Islamic Finance: Ethical  Analysis of its Status Quo

The financial system has proven to be crucial not only for the allocation and distribution of resources but also for the stability and growth of an economy. Re-structuring financial system in line with the socio-economic goals of Islam has been recognized as essential for a meaningful socio-economic reform in Muslim societies[1] . It prompted Muslims to establish Islamic Financial Services Industry (IFSI) which aimed to imply that Islamic principles, goals and values were conducive to the establishment of a system different from the conventional one. The emergence of the IFSI and its substantial progress over the last three decades have raised considerable interest and critique among religious scholars, academics and practitioners.

They hailed the existing IFSI as either different from conventional finance[2]  or 'business as usual[3] .' The present essay takes up this issue and examines whether Islamic finance does make any different or it is merely labeled otherwise. To this end, the essay attempts to study the context in which the IFSI emerged, differences between conventional and Islamic finance, financial intermediation in both industries as well as examples from the actual practices of Islamic finance[4] . By doing so, it employs three-fold ethical analysis of the subject in terms of its motives, the character or nature of the action itself, and the consequences of the actions or practices.

The essay will argue that the emphasis on allegedly interest-free and asset-based financing[5]  deprives Islamic finance of its meaning and shifts the attention to the legality of transactions. Nonetheless, the essay will also argue that human behavior informed by Islamic values and geared towards the objectives of Shari’ah may bring about a totally different intra- and international system characterized by considerably less disparity in growth, wealth and income, less damage to the environment and more genuine human happiness.

Conventional vs. Islamic Finance: Comparative Analysis

Although Islamic finance is presented as an alternative to the conventional finance, it has failed to question the system; the global capitalistic order, in its essence, objectives, and most of all in its consequences[6] . Instead of questioning, criticizing or challenging the conventional economic assumptions, offering an alternative and hence transforming the dominant system, it has adapted to it and consequently rendered legitimacy to the conventional system by having acknowledged its domination[7] . Hence, this part of the essay will question the conventional economic assumptions through the philosophy and objectives of human agency.

Human Behavior

Human behavior under neo-classical economic theory and accordingly, conventional finance, economic rationality and self-interest are the main drivers of human behavior. It is assumed that rational and self-interested individuals (homo oeconomicus) seek to attain their specific and predetermined goals to the greatest extent with the minimum cost possible. Consequently, shaped by self-interested human nature, supply and demand in market are deemed to be sufficient to deal with all economic issues. However, obviously market forces have failed to achieve balanced and equitable growth and distribution not only within countries but also between countries. The above stated issues lead to questioning the difference between the behavior of homo oeconomicus and a Muslim, i.e. a person whose behavior is guided by Islamic values, principles and goals[8] . Indeed, this difference could be seen as one of the major differences between conventional finance and ‘Islamic Finance’ which is guided by Islamic values and goals[9] . Yet, it is not to make an essentialist argument that homo oeconomicus or a Muslim economic behavior exist by nature. Rather, ''humans largely make themselves and each other, through the institutions, technologies, and other tools that they develop in the course of living and reflecting on how one should live.''[10]  So, it is believed that this or another behavior can be brought into being through formulation of a particular set of norms, mechanisms, and instruments. Therefore, models, formulas, contracts and products used in finance (whether conventional or Islamic) ''are not descriptions of the world, but actually means of bringing a world (and the human subjects that populate it) into being.''[11]

