Islamic Finance, Consumer Protection and Public Policy

Abstract

Islamic finance in its broadest sense has existed since the early years of Islam. While Islamic finance has much to offer with regard to financial management and ethical investing, it lacks cohesive and overarching regulatory structures. This chapter addresses these concerns by focusing on two central themes: (1) the importance of faith or religion for some people when it comes to financial decisions, and (2) the potential consumer protection concerns with respect to regulating what is or what is not “Islamic” in western financial markets. The chapter argues that Islamic finance, has much to offer to global finance, but its current practice falls far short of Islamic economic and ethical ideals.

Introduction

In a complaint filed against me years ago with the Law Society of Upper Canada (LSUC) (now renamed the Law Society of Ontario), the professional governing body of lawyers in Ontario, a client stated: “What this lawyer had me engage in is akin to me committing incest with my mother.”¹ The complaint arose from an “Islamic mortgage,” the closing and registration of which had been facilitated by my office. Essentially an Islamic finance company, UM Financial (“UM”), had advanced the funds to close a house purchase. UM claimed to have structured the transaction as a diminishing musharaka.² My role was to ensure that the homebuyers, a couple, received clear title to the house being purchased and the investor (lender), in this case the Islamic finance company, UM, had security for their “Islamic loan.” As part of the transaction, my office had the homebuyer clients sign standard real estate closing documents as well as documents governing and structuring the relationship between UM and the homebuyers.³ As is typical in such transactions, I was on a joint retainer for UM and the homebuyers.

Following the registration of the transaction, one of the buyers more thoroughly studied the documents and the structure, all of which were developed and prepared by UM. He concluded that the transaction was not “Islamic” or “Shari’ah-compliant.”

Because my client’s attempts to have the situation addressed by UM were unsuccessful, he filed a complaint against me with the LSUC. He was persistent and adamant in his position. He apparently harassed the LSUC non-stop, including showing up in person at its offices and essentially refusing to leave the premises unless it addressed the complaint. He also reportedly quoted to its members the hadith mentioned in footnote one.

The LSUC responded by dispatching its chief investigation counsel and a forensic auditor to deliver the complaint notice to me personally.⁴ Its members were obviously concerned, and I spent some time educating them about Islamic finance in my boardroom. The complaint was eventually dismissed with the direction that going forward I had to advise my clients that I was not providing them with “Islamic finance” or “Shari’ah-compliance” advise.⁵

This incident illustrates a number of issues, but for the purposes of this chapter, I will focus on the following:

• 1. The importance of faith or religion for some people when it comes to financial decisions; and

• 2. The potential consumer protection concerns with respect to regulating what is or what is not “Islamic” or “Shari’ah-compliant” in western financial markets.

These two issues run as the central themes through the discussion in this paper. This chapter is organized into four parts. Part I provides an overview of the origins, sources, and history of Islamic finance. Part II provides an introduction to the basic principles of Islamic finance. Part III touches upon some of the regulatory and policy concerns and issues. Part IV concludes with some observations about future prospects and recommendations.

Origins, Sources and Brief History

My client’s complaint centered around the concern that the loan he negotiated, and that my office had helped him finalize, was not consistent with Islamic finance rules. Islamic finance rules evolved out of Islamic economics, which in turn takes its inspiration from the Shari’ah.⁶ The Islamic financial system is based on religious teachings that emphasize that everything belongs to God and that human beings are accountable to God for their conduct (and intentions) on earth. Human beings have been tasked to be trustees over God’s wealth and must discharge this role within a framework that prioritizes, among other things, social and economic justice. The ethical, moral, social, and legal principles at the core of Islamic finance are derived from the Shari’ah (loosely and inaccurately referred to as Islamic law).⁷ It essentially involves balancing the material and the spiritual as well as the individual and collective interests within a God-centered ethical framework.

The Islamic finance system seeks to provide banking and finance services that comply with Islamic principles.⁸ It must operate within ethical and religious constraints, but it should also further social and economic justice. By complying with Islamic principles, the Islamic finance system aims to achieve a more equitable distribution of wealth and income, and it encourages full employment, socioeconomic justice, and stability.⁹ In essence, it can be described as a modified free enterprise system that locates itself in the middle of the spectrum between socialism and capitalism.

Islamic finance, in its broadest sense, has existed since the early years of Islam, starting with the social and economic justice teachings of the Prophet Muhammad (Peace be upon him—[pbuh]),¹⁰ as detailed in the Quran and Sunnah (teachings and sayings attributed to the Prophet).¹¹ Islam teaches that it is the continuation and culmination of the messages sent to previous prophets and messengers. Consistent with this view, at its core many of the central teachings and beliefs in Islam, including teachings on social and economic justice, are very similar to those of other major religious traditions. Historians of early Islamic civilization have documented that banking activities similar to those performed today took place from the early days of Islamic civilization.¹² In fact, the Islamic empire had a well-developed financial system, complete with a legislative system governing transactions, a judicial system enforcing contracts, different commercial papers and banknotes, and licensed bankers, which contributed to the development of modern banking practices.¹³ However, under the influence of European colonizers, many Islamic countries adopted Western banking models in the nineteenth century. It was not until the mid-twentieth century that Islamic financial institutions began to reemerge, partly driven by political Islam and a renewed sense of Islamic identity.¹⁴ Since then, the global market for Islamic finance has become one of the fastest-growing segments of global finance with a growth rate between 10–12% annually and a “Shari’ah-compliant” industry worth well over $2 trillion USD in 2015 and projected to grow to $3.2 trillion by 2020 according to Thomson Reuters.¹⁵

