OVERVIEW OF ISLAMIC FINANCE • OFFICE OF INTERNATIONAL AFFAIRS OCCASIONAL PAPER NO. 4 • JUNE 2006
Department of the Treasury
Office of International Affairs
Occasional Paper No. 4
August 20061
Overview Of Islamic Finance
DISCLAIMER
Occasional Papers from the Treasury Department’s Office of International Affairs exam-
ine international economic issues of current relevance in an effort to identify underlying trends
and issues for policymakers. These papers are not statements of U.S. Government, Depart-
ment of the Treasury, or Administration policy and reflect solely the views of their authors.
By Mahmoud Amin El-Gamal2
WhAt IS ISLAMIC FInAnCE?
Islamic finance started as a small cottage industry
in some Arab countries in the late 1970s. It dis-
tinguishes itself from conventional finance in its
ostensible compliance with principles of Islamic
law, or Shari’a.3 Its growth has been accelerating
ever since, in terms of the number of countries in
which it operates, as well as the areas of finance
in which it has ventured. However, reliable data
are not available on Islamic finance at the coun-
try, regional or global levels.4 In recent years, the
industry has attracted a number of western mul-
tinational financial institutions, such as Citigroup
and HSBC, which started offering Islamic finan-
cial products in some Arab countries (notably
Bahrain and the United Arab Emirates), and to a
lesser extent in the western world (including the
U.S., where HSBC offers various Islamic financial
products in New York, including home financing,
checking accounts, etc.). A number of Islamic fi-
nancial products also involve the acquisition of
assets (e.g., real estate, small corporations, etc.) in
the west (including the U.S.) in “Islamically struc-
tured” financing deals.
Islamic finance relies crucially on three sets of in-
dividuals with complimentary skills: (i) Financial
professionals who are familiar with conventional
financial products, as well as the demand for “Is-
lamic” analogues of those products within vari-
ous Muslim communities around the world, (ii)
Islamic jurists (fuqha or experts on classical juris-
prudence developed mainly between the 8th and
14th Centuries), who help Islamic financial pro-
viders to find precedent financial procedures in
classical writings, upon which contemporary an-
alogues of conventional financial products can be
built, and (iii) lawyers who assist both groups in
structuring Islamic analogue financial products,
1 This paper was originally written by the author in July 2004. Where necessary, the text has been updated by Treasury
International Affairs staff, and the revised paper was reviewed and approved by the author.
2 Mahmoud Amin El-Gamal is Professor of Economics and Statistics at Rice University. He is Chair of Islamic Economics,
Finance and Management in the Department of Economics. From May 2004 until December 2004 he was Islamic Finance
Scholar-in-Residence at the U.S. Treasury Department.
3 Shari`a literally means “the way” and is the Arabic term for Islamic Law as a way of life, comparable to the Hebrew Hal-
achah). Fiqh, commonly translated as jurisprudence, is the interpretation of Shari`a for specific circumstances by specialized
fuqha, or jurists.
4 One can find several quoted figures, used primarily for informational purposes. However, there appears to be no reliable
statistical basis for those numbers, so we have to settle for qualitative growth description.
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OVERVIEW OF ISLAMIC FINANCE • OFFICE OF INTERNATIONAL AFFAIRS OCCASIONAL PAPER NO. 4 • JUNE 2006
while ensuring their compliance with all applica-
ble and relevant legal and regulatory constraints.5
Due to the industry’s small size, a limited number
of key players in each of those three categories
have emerged as clear leaders.
hIStoRICAL RootS oF
ISLAMIC FInAnCE
In the late 19th Century, the Ottomans intro-
duced western-style banking to the Islamic world
to finance their expenditures. While some Islamic
jurists approved of modern banking practices, the
majority found those practices to be violations of
Islamic prohibitions against usury (Arabic term:
riba, equivalent to the Hebrew ribit, and inter-
preted in its classical Biblical sense of any interest
charge on loans, as opposed to the modern iden-
tification of usury with exorbitant interest). This
resentment continued through the European
colonial period, which lasted into the mid-20th
Century. Islamic revival played a central role in
the intellectual and social foundations of inde-
pendence movements of the mid-20th Century.
To many intellectual founders of the movement,
political independence was to be supplemented
with economic independence, through the defi-
nition of an Islamic economic system.
Early writings on what came to be known as “Is-
lamic Economics” focused on macroeconomic
developmental issues. By the 1970s, theoretical
discussions of Islamic economics had given rise
to practical discussions of Islamic finance, which
turned juristic in nature: how can Muslims replace
(conventional) financial practices (deemed to be
usury/riba-based) with Islamic alternatives. Mid-
Century literature suggested a profit-and-loss
sharing silent partnership alternative to interest-
based lending. The Arabic name of this contract
is mudaraba, which is akin to the medieval Eu-
ropean Commenda contract, and the Jewish Heter
Isqa, designed similarly to avoid usurious lending
in Jewish and early Catholic Law.6
This partnership-based focus survives in some
Islamic financial practices (e.g., as a substitute
for interest-bearing bank deposits). However,
with the help of Islamic jurists and lawyers, as
discussed in the introduction, Islamic financial
practitioners were soon able to provide close an-
alogues to almost all financial products, includ-
ing various debt-instruments and fixed-income
investment vehicles. We shall summarize some of
the most widely used Islamic financial modes of
operation in the following section.
