INTRODUCTION
Islamic banking has grown significantly over the last thirty years.Footnote 2 Islamic banks have made advances not only in the Middle East and southern Asia, but also in new Western territories such as France, the UK, Germany and Italy. These countries have taken certain legal and regulatory steps to introduce Islamic banking into their markets.Footnote 3 At the same time, this expansion has exposed the Islamic banking sector to new risks and brings further challenges.
Since Islamic banking has become a part of the global financial structure, it is hard to imagine that the Islamic banking sector was not affected by the recent banking and financial crisis. Admittedly, the financial losses of Islamic banks were very limited. However, it can be suggested that the impact of the crisis on the Islamic banking sector can be seen from two perspectives. First, there has been a growing global awareness of and interest in analysing current Islamic financial products in order to evaluate the so-called ‘immunity’ of these products. Second, the recent banking and financial crisis has highlighted the significance of a watertight regulatory regime and proved the urgent need for effective governance. Achieving this objective in the context of Islamic banking and finance is rather challenging. The requirements of Islamic law change the business model that Islamic banks use, which presents the regulator with a new set of issues to consider. Further, the enforcement of Islamic law principles in the financial context brings another legal challenge.Footnote 4
Although the legal and regulatory challenge that Islamic banks face might seem multidimensional, in essence it stems from one element: the application of Islamic law in business. For many observers, Islamic banking as a concept seems paradoxical because its two main components – Islam and banking – ought to conflict. This article does not aim to focus specifically on each of the legal and regulatory challenges faced by Islamic banks. Rather it examines the genesis of the legal and regulatory challenge that Islamic banking faces. It argues that Islam and its rulings do not inherently contradict the concept of banking in its entirety. It also suggests that the banking business is not always and entirely based on principles incompatible with Islamic legal rulings.
ISLAMIC BANKING: FROM THEORY TO PRACTICE
Islamic banking has gone through different phases of development. A long period of time was required to transfer Islamic banking principles from the theoretical to the practical sphere. Since this article aims primarily to address the genesis of the legal and regulatory challenge in relation to Islamic banking, this section is structured to provide the background that is needed to achieve this aim.
Foundations
Muslims believe that the religion of Islam represents a comprehensive code that is divine in its core and applies to all aspects of human life. Accordingly, Islamic law (sharia) has not only a spiritual aspect, ibadat, which focuses on the relation with the creator, but also a practical or material aspect, muamalat, which governs individuals' interaction, including their financial and commercial affairs. In practice, these two dimensions seem intertwined, since individuals are always reminded that they need to please their creator in their quest for their daily material needs. In addition, acting upon the rules of muamalat in daily life is deemed to be one of the ways of creating a stronger bond with God (Allah).
The most relevant example in this context is to be found in the rules of Islamic finance as they prescribe how finance should be conducted: not only in order to benefit the contracting parties but also to please God. In certain cases, achieving this requires individuals to refrain either from undertaking certain transactions or from accepting certain terms, despite their beneficial outcome to either one or both parties. For instance, Muslims are prohibited from engaging in speculative financial transactions or accepting terms that impose the payment of interest.
It can be suggested, therefore, that the material aspect of Islamic law (the rules of muamalat) is highly driven by the spiritual one (the rules of ibadat). Thus the two aspects cannot be separated. The spiritual aspect seems not only to complement the material aspect but also to provide the rules of Islamic law with its moral narrative. For example, interest is prohibited by Islamic law primarily because of its exploitative nature. The essence of this ruling is moral rather than legal, since conventional market rules allow the capitalist to use his or her capital freely. It was reported that the Prophet Muhammad said, roughly translated, ‘that he was sent to perfect honourable morals’.Footnote 5 With this in mind, it is important to locate Islamic law in the context of the wider jurisprudential debate on the authority of law, and more specifically the relationship between law and morality.