Once largely limited to the Middle East and Southeast Asia, “Shari’ah-compliant” finance and products are gaining attention outside these traditional markets. It made its first appearance in the West in 1978 with the establishment of the Islamic Finance House Universal Holding S.A. in Luxembourg.¹⁶ Today London has a significant presence in Islamic Finance.¹⁷

North America, considered to have one of the most stable banking systems in the world, has also witnessed growing interest in Islamic finance.¹⁸ “Shari’ah-compliant” products have been offered in Canada and the United States since the 1980s.¹⁹ The significant, relatively affluent, and religiously observant Muslim population in North America represents a substantial consumer market for investments, pensions, insurance, mortgages, and commercial businesses, as along with day-to-day banking. Islamic finance only began to get real traction in the United States in 1990s, when “the New York branch of the United Bank of Kuwait obtained two interpretive letters issued by the Office of the Comptroller of the Currency to offer Islamic retail banking services in the country.”²⁰ The first letter, issued in 1997, permitted the use of ijarah,²¹ whereby the bank would act as a “riskless principal,” buying real estate at the request of the lessee, then leasing it back to them until the final payment, at which time the lessee would be given title.²² The second letter, issued in 1999, allowed murabaha-based financial products. As in the previous scheme, the bank had to act again as a “riskless principal,” thereby permitting the activity. While the bank ceased operations in the United States in 2000, it bought and leased sixty homes for American Muslims.²³ Since 2000, many small Islamic financial institutions have entered the market, and many conventional financial institutions have begun to offer Islamic products with varying degrees of compliance with Islamic principles.²⁴

Islamic finance is also gaining interest in Canada and is expected to increase as Canada has a large, growing, young, and observant Muslim population.²⁵ The 2011 National Household Survey found Muslims make up 3.2% of Canada’s population.²⁶ The community is expected to reach 6.6% by 2030.²⁷ While some Islamic financial products are available, no major financial institution has successfully marketed any “Shari’ah-compliant” products or services.²⁸ The first Islamic financial body in Canada—the Islamic Co-operative Housing Corporation Ltd., a grassroots, community-based project—was established in Toronto in 1979.²⁹ Since then, several other Islamic financial institutions have been established throughout Ontario and Quebec. One such company, UM Financial, founded in 2004, became one of the primary Islamic financial providers in Canada. It partnered with Central 1 Credit Union of Canada and marketed “Islamic mortgages.” From 2006 to 2007, UM Financial provided $86.1 million in home financing. The company was essentially relabeling, using legal fictions/assignments, drafting parallel documents, and clouding disclosure to unsophisticated buyers. The company declared bankruptcy in 2011, and its founder and chief Shari’ah advisor were charged with fraud.³⁰

The fact remains that there is a growing appetite for Islamic finance products even in North America. Inevitably, there will be unscrupulous actors who prey on the lack of knowledge among consumers both of finance and Islamic principles, non-existence of religious standards or regulatory bodies, lack of government oversight and issues and obstacles in structuring “Shari’ah-compliant” products and transactions.

Introduction to the Principles of Islamic Finance

Islamic finance is differentiated from conventional finance by the fact that Islamic finance is God-centered and informed by principles of Islamic law.

Prohibitions

Islamic finance has become synonymous with a system that, at its core, prohibits: (1) usury (riba); (2) taking excessive or unnecessary risk or gambling where one party benefits only due to the loss of the other (qimar and maysir); (3) uncertain transactions/speculation (gharar); and (4) the limitation in dealing with products, industries and services considered prohibited (haram), such as alcohol, gambling, illegal drugs, certain weapons, pornography, and other areas deemed harmful to society or the individual, etc.

Riba (“Usury”)

For most people aware of Islamic finance, the first thing that comes to mind is the prohibition of riba, which is understood by most Muslims as interest per se. The basis for this prohibition of riba is said to be rooted in the Quran and the teachings of the Prophet Muhammad (peace be upon him), the Sunnah. Contrary to the understanding of most Muslims, the definition of riba has been contested and evolving throughout Islamic history and is often the subject of intense debate among Islamic jurists, scholars, and bankers.³¹ A conservative/orthodox understanding, which is the majority view, holds that the term applies to any form of interest and precludes its payment or collection.³² A minority, but growing, interpretation opines that riba refers to “usury” or excessive compounded interest.³³ The two underlying principles that are used as the basis to prohibit riba are the Quran’s³⁴ stipulation that only active trading serves as the basis for increasing wealth and the unfairness of manipulating desperate “poorer members of society by unscrupulous merchants.”³⁵ The prohibition and the principles behind riba have historically been central tenets of several major religions (e.g., Judaism ³⁶ and Christianity ³⁷). According to some observers, around 1000 A.D. there existed little difference between Christian Europe and the territories under Muslim rule pertaining to their attitudes toward interest.³⁸ Indeed, the Catholic Church lifted the ban on interest only in the mid-nineteenth century.³⁹ Moreover, there are banks in Israel that cater to Jews who refuse to pay or take interest.⁴⁰

Qimar (“Excessive Risks”) and Maysir (“Wagering”)

Transactions or dealings that involve unnecessarily or unreasonably risky undertakings in the hopes of achieving something are also prohibited.⁴¹ This includes qimar, which literally means betting and wagering.⁴² Qimar refers to taking ownership of something valuable (mal) through some form of wager.⁴³ Islamic law unequivocally prohibits every zero-sum scenario through wagering on very risky outcomes.

This prohibition also extends beyond qimar to maysir, which is broader and extends to all kinds of gambling and games of chance.⁴⁴ Evolving out of the pre-Islamic practice of divining arrows whereby seven persons gambled for shares (portions) of an allotted prize, the objection is to the fact that the agreement between the players is based entirely on wishful odds that have no real statistical probability.

In essence, these prohibitions aim at preluding “effortless gain” generated from any dealings.”⁴⁵ It is quite obvious that there will be a wide range of diverse opinions on what would or would not fall into these categories.