MoDES oF opERAtIon In
ISLAMIC FInAnCE
There are many contract and institutional forms
used within the industry collectively known as Is-
lamic finance. Specifics vary across countries and
sectors. In this overview, we shall concentrate on
some of the basic and central modes of financ-
ing that are most popular in Islamic finance to-
day. When significant differences exist between
implementations of a particular Islamic financial
transaction in different regions or sectors, we note
those differences briefly.
Consumer and Business Loan
Alternatives
The juristic-based understanding of forbidden
riba/usury suggested that Islamic finance has to
be “asset-based”, in the sense that one cannot
collect or pay interest on rented money, as one
does in conventional banking. Therefore, the eas-
iest transactions to Islamize were secured lending
operations, e.g., to finance the purchase of real
estate, vehicles, business equipment, etc. Three
main tools are utilized for this type of retail fi-
nancing:
5 In this regard, Islamic finance has to adhere to multiple legal requirements; for clarity, this paper will refer to religious
constraints as “juristic”, and reserve the terms “legal” and “regulatory” for sovereign-imposed constraints.
6 On Mudaraba/Commenda, see Udovitch, Abraham L. Partnership and Profit in Medieval Islam. Princeton, N.J: Princeton
University Press, 1970. On the Isqa (alternatively spelled Iska) contract, see Stern, J. “Ribit: A Halachic Anthology”, Journal
of Halacha and Contemporary Society, 46, 1982. Sample Iska forms are available at:
www.jlaw.com/Forms/iska_d.html.
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OVERVIEW OF ISLAMIC FINANCE • OFFICE OF INTERNATIONAL AFFAIRS OCCASIONAL PAPER NO. 4 • JUNE 2006
a. Buy-sell-back arrangements given the
classical Arabic name: murabaha. Under
this transaction, the bank obtains a prom-
ise that its customer will purchase the prop-
erty on credit at an agreed-upon mark-up
(interest alternative), then proceeds to buy
the property and subsequently sell it to the
customer. These are analogous to the Fed-
eral Reserve’s use of “matched-sale pur-
chases.” Depending on the jurisdiction and
the object of financing, this may or may not
impose additional sales taxes, license fees,
etc. In the U.K., a recent regulatory ruling
allowed Islamic financiers (HSBC) to prac-
tice double-sale financing without being
subject to double-duty taxation. In 1999, at
the request of United Bank of Kuwait (UBK),
which at the time offered an Islamic home
financing program in the U.S. (called Manzil
USA, the program was terminated shortly
thereafter), the Office of the Comptroller
of the Currency issued an interpretive letter
declaring Murabaha financing to be “func-
tionally equivalent to or a natural outgrowth
of secured real estate lending and inventory
and equipment financing, activities that are
part of the business of banking”. 7 The mark-
up in Murabaha financing is benchmarked
(i.e., made to track) conventional interest
rates.
b. Lease-to-purchase or diminishing part-
nership arrangements under the Arabic
names Ijara or Musharaka Mutanaqisa. A
typical structure requires the bank to create
a special purpose vehicle (SPV) to purchase
and hold title to the financed property. The
SPV then leases the property to the cus-
tomer, who makes monthly payments that
are part-rent and part-principal. Rents are
calculated based on market interest rates,
allowing monthly payments to follow a con-
ventional amortization table. The juristic
justification of this practice is that principal
parts of monthly payments increase the cus-
tomer’s ownership in the property, and allow
him to pay less rent (on the part ostensibly
owned by the bank through the SPV) over
time, thus replicating a conventional amor-
tization table. Again, at the request of UBK,
the Office of the Comptroller of the Cur-
rency examined the typical structure of Is-
lamic lease-to-own (Ijara) transactions, and
reasoned as follows:8“Today, banks structure
leases so that they are equivalent to lending
secured by private property ... a lease that has
the economic attributes of a loan is within
the business of banking... Here it is clear that
UBK’s net lease is functionally equivalent to
a financing transaction in which the Branch
occupies the position of a secured lender...”.
An added advantage to lease financing is
that Islamic jurists allow the SPV to issue
certificates securitizing the lease (ostensi-
bly, the certificates represent ownership of
the underlying asset, and thus allow their
holders to collect rent). In recent years, this
has given rise to a booming securitization
industry in Islamic Finance, as we shall dis-
cuss within the context of bond-alternatives.
Here in the U.S., both Fannie Mae and Fred-
die Mac have purchased and guaranteed
Ijara-based mortgages, subject to their note
requirements (which required overcoming
some legal and juristic hurdles). Those Is-
lamic mortgage-backed securities are cur-
rently being marketed as fixed-income in-
vestment alternatives for Muslims.
c. Recently, banks in Gulf Cooperation
Council (GCC) countries have been of-
fering consumer finance through a three-
party contract known by the Arabic name
Tawarruq (literally: monetization of some
commodity). This is a practice that Islamic
banks have used with more sophisticated
business clients for a number of years, but
only recently introduced for consumer fi-
7 Available on the OCC website at:
www.occ.treas.gov/interp/nov99/int867.pdf.
8 See
www.occ.treas.gov/interp/dec97/int806.pdf.
