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Islamic Economics and Financial Sector Reform

Author (s): 
Volker Nienhaus

Concepts of a genuine Islamic economic system date back to the 1940s when the idea of a separate Muslim state on the territory of British India after the retreat of the colonial power took shape. The goal was to create a system fundamentally different from the then known economic systems, namely the British type of (colonial) capitalism and the Soviet time of (atheistic) communism. The system should be based on private property and entrepreneurship, but the financial sector should operate riba-free. The initial idea, the replacement of interest-based debt finance by partnership-based equity-like finance, was formalized and widely adopted by Islamic economists since the early 1970s. In particular, Muhammad Nejatullah Siddiqi’s approach of profit and loss sharing (PLS) as the core principle for the operation of Islamic financial institutions became very popular. It was later called the “two-tier-mudarabah” model because PLS contracts were conceptually close to classical mudarabah partnerships, and they should be used for the relations of the Islamic financial institutions with the providers of funds (“savers”) as well as with the users of funds (“entrepreneurs”). The literature usually called these PLS based financial institutions “Islamic banks”. But in retrospect this was a “misnomer” with far-reaching implications.

The business model of a “typical” conventional bank was to collect deposits from the general public (“savers”) and to extend loans to the entrepreneurs, to the government and to private consumers. It soon became apparent that PLS based Islamic banks would have serious problems to finance the government and consumers because neither governments (in their general budget) nor households generate a profit which could be shared with a PLS bank. This insight triggered a debate on public finance in Islam, while consumer finance continued to be neglected for quite a while (at least in the academic world).

Besides – and quite independent from – academic discussions – an increasing number of Islamic financial institutions were established as banks and named “banks” in the late 1970s and early 1980s (for example the Dubai Islamic Bank , the Faisal Islamic Bank of Egypt, the Bahrain Islamic Bank, the Islamic Bank of Jordan – a notable exception is the naming of Kuwait Finance House). These new institutions followed the banking approach and engaged Shari’ah scholars in order to ensure that their transactions and products did not violate fundamentals of Islamic law.

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