The question of whether law and morality should be linked has been considered through different philosophical and legal theoretical frameworks. On the one hand, the main philosophical traditions in this respect could be described as the liberal and the communitarian. Liberals, in principle, stress the neutrality of law; it is only supposed to prevent harm to other individuals without being influenced by ‘conceptions of the good life’.Footnote 6 Law should not be based on a morality that reflects the interests of the community. Therefore, regulating the moral choices of individuals does not fall within the realm of law.Footnote 7 In contrast, the communitarian position in general contends that law should protect the well-being of the community by regulating moral choices of individuals and setting moral benchmarks.Footnote 8 Accordingly, it can be argued that Islamic law is more in line with the communitarian position than the liberal. Islamic law aims to create a sustainable order in society by extending its focus beyond modern law concerns of ‘control and discipline’.Footnote 9 Islamic law is concerned with wakening up the righteousness in individuals to do the ‘right thing’ in all their activities. It influences individuals' thoughts and conscience, which are eventually revealed in their conduct. In other words, Islamic legal rulings aim to protect what communitarians would describe as ‘the moral environment’ by relying on the moral conscience of individuals. Doing the ‘right thing’ is a very moral concept, yet it is the focal point of all Islamic legal rulings.Footnote 10
On the other hand, the relationship between morality and law is a highly debatable issue among legal theorists. For example, legal positivism and natural law seem to have taken different views on the subject.Footnote 11 Law from natural lawyers' perspective is made of the universally true principles of justice that are uncovered by humans, and its authority is derived from its inherent moral content.Footnote 12 In this respect, Austin argued that ‘natural law’ or the ‘law of nature’ is the unrevealed law of God while the revealed one is the divine law.Footnote 13 He maintained that God's commands and rules represent the essential principles of morality.Footnote 14 Blackstone also seemed to have considered natural law and divine law to be the same.Footnote 15 Further, in his Commentaries on the Law of England Blackstone stressed that the obligations imposed by God's laws are superior to all other laws.Footnote 16
Accordingly, Islamic law falls within the realm of natural law. Its aspiration for a sustainable order in society is built on the purpose of all its legal rulings: ‘doing the right thing’. It can therefore be argued that the rules of Islamic law do claim to be correct, since the law is based on God's morality, which could be widely accepted as a correct morality.Footnote 17 Furthermore, Islamic legal rulings are implemented and protected by individuals on the basis of their spiritual commitment: pleasing God and being rewarded in the hereafter. It can be argued that the spiritual aspect of the law, which is morally infused, shapes not only the rules of Islamic law but also their implementation. Obedient individuals are expected voluntarily and willingly to adhere to the legal rulings of Islam on the basis of their spiritual commitment.Footnote 18
Islamic legal rules can be divided into five categories, according to their implications. These categories are: forbidden, obligatory, recommended, disapproved and neutral. The first four are most relevant in this discussion. The first category is the one that prohibits actions and imposes punishments when individuals do not adhere to these rules. The second includes rules that oblige the individual to do the right thing, with omission demanding punishment. The third comprises rules that recommend taking actions that support the moral cause of the law. Finally, disapproval rules concern actions that do not count as not doing the right thing and at the same time do not serve the moral cause of the law. By not performing the recommended or performing the disapproved, the individual will not be subjected to any punishment. However, doing the right thing in these two categories fulfils their spiritual commitment to God.Footnote 19
Having considered the ethos of Islamic law it is essential to examine how it is manifest in the structure of Islamic law. Islamic law is not only made up of divine textual sources but also consists of a number of sources which have been developed by jurists using ‘human reasoning’ to extend the application of the textual sources to new, challenging cases. Islamic law is therefore made up of an array of sources that vary in nature and consequently vary in authority. The two main textual sources are the Qur'an and the Sunnah.
The Qur'an is the highest and most authenticated legal source, held to have been recorded in writing during the Prophet Muhammad's lifetime. The Qur'an can be defined as the words of God which were revealed to his last messenger, Prophet Muhammad. The nature of the Quranic rules varies, being detailed in some cases and general in others.
The Prophetic Sunnah is another source of revelation. As the Prophet Muhammad is divinely guided (as the Qur'an states), all his actions, omissions and sayings are regarded as divine revelation.Footnote 20 As a legal source, the term Sunnah is used to describe ‘a set of rules deduced from the pronouncements and conduct of the Prophet, which Muslims resorted to when the Qur'an did not expressly address an issue at hand, that eventually became an Arabian customary law’.Footnote 21 It must be noted that the Prophetic Sunnah has always had an important role in clarifying the vague, specifying the general and in some cases setting new rules.
In addition to these textual sources which represent the divine revelation, there are another two key sources that require the intellectual contribution of Muslim jurists, namely Ijmma and Qyias. Both have been widely considered as primary sources. Ijmma means the consensus of the entire community of Muslim jurists on a newly introduced legal doctrine. Qyias means legal analogy and reasoning exercised by jurists to produce an Islamic legal ruling.
Accordingly, the rules of muamalat, particularly in relation to finance and commerce, are not derived from one specific source; they are rather based on both revelation and human reasoning. The rules on Riba (usury and unearned income) and gharar (risk and uncertainty) can exemplify this point. The prohibition of Riba is explicitly stated in the Qur'an, yet what qualifies as Riba is not explained. The explanation of the meaning of the prohibited Riba can only be found in the Sunnah. The Prophetic Sunnah specifies two types of Riba found in common commercial and financial transactions. First, and most common, is Riba alnasi'ah, compensation paid for the deferral of payment.Footnote 22 Second is Riba alfadel, which generally occurs when two parties trade (barter) the same type of goods but in different quantities.Footnote 23 In the context of conventional banking, Muslim jurists use legal analogy and reasoning to extend the prohibition of Riba to include interest paid or charged by conventional banks.
