An Ideal Islamic Financial System: A Critical Look at Practiced Islamic Finance

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Islamic Finance is a growing industry which is constantly evolving and has been competitive to reach and sustain its growth momentum amid even the Great Recession and beyond. Assets of the global Islamic finance industry are estimated to grow to around $1.6 trillion by 2012 (Source: Reuters). Lately, the Vatican said that banks should look at the rules of Islamic finance to restore confidence amongst their clients at a time of global economic crisis. (Source: Osservatore, March 04, 2009). Some reports suggest that assets held by Islamic financial institutions may rise five-fold to more than $5 trillion (Source: Moody’s Investor Service).

But, Islamic finance industry mostly uses LIBOR linked financial contracts which are akin to debt financing than the more preferable participatory modes of Mudarabah and Musharakah.


Time Value of Money & Islamic Finance

In investment for trade (which Islam allows), the investment goes through the entire process of a commercial activity that involves risk taking at each stage and any compensation on investment is strictly dependent upon the outcome of the commercial activity. The profit for the businessman strictly depends upon the actual profit realized after taking market risk including price risk. It does not depend upon time.

Time value of money is the basis of interest. Time value of money is the problem for the investor to avoid keeping his money idle and to avoid forgoing the use of money that may bring positive value to his investment. However, it does not mean that the investor can demand an arbitrary increase (or is given as the case may be) as the cost of using money without taking the market and price risk.

Assigning weightage to investment based on tenor of investment through which horizontal distribution of profit takes place in Islamic banking creates the same yield curve as in the case of term deposits of conventional banks. The situation where losses are incurred would have been very interesting, but the money is invested in contracts in which the chance of loss is remote. Also, the arrangement is such that the bank makes sure that it gets comparable returns taking LIBOR as the benchmark rate. Now a discussion on those instruments (assets of the bank) will inquire that how these instruments enable the bank to provide compensation based on tenor.


Analysis of Diminishing Musharakah

In ‘Diminishing Musharakah’, two contracts i.e. tenancy and sale are included as two separate components of a Diminishing Musharakah contract. Both these contracts are separated by way of a unilateral undertaking in place of the actual simultaneous sale/purchase of units of the asset/property. The rent is calculated and charged on the basis of LIBOR. The rent increases when the LIBOR increases.

Upon close inquiry, one can notice that undertaking or promise makes the contract conditional. This argument is further substantiated by the fact that if the client refuses to undertake or promise to buy the asset (in units), the bank will not make contract with him. Furthermore, the promise gives the legal cover to the bank and is acceptable in a court of law.

Following table compares the conventional mortgage and ‘Diminishing Musharakah’. It can be seen from the table above that there is hardly any difference between the two modes of financing with respect to the flow of funds.



Conventional Mortgage

Diminishing Musharakah

Benchmark Rate KIBOR KIBOR
Basis of Rent KIBOR KIBOR
Nature of Installment Interest + Principal Repayment Rent + Sale of Units
Prepayment Penalty Yes Sale of Units at Higher Price
Rent + Sale contract Dependent Separated by unilateral promise
In subsequent years Interest decreases Rent payment decreases
In subsequent years Principal repayment increases More Units are purchased
Changes in Rent Based on KIBOR Based on KIBOR
Price and Market Risk No No
Price of Asset Locked at initiation Locked at Initiation
Cost to the borrower Same in both cases Same in both cases
Profit to the bank Same in both cases Same in both cases


Analysis of Risk Taking by Bank

There are several types of risks. The most relevant risk is the market risk including price risk i.e. the risk that the goods will not be sold or will be sold at lower prices that may or may not cover costs. In ‘Murabaha’ and ‘Diminishing Musharakah’, price and market risk is not taken by the bank. Insurance, import duty, levies, and all other expenses are indirectly charged from the customer through transfer pricing.

Had the tenancy and sale contract were made separately, the bank would have had to bear the market risk which the bank avoids by taking a unilateral undertaking from the customer to lease or purchase an asset in Ijarah/Diminishing Musharakah and Murabaha respectively.


Analysis of Murabaha

It is referred to as “cost + profit” transaction. In this transaction, if a person needs a machine worth Rs.100,000. The bank appoints the person as an agent to buy it and before it pays the amount (Rs. 100,000) to the supplier, the bank makes sure that the customer signs an undertaking to buy the asset. This undertaking by the customer is later used to sell the asset to the customer at a profit. The bank makes sure that it gets the required profit by locking the price at the outset and avoids taking any market related risk.