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nancing. For example, a customer wants
to borrow $1000 using an Islamic Juristic-
compliant mechanism. GCC Islamic jurists,
relying on an opinion within the Hanbali
school of jurisprudence, which is dominant
in that region, allow the bank to buy $1,000-
worth of commodities (e.g., wheat), and sell
them to the customer on credit at a mark-up
(equal to the interest rate they would have
charged on a loan, perhaps plus compensa-
tion for the transaction costs associated with
multiple sales). The customer may then turn
around and sell the commodity to a third
party (oftentimes the same party that sold
it to the bank), collecting the desired cash
immediately, with a deferred debt equal to
principal plus interest. In 2004, at least one
other bank in a GCC country announced a
new Tawarruq facility. Since this type of fi-
nancing can easily replace lending for any
purpose (consumer loans, unsecured loans,
etc.), it has allowed a number of conven-
tional banks to announce that they will
“Islamize” all of their operations. The most
significant such announcement was that
made by Saudi Arabia’s National Commer-
cial Bank, stating that it planned to Islamize
all of its lending practices by 2005.
Corporate and Government Bond
Alternatives
In its early stages of development in the 1980s and
90s, a number of bond alternatives were tried with
very limited success. Some were based on profit
and loss sharing (e.g., in Sudan and Pakistan),
while others guaranteed the principal but did not
guarantee a fixed rate of return (e.g., in Malaysia).
Once the securitization of leases (discussed in
the previous section) became fully understood, a
significant number of corporate and government
bonds were structured as lease-backed securi-
ties (under the Arabic name Sukuk al-Ijara).9
In
2004, the largest issuance was by the Department
of Civil Aviation of the United Arab Emirates for
$750 million. The second largest was by the Bah-
rain Monetary Agency for $250 million. The latter
was led by Citigroup, with heavy involvement of
the Norton Rose law firm to structure the deal. A
third interesting government issuance was by the
German Federal State of Saxony-Anhalt for €100
million, which is heavily marketed in the Arab
countries of the GCC as the first western-govern-
ment issued Islamic bond. The two largest cor-
porate Islamic bond issuances in the first half of
2004 were those of the National Central Cooling
Company (of U.A.E.) for $100 million and Hanco
Rent a Car in Saudi Arabia for $26.13 million.
Corporate bond issuances in the early part of
2006 totaled $10.2 billion, the most notable being
the Dubai Ports issuance of the largest sukuk to
date, a 2 year convertible $3.5 billion bond (profit
and loss sharing).10 In 2005, an estimated $11.4
billion in corporate sukuks were issued, up from
$5.5 billion and $4.6 billion in 2004 and 2003 re-
spectively. Sovereign issuances in 2006 total $2.7
billion thus far, up from $706 million in 2005, $1.5
million in 2004 and $1.2 million in 2003.11 An ad-
ditional $6.7 billion in sovereigns is slated to be
issued for the remainder of 2006.12
A number of those issuances were made by SPVs,
which buy some properties from the respective
governments or corporations using bond-sale
proceeds, and then lease the properties back,
passing principal and interest back to bond-hold-
ers in the form of rent. A number of different U.S.
and European investment banks are involved in
the securitization process (e.g., Citigroup for the
Bahraini and German state bonds, Credit Suisse
First Boston for the UAE cooling company, and
Barclays Bank with the Dubai Islamic Bank for
the Dubai Ports Co.).
9 Sukuk is the plural of sakk, an Arabic precursor of cheque, meaning certificate of debt or bond.
10 Managed by Dubai Islamic Bank and Barclays Bank. Details about the sukuk structure, and thus about potential risk-
structure differences from conventional bonds, are not available.
11 Sovereigns include government-owned institutions, utilities,etc.
12 Source: ISI Emerging Markets’ Islamic Finance Information Service (IFIS). Data as of May 2006.
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OVERVIEW OF ISLAMIC FINANCE • OFFICE OF INTERNATIONAL AFFAIRS OCCASIONAL PAPER NO. 4 • JUNE 2006
Lease-backed bonds are long-term securities, for
which underlying physical assets allow secondary
markets to exist. Shorter-term (Treasury bill-like)
bonds are also issued on occasion by govern-
ments of countries with significant Islamic bank-
ing operations (e.g., Bahrain). Those are typically
based on forward sales of some commodities, us-
ing the Arabic name salam, and adhering to the
classical juristic
ruling that price must be paid in-full at the incep-
tion of a salam-sale. By utilizing what is called a
“parallel salam”, the bond-issuer can match a for-
ward-purchase with a purchase-sale for the same
commodities and the same delivery date, but ini-
tiated at different times. Thus, corn deliverable in
six months can be sold forward today for $1 mil-
lion, and then bought forward in three months
(using a separate contract with a different coun-
terparty) for $1.01 million. While residual credit,
commodity and delivery risks may exist in this
structure, issuers typically guarantee the contract
so that the bond buyers would – in our example
– be guaranteed 1% in 3 months. Since the un-
derlying assets for this type of bond are debts, Is-
lamic jurists ruled that they cannot be traded on
secondary markets (except at face value, which
defeats the purpose). Thus, they were originally
envisioned as vehicles primarily for Islamic banks
to hold to maturity. Recently, however, Bahrain
has introduced some innovative repo (repurchase)
facilities, to allow Islamic banks to use those bills
more effectively for liquidity management.
