Islamic banking and finance

Based on Wikipedia: Islamic banking and finance

In 2004, a member of the Pakistani parliament stood up and made what he thought was a simple observation. A scholar from Al-Azhar University—one of the oldest Islamic universities in the world—had recently issued a decree stating that bank interest wasn't necessarily forbidden under Islamic law. The parliamentarian merely mentioned this fact.

Pandemonium erupted.

Members of the leading Islamist political party demanded an immediate response to these "derogatory remarks." When they were denied the floor, they walked out. When they returned, their leader declared that since Pakistan's Council of Islamic Ideology had already ruled that interest in all its forms was haram—forbidden—no member of parliament had the right to "negate this settled issue."

This confrontation captures something essential about Islamic finance: it sits at the intersection of faith, money, and modernity in ways that produce genuine heat. We're talking about a $2 trillion industry built on a fourteen-hundred-year-old religious prohibition—one that not everyone agrees actually means what most people think it means.

The Core Problem: What Exactly Is Riba?

The Arabic word "riba" literally means "excess" or "addition." In Islamic jurisprudence, it's typically translated as usury or interest, and the Quran explicitly forbids it. But here's where things get complicated: does riba mean all interest on all loans? Or does it refer specifically to exploitative lending practices that were common in pre-Islamic Arabia?

The mainstream position, held by most Islamic scholars and the foundation of the entire Islamic banking industry, is straightforward: riba means any predetermined, fixed return on money lent. If you loan someone a hundred dollars and expect back a hundred and five, you've committed riba. It doesn't matter if the rate is reasonable or if the borrower is wealthy. The structure itself is prohibited.

But a minority of scholars have always questioned this interpretation. Muhammad Abduh, Rashid Rida, and even Yusuf al-Qaradawi—hardly marginal figures—have argued for more nuanced readings. Some distinguish between exploitative lending to the poor (clearly prohibited) and commercial investment returns (potentially permissible). Others point out that during the Islamic Golden Age, many classical jurists believed the prohibition applied specifically to gold and silver currencies, not to paper money or other forms of exchange.

There's also a more fundamental question: even if riba is a sin, is it a crime? The scholar Muhammad Akram Khan has noted that neither the Prophet Muhammad nor the first four caliphs nor any subsequent Islamic government ever enacted a law against riba. Perhaps, he suggests, it's something to be discouraged rather than punished—a matter between a person and God rather than between a person and the state.

From Prohibition to Industry

For most of Islamic history, this was all rather theoretical. Muslims borrowed and lent money with interest, sometimes openly, sometimes through legal workarounds called hiyal—clever arrangements that maintained the form of Sharia compliance while achieving the same economic result as interest. The Ottoman Empire, which governed much of the Muslim world for centuries, never seriously attempted to eliminate interest-based banking.

The modern Islamic banking movement emerged in the mid-twentieth century, part of a broader Islamic revival that sought to distinguish Muslim societies from Western influence. Thinkers like Anwar Qureshi, Naeem Siddiqui, and Abul A'la Maududi began developing theoretical frameworks for interest-free banking in the late 1940s and early 1950s. They weren't opposed to banks themselves—they recognized these institutions as "necessary evils" in a modern economy. But they wanted to redesign banking from the ground up, replacing interest with profit-sharing arrangements.

The first experimental Islamic bank appeared in rural Pakistan in the late 1950s. In 1963, an Egyptian economist named Ahmad Elnaggar established what's often considered the first modern Islamic bank in the Nile Delta town of Mit Ghamr. Interestingly, Elnaggar didn't advertise the bank's Islamic character. The Gamal Nasser regime was hostile to Islamic movements, so the bank operated as a simple profit-sharing cooperative, appealing to rural Egyptians who distrusted state-run banks.

The Egyptian government shut down the Mit Ghamr experiment in 1968, but by then the concept had proven itself. Nine similar banks had opened across Egypt, and the ideas continued to spread.

Petrodollars and the Islamic Revival

Everything changed in 1973. The Arab-Israeli War and the subsequent oil embargo sent petroleum prices skyrocketing. Suddenly, the Gulf states found themselves awash in what came to be called "petrodollars"—vast wealth seeking investment opportunities. This coincided with a broader Islamic revival across the Muslim world, a cultural and political movement that sought to reassert Islamic identity after decades of Western colonialism and secular nationalism.