Gharar (“Prohibition on Excessive Risk and Deception”)

Another central pillar of Islamic finance is the prohibition of excessive risk, uncertainty and deception all grouped under the heading of gharar.⁴⁶ Obviously, business and investment always involve elements of risk, but disproportionate uncertainty or risk would violate Islamic principles. This of course rules out speculative trading. According to Muhammad Ayub, Islamic jurists have defined gharar as “the sale of a thing which is not present at hand, or the sale of a thing whose aqibah (consequence) is not known, or a sale involving hazard in which one does not know whether it will come to be or not.”⁴⁷ The prohibition against gharar tends to prohibit major financial products, according to most but not all Islamic finance scholars, such as “forward contracts, swap agreements, hedges, options, derivatives, and financial insurance.”⁴⁸ It also prohibits the sale of things that do not yet exist, which some scholars have interpreted to include, for example, fish that a fishing boat setting out to sea may catch on its expedition, a crop that has yet to be planted, and even an unborn animal.⁴⁹

Haram (“Prohibited”) Goods and Services

Another dictate is that Islamic financial institutions must not be involved in areas prohibited by Islamic law, such as alcohol, tobacco, pork, gambling, pornography, and weapons.⁵⁰ The degree in kind and level to which these are adhered to depend on the philosophy and strictness of the scholar or Shari’ah body, which may range from absolute prohibition to those who allow it to within a de-minimis threshold. Some of these prohibitions, to varying degrees, are similar to those found in the socially responsible investing (SRI) movement within conventional banking.⁵¹ In fact, in this context there may be some similarities between conventional and Islamic finance. Particularly, since the financial crisis of 2008, there has been pressure within Western countries for banking to become simpler, less reliant on highly leveraged capital structures, and for a more deeply ingrained sense of ethics.⁵²

Islamic Finance Products and Mechanisms

The foregoing restrictions do not mean that Islamic finance is averse to business or taking calculated and reasonable risks to generate a profit. On the contrary, Islam is understood to encourage trade and the productive use of capital.⁵³ As a result of these restrictions around riba, qimar/maisir, gharar, and the prohibition on engaging with haram goods and services, Islamic financial institutions have had to devise products and services that work around these “impediments” while generating profits. One of the fundamental conceptual shifts induced by Islamic finance is that transactions must be linked to assets using equity-based instruments and contracts as opposed to debt-based instruments. It also means that, at least in theory, there ought to be more emphasis on social justice, fairness, and ethical concerns. Provided that it is equity-based and avoids the above prohibitions, profits can be generated through the reallocation and management of risk and reward between capital providers and users.⁵⁴

At its simplest level conventional financing takes the form of equity or debt.⁵⁵ Equity financing means giving an ownership interest or shares of common stock to an investor with its attendant risk of investment loss in exchange for the opportunity to participate in gains or profits. Debt financing involves borrowing money and not giving up ownership or an interest in the asset or going concern. The creditor or lender has its loan secured through a mortgage or through personal property security regimes.⁵⁶ In some cases it may even be an unsecured loan. The debtor must, of course, invariably pay a fixed return in the form of interest, which a majority of Islamic scholars translate as riba. Islamic-compliant products attempt to shift this paradigm toward joint-venture and limited partnership structures whereby the profit and loss are shared in agreed-upon proportions. To comply with the various rules and prohibitions, numerous investment vehicles and contracts have been developed over the years that have been approved by Islamic jurists (although not all instruments and structures and their permutations or iterations are accepted by all scholars). These include, among others, murabahah, ijarah, mudharabah, musharaka, istisna, takaful, and sukuk.⁵⁷

Murabahah (“Rent to Own”)

The most commonly used transaction is the murabahah, where a commodity or asset is purchased by the financier for the buyer, who then pays the cost plus a fixed “profit” or mark-up over a period of time.⁵⁸ The purchase and sale price, costs, and the profit margins must be clearly agreed to between the parties at the outset. The asset must remain under the ownership of the financing institution until the agreed marked-up price for the asset is fully paid by the customer.⁵⁹ In some ways, it is similar to a rent-to-own type of arrangement. Most Islamic finance companies offering “Shari’ah-compliant” mortgages use a variation of this model, or at least claim to do so. One of the major problems from an Islamic perspective is that, contrary to the theory, in practice the Islamic finance company does not keep title for liability, practicality, or out of legal/regulatory considerations. When one factors in the use of security in the form of a mortgage versus keeping title, amortization schedules that do not match the term, terms that are less than the length required to pay off the full value, rates pegged to the market interest rate, etc., it becomes easy to imagine how the lines between interest/profit and conventional/Islamic finance get blurred.

A traditional murabahah structure is also employed quite often in the trade finance context.⁶⁰ For instance, a customer needs to buy goods but cannot afford funds up front, but there is a financier prepared to facilitate the transaction by advancing the funds. The financier buys the goods, paying full price on delivery, and upon receipt of the goods immediately sells it at a mark-up (a single payment at a later date or pre-agreed schedule) within an agreed-upon time. Depending on the reference points used, profit calculation formula, and amortization schedule used, this murabahah could easily mirror a conventionally financed transaction with Arabic terminology substitutions.

It works slightly differently in the commodity contexts. In the commodity context, upon receipt of the murabahah financed goods, the customer will immediately sell the goods back into the market with a mark-up immediately or in a deferred transaction.⁶¹ Unlike a traditional murabahah (where the financing is to facilitate acquisition of a property or equipment that the customer actually wants), a commodity murabahah structure can be used to facilitate the flow of funds to an entity, even where the entity does not want the underlying commodity (raising the concern about money making money in the Islamic context). The only additional requirement is that the commodity is not haram.