The prohibition of gharar is not as straightforward as the prohibition of interest. The literal meaning of this Arabic word includes elements of gambling, uncertainty and deception. Its prohibition finds its foundation in the Quranic prohibition of gambling, especially since gambling is associated with excessive risk and uncertainty. The Qur'an states ‘they ask you about wine and gambling; say, in both of them is great sin and some profits for men, but the sin is greater than the profits’.Footnote 24 However, the word gharar was not used in the Qur'an in a commercial context. Rather this was first found in the Prophetic Sunnah. In the Prophetic Sunnah, gharar was associated with commercial transactions where the Prophet explicitly forbade a ‘gharar sale’. The simple definition of the gharar sale is ‘any sale that incorporates a risk that affects one or more of the parties of the contract and may result in loss of his property’.Footnote 25
The Prophetic Sunnah also refers to gharar as denoting deception, peril, jeopardy and hazard.Footnote 26 Furthermore, Muslim jurists have associated gharar with transactions with a factor of uncertainty. Consequently, gharar covers both the unknown and the doubtful and ‘it obtains where consequences are concealed’.Footnote 27 Such uncertainties and ambiguity represent the unacceptable level of hazard (excessive risk), originally prohibited in gambling and which now applies to all commercial and financial transactions.
Based on the above, there are a number of observations that can be made. First, the key Islamic finance principles are first found in textual sources and then developed by Muslim jurists. Second and more importantly, Islamic finance principles – either in relation to gharar or Riba – fall mainly within the prohibition category, the first category of Islamic law rules discussed above. This means that in relation to Riba individuals are not allowed to charge or pay interest and their disobedience to these rules results in punishment. However, the only punishment stated in the Qur'an is that those who continue to consume Riba will ‘hear the declaration of war from Allah [God] and his messenger’.Footnote 28 The influence of the spiritual aspect of the law is very clear in this example. Disobedient individuals were warned of the dissatisfaction of God, and the declared war could be in this life or, certainly, in the next. In other words, the punishment is not material but those who are true believers will obey on the basis of their spiritual and moral commitment to ‘do the right thing’. The same argument also applies to the prohibition of gharar. Finally, the rationale for these two key prohibitions is of mainly moral foundation. In both Riba and gharar the interests of one of the parties will be prejudiced. This is viewed by Islamic law as morally unacceptable and, therefore, it should be discouraged.
Primitive application and the later development
Trade and commerce were found in the Arabian Peninsula even before Islam, and trading was a key business for the inhabitants. During the pre-Islamic period, certain types of contracts were used in business which caused injustice, such as enslaving those who were not able to pay their debt. In common with other religions, Islam aspires to enforce justice and lift hardship; therefore, certain contracts became prohibited. Furthermore, a number of guiding principles were stated in order to achieve the aspiration of a morally driven economic system.
The application of Islamic finance principles has been present in all commercial transactions since the early stages of Islamic state governance. It has been suggested that Muslims had developed an intermediary system which was capable of mobilising the required funds to facilitate trading without dealing with interest.Footnote 29 However, this type of primitive intermediation was not systematic as there was no designated institution structured to mobilise funds in accordance with Islamic finance principles. Instead, the Islamic form of financial intermediation was carried out by individuals on the basis of profit/loss sharing in the course of trading and money exchange.Footnote 30
The emergence of the current form of Islamic financial institutions and banks dates from the twentieth-century post-colonial period in the Middle East and Muslim countries. Certain powerful political movements in these countries called for cultural authenticity and economic reform as the basis for political reform. This change in the political mode coincided with the oil boom in the Arabian Peninsula and the Gulf. The resulting interaction created the more modern and institutionalised form of Islamic banking prevalent today.
Islamic banks were established to provide the same range of services that conventional banks offer, without using the same products. They have developed their own set of products which comply with the principles of Islamic finance (prohibition of interest, as a form of Riba, and gharar) and at the same time fulfil the contemporary needs of individuals and businesses.
Transition from national to international
As mentioned above, the evolution of Islamic banking and finance was embedded in a region where Islam was, and still is, the dominant religion. This did not, however, prevent Islamic banking and finance from reaching other new markets where the religious factor is given little if any consideration by either customers or regulatory and financial authorities. In fact, the new unexpected territories which the Islamic banking sector has reached only give weight to the economic viability of any financial products and their economic benefits. It is fair to say that the one factor that has dominated the internationalisation of Islamic finance is economics. This can be proved with reference to two different timelines: first, the oil boom period in the late 1970s, and second, the financial market following the banking and financial crisis of 2008. However, although macro-analysis of both examples indicates that on both occasions the growth of Islamic baking was economically motivated, micro-analysis shows that the particular economic driving factors differ.
