Islam and Finance
Discuss the relevance of the Classical Islamic law of contract to the Law of Islamic Finance by Mohammed Hasan
N.B: This is an academic essay I wrote in 2017 - not everything written - may reflect the current landscape of Islamic Finance.
This essay will assess the extent to which the legal principles derived from the Classical Islamic law of contract remain relevant today; relevance shall be defined as the applicability of these legal principles. The Classical Islamic law of contract can be summarised as ensuring clarity, certainty and equality in all contractual arrangements while guaranteeing the avoidance of riba (interest), gharar (speculation) and maysir (gambling). This essay will evaluate whether the lack of an established legal instrument to interpret and enforce Classical Islamic law and the pressure on Islamic Financial Institutions (IFI) to remain profitable will outweigh the attempts of “Group Itjihad” and “hybrid legal systems” to sustain the relevance of the Classical Islamic Law of Contract.
The conventional financial system has become increasingly complex, and the growing demand for liquidity, collateral, and equity finance are alien concepts to the time in which the Classical Islamic law of contract was developed. Technological advances allow financial institutions to simultaneously execute multiple transactions at an unprecedented scale; this inevitably raises the question as to whether the Classical Islamic law of contract can remain relevant in this context.
Classical Islamic Law of Contract has no future without a “living” legal instrument:
The Classical Islamic law of contract cannot remain relevant, in the vastly different context in which we now live, without a “living” legal instrument to interpret and implement these legal principles. Since the erosion of Classical Islamic law during the 18th and 19th centuries and its subsequent replacement by European continental law, Islamic law is no longer recognised as the “law of the land” in Muslim states.[1] Institutions governed by Islamic scholars that were once responsible for the interpretation, and creation of Islamic law, are “now…chiefly…vehicles for organising legal education and… the study of past views.[2]” Since the institutions, which give Islamic scholars the power to exert their authority, have been eroded, one of the challenges for classical Islamic law is to find a new source of stability and authority.[3] Al-Hamoudi argues it is impractical to implement the classical Islamic law of contract by “crafting rules and limitations to govern a deeply and fundamentally contemporary practice using source material that is medieval in its origin” [4]
The asymmetry of information between Western-trained finance experts and the Ulumaa (religious scholars) is stifling the creation of a legal system which accurately applies the Classical Islamic law of contract to the conventional financial system. The gap in understanding between finance experts with a cursory knowledge of Classical Islamic legal principles and the Ulumaa that lack an equally in-depth understanding of finance hinders the ability of Islamic Banks to create products which follow the Classical Islamic law of contract.[5] Vogel argues there is a conflict of interest between individuals who wish to keep the application of Classic Islamic law abstract in order to profit from the conventional banking system, and religious scholars that want to protect Classical Islamic law from manipulation and misinterpretation.[6]
In order to enforce the Classical Islamic law of contract, national laws must codify Islamic legal principles to ensure Islamic banks can enforce contracts, which provide Sharia compliant services. Vogel[7] argues that it is impractical to incorporate Classical Islamic legal principles into commercial contracts when the laws that govern the interpretation and enforcement of such contracts are ignorant of such principles. In Beximco v Shamil,[8] the English Court of Appeal refused to render a contract void on the basis that it was not sharia compliant; as determined by S.2(1) of the Rome Convention there could not be two different laws governing a contract.[9] In addition, the English courts reasoned English law should prevail since Sharia was not recognised as the law of state and that different Sharia scholars would differ in opinion.[10] Justice Morison expressed his concern as to the clarity and uniformity of Sharia when he said, "There is clearly great controversy as to the strictness with which principles of Sharia'a law will be interpreted or applied".[11]This demonstrates that the Classical Islamic law of contract will remain unenforceable without a modern scholarly interpretation of Classical Islamic legal principles, which can be translated and codified into national legal systems. Dr. Bälz argues that “Waiver of Sharia Defence” clauses (prevents parties to a contract from arguing that a transaction is not Sharia compliant as a defence to enforceability[12]), reduces the status of the Classical Islamic law of contract from a legal doctrine to an ethical concept.[13]
Globalisation of Financial markets: Consequences of Standardisation and the struggle to remain authentic
The globalisation of financial markets has put pressure on IFIs to standardise the regulation of their financial products, to sustain the growth of Islamic Finance amidst the shortage of Islamic scholars. The creation of Sharia Supervisory Boards (SSBs) and broad regulatory frameworks such as the Islamic Financial Services Board (IFSB) has become an exercise of corporate governance as opposed to an in-depth legal discussion as to whether financial products satisfy the Classical Islamic law of contract.[14] In addition, Islamic banks are forced to operate within a fractional reserve banking system and, use LIBOR as a benchmark,[15] both of these activities are essential to the growth of IFIs yet they are haram(religiously prohibited) according to the Classical Islamic law of contract. However, 18 large Islamic banks are currently developing an Islamic Interbank Benchmark rate[16].