Murabahah finance appears to be the closest to a conventional loan and the most straight-forward to effect. For this reason, as well as the way that murabahah is used today by Islamic finance companies, the murabahah structure has attracted the most criticism from Islamic scholars and finance experts for violating the spirit of Shari’ah principles while blindly adhering to form.

Ijarah (“Lease Finance”)

Another commonly used transaction is the ijarah, where the financier buys an asset from a party to lease to another party or from the customer to then lease it back to the customer for a fixed period, after which the lessee commits to repurchase the asset.⁶² The financial institution is entitled to a predetermined rental fee.⁶³ In essence, the ijarah structure is the equivalent of a traditional finance lease. In the Islamic context, it is arguably the second most common instrument, most often used for real property or asset financing. The asset is essentially sold to the customer at the end of the ijarah contract (or in the event of default) for a pre-agreed buyout price plus any accrued and unpaid rent. In some situations, the underlying asset may be split up (actually or theoretically on a percentage basis) to allow for a sculpted reduction in the purchase price payable or to allow for partial (voluntary or involuntary) payments of the purchase price during the term of the ijarah contract (to mirror amortization or early repayment under a conventional term loan). Again, Islamic jurists have differences of opinion as to what is permitted and what is not in the context of ijarah.

Mudharabah (“Profit/Loss Sharing”)

Mudharabah refers to a profit-sharing contractual agreement between a financial institution or investor and an entrepreneur.⁶⁴ This can be viewed as “venture capital.” At its core, it is a contract that provides for profit sharing between the investor and the entrepreneur who contributes skill, time, or goodwill. While the financial institution provides the necessary capital (rabb-ul-mal), the entrepreneur (mudarib) provides the operational capabilities. In the event of a loss, the financial institution loses its capital and the entrepreneur loses his or her invested labor and other intangible contributions.⁶⁵ The salvage value belongs to the entrepreneur based on the Shari’ah dictate that the rabb-ul-mal should absorb all losses. Under this arrangement, money contributed by the capital provider (rabb-ul-mal) is invested by the entrepreneur (mudarib) in the business and is used to acquire “assets” (interpreted very broadly in this context so that no tangible asset is required) with the goal of profit generation.⁶⁶ The mudharabah agreement typically stipulates that the mudharabah will generate profits periodically for set periods at a pre-agreed scheduled rate. All profit generated by the business is distributed between the rabb-ul-mal and the mudarib as previously agreed. Similar to the ijarah model, the agreements provide mechanisms for repayment of the original investment amount and for termination (on expiry, or earlier default).

Musharaka (“Partnership with Profit/Loss Sharing”)

Musharaka is literally translated as “sharing.”⁶⁷ Musharaka is a partnership in which both the customer and financial institution provide capital and share profits and losses based on a contract between the two parties concluded before the transaction is finalized. It is among the more common methods utilized to engage in project finance, real-estate purchases, letters of credit, and other investment projects.⁶⁸ Another form of musharakah that has surfaced relatively recently is the “diminishing musharakah.” According to this concept, an investor and customer or partner will participate either in the joint ownership of property or equipment, or in a joint commercial enterprise. Under the diminishing musharakah model, the share or interest of the investor will be paid off periodically along with the agreed profit. The investor’s share or interest will therefore decrease and will eventually be paid off fully leaving the customer or partner the sole owner of the property, or the commercial enterprise, as the case may be.

A contract of mudharabah normally presumes that the mudarib (entrepreneur) has not invested capital to the mudharabah. The mudarib is responsible for the management only, while all the investment comes from rabb-ul-mal. Conversely, the musharaka is the preferred vehicle when the mudarib also wishes to invest capital into the business of mudharabah. In such cases, musharakah and mudharabah are combined together. This is typically how it is done in the real estate market.

Istisna (“Agreement for Future Delivery”)

Istisna involves a funding party agreeing to produce, procure, manufacture, or construct and deliver a commodity or an asset at a predetermined future time at an agreed price to another party.⁶⁹ The asset or commodity is sold for an amount equivalent to the aggregate of all phased payments made plus a profit margin. This vehicle is often used in project or real estate development financing to facilitate the advance of monies during the construction phase. In such circumstances, to facilitate a long-term financing arrangement, it is very often paired with an ijarah. On completion of the underlying asset, the istisna will be replaced by an ijarah over the completed asset.

Takaful (“Mutual Benefit Society”)

Takaful, which is often translated as Islamic insurance, is essentially a mutual benefit society or co-operative system that aims to serve as a safety net for members in case of loss.⁷⁰ It serves as an alternative to conventional insurance products that are seen as violating Islamic restrictions. Takaful policyholders make contributions to a mutual investment pool and agree to guarantee each other.⁷¹ Contributions are based on the type of coverage policyholders require and their personal circumstances. Similar to conventional insurance, a takaful contract specifies the nature of the risk and time period of coverage.⁷²

Sukuk (“Investment Certificate”)

Sukuk, commonly referred to as Islamic bonds, is more accurately translated as “Islamic investment certificates.”⁷³ A traditional bond is best understood as a contractual debt obligation, and the bond issuer is obligated to pay the bondholder both the principal as well as the interest at agreed-upon intervals.⁷⁴ The primary difference between sukuk and a traditional bond is that sukuk is technically not debt and does not pay the security holder interest.⁷⁵ Instead, sukuk holders become shareholders, holding the assets that are then leased back to the original company for an asset-related return over a predetermined period of time based upon the profit from the underlying assets.⁷⁶

Each of these products/structures have numerous variations and iterations. There are many other products and instruments but the foregoing provides a good overview of the field and should give one a sense of how Islamic finance works. Table 7.1 provides a summary. The overview in this Part should also help shed some light on the potential for differences of opinion on the Shari’ah-compliance of the different products and vehicles. It also reveals the potential for confusion, misunderstanding, and even obfuscation and deception by unscrupulous actors who may wish to exploit religious sentiments. The next Part touches upon challenges, especially consumer protection concerns, that evolve from the status quo.