Investment Vehicle Alternatives (e.g., Mu-
tual Fund, private Equity)
For investment in corporate equity, it was easy
to see why Islamic investors should shy away
from companies that produced products that are
forbidden to Muslims (e.g., beer, pork products,
etc.), as well as some others that Islamic jurists
decided to forbid (e.g., weapons producers, cut-
ting-edge genetic research, etc.). The issue of in-
terest was much more difficult: Most companies
either have excess liquidity – in which case they
earn interest, or use leverage – in which case they
pay interest. Islamic jurists decided to invoke the
rule of necessity (the universe of equity securities
to choose from would be too small if they exclude
all companies that either pay or receive interest).
They decided to impose three financial screens:
(i) exclude companies for which accounts receiv-
ables constituted a major share of their assets; (ii)
exclude companies that had too much debt; and
(iii) exclude companies that received too much
interest. After experimentation with different cut-
off marks for financial ratios, the set of rules se-
lected by the Dow Jones Islamic indices became
globally accepted: (i) exclude companies whose
receivables accounted for more than 45% of as-
sets; and (ii) exclude companies whose debt to
moving average of market capitalization exceed
33%. Many add a third rule related to the first:
(iii) exclude companies whose interest income
exceeds 5% (or, for some, 10%) of total income.
Dow Jones, and later Financial Times, launched
their Islamic indices in the late 1990s, and contin-
ue to add various other Islamic indices paralleling
their other conventional indices, with the smaller
universe of equity securities. Mutual fund com-
panies either mimic their screening rules, or ob-
tain licenses from one of the indices, which they
use as a benchmark. These types of mutual funds
are usually dubbed “Islamic” or “Shari`a-compli-
ant.” While sales of mutual funds in general have
done well in Saudi Arabia and GCC markets, Is-
lamic mutual funds seem to have only a limited
marketing advantage over conventional ones. In
one study done by National Commercial Bank in
Saudi Arabia, investors indicated that all other
things equal, they would prefer an “Islamic” fund
to a conventional one. However, if other things
are not equal, they would prefer a conventional
fund with better returns, or offered by a more
reputable provider, to ones that are “Islamic” but
inferior along those dimensions. Consequently,
the total funds under management by Islamic
mutual funds have – to date – fallen substantially
short of initial expectations.
On the other hand, growing unanimity over the
general screens used by Islamic mutual funds has
enabled Islamic private equity and investment
banking boutiques to thrive. Those institutions
typically collect investor funds in GCC countries
(investors from Saudi Arabia, Kuwait, and U.A.E.
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OVERVIEW OF ISLAMIC FINANCE • OFFICE OF INTERNATIONAL AFFAIRS OCCASIONAL PAPER NO. 4 • JUNE 2006
being primary sources of funds). Through local
subsidiaries or partners in the west (U.S.A. and
U.K. being primary destinations for investment
funds), collected funds are used to acquire real
estate and small companies that pass the above
mentioned screens, or whose debt can be restruc-
tured to pass them (oftentimes through lease-
based leveraged buy-outs, a popular western
mergers and acquisitions tool of the 1980s and
1990s). There are 134 registered equity funds, six
hybrid funds, six sukuk funds, two Takaful funds
(insurance), five leasing funds and eight real es-
tate funds.13
Insurance Alternatives
The vast majority of Islamic jurists declared the
use of, and investment in, insurance companies
to be impermissible under Islamic jurisprudence.
This prohibition is based on two considerations:
the first consideration is that “safety” or “insur-
ance” is not itself viewed as an object of sale in
classical Islamic jurisprudence. Thus, Islamic ju-
rists argued, the insured-insurer relationship is
viewed to be one akin to gambling, wherein the
insured as buyer pays periodic premia as price, but
may or may not receive the object of sale (com-
pensation in case of loss), depending on chance.
The second consideration that prompted Islamic
jurists to forbid insurance is the fact that insur-
ance companies tend to concentrate their assets
in interest-based instruments such as govern-
ment bonds and mortgage-backed securities.
The alternative they proposed is marketed un-
der the Arabic name Takaful, which has recently
begun making inroads in Islamic countries, after
years of slow growth. The main idea behind Taka-
ful is similar to mutual insurance, wherein there
is no commutative financial contract that allows
one to interpret premium payments as prices and
insurance claim fulfillment as an object of sale.
Rather, policy holders are viewed as contributors
to a pool of money, which they agree voluntarily
to share in cases of loss to any of them. Early
Takaful companies were in fact structured as stock
insurance companies, but the language of “vol-
untary contribution” to insurance claimants was
used to argue that the contract was not a com-
mutative one. Inroads have recently been made
by Bank Al-Jazira of Saudi Arabia by modifying
its insurance to better approximate western-style
mutual insurance, and the model appears to be
boosting its underwriting success. Regardless of
structure, both types of Takaful companies do
not invest in conventional government bonds
and fixed income securities. However, as seen
elsewhere in this section, Islamized analogues of
those securities have become increasingly avail-
able in recent years, further contributing to the
industry’s growth. Despite the industry’s growth,
it has not yet reached a critical size that would
support the equivalent of re-insurance, or “re-
Takaful”, companies to emerge. Consequently,
Islamic jurists have invoked the rule of necessity
to allow Takaful companies to sell their risks to
conventional re-insurance companies, with the
provision that they should work to develop a re-
Takaful company as soon as possible.
