in Islamic banking such as those cited in footnote 9. In theindustry’s earlier stages, minimal compromises (e.g., in making promisesbinding in murabahafinancing) were deemed harmless temporaryrequirements until the industry matures. One could still make the distinctionat this point between “asset-based” Islamic financing on the one hand, andconventional finance that operates based on “renting money” or “selling moneyfor money.” Of course, as competition in this sector increased, murabahas begat tawarruq,where the underlying asset may for all practical purposes be fictional, justlike fiat money used in conventional finance.

If one believes (as I do) that much ofconventional finance in fact does not clash with Islamic law (shari‘a) and classical jurisprudence (fiqh), one may think that this profit-driventrend toward closer approximations of conventional finance is a good thing. However,if one also believes (as I do) that some aspects of conventional finance do infact contradict the substance of Islamic law, as well as the forms studied inclassical jurisprudence, then one can see an impending danger of subversion ofIslamic law. Indeed, by approving and eventually codifying (through AAOIFI, IFSB, OIC FiqhAcademy, etc.) legal stratagems toreplicate conventional financial practices, jurists and bankers eventuallydrown the substance of Islamic law in their contemporary reconstructions ofmedieval forms of classical jurisprudence.<![if !supportFootnotes]>[18]<![endif]>Indeed, through Islamic financing, an individual can get excessively indebted(e.g., becoming “house poor,” as many Americans do by spending substantialportions of their incomes on their home mortgages, now “Islamized”), takeexcessive risks (e.g., by investing in shorting-based hedge funds that haverecently surfaced), etc. By focusing on medieval juristic forms rather thaneternal legal principles of Islam, the industry may in fact violate thoseprinciples and become less Islamic than prudent utilization of conventionalfinancial products.

There is also a frightening worldly dangerassociated with current practices of shari‘a-arbitrage-basedIslamic finance. The three stages of development of an Islamic financialproduct bear a striking resemblance to methods used by money launderers andterrorist financiers. The degrees of separation often required for shari‘a-arbitrage-based Islamic finance,as discussed in “Mechanics of Shari`aArbitrage,” are often structured along the lines developed in the 1980s and 1990sfor asset protection and minimization of tax burdens (a legal form of taxevasion). Separation is accomplished through the establishment ofbankruptcy-remote special purpose vehicles(SPVs) or entities (SPEs), usually incorporated at offshore financial centersthat act as tax havens for investments of high-net-worth individuals.

Some degrees of separation are introduced inIslamic financial productsby virtue of being part of the conventionalproduct being mimicked, while others are introduced merely to separate theconventional part of a financial transaction from its Islamic part. Forinstance, protected capital mutual funds marketed in Saudi Arabiatend to rely on non-Islamic partners oradvisers to receive an option-like payment as management or advisory fees(e.g., by capping investor returns at some percentage, and giving thepartner/adviser all excess returns above that level as fees, i.e., paying witha call option). Of course, those partners or advisers, European and Americaninvestment banks, can turn around and hedge that risk by trading in optionsmarkets. Thus, Islamic product providers can offer the payoff structuresgenerated by derivative securities without themselves trading in thosesecurities.

Degrees of separation help isolate sources offunds or financial products from their destinations. The multiple-case exampledescribed earlier showed how by going from a loan, to ‘ina, to tawarruq,and then adding more intermediaries, the degree of jurist acceptabilityincreases with the number of intermediaries. Unfortunately, this is the samemethodology used by money launderers and criminal financiers to separate thesources of funds from their destinations. In that criminal context, the processis called layering, and it is the pivotal middle-step in a three-step process.The other two steps are placement of the funds into the legitimate financialsystem, and integration which allows the funds to reach their final destinationthrough that legitimate system. In the case of Islamic finance, the parallel toplacement is identification of a captive clientele, organizing them into amarket, and marketing the Islamized product therein. The analog of integrationis the stage at which conventional financial providers finally collect theirprofits, interest payments, etc., that were generated from that captive market.

The similarity of methodologies is not coincidental,since shari‘a-arbitrage Islamicfinancial practice strives to separate “Islamic” parts of a transaction fromits conventional parts, whereas criminal financial activities aim to separatesources of funds from their destinations. In this regard, the highly celebrated“asset-based” or “trade-based” nature of Islamic finance is a liability ratherthan an asset. One of the classical criminal financing tricks is to convertmoney into a commodity (diamonds, gold, Swiss watches, etc.), which can betaken through a number of layers, and finally – through over-invoicing orunder-invoicing – a sum of money is cleansed or transferred to its intendedparty. To the extent that shari‘a-arbitrageIslamic financial practice utilizes the same tools as criminal finance, theindustry may be vulnerable to abuse. For instance, if someone wished to get alarge sum of money from one country to another, it would be difficult to dothat through a loan with exorbitant interest. However, if the loan isstructured as tawarruqthrough murabaha,diamonds may be bought in one place with under-invoicing, and sold elsewhere ata very large profit (equal to the desired transfer).