In the earlier period, the only drive was the overflow of petrodollars which the economic structure of the Gulf countries at the time was not designed to absorb. Western financial markets, with their much more developed structure, represented a natural option for the surplus of petrodollar cash. Even though Western banks had already gained huge deposits from oil-producing countries,Footnote 31 these international financial centres wanted to capture further deposits through hosting Islamic financial institutions or even engaging more with these financial products. In contrast, the drive behind the proliferation of Islamic banking and finance in the Western markets in the wake of the 2008 banking and financial crisis was not only the attraction of new sources of liquidity but rather the search for new financial products with alternative structures. That crisis can be loosely pinned down to excessive risk, reckless lending and speculative trading driven by high interest rates. The structure of a large number of the current conventional financial products does not help reduce these damaging practices. However, Islamic financial products have proved to be capable of delivering the same services without being exposed to the previously mentioned problems. The restrictions that Islamic finance principles impose have created finance models that are based on the sharing of risk and on the prohibition of speculative and hazardous transactions.
To sum up, Islamic law is a key part of Islamic banking and its influence goes beyond the title to more fundamental issues. It restricts the transactions of these banks and it imposes what may be seen as a completely different business model. The fact that Islamic banking is now present on the international financial scene cannot go unnoticed. This fact raises certain questions regarding the difficulty that Islam brings to the regulatory process of Islamic banking, especially when Islamic banks operate within a conventional regulatory framework.
RELIGION AND BANKING: ARE THEY A PARADOX?
This section examines a basic, but rather important, issue and asks about the relation between religion, more specifically Islam, and banking and whether they conflict (which might render the existence of a real Islamic banking sector impossible). To answer this question, one should look beyond the literal meaning of religion and banking. Rather it is essential to address elements associated with these two concepts and which, to a certain extent, inform our perception of them.
In the context of individuals' relations with one another, religion has a number of predominant features. First, religions tend to contain sets of rules that aspire to direct and guide human behaviour and to promote certain values. The three Abrahamic faiths – Judaism, Christianity and Islam – share a number of noble aims such as justice, purity and righteousness. Yet human desires have always been a challenge to this endeavour. The problem is not the desires themselves but rather the way in which humans fulfil these desires. Religious rules that aspire to guide the fulfilment of human desires are the moral components of religions, which can be distinct from the actual religious components.Footnote 32 As noted earlier in Islam, it was reported that the Prophet Muhammad said ‘that he was sent to perfect honourable morals’.Footnote 33 Therefore, once religion has been featured in a transaction, the morality of the transaction becomes its central aspect. This applies to any commercial or contractual agreement.
This leads to the second feature. Religion has always been associated with restrictions and restraints on individuals' actions and behaviour. However, although the adherence to these restrictions is based on individuals' spiritual commitment, in most cases the limitations are morally justified. For example, one of the justifications of the prohibition of Riba is to stop exploiting the credit needs of the less fortunate.
Finally, a large proportion of religious rulings are not definite either in their meaning or in their application. It has been suggested by Firth that the vague nature of religious beliefs (upon which these rules are based) make them quite susceptible to personal variation.Footnote 34 Therefore, these rulings have become subject to many interpretive possibilities. This adds uncertainty to the features that shape our perception of some aspects of religion.
Banking, meanwhile, comes laden with completely different connotations. The word commonly conveys the notion of a constant pursuit of profits. Profit maximisation prevails over any other aim on the banking business agenda. The 2008 financial crisis demonstrated that prudence had clearly taken a back seat, and this had a devastating impact on the wider community. Profit maximisation becomes the end in itself, rather than a means to an end. Further, this transformation in the nature of profits and how they are perceived has been accelerated by the market trend for minimal regulation. In the banking context, these fundamental changes distance the business of banks from any moral commitments. Accordingly, the concept of banking implies prioritisation of profits at any expense and a wide margin of freedom. It also has connotations of individualism, since banking is one of the vehicles used by individuals to get the best for themselves, which in return justifies the market trend for minimal regulation in the financial context. This is rather different from the community aspect of religion, which prioritises the collective interest of the community, hence the restrictions and moral benchmarks imposed by religions.
On the face of it, the answer to the initial question seems to be clear: religion and banking are a paradox and ought to conflict. To some, therefore, the notion of Islamic banking represents a binary opposition, where one concept, whether Islam or banking, will be privileged at the expense of the other.Footnote 35 The application of the idea of binary opposition in the context of Islamic banking would lead to an undesirable result. Privileging either of these two concepts over the other would definitively change the nature of this sector. It simply makes it impossible to regulate Islamic banking in a way that balances both aspects without adversely affecting either one of them.