Islamic banking provided a perfect vehicle for both impulses. The Islamic Development Bank was established in 1975 to fund development projects in Muslim countries. The Dubai Islamic Bank, the first modern commercial Islamic bank, opened in 1979. That same year saw the creation of the first Islamic insurance company—called takaful—in Sudan.

Between 1980 and 1985, Islamic investments underwent what one observer called a "spectacular expansion." Deposits flooded in, attracted by promises of strong returns and something conventional banks couldn't offer: religious legitimacy. Islamic scholars were recruited to issue fatwas—religious rulings—criticizing conventional banks and endorsing their Islamic competitors.

This growth hit a speed bump in 1988, particularly in Egypt. The Egyptian government, concerned that Islamist movements were building financial independence that could translate into political power, reversed its tacit support for the industry. A media campaign against Islamic banks triggered a financial panic, and several companies went bankrupt. But the setback was temporary. By 1995, there were 144 Islamic financial institutions worldwide, including 33 government-run banks, 40 private banks, and 71 investment companies.

How It Actually Works

If you can't charge interest, how do you make money as a bank? Islamic finance has developed several alternative structures, each designed to achieve similar economic outcomes to conventional lending while maintaining Sharia compliance.

The most celebrated is mudarabah, a profit-sharing arrangement. Instead of lending you money at a fixed interest rate, the bank invests in your venture as a partner. If your business succeeds, you split the profits according to a predetermined ratio. If it fails, the bank loses its investment while you lose your time and effort. This aligns incentives: the bank has reason to care whether your business actually succeeds, not just whether you can make payments.

Musharaka works similarly but involves a full joint venture where both parties contribute capital and share both profits and losses according to their investment ratios.

More common in practice is murabaha, often called "cost-plus financing." Say you want to buy a car. Instead of lending you money to purchase it, the bank buys the car itself, then sells it to you at a marked-up price that you pay in installments. Economically, this looks a lot like a loan with interest. The bank's profit is predetermined, and you end up paying more than the car's original price. But technically, no interest has changed hands—just a sale with deferred payment.

Ijarah is the Islamic equivalent of leasing. The bank buys an asset and rents it to you, often with an option to purchase at the end of the lease period.

Wadiah covers basic safekeeping—the bank holds your money and guarantees its return, essentially a checking account.

The Critics Speak

Islamic banking has attracted passionate advocates who see it as a return to divine guidance, a rejection of Western economic dominance, and a path toward a more just financial system. Its most enthusiastic supporters envision a world with "no inflation, no unemployment, no exploitation and no poverty" once Islamic principles are fully implemented.

The critics are equally passionate, but their objections come from an unexpected direction: they argue that Islamic banking isn't Islamic enough.

The early theorists of Islamic finance emphasized profit-and-loss sharing as the core principle. Banks and depositors would share in the real risks and rewards of economic activity, creating more stable and ethical financial relationships. But in practice, profit-sharing arrangements like mudarabah account for only a small fraction of Islamic banking activity. The industry is dominated by murabaha—the cost-plus financing that critics describe as essentially interest by another name.

This has led to accusations that Islamic banks merely "comply with the formal requirements of Islamic law" while using "ruses and subterfuges to conceal interest." The structures are different, but the economic substance is similar. Meanwhile, customers often face "higher costs, bigger risks" than they would at conventional banks—paying a premium for Sharia compliance without receiving the genuine alternative that was originally promised.

There's a certain irony here. The hiyal—legal workarounds—that allowed Muslims to practice interest-based lending throughout Islamic history have simply been formalized and institutionalized. The modern Islamic banking industry has made these workarounds its primary business model.

A Precedent from the Prophet's Time

Advocates of Islamic banking point to historical precedents going back to the earliest days of Islam. One intriguing example involves Zubayr ibn al-Awwam, a companion of the Prophet Muhammad and one of the wealthiest men of his generation.

Zubayr developed a creative approach to money-keeping. When people deposited funds with him, he technically structured the transaction as a loan—money he was obligated to repay. This gave him the right to use the deposits for his own business ventures in the meantime. He charged no interest to depositors and paid none to them either.

The system worked remarkably well during his lifetime. Zubayr was a skilled investor, and his businesses generated substantial returns. But when he died, the accounting revealed just how leveraged he had become: he owed two million dinars to depositors. Fortunately, his investments were sound. His son Abdullah sold property to settle all debts while still leaving an inheritance for the family.

