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Review of Islamic Economics, No. 11, 2002, pp. 63-72

Review Article

Growing Mainstream

Relevance of Islamic Finance:

A Critical Review of Recent

Literature

Humayon A Dar

I. Introduction

Such has been the dearth of literature on modern Islamic banking and

finance that any good book on the subject published in the West tends

to acquire the status of a treatise. For example, Vogel and Heyes's

Islamic Law and Finance (1998)has been in heavy demand; many still

talk of Usmani's An Introduction to Islamic Finance (1999)and Mills

and Presley's.1 Islamic Banking by Lewis and Algaoud (hereafter LA),

published by Edward Elgar zoo^), and Islamic Finance in the Global

Economy by Warde, published by Edinburgh University Press ( 2 000 )

are worthwhile additions to the literature in this field. Unlike LA, who

maintain a sympathetic attitude to Islamic banking and finance

throughout, Warde appears aggressive and critical. He sets out to

challenge the traditional criticism of Islamic finance as an

epiphenomenon of Islamic revivalism (see, for example, Kuran,

1995). He questions not only the critics but also the mainstream

writings on Islamic finance, which, by and large, are poor in quaility,

being neither empirical nor interdisciplinary. He claims to adopt an

empirical, historical, comparative and interdisciplinary approach in

HUMAYON DAR is a lecturer in Islamic Banking and Finance, Economics

Department, Loughborough University.

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64 Review of Islamic Economics, No . 11, 2002

an attempt to understand the political economy of Islamic finance.

Undoubtedly, this makes the book interesting if controversial reading.

This review looks at these two books in the light of mainstreamliterature on Islamic economics, of which banking and finance is an

offshoot. The approach is necessary because analyses done by outside

observers tend to suffer from (and generate) misconceptions in their

efforts to understand Islamic banking and finance

11. Intended Messages

The two books have different messages to convey. While LA attempts

to introduce Islamic banking in a non-technical way, Warde provides

a critical account of the political economy of Islamic finance in a

global context. Following the mainstream Islamic argument LAcontends that Islamic beliefs and ethics help reduce adverse selection

and moral hazard problems in Islamic finance. Warde, on the other

hand, rather forcefully suggests that a major source of moral hazard

is the religion itself and coins the term 'Islamic moral hazard', defined

as unscrupulous behaviour on part of those engaged in Islamic

finance, behaviour encouraged by certain features of Islamic finance

(Warde, p. I 54). These features include:

(i) The assumption of righteous behaviour on the part of employees

and customers of Islamic banks.

(ii) The use of religion as a shield against scrutiny.

(iii) The religious and legal ambiguity that may allow borrowers to

escape their obligations with impunity.

(iv) Conflicts of interest involving the bank and its customers.

Warde contends that these factors have in the past contributed to

moral hazard problems in Islamic banking and finance. Specific

examples provided in this context are those of the Dubai Islamic

Bank, so-called Islamic money management companies in Egypt and

Islamic foundations (sort of NGOs established by religious

organizations) in Iran. While the argument may soui ~d ery forceful

to many, it will not impress anyone who has a basic familiarity with

the socio-economic environments in which Islamic financial

institutions operate. The kind of fraudulent behaviour mentioned is

not typical of Islamic financial institutions in the countries mentioned.

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Review of Islamic Economics, No. I I , 2002 65

In fact, such behaviour is also prevalent in other organizations; it

therefore seems unfair to use the term 'Islamic moral hazard', as there

is nothing Islamic in this kind of behaviour. Rather, it is acontradiction in terms. Furthermore, Islamic foundations in Iran are

not Islamic financial institutions in the sense the term is now widely

used in the literature on Islamic economics, banking and finance.

Rather, they are welfare organizations set up by Islamic missionaries.

It is true that problems of moral hazard and adverse selection

have hindered the use of profit loss sharing (PLS) in Islamic finance.

Many studies address this issue in some detail.2 But the kind of

behaviour that Warde distinguishes as 'Islamic moral hazard' notpeculiar to any Islamic context: everywhere rational economic agent

will try to exploit the loopholes in a legal and regulatory regime - hat

is, after all, what professional accountants all over the world d o in an

acceptable and legitimate way. In Muslim countries where property

rights have not been fully developed, informational asymmetries

contribute to agency problems. Thus, the lack of well defined

property rights, and not the religion, is a major source of moral

hazard, which makes it rather unfair to call it 'Islamic moral hazard'.

As a matter of fact there is a well-documented awareness of agency

problems in share contracts (in conventional as well as in Islamic

economic literature) and steps are being taken to reduce informational

asymmetries between providers of Islamic financial services and their

users. The Accounting and Auditing Organization for Islamic

Financial Institutions (AAOIFI) has already embarked upon

formulating accounting, auditing, governance and SharFa standards

for Islamic financial institutions (IFIs)- hese have in some cases been

implemented on a country level. This is a significant development and

should help mitigate informational asymmetries (and hence possibility

of moral hazard) between IFIs and the users of their services.