The pressure on IFI’s to remain profitable within a conventional financial system has arguably led to the creation of financial products which merely circumvent prohibitions outlined by the Classical Islamic law of contract and therefore remain substantively similar to products in conventional banking. For instance, the use of Murabaha, (purchase followed by cost plus credit-sale[17]), is considered by many scholars to be a circumvention of riba[18] that fails to offer a genuine alternative to interest based products. Although, the profit-loss sharing model is an integral part of the Classical Islamic law of contract, only five per cent of the assets of Islamic banks consist of loans that are based on genuine profit-loss-sharing.[19] Gamal argues in the pre-modern era, the transaction costs involved in circumventing the classical Islamic law of contract were prohibitively high and therefore focusing on the structure of transactions was a sufficient method of regulation.[20] However, today’s low transaction costs allows IFIs to “financially engineer” products to circumvent classical Islamic prohibitions, therefore the regulatory approach adopted by the Classical Islamic law of contract is no longer relevant. He argues without an emphasis on the “economic content” of transactions as opposed to names and legal structures, the regulation of Islamic finance will be rendered incoherent.[21]
Does the growing demand for Islamic finance signal a revival of Classic Islamic Legal Principles?
The growth of Islamic Finance is a symbol of the increasing demand for ethical banking services premised in Islamic legal jurisprudence; this signals a revival of the principles from the Classic Islamic law of contract. The creation of “Islamic Windows” by large banks such as HSBC, which profit from the conventional banking system, highlights the influence of Classical Islamic law of contract, which prohibit riba, maysir and gharrar. Although, Islamic finance accounts for a small percentage of the conventional financial system, its growing popularity is forcing large financial institutions to invest in products that are based on principles which prohibit their primary methods of making profit.
The creation of “Fiqh academies” and “Hybrid legal systems” could provide a solution to the current absence of a legal instrument to uniformly interpret and enforce the Classical Islamic law of contract. The Organisation of Islamic Cooperation (OIC) creation of “Fiqh academies” by inviting scholars to discuss the challenges of applying the Classical Islamic law of contract in a conventional banking system represents a revival of Ijtihad. The collaboration between religious scholars and experts from different disciplines to issue fatwas (legal opinions) on a variety of topics such as the permissibility of certain financial products provides a potential solution to bridging the gap between the Classical Islamic law of contract and the contemporary law of Islamic finance.[22] Hybrid legal systems also provide a solution to the conflict between national laws and the Classical Islamic law of contract, by codifying principles derived from Classical Islamic law into national legal systems. This facilitates the creation of organisations such as the International Islamic Financial Market, which serves to develop a global regulatory framework that can be used to uniformly interpret and enforce the Classical Islamic law of contract and more generally the Maqasid (objectives) of Sharia law.[23]
The real question is whether the institutions with the power to change the financial system will accommodate IFI’s and facilitate the creation of regulation that matches the Classical Islamic law of contract.
In conclusion, the Classical Islamic of contract is no longer relevant in the vastly different context in which we now live. The absence of a legal instrument, which can interpret principles, which are medieval in origin and uniformly apply them to the conventional financial system, renders Islamic financial products unenforceable. It is unsustainable to outsource the regulation of a growing industry to SSBs with a cursory knowledge of the Classical Islamic law of contract especially when the application of these principles remains unenforceable in jurisdictions where national laws conflict with such principles. In addition, the standardisation of regulation has led to a dilution of these legal contractual principles into merely ethical guidelines. The pressure on Islamic banks to remain profitable and operate within the confines a fractional reserve banking system which rewards practices that are antithetical to Classical Islamic legal principles has led to the creation of financial products which merely circumvent prohibitions such as riba. IFIs have ultimately failed to provide genuine alternatives to the conventional financial system and achieve outcomes, which adhere to the spirit of the Classic Islamic law of contract.
Although, the revival of Ijtihad and the emergence of hybrid legal systems may provide a framework to uniformly interpret and enforce the Classical Islamic law of contract, these solutions are still immature in their development. In addition, they do not resolve the conflicts of interest between powerful institutions profiting from the conventional financial system, traditional scholars that oppose the revival of Itjihad to protect the Classical Islamic law of contract from misinterpretation and institutions that aspire to create a financial system based upon Classical Islamic law.