To the extent that everything carrying the“Islamic” label (e.g., charities, etc.) is particularly suspect in theaftermath of September 11, 2001, the effects of abuseof Islamic financial practice – even on a very limited scale – can becatastrophic for the industry. Indeed, much smaller events such as the failureof Islamic finance “fund mobilization companies” in Egypt, accused by the governmentand many analysts of running pyramid schemes,<![if !supportFootnotes]>[19]<![endif]>has made it virtually impossible for Islamic finance to flourish in Egypt,which could otherwise be a primary market. Of course, in light of thisperceived danger, Islamic financial providers tend to exercise extreme care in“knowing their customers” and in using more reputable offshore financialcenters, etc. However, as competition continues to drive profit margins down,the temptation to cut costs along those dimensions can be expected to drivesome market participants to take unnecessary risks. All industries sufferoccasional scandalous collapses (e.g., Barings Bank, Enron, LTCM, BCCI) due tocareless risk taking, driven by greed. However, an industry as young as Islamicfinance, not to mention one that exists purely based on its “Islamic”brand-name which is (unjustifiably, but understandably) suspect at this time,cannot survive such a scandal. The current modus-operandi of shari‘a-arbitrage Islamic financing istoo dangerous.

CONCLUDING REMARKS

I opened this paper with a partial quotation of remarksby the BMAgovernor at a conference. The remainder of thegovernor’s remarks read as follows:

If the Islamic sector is to continue to grow and to become apowerful force in international financial markets, it must also be able toattract the business of those persons who might prefer to use Islamic banks, but are also prepared todeal with conventional banks and other financial institutions. Islamic bankingmust do this without in any way compromising its Islamic principles.<![if !supportFootnotes]>[20]<![endif]>

The real question is whether “Islamic principles” shouldcontinue to be judged purely on juristic grounds. If they are, then anycontracts approved by jurists on Islamic financial institutions’ payrolls willcontinue to be deemed “Islamic.” This reading of the governor’s remarks impliesthat Islamic finance will simply continue along its current shari‘a-arbitrage trend.

Alternatively, Islamic finance could strive toadhere to Islamic principles by considering the true spirit of Islamic law.That would require examining the evolution of classical Islamic jurisprudenceby the standards of its own time, legal limitations, and economicunderstanding. If that is accomplished, perhaps the industry can transcend thegovernor’s vision of serving those who would prefer to use Islamic finance, butonly if it is competitive. This group also constitutes a captive market, albeitnot as captive as the group who refuse to deal with conventional financialproviders. In that regard, while the governor’s vision is ambitious relative tothe current industry’s mode of operation, it is quite timid compared to theindustry’s true potential.

If we take the universal message of Islamseriously, we must believe that enshrined in the shari‘a (divine law, as opposed to the human understanding – fiqh– of a given time and place), then we mustbelieve that Islamic finance will be better finance. In fact, it should be sogood as to attract those who are indifferent as to whether or not it is calledIslamic, and whether or not professional financial jurists approve itscontracts. It is popularly said that a cobbler complained to Martin Luther thathe was just a cobbler, and wondered how he could act as a good Christian withinhis trade. Luther, the popular story says, instructed him: “make a good shoeand sell it at a fair price.”<![if !supportFootnotes]>[21]<![endif]>When Islamic finance is truly Islamic, rather than profit-driven shari‘a arbitrage,it should be good finance at a fair price. At that point, the industry canproudly abandon the “Islamic” brand-name, to everyone’s benefit.

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<![if !supportFootnotes]>[1]<![endif]>Professor of Economics and Statistics at Rice University, where the authorholds the endowed Chair in Islamic Economics, Finance and Management. Address:Dept. of Economics – MS 22, Rice University, Houston, TX 77005,elgamal@rice.edu.

<![if !supportFootnotes]>[2]<![endif]>Opening speech by the governor of the BahrainMonetary Agency, as reported in Monday Morning, February 25, 2004, cf.www.zawya.com/story.cfm? id=ZAWYA20040225134523. The issue of strict adherenceto Islamic principles is normally reduced to approval by shari‘a boards. Indeed, recent Islamicbanking laws in a number of countries and jurisdictions explicitly list theneed for appointment of a three-member shari‘aboard that is required to write periodic reports on adherence to the shari‘a, which reports must be includedin Islamic financial institutions’ annual reports. See, for instance, theIslamic banking Law no. 30 of 2003, published (with corrections) by theofficial Kuwaiti government newspaper Al-KuwaitAl-Yawm (Kuwait Today) on June 8, 2003 (issue 619, 49th year), Article 93.

<![if !supportFootnotes]>[5]<![endif]>For instance, M. Uzair, An Outline ofInterestless Banking (Karachi: Idaratul Ma`arif, 1955), and M. N. Siddiqi, Banking without Interest (Leicester, UK:The Islamic Foundation, 1983).