Table 7.1 Summary of key Islamic finance instruments

Practical Issues in Implementing Islamic Finance

While, at least theoretically, Islamic finance has much to offer with regard to economic and social justice, financial management, and ethics, the Islamic finance industry of today faces significant challenges, especially outside the Muslim world. Some of these issues are germane in Muslim states, too, but they are more pronounced or unique to jurisdictions that do not have an overarching Islamic judicial or regulatory body.

These challenges include the following: (1) lack of knowledge and sophistication on the part of Muslim consumers and the non-existence of uniform standards; (2) shortage of experts with an understanding of Islamic rules, finance, law, and their interactions; (3) lack of sophistication, professionalism, and the resulting lack of credibility; (4) legal impediments, regulatory confusion, and lack of oversight; and (5) politics and public opinion. A few of these issues are highlighted below to provide an overview.

Lack of Knowledge on the Part of Muslim Consumers and the Non-existence of Uniform Standards

Far too many consumers lack basic knowledge about finance and financial risk and may make unwise financial decisions. They may also be easily duped by fraudsters and high-powered salespeople. This is the main reason that governments often have extensive rules and regulations when it comes to investments and financial schemes. This is true for all money matters, but as the foregoing discussion on Islamic finance illustrates, the situation can be even more complex when there is a marriage between finance and faith.⁷⁷

Mahmoud Amin El-Gamal, a leading critic of the Islamic finance industry, argues that the industry is selling overpriced products to the religiously naive. He claims that sophisticated investors and the ultraorthodox religious players will see through what is being done in the name of Islamic finance, but he notes, “So you’re left with the gullible who don’t really understand the structure.”⁷⁸ This is all the more dangerous when the faith is blind as is the case too many times when religious followers put their trust in pious and charismatic individuals or groups who use religion to advance their agendas including financial ones.⁷⁹

Professor El-Gamal may be giving the ultraorthodox Muslims too much credit, because from my experience working with Islamic finance products, most Muslims, even the ultraorthodox, have a very limited or cursory understanding of Islamic finance in practice. The key questions are: (1) how do we get religious consumers to be more inquisitive, and (2) how do we get them to do more due diligence: This is particularly important given that consumer protection legislation in this context is virtually non-existent or deficient. The problem is heightened in non-Muslim jurisdictions because of a lack of awareness as to what is being done in the name of Islamic finance and the reluctance on the part of governments to intervene in a community’s internal religious questions. Muslim jurisdictions are not immune either. Many of them are relatively unsophisticated in terms of consumer protection and lack the ability to effectively dictate what is or is not Shari’ah-compliant, because that is the realm of the religious establishment (many of whom are independent and/or unregulated by the state) for the most part.

Those who actually study Islamic finance will quickly realize that one of the central and highly debatable questions in Islamic finance is whether Islamic financial institutions actually avoid interest-based instruments, or simply reframe or relabel them in order to “comply” with Islamic law.⁸⁰ In Partnership, Equity-Financing and Islamic Finance: Whither Profit-Loss Sharing? Mohammad Omar Farooq argues that in order to attempt to avoid interest, Islamic finance has developed “an impressive array” of transactional modes that claim to be based on profit-loss-sharing (PLS).⁸¹ However, while the Islamic finance literature “continues to emphasize PLS as the main modes, in practice Islamic financial institutions (IFIs) have deliberately and systematically avoided them.”⁸² Farooq goes on to argue that partnership modes of business organization, such as PLS, are inherently flawed, and that it is thus economically rational for Islamic financial institutions to use debt-like instruments while claiming compliance with Islamic law under the guise of PLS-like equity-based systems.⁸³ Meanwhile, in practice, instead of PLS systems, Islamic finance has turned toward the murabahah, a model that often carries no risk for the Islamic finance institution, despite risk-sharing being one of the key conceptual components of Islamic finance.⁸⁴ The mark-up model of the murabahah leaves all the risk on the buyer, except in the case of death or default, similar to conventional finance.⁸⁵ While “Islamically there is nothing wrong with murabahah,” there is also “nothing especially Islamic about it, either … Banking primarily based on this type of transactions robs IFIs of distinctively Islamic characteristics.”⁸⁶ Murabahah is ultimately not as Shari’ah-compliant as is generally claimed, and it is criticized by many scholars as well as some Islamic Financial institutions.⁸⁷ This leads to a “basic contradiction.” where the PLS models continue to dominate the literature; yet, in practice, IFIs continue to use murabahah and other modes that are functionally non-PLS and similar to conventional financial instruments.⁸⁸ While IFIs “proclaim that the conventional financing based on interest is unjust since there is no fair sharing of profit-loss and risk,” they themselves “do not utilize PLS modes substantively in their portfolios.”⁸⁹ Farooq goes so far as to suggest that IFIs “make up ruses” to “manufacture products and services that are only legally Islamic,” but have little difference in substance from conventional financial instruments.⁹⁰ Farooq is not the only one or the first to make such claims.⁹¹

This gap between the theoretical discourse and the practice of IFIs may be due to an exaggeration of the “usefulness” of PLS models.⁹² This exaggeration, in turn, may stem from a second fundamental issue within Islamic finance: the definition of riba. Specifically, the notion that riba, which is prohibited in Islam, is broadly equivalent to interest. While the traditional understanding of Muslims is that riba is equivalent to any interest, some scholars, such as Farooq, El-Gamal, Kuran, Rauf, and others argue that it only means “usury would be prohibited” but that “interest in all its forms as it exists in modern economy and finance can’t be necessarily categorized as prohibited.”⁹³ While the Quran does not explicitly define riba, the common understanding is that the traditional definition is arrived at via six hadiths. In an analysis of these hadiths, Farooq finds that it is a “daunting task” to utilize these hadiths to broaden riba’s scope “to contend that all forms of interest … in a modern economy are prohibited.”⁹⁴ Should the common understanding of riba be modified to a more narrow understanding of interest, IFIs would have more flexibility in the types of financial instruments they could offer. Moreover, even if one is to accept the traditional view of riba, consumers should be aware that there are differences of opinion on this issue.