This practice received approval from classical scholars, including the influential Ibn Taymiyyah. It demonstrated that banking-like functions could exist within Islamic constraints—though it also illustrated the risks involved when profits depend entirely on investment success rather than guaranteed returns.

The Global Expansion

By the early 2000s, Islamic finance had grown far beyond its Gulf state origins. The industry established international standards through organizations like the Accounting and Auditing Organization for Islamic Financial Institutions (founded 1990) and the Islamic Financial Services Board (founded 2002 in Malaysia). The first sukuk—Islamic bonds structured as certificates of ownership in underlying assets rather than debt obligations—were issued in 1990.

Major Western financial institutions took notice. Citibank launched Citi Islamic Investment Bank in Bahrain in 1996. The Dow Jones Islamic Market Index, established in 1999, provided a benchmark for measuring Islamic investment performance.

The expansion into the United Kingdom proved particularly instructive. In the 1990s, some British Islamic bankers tried to have it both ways, calling their returns "interest" to tax authorities (to claim deductions) while assuring Muslim depositors these were actually "profits" and therefore Sharia-compliant. Islamic scholars issued a fatwa accepting this arrangement for tax purposes, provided the underlying transactions were genuinely compliant.

Muslim customers weren't persuaded. The approach left "a bad taste in the mouth" and set back the UK market for years. The Islamic Bank of Britain, the first Islamic commercial bank established outside the Muslim world, didn't open until 2004.

Historical Depth

While the modern Islamic banking movement is essentially a twentieth-century phenomenon, its proponents draw on a rich historical tradition. According to economic historians, by the tenth century, Islamic law supported credit and investment instruments as sophisticated as anything in the non-Islamic world.

Medieval Islamic commerce featured bills of exchange, various forms of partnership including limited liability arrangements, promissory notes, trusts, and checking accounts. Muslim traders used check systems—called sakk, from which we get our English word "check"—as early as the ninth century during the reign of Harun al-Rashid. These commercial innovations later spread to medieval Europe, influencing the development of Western capitalism.

What didn't exist, interestingly, were durable institutions recognizable as banks. The first Muslim majority-owned banks appeared only in the 1920s. The banking functions existed, scattered across merchants, money-changers, and wealthy individuals like Zubayr, but the consolidated institutional form we associate with modern banking was a later import.

The Scale Today

By 2014, roughly $2 trillion in assets were managed according to Sharia-compliant principles—an impressive figure, though still representing only about 1% of global financial assets. The industry is concentrated in a handful of markets: the Gulf Cooperation Council states (Saudi Arabia, the United Arab Emirates, Kuwait, Bahrain, Qatar, and Oman), Bangladesh, Pakistan, Iran, and Malaysia.

Growth rates have consistently outpaced conventional banking. Between 2008 and the mid-2010s, Islamic banking expanded at 10-15% annually, and projections suggested continued rapid growth. By 2008, there were over 300 Islamic financial institutions operating in 51 countries, plus 250 mutual funds following Islamic principles.

The growth in Europe has been particularly notable, driven by increasing Muslim populations and the relative lack of existing supply. Luxembourg has positioned itself as a hub for Islamic funds, suggesting that geographic boundaries matter less than regulatory frameworks and financial expertise.

An Ongoing Experiment

Islamic banking remains, in many ways, an ongoing experiment in applying religious principles to modern economic life. Its supporters see it as proof that faith and finance can coexist, that alternatives to interest-based banking are viable, and that the global financial system doesn't have to follow a single Western template.

Its critics—including some devout Muslims—worry that the experiment has produced form without substance, that the industry has become more about legal compliance than ethical transformation, and that the original vision of genuine profit-and-loss sharing has been largely abandoned in favor of structures that differ from conventional banking mainly in their complexity and cost.

Both perspectives contain truth. The industry has demonstrated that Sharia-compliant finance can operate at scale, attracting both devoted Muslims seeking religious consistency and investors interested in alternative financial structures. At the same time, the tension between theoretical ideals and practical implementation remains unresolved.

Perhaps that's inevitable. Money is complicated. Religion is complicated. Combining them was never going to be simple. What's remarkable is that the attempt is being made at all—and that the resulting industry, whatever its imperfections, represents a genuine alternative to the assumptions that have dominated global finance for centuries.

The parliamentary pandemonium in Pakistan was about more than interest rates. It was about whether tradition and modernity can be reconciled, whether sacred principles can survive contact with economic reality, and whether a different way of organizing money is possible. Those questions haven't been answered. They're still being asked.