In order to investigate the binary opposition argument with reference to Islamic banking, the two main concepts in question – the business of banking and the religion of Islam – should be re-examined. This requires breaking down and analysing the components of these two concepts. It must be noted that the term that will be used to describe this process is ‘deconstruction’; however, it does not mean the literary analysis of words and structure of language as presented by the French philosopher Jacques Derrida. Instead, it is used to dismantle these concepts into their main components. This is to support the argument that the features that have been discussed above have not always been the only characteristics associated with either Islam or banking. There are other features of these two concepts in addition to those mentioned earlier which might change our understanding of Islam and of banking. Proving this means that Islamic banking is not an impossible tautology.
Deconstructing ‘banking’
The analysis in this section questions the current conception of banking, which is dominated by individualism and manifested in excessive profit maximisation and freedom. It proposes that banking is not limited to this one conception that makes its association with religion paradoxical.
The level of government intervention in the financial market has been fluctuating since the first ‘financial revolution’ of the late eighteenth and early nineteenth centuries, up until now.Footnote 36 The form of this intervention has rotated between two models: a light-touch approach and a prescriptive approach. These two models differ fundamentally in relation to the level of freedom that participants enjoy and the business practices that are approved. It can be argued that the concept of ‘banking’ has rotated over the years between these two paradigms, which differ essentially in terms of their business priorities and the margin of freedom that the participants have. Therefore, it may be suggested that the notion of ‘banking’ has been informed and influenced by government involvement in the market. There are certain examples that can be seen through the history of the banking and financial markets which support this argument.
The main feature of the decades that preceded the 1931 financial crisis and the Great Depression in the 1930s was the liberal order governing financial markets.Footnote 37 This meant that the prevalent model of banking was risk- and profit-driven, with minimum regulatory intervention and prudence not a key feature. The 1931 crisis was the event that brought significant changes to the notion of banking at the time. Banking after the Great Depression and following the banking reforms was very different from how things had been during the run-up to the crisis and consequent depression.
The US president, Franklin Delano Roosevelt, took certain measures in the wake of the 1931 crisis to re-introduce or change the principles of banking. Contrary to the banking model in the 1920s, prudence was prioritised over risk.Footnote 38 Banks' freedom was restricted. The US Banking Act 1933, which was a major part of the Great Depression reforms, included many features that minimised the margin of freedom that banks enjoyed. The Act enforced the separation of investment and commercial banking and, more importantly, it added further restrictions on the use of banks' credit for speculation.Footnote 39 These changes formed a new notion of banking, to which restrictions, prudence and risk aversion were central.
It must be noted that such a transformation was not exclusive to the United States. The financial crises of the 1930s brought the winds of change to financial politics at the international level, including in the UK. The financial world after 1931 had a new order, in which there was no place for bankers' laissez-faire approach to domestic finance. Instead, a more interventionist approach was introduced to make banking and finance serve wider political and economic objectives.Footnote 40 This new agenda was mainly driven by the rise of a new class of economists and state officers who were socially supported by labour and national industrial movements.Footnote 41 In fact, the agenda shaped the economic and financial policies in the US and the UK for a long period after the Second World War. By the early 1960s there were some emerging events that challenged the less liberal and more interventionist financial policies in use at that time. For instance, the emergence of the Euromarket, which was supported by the UK and the US, required some liberal regulatory initiatives.Footnote 42 However, domestic banking continued to be restricted and risk-averse during that period.
The real change in the concept of banking took place in the late 1970s and early 1980s. This period was as critical as that of the Great Depression with regard to its impact on the notion of banking. During the 1980s liberalisation came back into fashion and policy-makers in the UK and US adopted a financial policy liberalisation which was driven by the political powers of the time.Footnote 43 The concept of banking was bound to change with the removal of a whole system of restrictions, thus allowing banks to be involved in the securities markets.Footnote 44 The main feature of the so-called ‘second financial revolution’ of the 1980s and 1990s was financial ‘deregulation’.Footnote 45 It meant removing nearly all restrictions from the banking and financial markets and redesigning the rules to support a structure of self-regulation. This approach continued to dominate the market and financial polices throughout most of the first decade of the twenty-first century, until 2007–8. Banks became heavily involved in complicated security structures that were widely available in the capital market.