Warde's message is political: his language is polemical, his

analysis is at best political-economic, and the book is full of political

examples. Political analysis tends to be selective and Warde is no

exception. On occasions, he furnishes truncated or no evidence in

support of otherwise very strong statements. For example, he

mentions a survey on customer satisfaction, which revealed

dissatisfaction of customers of Albaraka Bank London (Warde, p.

158) . But he fails to mention a number of other studies showing that

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66 Review of Islamic Economics, N o . I I , 2002

Islamic bank s in fact provide services o n a par w ith, if no t better th an ,

their conventional counterparts.3 Similarly, the discussion of Saudi

an d Pakistani involvement in the US-led w ar against the Soviet Unionin Afghanistan suggests that Islamic banking played an im portan t role

in funnelling aid to th e Mu jahideen. In the curren t scenario, this kind

of statements deserves explanation and can be potentially misleading.

It is true that the book was written and published in a completely

different political environment, yet the arguments furnished in the

book need substantiation by facts, a lack most evident where it is

most needed.

111.Overview of the Books

i. Islamic Banking by Lewis an d Algaoud

Like most books written on the subject, LA starts with a lengthy

introduction to the phenomenon of Islamic banking in the light of

Islamic economics and law. There is some repetition of material

already available in a few recently published books (mentioned

abov e). T ha t said this is the first book o n Islamic banking t o provide

a n accu rate account of the historical development of Islamic banking.

While most ot her boo ks refer t o M it G ham r Savings Bank in Egypt as

the first modern experiment with Islamic banking and finance, LA

refers to even earlier developm ents in M alaysia an d P akistan.

The authors assume that their readers know very l i t t le about

Islam. Even some very basic terms are defined, which readers familiar

with Islam will find irrelevant. An appealing aspect of the book is

tha t, following o n from its very general introduc tion, i t maintain s its

easy style throughout, and ends with a non-technical discussion on

usury, giving the impression that after all Islamic banking is not as

difficult or peculiar a practice as many would otherwise think. The

middle chapters (especially chap ters 4 and 7) provide a useful analysis

of financial in terme diat ion an d co rpo rat e governance. T he

mainstream issues in these areas are related to Islamic banking in a

relaxed style. This feature makes it a good introductory book for

those who have only recently become interested in Islamic banking.

Th ose with som e basic know ledge of Islam m ay wish to skip chapter

2, which is a general introduction to Islam and the Islamic law.

Similarly, chapter 8 may not be of interest to those whose primary

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Review of Islamic Economics, No. I I , 2002 67

concern is with the practical issues in Islamic banking rather than its

theological foundations.

The analysis of operations of Islamic banking is distinctivelydifferent from many previous studies. LA appears to be the first book

indicating that the practice of Islamic banking is moving, slowly but

gradually, towards its paradigm version based on profit loss sharing

(PLS), as suggested by Siddiqui 1983 and Chapra 198 5 . It reports that

now more than one-third of financing by 199 Islamic banks world-

wide is based on PLS, which is in contrast to the previous

disappointingly low figures. O n an individual level, Faisal Islamic

Bank of Egypt now invests on PLS basis one-third of its funds,contrary to the previous figure of about 20 percent. Furthermore,

direct investment is reported to be emerging as significant financing

activity by Islamic banks. For example, Jordan Islamic Bank for,

Finance and Investment invests about 40 percent of its funds directly

in companies and joint ventures of different types.

Another significant contribution of LA is a discussion (chapter 7)

of corporate governance with reference to Islamic banking. The

discussion is limited to three Bahrain-based banks. The authors notethat there are significant governance differences among the three

banks. Financial reporting is not uniform across the banks. For

example, Bahrain Islamic Bank (BIB) includes Mudaraba investment

accounts along with current accounts, contrary to Faisal Islamic Bank

of Bahrain (FIBB) that treats them as off-balance sheet entities, owing

to the fiduciary nature of these investments. Al-Baraka Islamic

Investment Bank (AIIB) takes a middle course by dividing the

Mudarabainvestment accounts into joint investment accounts

(unrestricted PLS accounts) and specific Mudaraba accounts

(restricted PLS accounts), treating the former as a balance sheet entity

and the latter as an off-balance sheet entity. Given these variations,

there was a need to discuss the need for standardization of

accounting, auditing and governance of Islamic banks. This is an

important omission, specially as the Accounting and Auditing

Organisation for Islamic Financial Institutions based in Bahrain,4

where one of the authors is based. (Warde, [chapter 101, fills this gap

by providing an exhaustive discussion of international regulatory

framework and its relevance to Islamic banking.)

