Islamic Finance

The notion of " Islamic finance " was born during the tumultuous identity-politics years of the mid-twentieth century. Indian, Pakistani, and Arab thinkers contemplated independence from Britain, and independence of Pakistan from India, within a context of " Islamic society. " Islam was assumed to inspire political, economic, and financial systems that are distinctive and independent of the Western (Capitalist) and Eastern (Socialist) models of the epoch. The term " Islamic economics " was coined by Abu al-A`la Al-Mawdudi, whose students and followers worked to develop an ostensible Islamic social science (Kuran, 2004). Mawdudi's influence on Arab Islamists began with the writings of Sayid Qutb, the father of modern Arab political Islam, whose quasi-exegesis Under the Qur'anic Shade referred exclusively to Mawdudi's writings on economic matters. Mawdudi's migration from majority-Hindu Indian society to maority-Muslim Pakistan thus became a prototype for Islamist migration away from secular political and economic systems. From Islamic Economics to Islamic Banks In the first few decades of its existence, Islamic economics focused on comparative economic systems (a fashionable field at the time) as well as neo-Classical and Keynesian modeling with a highly stylized homoislamicus (a moral and ethical individual who shuns excessive greed and consumerism) in place of mainstream economics' homoeconomicus (a selfish utility and profit maximizer); Haneef (1995). As a byproduct, Islamic banking emerged in the Islamic economists' literature as a financial system based exclusively on profit-and-loss sharing, which was argued to be more equitable and stable; Chapra (1996), Siddiqi (1983). In the process, Islamic economists focused on the Islamic prohibition of riba or usury, which they interpreted as a prohibition of all interest-based lending, in accordance with earlier interpretations of the Judeo-Christian canon. Classical Islamic jurisprudence had interpreted interest-based lending, the cornerstone of fractional-reserve depositary banking, as riskless – and therefore illegitimate and inequitable – return for idle capitalists. Indeed, the importance of credit and counterparty risk for any financial analysis remains conspicuously absent from the writings of the Islamic-economics faithful. The preferred financial model, they postulated, would be based on the ancient silent-partnership model known in Islamic writings as mudaraba, corresponding to the Jewish heter iska and the Christian-European commenda; Udovich (1970). An " Islamic bank " was envisioned as a two-tier silent partnership. Thus, deposits seeking a return (as opposed to fiduciary deposits, for which 100% reserves are required) would not be guaranteed loans to the bank, but rather silent-partnership investments in …