Bank Deposit and Fixed Income Security
Alternatives
In the Islamic world, Islamic banks can only ac-
cept fiduciary deposits, for which they cannot
pay interest, since interest would be considered
usury/riba once the principal is guaranteed. On
the other hand, they are allowed to accept “in-
vestment account” funds, which they may in-
vest on behalf of the account holders, and share
profits and losses thereof. This clearly gives rise
to a moral hazard problem, and a regulatory is-
sue regarding protection of investment account
holders who are neither protected as creditors
(first claimants), nor as stock-holders with rep-
resentation on boards of directors. Attempts by
significant juristic bodies to justify interest-bear-
ing bank deposits have been strongly rejected by
most Islamic jurists, especially the ones to whom
13 As of February 2006.
www.failaka.com.
14 For a summary of this debate and its juristic grounds, see El-Gamal, Mahmoud “Interest and the Paradox of Contempo-
rary Islamic Law and Finance”, Fordham International Law Review, December 2003.
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OVERVIEW OF ISLAMIC FINANCE • OFFICE OF INTERNATIONAL AFFAIRS OCCASIONAL PAPER NO. 4 • JUNE 2006
Islamic bank customers look for guidance.14
In the U.S., a number of attempts took place in
the U.S. to license an Islamic bank, a number of
conventional banks are offering Islamic financing
products, and working towards offering FDIC-
insured variable-interest (tied to rate of return
on portfolio of Islamic mortgage, auto-financ-
ing, etc.) NOW, money market, and other types
of bank accounts. Interpretation of such services
as “deposits” is controversial, and their appeal to
target clientele is uncertain. In particular, and in
analogy to the limited appeal of Islamic mutual
funds, it may be the case that potential Islamic
bank customers who are sufficiently sophisticat-
ed to accept deposit insurance will also be suf-
ficiently sophisticated to seek the best combina-
tions of returns and offering institution-size. On
the other hand, the novelty of “Islamic banking”
availability, coupled with the possibility of obtain-
ing FDIC insurance of the principal, may prove to
be sufficiently attractive for a group of Muslims
who have so-far shied away from depositing their
funds in savings or money market accounts, as
well as others who have such accounts but prefer
to buy the “Islamic” brand-name.15
In the meantime, as we have shown, market-based
fixed-income alternatives have been available for
quite some time based on securitization. Thus,
Islamic finance clients can buy Islamic mortgage-
based securities, or invest directly in pools of se-
curitized fixed-return Islamic financial products.
In this regard, while securitized Murabaha (cost-
plus credit sale receivable) portfolios are deemed
non-tradable except on face value, Islamic jurists
have allowed trading mixed portfolios of sale-
based and lease-based receivables, provided that
the latter constitute at least 51%. If the market
for Islamic-finance assets continues to grow, the
ability to offer all types of fixed-income instru-
ments, including bank savings accounts, should
become more common in the West. It may take
time for Middle-Eastern and Asian clients to ac-
cept this notion, given the vigor with which they
have constantly argued against interest-based
transactions as the forbidden Riba.
GEoGRAphIC DIStRIButIon
oF ISLAMIC FInAnCE
Intensive efforts have been spent in recent years
to harmonize Islamic financial practices, from cre-
ating accounting standards for Islamic financial
products (through the Accounting and Auditing
Organization for Islamic Financial Institutions,
AAOIFI), to integration of those standards with
global corporate and risk management standards
(i.e., Basel Accords I and II) through the recently
created Islamic Financial Services Board (IFSB).
Those efforts are motivated by two objectives: (1)
to create a worldwide network of financial mar-
kets, including the offshore markets in Labuan
(off the Malaysian coast), Bahrain, and Dubai,
thus enhancing depth and liquidity of markets for
industry securities; and (2) to integrate the indus-
try more effectively with the international finan-
cial system. However, country and region-specific
features have not faded away. We list some of the
defining features of Islamic finance in the various
relevant sub-regions in this section.
Gulf Cooperation Council (GCC)
Countries
Not surprisingly, the rise of Islamic finance in the
late 1970s coincided with the two oil shocks of
that decade, which created an immense amount
of wealth. The earliest private Islamic banks of
the modern era were Dubai Islamic Bank, Faisal
Islamic Bank Egypt, and Faisal Islamic Bank Su-
dan, the latter two being sponsored by Prince
Muhammad Al-Faisal, son of the late King Faisal
of Saudi Arabia. Other early entrants in the in-
dustry were the various financial arms of Saudi
Sheikh Saleh Kamel’s Dallah Al-Baraka groups,
and Kuwait Finance House, among others.
In its early stages, most governments in the GCC
15 For instance, a small market exists for “Halal (permissible) meat”, analogous to Kosher products, based on specific
slaughter and processing procedures. Those products appeal to customers who otherwise would only consume vegetarian
products, as well as others who would buy regular meat products but prefer to buy “Halal” meat.
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region, and the Arab world more generally, were
either hostile to, or at best ambivalent about, Is-
lamic finance. Indeed, to most people’s surprise,
the latest country to allow Islamic banking in the
region is Saudi Arabia, where the Saudi Arabian
Monetary Authority has always been concerned
about and averse to introducing non-standard
banking practices.