The year 2008 marked another important date in relation to our understanding of banking. As with the 1931 financial crisis and the 1980s financial deregulation, the 2008 crisis ushered in policy changes that altered the notion of banking yet again.Footnote 46 It is difficult to ignore the similarities between the perception of ‘banking’ during the period preceding the Great Depression and that in the run-up to the 2008 global financial crisis. In both periods the concept of banking was associated with high risk, profit maximisation and a dominant liberal financial order where individualism was at the centre. The International Monetary Fund (IMF) in their April 2009 ‘World economic outlook: crisis and recovery’ identified a number of common elements between the Great Depression and the 2008 global financial crisis, in particular the banking model that dominated the market before the Great Depression and in the run-up to the 2008 crisis.Footnote 47
A clear official dissatisfaction could be found in the language used to describe banking practices during the periods that preceded the Great Depression and the 2008 crisis. In Roosevelt's 1933 inauguration speech, bankers were described as ‘callous’, ‘selfish’ and ‘unscrupulous’.Footnote 48 Slightly less harsh terminology was used to describe bankers in the UK in the wake of the 2008 banking and financial crisis: the Treasury Committee in its report on the crisis stressed that banks' own reckless behaviour were largely responsible.Footnote 49 In April 2010 the leader of the Liberal Democrats, Nick Clegg, described bankers as ‘greedy and reckless’.Footnote 50
In both cases, subsequent political change was made manifest in interventionist and restrictive financial policies. Accordingly, in the same way as after the Great Depression, the 2008 crisis was followed by a tendency to reassess the current model of banking practices and re-introduce a different concept of banking: that is, a notion of banking entailing prudence, risk aversion, more restriction and less individualism. Thus the concepts underlying banking have rotated between two opposing paradigms. This analysis reveals that banking does not necessarily mean excessive risk, unrestricted freedom and profit maximisation driven by individualism, which is the paradigm that ought to conflict with the conception of religion.
Deconstructing ‘Islam’
As mentioned earlier, religion in general encompasses a number of presumptions: first, a heavy moral connotation, which in some cases can be described as rather utopian and, second, limited freedom due to the imposition of many restrictions in the quest for moral order. Added to these is the high level of uncertainty associated with the interpretation of religious texts. A question that may be asked at this point is whether this description of religion applies to Islam, particularly in the financial and economic context? Finding the answer to this question is essential to deciding whether the concept of Islam conflicts with the alternating conceptions of ‘banking’ discussed above.
There are two distinct issues that deconstruction of the concept of Islam should consider in the economic and financial context: the utopian quest of religions (and the consequential limitation of freedom) and the inherent uncertainty that is associated with the application of religious rulings. The latter point is of special relevance to Islam. On some occasions, deducing a particular legal ruling from a general rule in the Qur'an would require a reference to a specific Prophetic statement. However, Prophetic statements vary in certainty and authenticity depending on the chain of transmission and the authority of the narrators.Footnote 51 This eventually impacts on the certainty of the deduced legal ruling. Further, the four classical Islamic schools of thought (Shafi'i, Hanafi, Maliki and Hanbali), all differ in their legal doctrines of Islamic law.Footnote 52
Addressing the first issue requires a brief introduction to the Islamic framework that governs economics. Islamic economic theory is, without a shadow of doubt, morally driven. However, it can be suggested that there are certain aspects of the theory which show that it has not lost touch with reality. Islamic economic theory has a realistic interpretation of equality: rather than declaring that individuals should be equal in poverty or in wealth, it states that all people should have equal opportunity.Footnote 53 Moreover, income inequality is explicitly permitted within the theory; the Qur'an states ‘He has raised you in ranks, some above others that He may try you in what He has bestowed on you.’Footnote 54 It is clear, therefore, that an acceptable form of moderate inequality is realistic. However, as the verse states, those who are more fortunate must use their fortune responsibly and in line with their moral commitment. This is an example of how the theory maintains its moral drive without losing its ties with reality. Accordingly, it can be suggested that imposing restrictions in the context of banking and finance is an example of the Islamic realistic take on this subject.
Islamic economic theory understands the reality of individuals' quest for maximum profits. It therefore balances this out with certain restrictions in order to protect wider interests. Such an intervention is not exclusive to Islam; as discussed earlier, the principles of banking have kept rotating between two models with very different levels of intervention by the state. Although the ideological grounds for intervention may differ from those of Islamic economic theory, the state has stepped in on more than one occasion, mostly in financial crises, to restrict the freedom of banking practices and redefine the conception of banking business.
This leads to the second issue, the presumption of uncertainty in relation to religious rulings. Examining the issue of uncertainty is relevant and important to the argument that Islamic banking is not a paradox. The issue of uncertainty raises serious concerns in the context of economics and, more importantly, banking. As discussed earlier there is a certain level of uncertainty that can be associated with Islamic law. In the following section it will be argued that this type of uncertainty is not completely alien to conventional finance.
The argument will be advanced on two grounds. First, uncertainty cannot be distinguished from risk, which itself is embedded in the banking business; second, the type of uncertainty that is associated with Islamic rulings is not different from a similar form of uncertainty that is classified as legal risk in the context of banking and finance.