The differences in interpretation of riba are not only being advanced by “modernists” or “liberals.” Even a group of conservative jurists passed a fatwa permitting interest-based transactions as a necessity in the West given the lack of viable alternatives and the importance of acquiring a residence as a foundation for economic empowerment.⁹⁵ They did by inference add a few caveats, including the following: (1) there must be no viable and practical Islamic alternative available; (2) the house to be purchased must be for the buyer and his household; (3) the buyer must not have another house; (4) the buyer must not have any surplus of assets that can help him buy a house by means other than mortgage, and (5) the buyer must be actively working for or seeking out Sharia’h-compliant options.⁹⁶

Another issue is the lack of uniform standards within a regulatory framework, creating large differences in practices and variations in instruments that all pass as “Shari’ah-compliant.”⁹⁷ What is and what is not Shari’ah-compliant differs widely depending on the school of jurisprudence and the geographic area—and even within these domains, because each scholar’s opinion is considered valid by his or her respective followers.⁹⁸ There is no official clergy or central religious authority (at least in the Sunni context) that can be called upon to give the final word on what is Islamic finance or even Islamic law.

Different countries and different sects—and even schools of Islamic thought within those countries and sects—each have their own interpretation of religious as well as financial teachings of Islam. Contrary to popular perception, Islamic law is not monolithic. Rather, it is pluralistic and dynamic and, therefore, allows for flexibility to meet the demands of the changing social and economic circumstances, but it also creates obvious obstacles from a legal/regulatory and practical perspective. In the absence of a supreme authority (e.g., the highest court in jurisdiction for instance) with the power to rule on whether something is ultimately Shari’ah-compliant, the rules may be unpredictable and susceptible to a multitude of interpretations that result in “fatwa shopping.” Interestingly, some scholars and critics have highlighted this practice, whereby Islamic finance bodies search out “Islamic” legal opinions to justify or rationalize what they want to do rather than seeking out the most reliable or “authentic” rulings in line with the spirit and letter of Islam.⁹⁹ In fact, studies have demonstrated that some Islamic finance professionals search for favorable scholars for quick recognition of products¹⁰⁰ thereby giving an Islamic identity to products that are de facto conventional in nature.¹⁰¹

Education and reflection are critically important but highly unlikely to bear any immediate fruit because of the complexity of the field and the belief among many Muslims that they simply need to have good intentions and should leave the mechanics to “scholars.” The fact that unscrupulous actors may take advantage of them is brushed off: “My intentions are good, if they want to dupe me then they will face God on the day of judgement.”¹⁰² Although an understandable theological position, this fatalistic view is fertile ground for exploitation.

Shortage of Experts with Simultaneous Understanding of Islamic Rules, Finance and Law

The dearth of competent specialists trained in the field is a widely highlighted global problem in Islamic finance.¹⁰³ Many have argued that there is a lack of human capital with Islamic finance know-how.¹⁰⁴ I suspect the problem is not a shortage of Islamic scholars with know-how about Islamic finance, because this is not necessarily accurate.¹⁰⁵ As Zulkifli Hasan notes, there are plenty of scholars with Islamic finance knowledge, but institutions stick with a known group for credibility and business reasons. I would also add that some are relied on because companies get what they want from these Shari’ah scholars who are paid handsomely and some of whom sit on dozens of boards.¹⁰⁶ Sometimes the problem is exacerbated even when people have Islamic finance training or knowledge, because they do not appreciate or understand the whole picture. This results in approval of documents, instruments, or structures that are no different from conventional finance options, and sometimes it even results in these scholars or specialists being used to market exploitative or egregiously non-Shari’ah-compliant products and services. Scholars or specialists who lack a more holistic understanding or who fail to appreciate the technical and complex interplay often involved in such documents or transactions are sometimes inadvertently duped by shady businesspeople or occasionally even well-meaning proponents of Islamic finance.¹⁰⁷

In the Canadian context, I have witnessed many schemes being approved as Shari’ah-compliant, such as the “musharakah” agreement used by UM Financial mentioned earlier, when financial institutions are doing nothing more than relabeling, playing with terminology, and drafting parallel documents. In such contracts, even though terminology from Islamic finance is widely used, the key thing is that (1) the borrowers may not fully realize that they are effectively paying “interest” on the loan, because it might be labeled otherwise, and (2) there is a range of opinion among Islamic finance scholars about what products/services are consistent with Islamic principles.

With such contracts, an Islamic scholar who only understood the rules of theoretical Islamic finance would not be able to understand these transactions. The scholar must understand the theory of Islamic finance, the practical details, and the conventional loan procedures, as well as the legal and real estate practice and procedures. Such people are few and far between.¹⁰⁸

Lack of Professionalism and the Resulting Lack of Credibility

Though there are some studies focusing on customer satisfaction with Islamic finance companies in the Muslim world, there appear to be no such studies in the context of Islamic finance companies in the West. Anecdotally, the customer service landscape in the western Islamic finance market is far from glowing. As small-time operators or community-based groups, customer service is usually not their forte. The disgruntled client, whose story I shared at the start of this chapter, only went to the Law Society because he thought I was part of UM. Moreover, he had been unable to get a satisfactory response from UM on his questions or complaints even after months of trying. He found it difficult to reach UM and when he did, they were unresponsive. UM is not alone in lacking professionalism and sophistication. As small, independent, private, and non-mainstream, Islamic finance entities cannot be expected to meet the service levels people have grown to expect from conventional financial institutions. Much of this has to do with limitations in terms of financial resources, human resources, and, to some extent, even cultural factors. This of course creates a vicious circle that results in even poorer service over time and lowered expectations.

