THE ISLAMIC FINANCIAL SYSTEM:

AN INTRODUCTION
by
Dr. M. Umer Chapra
for the Muslim Almanac
 All major religions, including Hinduism, Judaism, Christianity
and Islam, have prohibited interested. This raises two questions. The
first question is whether an interest-free financial system has ever
been established and how effective it was in mobilizing and utilizing
savings, the primary objective of a financial system. The second
question is that, even if the system was successful then, can it be
workable now when the international financial environment is
significantly different from what prevailed during the heyday of
Muslim civilization.

The answer to the first question is that from the very early
stage in Islamic history, Muslims were able to establish an interest-
free financial system in conformity with the teachings of the
Shari‘ah. The system was based primarily on the profit-and-loss
sharing (PLS) modes of mudarabah (commenda) and musharakah
(partnership). It worked quite effectively not only during the heyday
of Islamic civilization but also for centuries thereafter. It was able to
mobilize the “entire reservoir of monetary resources of the medieval
Islamic world” for financing agriculture, crafts, manufacturing and
long-distance trade. The system was used not only by Muslims but
also by Jews and Christians to the extent that interest-bearing loans
and other usurious practices were not in common use (Udovitch,
1970, p. 257; see also p. 268)

Bankers were known in early Muslim history as sarrāfs or

sayārifah. By the time of the Abbasid caliph al-Muqtadir (295-
320AH/908-932AC), they had started performing most of the basic
functions of modern banks (Fischel, 1992). They had their own
markets, something akin to the Wall Street in New York and the
Lombard Street in London, and fulfilled all the banking needs of
commerce, industry and agriculture within the constraints of the
then-prevailing technological environment (Duri, 1986, p. 898).

2
 The ability to mobilize financial resources, along with a
combination of several economic and political factors, provided a
great boost to trade which flourished from Morocco and Spain in the
West, to India and China in the East, Central Asia in the North, and
Africa in the South. The extension of Islamic trade influence is
indicated not only by the available historical documents but also by
the Muslim coins of the seventh to the eleventh centuries found
through excavations in countries like Russia, Finland, Sweden,
Norway, the British Isles and Scotland, which were on the outskirts
of the then-Muslim world (Kramers, 1952, p. 100; see also pp. 101-
106).

Due to a number of socio-political and historical circumstances

the Muslim world lost its position of leadership in the economic,
political, educational and technological fields and a number of
Islamic institutions, including the Islamic financial system, got
displaced by Western institutions, some of which are in clear conflict
with Islamic teachings (see Chapra, 2000, pp. 173-252). However,
the independence of Muslim countries from foreign domination
around the middle of the 20th century has led to the revival of Islam
and an effort is being made to reinstate most of the lost institutions,
the Islamic financial system being one of them.

This brings us to the second question of whether Islamic

finance is workable now in an environment which is significantly
different from what prevailed during the heyday of Muslim
civilization. Economies have become more complex and the
financial system cannot be a replica of the past. Therefore, even
though the PLS modes continue to be emphasized, the debt-creating
sales-based modes of murabahah,i ijarah, (leasing), salamii and
istisnaiii are currently playing a more important role. This is because
the institutional infrastructure necessary for movement into the PLS
modes has not yet become available. As compared with the PLS
modes, the rate of return in the sales-based modes gets fixed in

3
advance. Nevertheless, there is a difference between these modes
and pure lending and borrowing on interest. They are not only asset-
based but also require the financier to share in the risk at least to
some extent.

The impression that one gets from the rapid expansion of the
system so far is that the system has been working successfully and
is capable of handling all the financial needs of both the public and
private sectors. According to a rough estimate there are more than
250 Islamic banks around the word, of which one is even in the U.K.
In addition, a number of conventional banks, including some major
multinational western banks, have opened either branches or
windows to offer Islamic financial services. All these together have
assets close to $500 billion. The prospects for the future are even
brighter because, in spite of the rapid expansion of the system, only
a small part of the potential market has been tapped so far. While in
the 1950s and the 1960s Islamic banking was only an academic
dream, it has now become a reality. It has also attracted the
attention of Western central banks like the Federal Reserve and the
Bank of England, international financial institutions like the IMF and
the World Bank, and prestigious centres of learning like Harvard
University and the London School of Economics.

Nevertheless, the system is still in its infancy. When it comes

of age with the passage of time, it may be able to not only
accelerate development in the Muslim world but also exert a healthy
influence on the international financial system which has been
experiencing a great deal of instability over the last three decades.
It may be difficult to overcome this instability without injecting
greater discipline into the financial system. The prohibition of
interest by the major religions can be helpful in this task. The
assured positive rate of return on deposits and loans that the rate of
interest involves stands in the ways of ensuring such discipline.

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 Prohibition of interest will make the investment depositors as
well as the bankers share in the risks of banking business. The
depositors will, therefore, tend to take a serious interest in the
affairs of the bank and demand greater transparency and more
effective management. The bankers will also be under pressure to
evaluate the loan applications more rigorously than what they tend
to do when they do not have to participate in the risk. Even the
debt-creating Islamic modes of finance, which are linked to the
purchase and sale of real goods and services, will help make credit
expand in step with the growth of the real economy. The excessive
expansion of credit, particularly that for speculation in the stock,
foreign exchange and commodity markets which accentuates
instability in the financial system, will thus be substantially reduced.

Dr. M. Umer Chapra

Formerly Senior Economic Advisor
to the Saudi Arabian Monetary Agency,
Riyadh
now Research Advisor to the
Islamic Research & Training Institute
of the Islamic Development Bank, Jeddah

ENDNOTES

5
i
Murabahah (also called bay‘ mu’ajjal) refers to a sales agreement whereby the seller
purchases the goods desired by the buyer and sells them at an agreed marked-up price, the
payment being settled within a specified time frame, either in instalments or lump sum. The
seller bears the risk for the goods until they have been delivered to the buyer.
ii
Salam refers to a sales agreement whereby full payment is made in advance against an
obligation to deliver the specified fungible goods at an agreed future date. This is not the
same as speculative forward sale because full, and not margin, payment is required. Under
this arrangement the seller, say a farmer, may be able to secure the needed financing by
making an advance sale of only a part of his expected output. This may not get him into
delivery problems in case of a fall in output due to unforeseen circumstances

Istishnā‘ refers to a sales agreement whereby a manufacturer (contractor) agrees to

iii

produce (build) and deliver a certain good (or premise) at a given price on a given
date in the future. This, like salam, is an exception to the general Shari‘ah ruling which
does not allow a person to sell what he does not own and possess. However, unlike
salam the price need not be paid in advance. It may be paid in agreed instalments, or
partly at the front-end and the balance later on as agreed.

References
1. Chapra, M. Umer (2000), The Future of Economics: An Islamic Perspective (Leicester: The
Islamic Foundation).
2. Duri A.A. (1986), “Baghdad”, The Encyclopedia of Islam (Leiden, E.S. Brill), Vol.1, pp.894-
909.
3. Fischel, W.J., (1992), “Djahbadh,” in the Encyclopedia of Islam, Vol. 2, pp.382-3.
4. Kramers, J.H., (1952), “Geography and Commerce”, in T. Arnold and A. Guillaume (eds.),
The Legacy of Islam (London: Oxford University Press).
5. Udovitch, Abraham, (1970), Partnership and Profit in Early Islam (Princeton, N.J.: Princeton
University Press).