In relation to the first aspect, on the one hand it must be noted that there is not unanimous agreement that financial uncertainty is a form of risk. For instance, Frank H Knight in his 1921 seminal work Risk, Uncertainty and Profit, adopted the view that risk can be distinguished from uncertainty.Footnote 55 His thesis revolved around two factors: the individual's knowledge of the relevant events and the ability to classify or group these events.Footnote 56 Accordingly, Knight identified three types of unknown outcomes, which he used to distinguish between risk and uncertainty: a priori probabilities, statistical probabilities and estimates.Footnote 57 Knight described the first two types as a ‘judgment probability’ and identified them with risk, whereas he identified the third with uncertainty.Footnote 58 His distinction between risk and uncertainty has, however, been the subject of some academic criticism.Footnote 59
It has been suggested that there has always been an association between uncertainty and risk, to the extent that they have often been viewed as the same.Footnote 60 Even those who argue that risk could/should be distinguished from uncertainty concede that on certain occasions risk and uncertainty ‘converge or overlap’, the most relevant example to our discussion being the issue of confidence and the importance of certainty to ensure confidence.Footnote 61 It has therefore been argued that uncertainty is an ‘essential component’ of risk.Footnote 62 This interpretation of risk and uncertainty is in line with the industry's current understating of legal risk, as will be seen below.
Since uncertainty cannot be distinguished from risk, the purpose of this discussion is to suggest that the uncertainty found in the interpretation of Islamic law is not a kind of risk with which conventional finance is unfamiliar. However, the classification of uncertainty associated with Islamic law and the form of risk that it might fall under require further analysis. On the face of it, it can be suggested that uncertainty associated with Islamic law should fall under what is known as sharia risk. However, when the Islamic Financial Services Board addressed the issue of sharia risk, it focused on the risk of non-compliance with Islamic law, stating that:
Shari'ah non-compliance risk is the risk that arises from IIFSs' [Islamic Institutions Offering Financial Services'] failure to comply with the Shari'ah rules and principles determined by the Shari'ah Board of the IIFS or the relevant body in the jurisdiction in which the IIFS operates.Footnote 63
Accordingly, sharia risk is mainly concerned with the application of already ‘determined’ sharia rules and principles.
However, and in the same context, there is the risk that arises from the level of uncertainty that is associated with interpreting Islamic law in the first place. In other words, the issue here concerns the risk that the institution might face if the interpretation process that has produced these ‘determined’ rules and principles is challenged or questioned. This can be found with reference to the interpretation of religious texts – mainly the Qur'an and Sunnah, especially since the application of these two sources depends greatly on reasoning and legal analogy. In view of that, and although there is a designated methodology that should be followed in the interpretation process, there is no guarantee that all interpretations will reach the same outcome. Islamic law, as any other law, is subject to different interpretations. However, Islamic law does not have the comfort of a definitive authority that provides a binding interpretation which others have no choice but to follow.
The question that arises in this respect is whether the kind of uncertainty that Islamic banks are exposed to falls under the general legal uncertainty familiar to conventional banking. One side of the argument is that this type of uncertainty would not be regarded as legal uncertainty, since it is related to sharia – which in many countries is not part of domestic law. On the other side, it can be argued that once these rules have been included in a legally binding agreement they become part of the agreement. Therefore, disputing these rules, regardless of whether the court has given them any legal weight or not, may still affect the legal certainty of the agreement. This can be seen in The Investment Dar Company KSCC v Blom Developments Bank Sal.Footnote 64
Defining legal risk has generally proved to be challenging, and a number of definitions have been produced by national and international bodies. However, there is no comprehensive definition that commands universal acceptance. Legal risk definitions have dealt with certain aspects of this type of risk, yet only a few definitions mention legal uncertainty. This not to say that the importance of legal certainty has not been fully understood in the financial business context. It has been suggested by McCormick that ‘the financial marketplace can only function properly in an environment that provides a satisfactory level of legal certainty … a successful marketplace does not welcome legal (or regulatory) surprises’.Footnote 65
Legal risk has been vaguely identified by the Basel Committee on Banking Supervision, having been included in their second report under operational risk.Footnote 66 The report states that legal risk ‘includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements’.Footnote 67 Clearly the committee has not managed to introduce a concrete definition of legal risk, especially since the given definition only encompasses what can be mainly described as the results of legal risk rather than the actual risk itself.