Given that the competitive advantage of Islamic banking lies in the fact that the products and services offered are indeed Shari’ah-compliant, some of the practices described earlier in this chapter diminish public faith in Islamic finance companies. While Islamic financial institutions usually have internal boards to verify that their products comply with Islamic principles, this approach “gave rise to conflicting rulings and products of Islamic banking that confused clients and investors,” notes a 2017 statement by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). “If the confusion persists, the credibility of Islamic banking and finance as a whole may be jeopardized.”¹⁰⁹ Consumer confidence is also impacted significantly when there are damaging reports, such as UM going into receivership or its principals being charged with criminal fraud.

The situation will not improve until Islamic financial institutions take concrete steps to implement standards. The Islamic banking world has increased its efforts to standardize regulation and supervision. The Islamic Development Bank is playing a key role in developing internationally acceptable standards and procedures for strengthening the sector’s architecture in different countries. Moreover, international organizations, such as the AAOIFI, the Islamic Finance Service Board (IFSB), the International Islamic Financial Market, the Liquidity Management Center, and the International Islamic Rating Agency, are working to set Shari’ah-compliant standards and harmonize them across countries.¹¹⁰ However, despite the efforts of these international organizations to place the Islamic finance industry on a sound footing, “there are no generally acceptable guidelines or standards on accounting, auditing, legal, governance, and Shari’ah issues as yet.”¹¹¹ Moreover, the problem is even worse in non-Muslim jurisdictions for obvious reasons.

Unsurprisingly the fragmented regulatory structure of Islamic finance has attracted criticism. Academics and practitioners alike have argued that the lack of standardization of Shari’ah rules creates problems of consistency, predictability, and fairness. Several commentators have argued that such a fragmented regulatory structure hinders the success and advancement of Islamic finance, and it also reinforces consumer protection concerns as well as consumer confidence.¹¹²

In addition to issues of expertise, the absence of holistic and interdisciplinary knowledge, the lack of standardization as well as the potential conflict of certifiers serving as regulators, and of course “fatwa shopping” are problematic for the practice of Islamic finance. This is all the more dangerous given that some of these same scholars are also serving as auditors, standard setters, legislators, and regulators.

Legal Impediments, Regulatory Confusion and Lack of Oversight

There are currently two predominant types of regulatory regimes governing Shari’ah-compliant institutions in Muslim countries. One approach places Islamic institutions under the central bank, but in a regime entirely different from that of the conventional banks.¹¹³ A second practice recognizes the uniqueness of the Islamic institutions but places them under the same supervision and regulatory regime that governs conventional banks, with slight modifications and special guidelines.¹¹⁴ In Canada and the United States, similar to most non-Muslim countries, the industry is governed by a regulatory and supervisory framework developed for conventional finance with no consideration for the uniqueness of Islamic financial institutions.¹¹⁵ Therefore, the regulatory regime does not take into account the special nature of Islamic finance, which creates several compliance issues for Islamic financial institutions.¹¹⁶

One of the biggest challenges to the development of Islamic finance in Canada and the United States is the difficulty for new institutions getting through the application process to receive a banking license.¹¹⁷ Even if an Islamic bank was to get licensed, the restrictions on real estate ownership would obviously be an issue for Islamic-financial institutions, especially if the Islamic finance company wishes to structure “pure” Islamic models.¹¹⁸ According to the majority opinion, the Islamic institution must hold legal title until the process is complete. Banking laws may also restrict non-real estate investments, limiting them to fixed-income and interest-bearing securities, which are deemed prohibited by most proponents of Islamic finance.

Taxes pose another challenge.¹¹⁹ Sharia-compliant products generally do not fit within the definitions that currently govern the conventional financial products, despite their similar economic features. Both tax authorities and taxpayers lack knowledge of the specific features of Islamic products. Considering the technical, interpretive, and policy-related issues, obtaining rulings from the relevant authorities can be quite lengthy and costly.¹²⁰ One glaring tax issue in the context of real property is land transfer.¹²¹ Institutions that purchase a home and then resell it to the final purchaser may face, in addition to other issues, double or even triple transfer tax costs depending on the transaction and the jurisdiction. Some jurisdictions may have worked around it, but it remains a problem in other jurisdictions.¹²² For instance, in Ontario where the Islamic Co-operative Housing Corporation and Ansar Co-operative Housing Corporation (hereinafter collectively the Co-op) purchase homes for people and keep the title until the Co-op’s contribution is paid off, the Ministry of Finance initially did not concern itself with collecting taxes on subsequent transfers. After years of not making it an issue, the Ministry then started reassessing homeowners thousands of dollars in taxes. They took the position that land transfer taxes were payable when the house was initially purchased and again when title is transferred to the actual homeowner. Following meetings with Ministry officials where they were briefed on the structure of the home purchase model, the Ministry tentatively suspended this practice, but there is still no definitive ruling on this despite waiting more than ten years.¹²³ This obviously creates uncertainty for the thousands of homeowners who can be reassessed at any point within a certain limitation period.