Undertaking to purchase the asset once the asset is bought by the client as an agent of the bank makes the contract conditional. This undertaking is taken from the client before the bank releases funds. This argument is further substantiated by the fact that if the client refuses to undertake or promise to buy the asset, the bank will not make contract with him. Furthermore, the promise gives legal remedy to the bank and is acceptable in a court of law.

Respected scholar Maulana Mufti Taqi Usmani in his book “Introduction to Islamic Finance” describing the less ideal nature of Murabaha with respect to contributing to the goals of socio-economic redistribution in economy wrote:

“The instruments of leasing and Murabaha are sometimes criticized on the ground that their net result is often the same as the net result of an interest-based borrowing. This criticism is justified to some extent, and that is why, the Shariah supervisory Boards are unanimous on the point that they are not ideal modes of financing and they should be used only in cases of need with full observation of the conditions prescribed by Shariah.” (p. 13)

Commodity Murabaha used by the Islamic bank’s treasury for asset liability management (basing their actions on the opinion of scholars that ‘Murabaha is allowed, even if not ideal’) took the allowance to the extreme whereby in Commodity Murabaha transactions, the subject matter is not genuinely required by both financial institutions, but each of them takes ownership literally for some minutes and execute a complex sale resulting in a profit for one and fulfillment of liquidity requirement for the other.

Similarly, use of sale and lease back transaction in house construction finance and in commercial finance is also a transaction in which Islamic bank purchases the asset without any need of its own from the same customer to whom the asset is leased subsequently. The lapse of at least one year period between sale and lease recommended by Shariah scholars is also not a sufficient justification as the Islamic bank takes undertaking from the client beforehand to lease it after one year.

With Murabaha as an alternative, profitable companies will not opt for Mudarabah/Musharakah because they will not like to share profits and else would go for cheaper way of sourcing funds i.e. debt financing. Less profitable companies will want to go for Mudarabah/Musharakah, but bank as conservative financial institution will not take risk with these companies. The argument that Mudarabah/Musharakah financing is not possible due to lack of authentic documentation and trust level is also very weak. Islamic banks operating in developed markets (it is to be noted that the developed countries are the hub of Islamic banking) where such problems are not found have also not gone for Mudarabah/Musharakah financing. As a matter of fact, Islamic banks do not want to take market and price risk. Default, credit, political, exchange and other risks are also taken by conventional banks. If Mudarabah and Musharakah are deemed ideal alternatives by Islamic banking experts and scholars favoring it; then, they would have been better off entering into investment banking before they entered into commercial banking.


Analysis of Salam

Salam is an alternative for short selling. Its allowance is confirmed from an authentic Hadith. It is a sale in which payment (in full) is at spot but delivery is deferred. But, it is to be noted that the transaction approved by Prophet Muhammad (pbuh) did not involve a financial intermediary. Ideally, we have to eliminate the need of excessive financial intermediation and look for the alternative methods, some of which have been suggested by the author in the book ‘Proposal for a New Economic Framework Based on Islamic Principles’ and more research is required in this regard. In parallel Salam, the same problem of contingency in contracts persists.

Analysis of Mudarabah

One of the major impediments in the use of Mudarabah on the asset side of a bank i.e. for financing is that only Rabb-ul-Maal is considered to bear all the financial losses. Therefore, if an Islamic bank enters into the Mudarabah contract as a Rabb-ul-Maal, only the Islamic bank would have to bear all the losses. Mudarib (Fund manager) bears no loss while he has the complete authority in running the affairs of the business. The Rabb-ul-maal (investor) is not allowed to interfere in the affairs of the business. When a loss occurs, the Mudarib acts like an employee of the business and when the profit occurs, he shares in the profit as if he was the only reason behind the profits. This juristic viewpoint didn’t create much problem during early Islamic era when often, the Mudarib was a poor and resource-less person in financial need with limited incentive and authority to enter in corruption and no capacity to participate in loss sharing if the loss was caused by any reason other than negligence on his part.

The principle that loss sharing should be based upon and limited to the amount of capital invested is not a condition mentioned in Quran or Hadith. Fuqaha recommended it, but it does not mean that it can not be modified, especially if doing so is necessary and will make the preferable Islamic modes of financing more applicable. When we make terms and conditions for employment contracts, for appointment of Shariah Advisors etc, any condition not in violation with Islamic principles is allowed and is used. Similarly, limiting loss sharing up to the amount of capital invested is not the only way loss sharing could take place.

Furthermore, in Musharakah, loss participation by all partners across the board is justifiable because all partners are also allowed to work. But, due to the condition in Mudarabah that working partner is the sole authority to make decisions on business, making Rabb-ul-Maal completely responsible for sharing all losses is unjustified in the first place.