However, demand for financial products allowed
a number of local and western financial practitio-
ners to create a small industry, using investment
funds from the Gulf region, especially Saudi Ara-
bia. Over the past decade, Bahrain has pursued
Islamic finance as a significant niche that could
allow it to build on its strong banking sector, per-
haps to become a regional financial center. Lo-
cal investment banking talent also emerged in
Bahrain (e.g., First Islamic Investment Bank) and
Kuwait (e.g., The International Investor) to capi-
talize on the growing industry, which had earlier
centered in London and Geneva. Not to be out-
maneuvered, a number of multinational financial
institutions (e.g., Citigroup, HSBC, and UBS) set-
up Islamic financial arms in the region (mainly
in Bahrain and U.A.E.) to cater to commercial as
well as investment banking needs within the Is-
lamic finance niche.
Islamic finance arms of multinational banks, with
their superior resources, later helped indigenous
Islamic finance companies to establish the Ac-
counting and Auditing Organization for Islamic
Financial Institutions (AAOIFI), and most re-
cently initiate the drive to get Central Banks, as
well as the IMF and World Bank, to establish the
Islamic Financial Services Board in Kuala Lum-
pur, Malaysia. We have already seen the primary
role played by multinational investment banks in
the most recent wave of Islamic bond issuances,
both by sovereign states in the region (Bahrain
and Qatar), as well as corporations.
Southeast, South and Central Asia
Malaysia developed one of the earliest mature
Islamic finance markets in the mid-1980s. Initia-
tives to integrate ethnic Malays in the country’s
formal financial sector culminated in converting a
pilgrimage savings plan into a full-fledged Islam-
ic bank: Bank Islam Malaysia Berhad. Over the
next two decades, conventional Malaysian banks
were allowed to offer Islamic financial products
through “Islamic windows”. Malaysia’s central
bank, Bank Negara, began supervision of Islamic
banking practices at its inception. Special bonds
called Government Investment Certificates were
issued to facilitate open market and inter-bank
operations. Those bonds guaranteed the princi-
pal, but gave interest only as an unanticipated gift
based on profitability of government investments.
Malaysian Islamic money markets were success-
ful early on, and attracted some investment capi-
tal from GCC investors eager to invest some of
their capital in Islamic countries.
However, as advanced as the Malaysian Islamic
financial sector was relative to its Arab counter-
parts, it suffered a fundamental drawback. Much
of the development of that sector relied on a ju-
ristic opinion held by Malaysian Islamic jurists,
who allowed trading debts and pure-debt instru-
ments. That allowed Malaysia to evolve a highly
efficient parallel Islamic financial system. How-
ever, Islamic jurists of other regions did not ap-
prove of this debt-trading practice. As the Arab
market grew, and Malaysia feared that Bahrain
would replace London as the sole center of global
Islamic finance, Malaysians strove to harmonize
their Islamic financial markets with Islamic finan-
cial practices elsewhere in the world. To empha-
size its leading role in this industry, the Malay-
sian central bank led the creation of the Islamic
Financial Services Board, which is now housed
in Kuala Lumpur and relies on Malaysian contri-
butions for running expenses. In the meantime,
Malaysians continue to allow more innovation
for their own domestic Islamic financial market,
allowing conventional futures trading, debt trad-
ing, etc., and recently creating a deposit insurance
mechanism for Islamic banking. Other countries
in Southeast Asia, e.g., Indonesia, Singapore, etc.
have relatively small Islamic financial sectors,
which are likely to evolve as a hybrid between the
Malaysian and the more conservative Arab and
Pakistani models.
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Pakistan is another interesting case to consider.
General Zia-ul-Haqq, in his many efforts to use
Islamic fervor for his regime’s legitimacy, de-
clared full-fledged Islamization of the financial
sector in the 1980s. However, bankers merely
continued their conventional banking practices,
replacing the term “profit” with “interest”. The
Pakistani Shari`a Appellate Court repeatedly is-
sued ultimatum orders to Islamize the system for
real at various dates, but that proved impossible.
A new Islamic banking initiative was started in
2004: there are four Islamic banks, two are in the
pipeline and 15 conventional banks have Islamic
branches. The State Bank of Pakistan (the Cen-
tral Bank) appointed its own 5-member Shari’a
board (Islamic juristic authority) composed of
an Islamic jurist, accountant, lawyer, banker, and
central bank representative and has posted a list
of permissible Islamic banking contract forms on
its website. This may be a prelude to more gen-
eral imposition of Islamic banking practices in
Pakistan.
Iran also declared the Islamization of its banking
sector shortly after the Islamic revolution. How-
ever, since most banks were either national or
nationalized, interest payments between those
banks were seen to cancel out in the consolidat-
ed balance sheet, and were therefore permitted.
For dealings with the public, some banks did not
guarantee interest rates, but in practice paid rates
equal to the interest rates determined elsewhere
in the system. Hence, Iranian banking has not
changed significantly before and after the revolu-
tion. Finally, a small number of boutique Islamic
financial shops started in the various “stans” (es-
pecially Kazakhstan) in recent years, but there are
no signs of an Islamic financial industry evolving
in central Asia at this time.
