Doing Finance the Islamic Way 16th Private Sector Meeting for OIC Member Countries Sharjah, UAE, March 2014 Abdelaziz Chazi Ph.D. Associate Professor of Finance American University of Sharjah

Introduction The world has witnessed lately one of its worst financial and economic crises since the 1929 great depression. This crisis, which started as a subprime mortgage crisis, surprised everybody by its magnitude and time span. Within six months, in 2008, giants of the US finance industry were either taken over (Bear Stearns, March 16 th ), nationalized by the US Treasury (Fannie Mae and Freddie Mac, September 7 th ), or simply filed for bankruptcy (Lehman Brothers, September 14 th ).

The excessive use of derivatives, market-based trading on debt, short selling, as well as speculation have been largely blamed for the crisis. Given that all these transactions are not permissible in Islamic law, voices are wondering whether an Islamic financial system could have survived the crisis better than the conventional one.

Islamic Finance Principles Islamic finance is based on religious and ethical premises that seek more social justice and equality in the marketplace. According to these precepts, although efficiency of the financial system is important, it is given a lower order of importance compared to ethical values. The priority given to seeking social justice does not mean that the Islamic financial system would be inherently inefficient; it only prioritizes the goals of the market players.

Money in Islam The Islamic financial system treats money as a mere medium of exchange that does not have an intrinsic value. Thus, money should not be treated as a commodity and cannot generate more money without the involvement of physical commodities in the process.

Defining Riba Therefore, all transactions where money is sold (in the form of debt) or rented, at negotiated prices, are deemed to be non Shariah compliant and thus non-permissible. Shariah scholars condemn usury that results from renting money and name the return on money “Riba”.

Prohibition of Riba Islamic law (Shariah) disallows riskless profit, which is, according to Islamic scholars, the source of most conventional banks’ returns. Default risk alone is not considered enough risk- taking by the lender to legitimate the banks’ returns. For returns to be legitimate, banks have to engage in profit and loss sharing with their clients by financing asset backed projects instead of providing interest-based loans.

Defining Gharar Another basic characteristic of Islamic finance is the prohibition of returns made while facing excessive uncertainty (Gharar). Participants in the marketplace cannot transact in situations of high uncertainty as this would amount to gambling.

Information based Gharar Gharar can be caused by lack of information by either or both parties, either intentionally or unintentionally. The parties to a transaction have to have complete and accurate information about the subject of the transaction, the price, the terms of payments and the like. Any perceived lack of information by either one of the parties can void the transaction.

Settlement Risk Gharar can also materialize in the case of settlement risk, i.e. when the seller may not be able to deliver the commodity subject of the transaction, or simply is not in possession of the commodity at the time of the sale. Hence, short selling is not permissible under Islamic finance as it involves elements of Gharar.

Derivatives Derivatives are not permissible as well because of the forward commitment from both parties, which entails excessive uncertainty with regard to the ability to fulfill one’s commitment in the future.

Speculation Under the same principles, speculation is deemed non-permissible because of the amount of uncertainty it brings to the market as a whole. Although speculation may benefit market participants, it is believed that the damage it carries is higher than its benefits.

Conclusion The major norms of Islamic finance relate to the non-permissibility of usury (Riba) and excessive uncertainty (Gharar). Thus, returns made in situations of zero, or excessive, risk are not allowed in Islamic finance. Some degree of risk is tolerated and even required for returns to be legitimate.