It is noteworthy that Islamic finance was established within a global or capitalist financial system. The latter pursues objectives of its own and consequently, has fostered development of means, tools and mechanisms that cater for these objectives. In such circumstances, the establishment of Islamic finance can be seen as Muslims' desperate search for ways to preserve their 'alleged and constructed authenticity' in a world where rules of game are set by others, and the space of debate is largely informed by anything but not Islamic sources.[12]  ''It is the West that defines the space of the debate and it  occurs within a single 'cultural framework: that of the West.''[13]  This very statement implies that the discourse on Islamic finance takes place within the dominant episteme, i.e. ''a world-view, a slice of history common to all branches of knowledge, which imposes on each one the same norms and postulates, a general stage of reason, a certain structure of thought that the men of a particular period cannot escape – a great body of legislation written once and for all by some anonymous hand.''[14]  By virtue of this very episteme, those who are engaged in Islamic financial engineering are not likely to think out of it. Consequently, the means – financial products and mechanisms - they come up with are most likely to be similar to conventional ones no matter how well the former are dressed into an 'Islamic garb.' In this sense, Islamic finance is the effect of ‘configuration of knowledge, technology, infrastructure and so forth‘[15]  informed by the dominant episteme. In short, just like conventional finance is the brainchild of modernity, Islamic finance as it is today is the product of modern age.

More important, financial engineers have easily adopted the modern methodology of inventing social constructs, i.e. abstractions from reality, and have endowed these social constructs such as the financial system with objectives of their own which may override those of a human being and may achieve its objectives at the expense of those ordained by the Creator for human beings. The incompatibility of objectives of a social construct and those of a human being may be epitomized by the dichotomy between nation-state and rights of human beings or in the current case, between viability of financial system as such and welfare of human beings. Moreover, in order to ensure viability of such a social construct embedded in current realities, religious scholars and financial engineers adopt the language of “necessity“ or “need.“ Such an approach implies that the dominant paradigm forces them to issue rulings that would let Muslims adapt to the conventional system.[16]  The method of ‘Maslaha mursala’, ‘free Maslaha’, that is, independent from the Text. The justification for introducing such rules are ‘necessity’, Haja or DaruraHaja orDarura of a human being was taken as the basis for drawing new rules. Not the Haja or Darura of a social construct. Although the world is now moving in the direction of human-centered design, we need God-centered design. All of our life revolves around worshipping God.

Socio-Economic Consequences

Socio-Economic Consequences because if we are to respect an Islamic conception of life and death and humankind’s common welfare and interest, as well as the individual’s development, freedom, welfare, and solidarity and human brotherhood, it is important to engage in fundamental reflection about the growth and development models offered to contemporary societies.[17]  Since industrialization, the first and foremost objective of economic policy has been to foster growth in the pursuit of development and happiness of the population. However, it has been observed that because of rising inequality, growth alone is not a reliable indicator of socio-economic development. Despite economic growth in many parts of the world, a large number of people are malnourished and ill-treated as a result of unhindered market forces. ''Steady-state growth models and 'trickle-down' theory have demonstrated conclusively that they enhance inequalities of asset distribution by enabling the powerful and better-endowed groups to grow at an even faster rate than which they were growing before, leaving the masses in deeper misery.[18]  It follows that economic growth under neoliberalism is not serving all; rather it is promoting poverty which turns into vicious circle and path dependency. Moreover, because the growth in GDP is the main indicator of development of countries, all economic activities are clustered around increase in production and consumption. Consequently, financial engineering is supposed to create products and tools that would inject more money into the economy in order cater for the increasing needs of economy in terms of production and consumption.

However, ever-widening production and consumption, the economic progress since the Industrial Revolution have caused severe environmental problems such as air and water pollution, loss of forest cover, erosion of soil, climate change and global warming, devastation of natural habitats, diminishing natural resources, destruction of biodiversity, overpopulation etc. It leads to a conclusion that such production and consumption patterns are not sustainable in the long run, and there is an urgent necessity for the re-consideration of development models as well as an thinking of alternative that would foster human beings' development, promote justice, stop exploitation and fulfill the basic human needs.