A more conclusive attempt was made by the deputy governor of the Reserve Bank of India, Shyamala Gopinath, at the symposium on ‘Changing dynamics of legal risks in the financial sector’:
legal risks primarily arise either due to lack of clarity of the documentation of the product or the act of the counterparty. Change in legal environment due to legislative changes and Court interpretations/proceedings also result in legal risk.Footnote 68
It can be argued that one of the striking features of this definition is the identification of legal uncertainty, whether brought about by unclear documentation or by conflicting legal interpretations. In contrast, the Bank of England was much clearer in terms of including legal uncertainty in two of its definitions of legal risk. The first definition describes legal risk as ‘the risk that a poor legal framework or legal uncertainties will cause or exacerbate credit or liquidity risks’.Footnote 69 The second defines legal risk as ‘the risk that unexpected interpretation of the law or legal uncertainty will leave the payment system or member with unforeseen financial exposures and possible losses’.Footnote 70 Although both definitions include legal uncertainty within the realm of legal risk, they both define legal risk in the context of payment systems, and both are cause-based definitions.Footnote 71
Leading on from this, it is difficult to establish one universal definition for legal risk, as this type of risk may vary from one institution to another depending on the nature of the business, the documentation used and the level of complexity of the products.Footnote 72 The issue of legal uncertainty therefore represents an aspect or a component of legal risk which financial institutions are exposed to, and in this respect Islamic financial institutions are similarly affected. Although, admittedly, legal uncertainty and unexpected interpretations associated with Islam may, on some occasions, have a different nature from those to which conventional banks are exposed, they still represent an aspect of legal risk which would fall within the operational risk of an Islamic financial institution. These two forms of legal risk are based on uncertainty. However, it must be noted that, in relation to Islamic banking, legal risk in particular may be described as a multifaceted risk. This is because, first, there is the challenge of conflicting interpretations of Islamic law and, second, there is the challenge of applying these interpretations within the legal framework of a particular financial market in which these institutions operate where Islamic law is not necessarily recognised as a source of law.Footnote 73
Accordingly, two key observations can be made. First, although the legal uncertainty associated with Islamic banking is rather challenging, it can be argued that it is still a form of the legal risk to which the business of banking in general is exposed. In other words, ‘unexpected interpretations’ or ‘legal uncertainty’ (which were both mentioned in the Bank of England definition of legal risk) are not unheard of in the context of conventional banking and finance, and they cannot only be found in relation to Islamic banking. Second, despite the gravity of the challenge that legal uncertainty imposes on Islamic banking, it has not yet proved to be challenging to the existence of this sector. For example, Al-Baraka International Bank Ltd was one of the very early Islamic financial institutions to operate in the City of London. It started its operations in the UK after taking over Hargrave Securities in 1982, which was originally licensed as a deposit-taker. However, the boom period of Al-Baraka's business was in the late 1980s and early 1990s; by 1991 it had extended its network of branches in London and Birmingham.Footnote 74 Nevertheless, this was a relatively short-lived success, as the bank announced on 31 March 1993 its decision to discontinue its business and close its branches in the UK,Footnote 75 after failing to reach an agreement with the Bank of England over a number of supervisory and regulatory issues.Footnote 76
In the case of Al-Baraka, the Islamic nature of its business did not clash with the regulatory framework nor did the bank suffer from any ‘financial deficiency’.Footnote 77 In fact, the closure was related to the institution's structure. The main problem was that of being solely owned by one Saudi sheikh, Saleh Abdullah Kamel.Footnote 78 The legal risk and uncertainty that can be associated with the Islamic character of these institutions did not cause the closure of Al-Baraka. Rather it was as a result of more general structural matters common to Islamic and conventional banks alike.
CONCLUSION
There is no doubt that the global proliferation of Islamic banking and the aftermath of the global financial and banking crisis have exposed this sector to further attention by regulators and participants. In this respect, the legal and regulatory aspect of the sector remains a major concern, stemming in essence from the fact that the sector is Islamic.
However, analysis of both Islam and banking has illustrated that the fact of being Islamic does not pose a chronic legal challenge to the sector and it does not contradict the concept of banking. On the one hand, the concept of banking has rotated throughout recent history between two models, one of which does not bear any features that entirely conflict with Islam. A prudent form of banking, and one that is less driven by profit maximisation, can to a certain extent co-exist with most Islamic law rulings. On the other hand, as has been demonstrated, the challenges shown by the Islamic characteristics of the business are not completely alien to banking per se. For example, the problem of uncertainty associated with Islamic law is one of the challenges that have been identified in the legal and regulatory context. It is fair to suggest that the Islamic characteristic of this banking sector produces a form of uncertainty that is a component of legal risk, which in principle is common to all financial institutions. Further, this form of legal risk has not proved to be a challenge to the existence of this sector. The past experience of Islamic banking in the UK has shown that the failure of one of the sector's early institutions, Al-Baraka Bank, was not due to the legal uncertainty caused by it being Islamic in character. Rather it was due to more general and conventional (mainly structural) issues that have no relevance to the Islam.
This means that when dealing with the legal and regulatory aspects of Islamic banking, regulators are not faced with a binary opposition which requires privileging one concept over the other. In other words, regulating Islamic banking is not impossible, as Islamic banking is not itself a paradox. However, one should not minimise the difficulty that the regulators face in creating a balance between these two concepts. It is therefore suggested that achieving this balance requires joint efforts between the industry's main players and the regulators.