It is considered that in case of loss, Mudarib loses the compensation to his efforts. But, Mudarib was not an employee. He was a joint partner, more precisely, a working partner. Taking the position that he lost the compensation to his work is inviting opportunity cost which Islamic economics does not acknowledge apparently.

In Mudarabah, the prevalent concept of loss sharing makes it different from a General partnership (all partners have unlimited liability) and even with limited partnership (some or all have limited liability). In Mudarabah, Rabb-ul Maal not only has unlimited liability, but no authority to participate in the business. Consider an Islamic economy with Mudarabah on asset and liability side and there is no other instrument used, Mudarib (usually blue chip companies) with no liability to share loss can obtain financing from banks who would be Rabb-ul-Maal in asset side use of Mudarabah. On liability side, bank will be Mudarib and the small savers and investors will be Rabb-ul-Maal. So, any loss incurred by blue chip companies is ultimately paid by small savers and investors who have all the liability to share losses without having a say in the affairs of the business!

Restricted Mudarabah and clause of willful negligence is insufficient to protect them from losses strictly due to business cycle fluctuations. This example shows that with current structure, even Mudarabah used alone in an economy is insufficient to bring about any egalitarian change let alone prove to be more destructive than interest based system.

Let us analyze trust deficit and documentation problems which are cited as reasons why Mudarabah is not being used widely. Relax these assumptions and now consider there is no trust deficit and documentation problem in the economy. If a loss occurs due to business cycle fluctuations, no part of the loss is borne by the business that had all the authority to run the business. The loss is borne not by the bank as well because bank is Mudarib on liability side. All loss is borne by the small savers and investors. Now consider the government prohibits interest based lending and borrowing too. Will the people want to be Rabb-ul-Maal in Mudarabah with bank or the shareholder in a blue chip company which can take all the money, invest it, earn from it and if loss occurs, pass it onto the small savers! Mudarabah (with current structure) even when assumptions of trust deficit and documentation problem are relaxed and even when there is no competing conventional banking system is ineffective to say the least.

If we look at Mudarabah as it is currently understood, Mudarib is basically an employee who would get Ujrat-e-Misl in case of loss and his compensation will feature some share in profit also. He is not liable to bear any loss. Rabb-ul-Maal is basically the entrepreneur (who has the ultimate responsibility to share losses). How is it a participatory mode then? This should not be cited as a participatory mode with current structure. Secondly, it is also different from a principal agent relationship in corporate form of organization. In that, the principal hires the agent only because of his inability/incapacity, but the rules do not restrict him not to influence agent’s decisions. Important decisions taken by the agent(s) have to be vetted in AGM. Mudarabah rules even do not allow that much participation. So, in my humble opinion, we first need to justify that how Mudarabah is a “just” mode of financing, let alone a participatory one and a most preferable one.

The argument that Asset backed nature of financing would ensure effective risk management is also weak as CMOs, MBS, ABS etc were instruments with mortgage loans as their underlying assets. The problem was with excessive leveraging and lax regulation and not with securitization per se. Securitization in Islamic finance as in Sukuks also suffered a setback in Dubai Crisis in 2009/10. Asset backed financing also lacks the potential to provide need based loans for education, marriage, financing to pay short term debt, salaries, other accrued expenses to 3rd parties etc.

With important covenants in place, equity financing can be used and is used widely. It is interesting to study the size of debt and equity market in developing countries. For instance, in Pakistan, corporate bond market hardly exists, whereas equity financing is more prevalent and widely used. Equity financing through shares will forever deny the claims of bankers in general and Islamic bankers in particular who hide behind trust deficit and documentation problems. Why people invest in shares of companies without any guarantee over par value let alone dividend and even when the cash inflows are far from sight? This is an important question to answer even if some financial tycoons help promote the practiced Islamic Finance the way it is practiced for commercial reasons.


Salman Ahmed Shaikh is a researcher in Islamic Economics. He is author of “Proposal for a New Economic Framework Based on Islamic Principles”. He has also written 14 papers on Islamic Economics. He is a faculty member at Szabist, Pakistan. He can be contacted at

Salman Ahmed Shaikh is a researcher in Islamic Economics. He is author of “Proposal for a New Economic Framework Based on Islamic Principles”. He has also written 14 papers on Islamic Economics. He is a faculty member at SZABIST, Pakistan. He can be contacted at

  • Afshan Merani

    It’s all a lie to me really. Interest is interest, however you sugar coat it.