Literature Review ISLAMIC FINANCE: ETHICS, CONCEPTS, PRACTICE Usman Hayat, CFA Adeel Malik, PhD Literature Review ISLAMIC FINANCE: ETHICS, CONCEPTS, PRACTICE Usman Hayat, CFA Adeel Malik, PhD Statement of Purpose The CFA Institute Research Foundation is a not-for-profit organization established to promote the development and dissemination of relevant research for investment practitioners worldwide. Neither the Research Foundation, CFA Institute, nor the publication’s editorial staff is responsible for facts and opinions presented in this pub- lication. This publication reflects the views of the author(s) and does not represent the official views of the CFA Institute Research Foundation. The CFA Institute Research Foundation and the Research Foundation logo are trademarks owned by The CFA Institute Research Foundation. CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trademarks owned by CFA Institute. 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ISBN 978-1-934667-79-8 1 November 2014 Editorial Staff Elizabeth Collins Mary-Kate Hines Editor Assistant Editor Cindy Maisannes Christina Hampton Manager, Publications Production Publishing Technology Specialist Contents Islamic Finance: Ethics, Concepts, Practice .................................... 1 Introduction ............................................................................. 4 Islamic Economic Thought .......................................................... 13 Shari’a and the Prohibitions Shaping Islamic Finance ..................... 24 Islamic Finance in Practice .......................................................... 32 Regulatory Issues ...................................................................... 45 Governance and Responsibility ................................................... 50 Political Economy of Islamic Finance ............................................ 60 Form vs. Substance .................................................................... 68 Empirical Studies and Concluding Thoughts ................................. 81 Glossary ................................................................................... 88 Suggested Readings .................................................................. 89 References ............................................................................... 107 Islamic Finance: Ethics, Concepts, Practice Usman Hayat, CFA Content Director (Islamic Finance and Environmental, Social, and Governance Issues in Investing) CFA Institute Adeel Malik, PhD Islamic Centre Lecturer in Development Economics University of Oxford & Globe Fellow in the Economies of Muslim Societies Oxford Centre for Islamic Studies Islamic finance, widely regarded as one of the fastest-growing segments of global finance, is the subject of many debates. Should religion have anything to do with finance? Can guidance on economics and finance be derived from Islam? What exactly is meant by the prohibition of riba in Islam? Is equity financing superior to debt financing for long-term economic prosperity? Is the Islamic financial sector “Islamic” only in form, not in substance? Can there be such a thing as an Islamic commercial bank operating within the prevalent monetary and banking system? Will following the legal minimum of Islamic commercial jurisprudence by commercial financial institutions lead to fulfill- ment of the higher objectives of Islam? These are but a sample of the larger debates regarding Islamic finance. Such debates in Islamic finance invite many opinions. However, it is a matter of fact rather than opinion that Islamic finance is the most prominent faith-based finance in the world today. One way to describe it is “finance that is consistent with Islamic teachings.” Specifically, Islamic finance must avoid “sin” (i.e., prohibited) businesses; it must also abide by the Islamic prohibitions of riba and excessive gharar, which are generally understood to include lending and borrowing of money at interest and sale of risk.1 Consider a simple example: Islamic finance is not to be used to finance a brewery because the underlying activity—consumption of alcohol—is prohibited by Islam. Similarly, the money cannot be used for lending money at interest (as is the case in a conventional bond) or sale of risk (as in conventional derivatives and proprietary insur- ance) because of the prohibitions of riba and excessive gharar. An idea strongly 1We are of the view that translating the Arabic terms riba and gharar tends to cause more confusion than clarity. Therefore, throughout this review, we do not use any English transla- tion of these terms. ©2014 The CFA Institute Research Foundation 1 Islamic Finance associated with Islamic finance is that financiers and those being financed need to assume risk associated with business outcomes or ownership of an asset. Where risk is to be managed through insurance, it should be done through a mutual risk-sharing arrangement. Since the 2007–08 global financial crisis, often blamed on the bloated size and excesses of the financial sector, Islamic finance is seen as a curious form of finance that seems to be saying the kinds of things many want to hear from the financial sector—emphasizing ethics and making finance a servant (not the master) of the real economy where goods and services and produced. What started out as relatively abstract literature on Islamic economics in the 1940s has become a rapidly growing body of knowledge in Islamic finance. This review seeks to cover the major themes of this literature. We cover materials written in English or for which English translations are readily available. Most of these materials have been published since the year 2000, when the industry and its literature experienced substantial growth and ideas in Islamic financial practice have become more specific. We provide an overview of the available literature, a description of the existing state of knowledge, major themes and sub-themes associated with the topic, and a list of suggested readings. For the reader’s convenience, this review does not assume any prior knowledge of Islamic finance. Some further clarifications are in order. A significant part of the literature on Islamic finance is legalistic—for example, discussing why something (e.g., futures and options) is prohibited or permissible in Islamic commercial jurisprudence. In the interest of the nonspecialist reader who is unlikely to be interested in the technicalities of Islamic commercial jurisprudence, we have included such material only to the extent necessary. Islamic finance sprang from Islamic economic thought, which is itself a wide body of knowledge. We cover only those elements of Islamic economics that are essential for understanding Islamic finance. We have divided the material into multiple sections and added highlights to the beginning of each section. Readers can thus select and read the sections that appeal to them the most. Some topics in the literature have been written about extensively (e.g., the prohibition of riba); others have received far less attention (e.g., ecology as it relates to Islamic finance). If a topic is addressed sufficiently by a few titles, we limited the number of works included in the discussion and the list of suggested readings. For the ease of readers, we have also added a brief glossary of the Arabic terms used in this review. This literature review • introduces the subject and outlines the context to the literature, 2 ©2014 The CFA Institute Research Foundation Islamic Finance • discusses Islamic economic thought and highlights its pertinence for Islamic finance, • explains the major elements of Islamic law and prohibitions concerning Islamic finance, • addresses the use of “nominate” contracts and promises in structuring Islamic finance products, • touches on regulatory issues, • spells out governance and social responsibility, • discusses the political economy in which Islamic finance operates, • elaborates on the “form versus substance” debate, and • summarizes the findings of some of the empirical studies while offering concluding thoughts. We have tried to make this literature review comprehensive and objective. We hope that it provides a simple and clear explanation of the concepts and debates in Islamic finance. ©2014 The CFA Institute Research Foundation 3 Introduction This section will provide the background for the remaining sections. We supply a brief history of the industry and statistics about its size, composition, and growth. Highlights of this section are as follows: • The ideas associated with Islamic finance have wide appeal and are not necessarily exclusive to Islam. • Unlike Islam, which dates back to the 7th century, modern Islamic finance practice is a 20th-century phenomenon. • Modern