Dr Osama Mohamed Ali, Deputy General Counsel of the Geneva-based Dar Al Maal Al Islami(DMI), examines the role of equity and morality in Islamic banking and their application to modern banking practice.

The last ten years have witnessed the emergence of a number of Islamic financial institutions including banks, investment and Takaful (the Islamic equivalent of insurance) companies.

The geographical and operational expressions of these institutions has taken place mainly in the Islamic countries but a relatively active presence has also been noted in Europe and, to a lesser extent, in the USA.

Islamic countries include both countries like Egypt, Turkey and Indonesia in which Islamic banking, investment and insurance institutions operate alongside the mainstream Western style institutions-in addition to the few countries such as Sudan and Pakistan which have applied, or are in the process of applying, Islamic principles to the entire banking and business sector.

The funds currently managed world wide by Islamic institutions, are believed to be in the region of US $60b (the exact figures will be shortly published in the Encyclopedia of Islamic Banking).

Whilst this figure falls short of the initial expectations of the promoters of Islamic banking, the asset base of Islamic institutions is expected to increase substantially in the coming years.

The concepts of equity and morality are at the root of Islamic banking. These concepts mean the universally accepted principles of justice and fairness which, although not necessarily incorporated in written laws and regulations , often play and effective role as a source of law.

In order to ascertain their importance in Islam, it is essential to recall the context and environment from which this religion emerged during the 7^th century AD in the Arabian Peninsula.

The Arab Community of the Peninsula was in a notorious state of social injustice and violence. With the arrival of the Islamic faith-which which initially was mainly adopted by the poor-values such as equality ,honesty, fairness respect of engagements, modesty, esteem for labour and effort and timely payments of wages etc appeared and were accepted.

These values were specifically mentioned in the Quran and confirmed by the sayings and practice of the Prophet and consequently formed an integral part of the Islamic jurisprudence heritage.

They are comparable with what is frequently referred to as the universally acknowledged principles of justice and equity and, being a source of law, are often used by judges in order to remedy legislative and case law lacunae.

In Islam such moral and equitable values form an integral part of the rules of law governing contractual and financial relations to such an extent that the relationship which exists between equity, law and religion is an organic rather than a supplementary relationship.

The impact of these concepts on the Islamic  law relative to finance has consequently been significant.

Usury, referred to in Islamic Law as Riba ,means inter alia, interest paid or received when a loan is extended and is considered to be an unjustified and reprehensible form of exploitation-since the borrower often has no alternative but to accept the conditions of the usurer.

Riba is also considered to be a factor hampering interaction between the financier and his client since the latter will furnish adequate securities and collateral prior to obtaining the financing.

As a result the financier generally is not particularly keen to scrutinize and appraise the project financed. Repayment of principal and profit is often guaranteed irrespective of the success or failure of the project.

While avoiding exploitation is generally declared as the reason for the prohibition of Riba, there is another motive. This is the desire to promote and enhance the production process.

Those who have the funds, if deprived of the opportunity to lend for interest, will very likely look for a partner in order to invest the idle funds.

Since, in partnerships, investments are structured on a profit sharing basis, both the owner of funds and his partner will be interested in the objective evaluation, appraisal, execution and monitoring of projects.  

By creating a more effective relationship between the parties , thereby ensuring better chances for the success of projects and transactions, there exists a greater incentive for the parties to manage the project efficiently and in a cost effective manner.

By avoiding the negative effectives of exploitation and introduction profit sharing schemes, Islamic finance promotes values such as social solidarity, interaction between operators with a view to enhancing economic and social development. What real effect has this had on Islamic finance in day-to day operations? Islamic financial institutions have developed a set of contracts in order to conduct their operations. These contracts-with the exception of the Morahaba and Qard Hassan –are based on profit sharing. In fact the standard financial contracts used by the major Islamic financial institutions reflect in their preamble and body the basic elements of profit sharing. For example, reciprocity between the parties in terms of rights and duties, the equitable manner of distribution of profits etc.

The basic moral and equitable principles requiring a balanced and fair rapport between the parties start to operate from the project appraisal phase, at which time the calculation of rates of return and distribution of profits between parties commences.

Islamic institutions are now in the process of developing their own accounting methods in order to ensure that such profit sharing schemes are fair and profitable to both parties, deflecting the views of their critics that the rates applied for profit sharing and Morabaha are effectively equivalent to prevailing rates. It is sometimes stated that because Islamic  accounting methods are not yet fully worked out in a way reflecting both fairness and profitability. Islamic institutions are more inclined at present to concentrate on Morabaha and short term transactions both of which are not really profit sharing arrangements.

It is, however difficult to accept this since the absence of such methods in real terms do not preclude the expansion of various Islamic financial methods. In case of default in repayment, the financier suffers an additional loss because of delay in the fulfillment of his client’s obligations.

The conventional system requires the defaulting client to pay liquidated damages agreed upon in the financing contract or alternatively pay statutory damages ordered by the court.

Here, contemporary Islamic jurists are not unanimous on the course of action to follow. The majority of Islamic financial institutions have however, obtained from their respective religious boards or advisers, a Fatwa , whereby if the default is unjustified, the defaulting client shall pay the damages suffered by the financial institution.

These damages are determined by reference to the average return generated by the institution during the period of default. Clearly, this solution is reasonable since the institution does not receive more than it would have derived from the funds that the payment been made in time.