Hoarding of wealth, speculative and wasteful practices would be strongly reprehended. Indeed, the principle backed by self-interest alone as a secular core value is in direct conflict with the core Islamic value of 'moderation,' which would mean necessities of life together with some comforts aimed at minimizing the hardships of life.[19]  Since the current production and consumption patterns reflect wasteful practices reprehended in Islam, it is suggested that Islamic financial system should finance the real needs of economy and hence, should be aligned with moderate production and consumption patterns. If so, financial practices would leave present and future generations neither with mind-boggling debts nor with dearth of resources.

Conventional vs. Islamic Financial Intermediation:

The industry of financial intermediation and banking – transferring funds from savers to investors - are new toShari'ah. It is believed that financial intermediation is the most efficient way of saving and investing because it reduces the transaction costs usually spent on acquisition of information about savers and investors and hence, is in a better position to solve the problems arising from asymmetry of information. Scholars and practitioners involved in Islamic finance have been trying to create Shari'ah-compliant products that would let Islamic banks mobilize savings and deploy them without interest. The question how mobilized resources should be deployed has direct implications for which model of financial intermediation an Islamic bank should pursue:

The model of an intermediary designed after conventional commercial banks or one like an investment company serving individuals seeking profits as well as the community development.[20]  Based on this, there are generally two dissenting views on the structure and objectives of Islamic banking. These views have been classified as Chapra's and Ismail's models.[21]

(a) Chapra's Model or Model of Universal Banking

This view favors profit-and-loss-sharing (PLS) modes of financing and places greater emphasis on social welfare responsibilities and religious commitments of Islamic Banks.[22]  Scholars supporting this view believe that Islamic banks would contribute to the achievement of Islamic economic objectives if financial system fulfills two conditions: first, risk-sharing by the financier so that the entire burden of losses is not shifted on the entrepreneur; and second, equitable distribution of the benefit of deposits provided by a wide spectrum of the population to a similarly wide spectrum of the population.[23]  Although debt-creating asset-based financial contracts (e.g.Murabahah etc.) are not negated, yet their wide use is not recommended because of excessive consumption credits these contracts may lead to. Proponents of this view believe that equity-based PLS modes of financing are more conducive to the socio-economic objectives of Islam. Interest-based financial intermediation would be replaced by PLS modes of financing that would inevitably promote small and medium entrepreneurship or micro-entrepreneurs because collateral-based lending and credit worthiness pre-requisites would give way to the viability of project financed.[24]  In this regard, this view promotes universal banking as a model for Islamic financial intermediation.[25]

(b) Ismail's Model or Model of Commercial Banking

It is another vision for Islamic banking that Islamic Banks should act as normal commercial banks and aim to maximize their profit as long as it is done in compliance with Islamic law.[26]  Supporters of this view emphasize the equal importance of debt-creating modes of financing and find the overemphasis on PLS modes of financing inappropriate, unfounded in any Qur'anic text and even incompatible with the methodology of Shari'ah.[27] Moreover, it is argued that Islamic banks bear responsibility in front of their shareholders and depositors and should not be burdened with extra socio-economic responsibilities which may fall within the jurisdiction of government. Besides, it is believed that Islamic banks undertaking a wide spectrum of social activities may not prove viable both in short and long run. This view suggesting commercial model of banking for Islamic banks is somewhat similar to the neo-classical worldview according to which society is served by individuals pursuing their self-interest, and as it was said ‘the rising tide will lift all boats’. It follows the logic that 'the business of business is business' which clearly implies that profit maximization is the only legitimate and overriding objective of a commercial institution as long as it operates within the prescribed rules of the game.[28]

 Practical Examples from the Islamic Finance:

Despite the emphasis of a number of scholars on the superiority of equity-based (PLS) financing over debt-creating asset-based modes of financing, Islamic banks have resorted to the overwhelming use of the latter modes of financing such as MurabahahIjarah, SalamIstisna.[29]  The direct implications of the extensive use of the latter modes of financing are inculcation of the culture of consumerism ‘living beyond means’ overconsumption coupled with overproduction and hence, irreversible damage to the environment by depleting its resources. However, this essay will not deal neither with PLS nor debt-creating asset-based modes of financing.