Arab World excluding GCC
As previously noted, Faisal Islamic Banks in Egypt
and Sudan were among the very first Islamic
banks. Faisal Islamic Bank Egypt was established
by special decree, and Islamic banking in Egypt
remains extremely limited, although some state
banks are allowed to offer Islamic transactions to
fulfill the market demand. Official and public per-
ceptions of Islamic banking in Egypt were severe-
ly damaged in the aftermath of massive failures of
Islamist “fund mobilization companies” that ap-
parently attracted remittances of many Egyptians
working in GCC countries, ostensibly to invest in
trading real assets, but in fact constituted pyramid
schemes.
In contrast, Sudan Islamized its entire banking
sector. A very conservative (and hence relatively
inefficient) version of Islamic finance is followed
in Sudan, for instance with government bonds
based on profit-and-loss sharing partnerships.
There are indications currently that banks in the
Southern part of Sudan will be allowed to operate
conventionally or Islamically as they please, while
banks in the north will remain purely Islamic.
Elsewhere in the Arab and Islamic world, a num-
ber of GCC-based banks have had Islamic opera-
tions for a number of years. The general rise in
Islamic sentiments in the region is accompanied
with high levels of adherence to classical law in
all matters ranging from dress-codes to finance.
Consequently, countries that originally resisted
Islamic banking are currently inviting it to sat-
isfy their nascent demand. Recently, for instance,
Lebanon increased substantially its Islamic bank-
ing profile with Saudi-based Al-Baraka, and Syr-
ia licensed its first Islamic bank, which is jointly
Qatar-Syrian owned. One can expect private Is-
lamic finance to continue to grow substantially all
around the Arab and Islamic world. Depending
on political environment, some governments may
even opt for Islamization of some state-owned
banks as a measure to limit capital flight and ap-
pease Islamist elements within their borders.
north America and Western Europe
Islamic finance has arisen in the West primarily as
a result of the popularity of U.S., and to a lesser
extent U.K. and German, financial assets among
GCC investors, who are the primary financiers
of Islamic finance. Whether we consider Islamic
mutual funds that select among stocks on the
NYSE and NASDAQ, commercial real estate in-
vestment, or acquisition target corporations, those
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OVERVIEW OF ISLAMIC FINANCE • OFFICE OF INTERNATIONAL AFFAIRS OCCASIONAL PAPER NO. 4 • JUNE 2006
investors favor the legal transparency and lower
risk associated with mature western markets.
These investment preferences did not change af-
ter September 11, 2001. However, a combination
of fear of asset-freezing dragnets and public im-
age consciousness about being heavily invested in
the West prompted indigenous and multinational
Islamic finance providers to restructure transac-
tions in a manner that gives those investors indi-
rect investment access to those markets.
For the past three decades, Islamic finance prac-
titioners have also attempted to tap the relatively
educated and professional Muslim populations
in the west (again, primarily the U.S. and U.K.).
Arab banks have tried repeatedly, with mixed
success, to engage in home and auto financing
in the U.S. and U.K. (Al-Baraka was one of the
earliest, United Bank of Kuwait coming later and
utilizing some of its models). Most recently, Is-
lamic Bank of Britain, Plc. (in part pioneered by
Abu Dhabi Islamic Bank) was licensed in the
U.K. in August, 2004. Western home-grown bou-
tique financial institutions, structured as co-ops,
savings and loans, and investment companies,
also started in the late 1970s and 1980s, but re-
mained very small in size. Recently, the securiti-
zation successes through participation of Fannie
Mae and Freddie Mac have allowed the market
for Islamic home financing to grow significantly
in the U.S., with some providers seeking to sell
hundreds of millions worth of GSE-guaranteed
mortgage backed securities in GCC countries, as
cheaper alternatives to investment banking and
boutique private equity financial instruments.
Participants in this industry, home-grown and
foreign, have recently had a number of regulatory
successes, including the above cited OCC letters,
and potential FDIC approval of various deposi-
tary products in the U.S., as well as licensing of
the first full-fledged Islamic bank and elimination
of double-duty taxation for HSBC Islamic home
financing in U.K. Islamic finance is likely to con-
tinue to grow in the U.S. and western Europe, but
not to the extent expected by market participants
who hope that a significant proportion of Mus-
lims in those countries will participate in this in-
dustry. For instance, while Islamic mutual funds
are widely accessible, they have only attracted a
very small percentage of savings of Muslims in
those countries. The market-size for Islamic mu-
tual funds was over-estimated, and market-sizes
for other Islamic financial products – estimates
of which prompted many recent developments
in legal and regulatory infrastructures – may very
well be likewise over-estimated.
pRoS, ConS, AnD
pRELIMInARy poLICy
ConCLuSIonS
Islamic finance is an industry which in many
ways tries to “reinvent the wheel,” producing suc-
cessive approximations of western financial prac-
tices. However, it is an industry that is likely to
survive in the medium term, due to continued
existence of customers who value Islamic jurist
approval of its modes of operation. To the extent
that Islamism in all its forms is on the rise, the
industry is likely to continue to grow, but I be-
lieve its growth prospects are limited. However,
its absolute size (though not known accurately)
has already reached levels that require monitor-
ing the sector, and ensuring the development of
appropriate prudential regulations therein as well
as harmonious development within the interna-
tional financial system. We close with a list of the
most important pros and cons of Islamic finance
in the short to medium-term.