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6 8 Review o f Islamic Economics, N o . I I . 2002

Chapter 8 compares Islamic and Christian attitudes to usury,

which seems misplaced after the detailed discussion of corporate

governance in the previous chapter. However, there are some

interesting observations. The authors note that some of the devices

used by early Christians in response to the prohibition of usury by the

Church were remarkably similar to the financing instruments used by

Islamic banks today. They furnish an interesting example of the

Christian distinction between usura and interesse. The former is

simply the money paid for the use of money, and was banned by the

Medieval Christian laws. The latter refers to the compensation made

by a debtor to a creditor for damages caused by the creditor as a resultof default in payment of the principal, corresponding to any loss

incurred or gain foregone on the creditor's part. This was permissible.

However, the unlawfulness of usura and the acceptability of interesse

resulted in misuse of the latter, which later resulted in the acceptance

of interest in Christianity. The parallel exists in the Islamic law in the

form of a distinction between mark-up financing and interest.

Although, the mark-up financing is permissible, it is prone to misuse

and is potentially a 'back-door for interest to creep in' [LA, p. 1141.

Heavy use of mark-up financing may seem innocuous to many, but,

when seen in a historical perspective, may be damaging for the Islamic

stance on interest. Perhaps, this is why it has already been proclaimed

unlawful in Pakistan.

The book provides quite a good account of Islamic insurance, an

area by and large ignored in other books on Islamic banking and

finance. Most of the writers on Islamic insurance originate from

Malaysia, creating an impression that Islamic insurance is primarily aFar Eastern phenomenon. LA report, contrary to the common

perception, that Saudi Arabia has the largest number of Islamic

insurance companies (eleven), followed by Malaysia (with five).

Other aspects of Islamic finance are also discussed, albeit briefly.

Islamic unit trusts, Islamic investment banking and project finance are

examined in chapter 9, with some suggestions for future directions to

be taken in this field. Overall the book is a useful reading for

researchers as well as students of Islamic economics, banking andf ' nance.

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Review o f Islamic Economics, No. I I , 2002 69

ii. Islamic Finance in the Global Economy by Warde

Referring to many frameworks at a time runs the danger of diluting

methodology. Consequently, Warde is simultaneously confusing andintelligent. For example, while discussing the adaptability of Muslim

traditions in light of changing circumstances Warde overemphasizes

the role of Maslahah (public interest). This emphasis in its own right

may seem innocuous but clever mixing of the principles of Maslahah

and Darurah (overriding necessity) may prove fatal, especially in

Muslim societies dominated by non-Muslim traditions and

institutions. This, in effect, amounts to internalizing whatever, right

or wrong, happens to enter into Muslim ranks. A clear indication of

this is provided in the form of the use of interest by individuals,

businesses and governments in Muslim countries, which without

doubt lies outside the consensus view on the non-acceptability of

interest in any form and guise (pp. 43-44). The book, however, rightly

suggests the need for close co-operation between conventional strands

of economics and Islamic economics. Although comparison of homo

economicus and homo Islamicus is useful (pp. 44-48), mainstream

Islamic economists would not accept the suggested causality in

theorizing. Like the argument on interest (discussed above), Warde

suggests revision of theory in the light of practice, which is the exact

opposite of what the purists suggest.

The analysis is political-economic with rather more emphasis on

politics than economics. For example, chapter I, which is on 'Islamic

Finance: Theory and Practice,' discusses Islamic finance in an

economic framework in only four pages (pp. 5 - 9 ) while the remainder

of the chapter (pp. 9-28) by and large deals with political issues facing

the contemporary world in general and Islamic finance in particular.

The author makes some bold statements which may not be acceptable

to mainstream Islamic economists. Similarly, although Warde

dedicates one whole chapter to the country-level experiments with

Islamic banking and finance (chapter G), his approach is journalistic

without proper economic analysis of the Islamisation of banking and

economy in the selected countries, namely, Pakistan, Iran, Sudan,

Malaysia and Bahrain.

An economist reader would note lack of references to

mainstream Islamic economics literature. The author has tended to

dismiss it for being inadequately rigorous. Few serious references to

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70 Review of Islamic Economics, No. I I , 2002

Islamic economics and its critique include Kuran (who is the most

credible critic of Islamic economics), Baqar as-Sadr, and M. Akram

Khan. Perhaps Mallat, an expert in Islamic law and by no means anIslamic economist, is the major link between the author and Islamic

economics. Warde quotes Baqar as-Sadr through Mallat. Influenced

by Mallat, Warde's view of Islamic economics is primarily based on a

legal analysis, which is not necessarily held by a majority of Islamic

economists.