Bibliography
Books:
Ayub MG, Understanding Islamic Finance (John Wiley & Sons 2007)
El-Gamal MA, Islamic Finance: Law, Economics, and Practice (Cambridge University Press 2006)
Ercanbrack J, The Transformation of Islamic Law in Global Financial Markets (Cambridge University Press 2014)
Hallaq W, Authority, Continuity, and Change in Islamic Law (Cambridge University Press 2001)
Vogel FE and Hayes SL, Islamic Law and Finance: Religion, Risk, and Return (Brill Academic Publishers 1998)
Journals:
Ahmed H, ‘Islamic Law, Adaptability and Financial Development’ (2006) 13 Islamic Economic Studies
Bälz K, ‘Sharia Risk? How Islamic Finance Has Transformed Islamic Contract Law’ (Occasional Publications no. 9, Islamic Legal Studies Program, Harvard Law School, September 2008) 3, (www.law.harvard.edu/programs/ilsp/publications/balz.pdf.) Accessed 25 March 2014.
Dusuki A, Abozaid A. A Critical Appraisal on the challenges of realizing Maqasid Al-Shariah in Islamic Banking and Finance. IIUM Journal of Economics and Management 15, no. 2 (2007): 143-165
El-Gamal M, ‘Incoherence of Contract-Based Islamic Financial Jurisprudence in the Age of Financial Engineering’ (2008) 25 Wisconsin International Law Journal
Foster N, ‘Islamic Finance Law as an Emergent Legal System’ (2007) 21 Arab Law Quarterly 170
Hallaq WB, ‘Was the Gate of Ijtihad Closed?’ (1984) 16 International Journal of Middle East Studies 3
Hamoudi H, ‘Present at the Resurrection: Islamic Finance and Islamic Law’ (2011) 26 American University International Law Review
Soualhi Y, ‘Bridging Islamic Juristic Differences in Contemporary Islamic Finance’ (2012) 26 Arab Law Quarterly 313
Cases:
Beximco v Shamil [2004] EWCA Civ 19
Websites:
‘Islamic Interbank Benchmark Rate’ (Financial Thomson Reuters) http://financial.thomsonreuters.com/en/products/data-analytics/market-data/financial-benchmarks/shariah-compliant-interbank-market.html accessed 27 December 2015
[1] Ercanbrack J, The Transformation of Islamic Law in Global Financial Markets (Cambridge University Press 2014), p2-5
[2] Vogel FE and Hayes SL, Islamic Law and Finance: Religion, Risk, and Return (Brill Academic Publishers 1998), p47
[3] Opt. Cit. Vogel, p47
[4] Hamoudi H, ‘Present at the Resurrection: Islamic Finance and Islamic Law’ (2011) 26 American University International Law Review, p1110
[5] Opt. Cit. Vogel, p45-7
[6] Opt. Cit. Vogel, p46
[7] Opt. Cit. Vogel, p51
[8] Beximco v Shamil [2004] EWCA Civ 19
[9] Opt. Cit. Beximco [2004] p857, para 30
[10] El-Gamal M, ‘Incoherence of Contract-Based Islamic Financial Jurisprudence in the Age of Financial Engineering’ (2008) 25 Wisconsin International Law Journal, p607
[11] Foster N, ‘Islamic Finance Law as an Emergent Legal System’ (2007) 21 Arab Law Quarterly 170, p174
[12] Bälz K, ‘Sharia Risk? How Islamic Finance Has Transformed Islamic Contract Law’ (2008) Harvard Law School, p23
[13] Hamoudi H, ‘Present at the Resurrection: Islamic Finance and Islamic Law’ (2011) 26 American University International Law Review, p1117
[14] Opt. Cit. Hamoudi, p1118
[15] El-Gamal MA, Islamic Finance: Law, Economics, and Practice (Cambridge University Press 2006), p26
[16] ‘Islamic Interbank Benchmark Rate’ (Financial Thomson Reuters) <http://financial.thomsonreuters.com/en/products/data-analytics/market-data/financial-benchmarks/shariah-compliant-interbank-market.html> accessed 27 December 2015
[17] Opt. Cit. Gamal (2008), p606
[18] Dusuki A, Abozaid A. A Critical Appraisal on the challenges of realizing Maqasid Al-Shariah in Islamic Banking and Finance. IIUM Journal of Economics and Management 15, no. 2 (2007): 143-165, p147
[19] Opt. Cit.Duski A, (2007), p147
[20] Opt. Cit. Gamal (2008), p617
[21] Opt. Cit. Gamal (2008), p617
[22] Soualhi Y, ‘Bridging Islamic Juristic Differences in Contemporary Islamic Finance’ (2012) 26 Arab Law Quarterly 313, p317
[23] Opt. Cit. Foster, p180