Another potential issue that may arise is the loss of rebates or credits on property and other tax implications.¹²⁴ The wide variety of the Islamic financial products may alone create the need for significant resources to approach the tax authorities. The interplay and interaction between federal and state/provincial laws, regulations, and policies may raise even more complexities for Islamic finance companies.¹²⁵

Lastly, as touched upon earlier in this chapter, the non-existence of oversight or regulatory bodies in the Islamic context adds to the complexity. At least in Muslim countries some steps are being taken to address this issue. The Bahrain-based AAOIFI is working toward establishing worldwide norms and standards for Islamic finance and banking practices. The AAOIFI, with hundreds of member institutions across forty-five countries, has adopted guidelines to centralize these boards and introduce new standards. Its standards are already widely used within the Islamic finance industry, and are compulsory in some countries.¹²⁶ The fact remains that there are no such standards or regulatory bodies that can oversee them in non-Muslim jurisdictions. This makes it difficult to engage with mainstream authorities in working around regulations, laws, policies, etc.

Politics and Public Opinion

A more recent obstacle, which became exceedingly pronounced in the wake of the tragic events of 9/11, is the false association that Islamic finance is necessarily connected with terrorism, extremism, and even money laundering.¹²⁷ Some anti-Muslim activists have taken it upon themselves to raise the alarm about Islamic finance being a back door to introduce Shari’ah into Western lands.¹²⁸ They are playing on the fear of Shari’ah as it exists in the minds of far too many in this day and age.¹²⁹ This is no exaggeration. Anti-Muslim activists are campaigning and lobbying governments to oppose any accommodation in the Islamic finance context. During my meetings with the Ministry officials on the issue of double land transfer tax on a behalf of my clients, the extent of the lobbying became clear to me. In fact, for more than twenty years the Ministry had no issue with how the transactions were structured, and they did not expect land transfer tax a second time when a property was transferred from the Islamic finance company to the homeowner. The Minister had accepted the following:

• 1. that the property was initially purchased on behalf of the homeowner;

• 2. that land transfer tax was paid when the property was acquired from the seller;

• 3. that the Islamic finance institution was simply holding title as security for the amount it had advanced toward the purchase; and

• 4. that the structure of the transaction was not to evade taxes but to comply with religious requirements.

The Ministry all of sudden changed its view and started assessing land transfer taxes on all transfers to owners. During the meeting it became clear that it had been lobbied by “people from the community” who feared that allowing Islamic finance would legitimize Shari’ah and open the doors to all that it supposedly means. This has been a theme advanced by Islamophobes, including some self-proclaimed secular Muslims. I was even asked a hypothetical by one of the attendees: would Muslims who used conventional banks be labeled as apostates if Islamic institutions were available. My answer, of course, was that both systems coexist in Muslim countries and I have yet to hear of anyone being branded an apostate for choosing conventional banking. Islamophobia is alive and well in the Islamic finance context as well.

Contrary to some fear mongering, Islamic finance is not the lead chariot in “Islamization” and is not especially susceptible to money laundering or terrorist financing.¹³⁰ Yes, it can be abused, just as conventional financing can. For the vast majority it is simply an exercise in attempting to integrate their faith into their financial dealings. Though theory and practice diverge in the attempt to implement faith, this should not detract from the idealism of those who seek to abide by it. It certainly should not be seen as part of a conspiracy to spread Shari’ah or fund terrorism.

Conclusion

Islamic finance, in theory, has much to offer to global finance, but its current practice falls far short of Islamic economic and financial ideals. As many scholars and practitioners have pointed out, Islamic finance as it exists in practice today for the most part is a financial system: “characterized by an incoherent web of rules, convenient and specific blindness respecting those rules in particular contexts, and deceptive and obfuscatory measures intended to lend the entire affair a patina of legitimacy as Islamic. Social justice and fairness are not significant components of the system.”¹³¹ This unfortunate reality should not cloud the need for, and promise of, Islamic finance. What many critics do not realize is that the instability of conventional, debt-based, finance has been criticized by many Western scholars who are quite innocent of Islamic finance or of the Shari’ah. Starting with Irving Fisher in the 1930s, many have noted how a profit–loss sharing system would produce a more stable economic system. Well-known economists, such as Willem H. Buiter,¹³² have argued that the world has too much leverage and too little equity, while the question posed by Luigi Zingales in his Presidential address to the American Finance Association was “Does Finance benefit Society.”¹³³ The alternative faith-based proposal of Islamic finance is to share both profits and losses. As Timur Kuran, an unsympathetic observer, notes in the context of Islamic finance in Egypt:

Having suggested that in its present form Islamic banking would not solve any of Egypt’s pressing economic problems, let me acknowledge that Islamic banks might bring benefits by abiding by their stated mode of operation. The charters of Islamic banks instruct them to lend on the basis of “profit and loss sharing” rather than for a fixed return.¹³⁴

The concept of profit/loss sharing has broad appeal, even outside of Islamic finance; Martin Weitzman¹³⁵ of MIT, for example, has argued for a sharing economy.

The glaring defect of Islamic finance as it exists is that the practical implementation of profit/loss-sharing arrangements remains fairly limited. Furthermore, there seem to be no realistic prospects of a change toward equity instead of debt. Even though the returns to equity (profit/loss-based) are clearly very much higher than that of bonds (interest based) in the long-run, Islamic finance has simply not risen to the challenge of realizing this long-run potential. This sloth is inexplicable in view of the Quranic warning that usury will bring war upon those who practice it:

O you who believe, fear Allah and give up what remains due to you of interest if you are indeed believers. And if you do not, then be warned of war (against you) by Allah and His Messenger, while if you repent you shall have your capital. Do not do wrong and you shall not be wronged. (Quran 2:278–279)

If the Islamic finance industry and government regulators address the concerns and complaints made by a growing number of critics, including former champions¹³⁶ of the industry, then there is still hope that the original ideals of Islam can provide a more equitable and stable economic system. In this case, faith has not sufficiently guided finance.