Equity and justice further require the institution to establish that the delay is unjustified and the client does not suffer from genuine financial difficulties. If this is the case, then the institution, because it is also interested in the success of the project or transaction may then reschedule the amount in question. Additionally-subject to a thorough appraisal-the institution may decide to grant the client an interest-free loan (Kard Hassana) in order to ensure that the difficulties suffered do not put the project in further difficulty.

Islamic institutions have been very reluctant to become involved in equity investments mainly because of internationally quoted shares belonging to companies which in some way or another pay or receive interest.

It is believed however, that in many cases the receipt or payment of interest-naturally banks excluded –is incidental and does not constitute the central activity of the company whose shares are quoted. It would therefore be unfair to exclude Islamic banks from this activity.

Here again , it is very likely that the moral and ethical considerations play an important role in determining whether the basic activity of the company in question is acceptable or not.  

Since, in partnerships, investments are structured on a profit sharing basis, both the owner of funds and his partner will be interested in the objective evaluation, appraisal execution and monitoring of projects.

Islamic institutions have developed an alternative to conventional insurance as the latter contains an element of uncertainty, which according to Islamic law, renders the contract void.

Also, the large funds collected by conventional insurance companies are involved in transactions and financial vehicles which are not necessarily in conformity with Islamic rules and standards. This is why Takafol-which is based on solidarity between the participants –has been developed. Here the participants in the scheme agree to pool their resources in order to donate to the party which has suffered losses.

If ever the insured event occurs, the compensation has already been agreed upon. Under Islamic law, because of the donation factor the element of uncertainty in Takafol does not make contract void. Moreover, the Takafol company to which the investment of the funds have been entrusted undertakes to invest the participants funds in Islamically acceptable products and transactions.

In order to ensure that the Takafol operations are not adversely affected by the amount of risks covered occurring , Takafol  companies have reached an understanding with Retakafol whereby adequate coverage is made.

Business laws aim at achieving sound results and avoiding the occurrence of problematic situations between the parties. With the tremendous growth of business activity , codification and drafting of extensive contractual terms and regulations has become a permanent feature of current financial centres.

In these circumstances the question may be raised whether equity and morality are of any relevance to this specialized and lucrative activity. Considerations of equity and morality are not intended to be philanthropic. But by creating a more effective relationship between the parties, thereby ensuring better chances for the success of projects and transactions, there exists a greater incentive for the parties to manage the project efficiently and in a cost effective manner.

Furthermore, the application of moral and equitable principles to the financial field is likely to encourage banks to finance projects which enhance the development and prosperity of the community.

It is still premature to say that Islamic institutions have already achieved these results. Indeed, the experience of Islamic banks is still geographical  and operationally limited, making it difficult to measure its global impact.  

Additionally-subject to a thorough appraisal-the institution may decide to grant the client an interest-free loan (Qard Hasana) in order to ensure that the difficulties suffered do not put the project in further difficulty.  

Nevertheless, the scrutiny of the records of Islamic banks in Egypt, Sudan and elsewhere reveals that so far, the application of Islamic banking has been successful, particularly with respect to small and medium sized enterprises, and it is hoped that as the experience continues, an even more positive will be seen.

Financial arrangements organizing the relationship between clients and  financiers, whether institutions or individuals reflect a strong relationship between the contractual terms agreed upon and the underlying philosophy based on equity and moral considerations.

This relationship described earlier as organic starts to operate from the pre-contractual  Phase and continues to prevail throughout the execution of the contractual terms. Under such circumstances the contact will be concluded only after through project and client appraisal and will very likely reflect a true consensus between the parties.

As to the contractual conditions on which the implantation of the project or transaction rests, it is worth noting that they have to comply with a number of moral requirements in order to  be legally acceptable.

Such moral requirements include-but are not limited to-he respect of contractual commitments, respect and fair valuation of human effort, cooperation between individuals and social groups in a manner compatible with the promotion of the economic and social development of the community, discouragement of unjustified gain-i.e. through inadequate effort-and the necessity of ensuring the existence of balanced rights between the parties.

 As to the contractual conditions on which the implementation of the project or transaction rests, it is worth nothing that they have to comply with a number of moral requirements in order to be legally acceptable.

Such moral requirements include-but are not limited to-the respect of contractual commitments, respect and fair valuation of human effort, cooperation between individuals and social groups in a manner compatible with the promotion of the economic and social development of the community, discouragement of unjustified gain-i.e. through inadequate effort- and the necessity of ensuring of balanced rights between the parties.

 Furthermore, the execution of the contractual conditions must always be conducted in the same spirit of equity and morality which has presided over its elaboration and conclusion. The parties and eventually arbitrators will also resort to the same moral standards in order to ensure that the construction of contractual terms is effected in a manner compatible with the same moral and social values.

In order to ensure adherence to the basic moral and ethical requirements on which their activities are founded, Islamic institutions resort to a number of control mechanisms such as legal audits and Shariah boards or advisers. For more than a decade Islamic finance has undergone the fascinating and challenging experience of applying the principles proclaimed 14 centuries ago to the ever changing modern financial and social context.

 Islamic institutions are faced with the challenge of reconciling the exigencies of modern business requirements with the fundamental principles and moral values of Islam. The implantation of Islamic institutions and the objective assessment of results suggest that the system has so far at least proved its viability. By creating an effective and durable system, Islamic finance has provided a real option for the Islamic world and a channel through which international trade and cooperation may be conducted and promoted.

 Through perseverance and professionalism, Islamic banks will be able to consolidate and enlarge their ambit of activity while adhering to the principles and values which constitute their raison d’etre. The challenges is now for Islamic finance to consolidate and enhance its activities through the establishment of an effective and competitive operational base.