<![if !supportFootnotes]>[6]<![endif]>For a discussion of a recent heated debate, see M. El-Gamal, “Interest and theParadox of Contemporary Islamic Law and Finance,” Fordham International Law Review (December 2003), 108-149.

<![if !supportFootnotes]>[7]<![endif]>For instance, see M. S. Khanand A. Mirakhor (eds.), Theoretical Studies in Islamic Banking and Finance (Houston: TheInstitute for Research and Islamic Studies, 1988).

<![if !supportFootnotes]>[8]<![endif]>Initially, the focus was on the prohibition of riba. Morerecently, avoiding forbidden ghararhas also been important to the development of takaful as an alternative toconventional insurance, as well as the ongoing attempts to synthesize Islamicderivative securities to replace conventional options. For an economicexplanation of the roots of this “closest permissible alternative” approach,see M. El-Gamal, “The Economics of 21st Century Islamic FinancialJurisprudence,” Proceedings of the FourthHarvard University Forum on Islamic Finance (Cambridge: Center for MiddleEastern Studies, Harvard University, 2002), 7-12.

<![if !supportFootnotes]>[9]<![endif]>Al-Najjar 1993. See also, Sheikh Saleh Kamel’s acceptance speech for theIslamic Development Bank’s prize in Islamic finance in1996 (quoted in El-Gamal, “Interest and the Paradox”).

<![if !supportFootnotes]>[10]<![endif]>This focus on form rather than substance defies a famous Islamic juristicdictum: “What matters in contracts is substance (lit. meaning), and not wordingand form” c.f. ibn Qayyim al-Jawziyyah, I`lamal-Muwaqqi`in `an Rabb al-`Alamin (Bayrut, Dar al-Kutub al-`Ilmiyyah,1996), vol.3, pp.78-80. However, as distasteful as it may sound, surprisinglymany Islamic finance practitioners defend legalistic formalism with the exampleof marriage contracts, wherein the contract form can distinguish between one ofthe best permissible practices (valid marriage), and one of the worst sins(adultery). Since this example has been repeated frequently, it is worthwhileto note that its tastelessness is surpassed only by its jurisprudentialincoherence. A fundamental difference between this example and the case offinancial transactions (which renders the analogy flagrantly invalid) is thedefault ruling of prohibition of sexual relations unless legalized through a marriagecontract, as opposed to the default ruling of permissibility of all financialtransactions, except for those including a prohibiting factor (e.g., ribaor gharar).

<![if !supportFootnotes]>[11]<![endif]> See al-Qaradawi1987. The binding promise fatwawas based on the opinion of the Malikijurist ibn Shubruma, and adopted in the firstinternational conference of Islamic banksin Dubai, 1978.

<![if !supportFootnotes]>[13]<![endif]>Available on the OCC website at www.occ.treas.gov/interp/nov99/int867.pdf.Similar language was used earlier for lease financing (under the Arabic term ijara),essentially accepting UBK’s argument that “the economic substance” of ijara financing makes the transactionequivalent to secured lending, which is part of conventional banking practice;see www.occ.treas.gov/interp/dec97/int806.pdf.

<![if !supportFootnotes]>[14]<![endif]>For a comprehensive list of opinions and texts upon which they were based, seeW. al-Zuhayli, Financial Transactions inIslamic Jurisprudence (trans. M. El-Gamal), (Damascus: Dar al-Fikr, 2003),1:214-216.

<![if !supportFootnotes]>[17]<![endif]>At least one banker operating in the United States indicated to me that hewould prefer financing auto purchases through tawarruq,since the transactions costs associated with murabaha(which requires two sales of the car) and ijara(which requires additional costs for title,insurance, etc.) are simply too high. In his view, tawarruq gives him a tool to offer auto loans at more competitiverates, using a method that is approved by the relevant jurists.

<![if !supportFootnotes]>[18]<![endif]>Please see M. N. Siddiqi’s paper in this book, which discusses the issues oflegal objectives (maqasid al-shari‘a) much more extensively, and eloquently, than I do.

<![if !supportFootnotes]>[21]<![endif]>This popular saying (cited by everyone from evangelical preachers, to musicbands, see, respectively, www.covchurch.org/cov/news/item3369.html andwww.ocweekly.com/ink/02/47/music-kane.php) is likely an elaboration (possiblyapocryphal, but illustrative nonetheless) on a passage in Luther’s “Address tothe Nobility of the German Nation” in 1520, wherein he said: “A cobbler, asmith, a peasant, every man, has the office and function of his calling, andyet all alike are consecrated priests and bishops, and every man should by hisoffice or function be useful and beneficial to the rest, so that various kindsof work may all be united for the furtherance of body and soul, just as themembers of the body all serve one another,” c.f. Fordham University’s ModernHistory Sourcebook at www.fordham.edu/halsall/mod/luther-nobility.html.Banking, like all other professions, can be beneficial to society whenpracticed in an ethical and professional manner. In that regard, an Islamicbanker does not need to market his craft as “Islamic banking,” just asreligious practitioners of other trades do not need to use religiousbrand-names.