Islamic finance may have already succeeded in
integrating some part of the global Muslim pop-
ulation (those who had decided not to deal with
conventional finance) in the formal international
financial system. In the process, Islamic jurists
were forced to analyze classical Islamic jurispru-
dence in light of contemporary legal, regulatory,
economic and financial systems. This gave rise
to a continuing process of growth in Islamic ju-
risprudence, which ultimately may further pro-
duce an efficient integration of Muslims who had
previously shunned the conventional financial
sector. Moreover, recall that the primary mar-
ket for Islamic finance is in developing countries
– which may have formally borrowed modern
legal, regulatory, and financial standards from
advanced countries, but fall significantly short of
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OVERVIEW OF ISLAMIC FINANCE • OFFICE OF INTERNATIONAL AFFAIRS OCCASIONAL PAPER NO. 4 • JUNE 2006
those standards in practice. In this regard, one
may recall that provisions in laws of contracts
under classical Islamic jurisprudence were, in es-
sence, prudential regulations of that time. To the
extent that those provisions are respected in Is-
lamic financial practice (which is not necessarily
the case), Islamic finance may in fact be a catalyst
for improving financial practices in those coun-
tries. For instance, the focus on secured rather
than unsecured lending (albeit being abandoned
with the growth of Tawarruq financing), coupled
with proper marking-to-market of asset val-
ues, can improve collateralization practices that
have been non-existent or poorly implemented
in some majority-Muslim countries, leading to
catastrophic bad loan volumes that threaten their
banking systems.
On the other hand, one cannot but conclude that
the modus operandi of Islamic finance, including
the evolving opinions of its professional Islamic
jurists, is a prolonged reinvention of the financial
wheel. One needs only to observe the evolution
of standards from original practices of Murabaha,
to more advanced Murabaha with agency provi-
sions, and finally Tawarruqpractices, to notice how
competition and better understanding of banking
practices brings Islamic financial practice closer
to its conventional counterpart. However, the
industry’s survival to-date has relied on its cap-
tive market of pious Muslims, who may abandon
it if full convergence is obtained. Moreover, just
as some manufacturers may delay the introduc-
tion of their latest products to smooth demand
over time, Islamic financial providers prefer to
introduce “innovations” (better approximations of
conventional financial practice) gradually, to ex-
tract the most rents, and gently prepare their cli-
entele. This implies that some level of inefficiency
is intrinsic to this industry, taking the forms of
transactions costs, additional legal costs, and fees
for Islamic jurists. Moreover, the industry by its
very nature has a longer lag in “chasing past re-
turns.”16
However, due to catering to a captive
clientele, the industry has been able to survive
and continue its growth despite this continued
inefficiency.
With time, competition is likely to reduce ineffi-
ciency in the industry (though it cannot be elimi-
nated if the industry were to maintain its Islamic
character). To attain higher levels of efficiency, Is-
lamic jurists will have to continue their process
of understanding modern financial practices, and
developing an Islamic jurisprudence that is appro-
priate for today’s legal, regulatory, and financial
realities. In this regard, while some developments
facilitate Islamic finance (e.g., the English elimi-
nation of double duty taxation on HSBC Islamic
financial structures involving double-sale for fi-
nancing purposes), one should not encourage
regulatory adjustments to accommodate Islamic
financial practices. Islamic finance has shown its
ability to adapt to existing regulatory frameworks
(e.g., recent attempts to develop FDIC-insured
Islamic money market accounts, CDs, and NOWs
in the U.S.).17 I have also argued that this adapta-
tion eventually changes the very Islamic jurispru-
dence upon which the industry is built. Toward
that end, regulators’ primary concern should con-
tinue to be protection of consumers of financial
services, as well as safety, stability, and fairness
of the overall financial system. To the extent that
current Islamic jurisprudence has not yet reached
a level of maturity that allows it to coexist harmo-
niously within the best legal and regulatory stan-
16 For instance, Islamic REITs are currently very popular (June 2004), when REITs were in fact a very good investment in
2001-2. Similarly, a number of new “Islamic Hedge Funds” are beginning to reach the market now, again years after the
optimal performance of conventional hedge funds. This chasing of past returns has proved taxing in the past. For instance,
the Dow Jones Islamic Index (DJII) debt ratio screen was originally set for debt to assets. In the middle of the tech bubble
in the late 1990s, jurists changed the 33% cutoff for debts to assets into one for debts to market capitalization (just as
market capitalization was soaring). That allowed DJII-licensed mutual funds to make spectacular returns for a very short
period of time, by being NASDAQ heavy. Once technology sector stocks crashed, many of the stocks had to be excluded
from the DJII universe because their market capitalizations had fallen too low (i.e., they bought high and sold low), disal-
lowing investors to benefit from the partial recovery that ensued.
17 NOWs are negotiable order of withdrawal accounts
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OVERVIEW OF ISLAMIC FINANCE • OFFICE OF INTERNATIONAL AFFAIRS OCCASIONAL PAPER NO. 4 • JUNE 2006
dards, it would be unwise to push market par-
ticipants toward standardizing their financial and
religious-legal standards at this time. Premature
standardization of the current inefficient practices
may become tantamount to irreversible codifica-
tion of what can be considered an anachronistic
financial model.