Warde observes some interesting phenomena, especially in the

second aggiornamento of Islamic economics. He notes the increasing

role of conventional banks in offering Islamic financial products,which have lately been more aggressive than Islamic banks in terms of

product innovation and marketing of Islamic financial products.

Given the severe competition from conventional banks, Islamic banks

need to concentrate on PLS to truly differentiate themselves from their

conventional counterparts. Furthermore, they should attempt to

achieve the social goals of Islamic economic system, which were

emphasized as one of the primary reasons for Islamic banking during

the first aggiornamento. However, Islamic banks face a dilemmawhen competing with conventional banks on the basis of profitability

while, at the same time, pursuing the social goals of an Islamic

economic system.

IV . Conclusions

Islamic banking and finance, like Islam itself, tends to be one of the

most misunderstood phenomena of present times. In some cases the

practitioners of Islamic finance have themselves to blame for this

confusion. In other instances, the misunderstanding is based on lack

of adequate information available on the practice of Islamic finance.

For example, one source of confusion is the rather elitist practice of

Islamic finance in the Middle East. Many IFIs by and large ignore the

socio-economic objectives of Islamic finance. Although ordinary

Muslims (and many scholars) perceive Islamic finance as a key to

economic development by providing long-term funding to businesses

that would otherwise have no or limited access to finance, IFIs have

been involved in short term financing mainly in trade and commerce.

However, the trend has recently begun to change: any sweeping

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Review of Islamic Economics, N o. I . 2002 7 T

generalization about Islamic finance is likely to be misleading, if not

downright wrong.

To sum up, of the two books, an economist would like LA morethan Warde, although the latter is more interesting and full of real

world examples. This is because an economist would feel

uncomfortable drawing conclusions from disparate examples from

various countries, without a proper empirical analysis. As suggested

in the Introduction, there is a need to understand Islamic banking and

finance in the light of Islamic economics. This is exactly what LA does

and, hence, should be an economist's preferred choice.

I . For a review of these books, see Dar 2001.

2. See, for example, Dar, Harvey and Presley 1999; Dar and Presley 2000; andAggarwal and Yousef 2000.

3. See Al-Fadh ly 1998.

4. In January 2002 , the Bahrain Monetary Agency, the central bank, promulgated

a new set of prudential regulations for Islamic banks. These regulations were

prepared with the help of AAOIFI, and aim at reducing informational

asymmetries by requiring IFIs to report all their financing activities according toAAOIFI standards.

Aggarwal, R.K. and Yousef, T. (2000 ) 'Islamic Banks and Investment Financing',

Journal of Money, Credit and Banking, 32 ( I ) , Febru ary), pp. 93-120.

Al-Fadhly, M. (1998) 'Financial Performance of Islamic Banking in Kuwait'.

Unpubl ished Ph.D dissertat ion: Department of Economics, Loughborough

University.

Chapra, M.U. (1985) Towards a Just Monetary System. Leicester: The Islamic

Foundation.

Dar, H.A., Harvey, D.I., and Presley, J.R. (1999) 'Size, Profitability, and Agency in

Profit and Loss Sharing in Islamic Banking and Finance', Proceedings of the Second

Harvard University Forum on Islamic Finance. Cambridge, M. A.: Harvard

University.

Dar, H.A. and Presley, J.R. ( 2 000 ) 'Lack of Profit Loss Sharing in Islamic Banking:

Mana gement a nd Con trol Imbalances', International Journ al of Islamic Financial

Services, 2 (2 ), (July-September), pp. 3-18.

Dar, H.A. (2001) 'Islamic Economics, Banking and Finance: A Critical Review of

Recent Literature', The Muslim World Book Review, 2 1 (3 ), (April-June), pp. 3-16.

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72 Rev iew of Islamic Econ omics, N o. I I, 2002

Kuran , T. (1995) 'Islamic Economics and the Islamic Subeconomy', J our na l o f

Econ omic s Perspectives, q (4),pp. I 5 5-73.

Lewis, M.K. and Algaoud, L.M. (2001 ) Islamic Ban king. Cheltenham: Ed ward Elgar.

Mills, P. and Presley, J.R. (1999) Islamic Finance: T he or y an d Practice. Basingstoke:

Macmillan.

Siddiqui, M.N. (1983) Issues i n Islamic Baking . Leicester: Th e Islamic Found ation.

Usmani, M.T. (1999) A n In troduct ion to Is lamic Finance. Karachi: Idaratul Ma'arif.

Vogel, F.E an d Hayes, S.L. (19 98) Islamic Law and Finance: Risk, Religion and

Re turn . Th e Hague: Kluw er Law International.

Warde , I. (2000 ) Is lamic Finance in the Global Economy. Edinburgh: Edinburgh

University Press.

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