The essay will rather grapple with dubious financial products such as bay'-al-'inah and tawarruq. Their success or failure can be assessed on the basis of the extent to which these emphasis new contracts maintain the main characteristics implied by the prohibition of Riba and preserve the objectives of this prohibition.[30]  By having examined these financial practices, one may conclude that they are nothing more but change of names.

A.   Bay'-al-'Inah (or buy back)

The contract of bay' al-`inah normally involves a sale of an asset or property by a first party to a second party for immediate or spot payments followed by an immediate sale of the same asset by the second party to the first party for a higher amount on deferred payments. Neither party uses the asset neither for consumption purposes nor derivation of usufruct (Manfa'ah). It is believed that this financial product is used to circumvent the Qur'anic prohibition of interest since the main objective of bay' al 'inah involves two consenting parties both of whom are willing to pay and receive a contractual rate of return on a loan. Even though bay' al-`inah is not a loan, it resembles one when both parties ignore the real intent of buying the said property.[31]  In a purchase contract, benefits must accrue to the buyer from the object of sale: either consumer goods are meant for consumption, or a trader who purchases an asset will later sell it with the purpose of making a profit. However, in an `inah sale the condition of the benefit is not met by both contracting parties. The object in this transaction is simply used as a Hilah to gain the profit from the amount lent: neither of the parties has the intention of deriving the benefit from the object of sale.[32]

Apart from having failed to meet the legal requirements, the negative consequences it entails are overwhelming too. The economic implications of an `inah sale are as serious as those of loans for credit crunch. In the event of a banking crisis, one who defaults on the 'inah sale will face similar consequences as most loan defaulters, and bad debts will deplete capital. Most scholars do not approve of bay' al-`inah although it is widely practiced in Malaysia and Brunei.[33]  It is believed that its widespread practice would put Islamic financial system into the culture of debt financing. Moreover, bay' al-'inah readily supports wealthy and large corporations, but does not help start-ups which usually have less than sufficient assets or collateral to support their demand for funding.[34]  From the above description of the practice of bay’ ul ’inah, it follows that it perfectly fits the dominant neo-liberal economy and has become one of its innovative tools in conquering new markets.

B.   Tawarruq

Tawarruqis a mode of financing that aims at providing cash or personal finance to a customer. Like bay’ ul ’inah, it involves certain goods or assets between the provision of cash to the customer and the customer repayment of a larger sum in the future. The difference between tawarruq and inah is that in tawarruq, the second transaction takes place between the customer and a third party other than the seller.[35]  Because tawarruq involves a bank that acts on behalf of the customer, it also increases the cost of financing by adding broker commissions to buy and sell. Just like in bay’ ul ’inah, goods are not meant for use by the buyer but rather as a Hilah to legalize the transaction. Thus, such practice decouples financing from the real exchange and production market because, although commodities are purchased and sold, they are not intended in the transaction, and they go back to the market without giving a signal to producers to replace them.[36]

In addition to the fact that most scholars do not consider tawarruq as a permissible financing due to a hidden interest, the mere look at its economic performance would give a clue why it is meant to fail the socio-economic objectives of Islam and, thus, is not desirable. The economic role of tawarruq can hardly be different from that of lending and borrowing money. A system that arranges for exchange of money with more money will suffer from the inequity that this exchange involves as well as instability such exchanges foster. ''From the macroeconomic point of view, the position of Islamic banks practicing tawarruq is exactly the same as that of the conventional banks giving (interest-based) loans to their clients. They lack the shock absorbing capacity that would have come if their operations were based on profit sharing.[37]

Given its inequity and instability, a tawarruq-based system will also be inefficient. Like interest-based debt financing, there is no integration between the real sector of goods and services and the financial sector. No real asset corresponds to an interest bearing loan. In the same manner, no real asset corresponds to the debt obligation created by the first of the three transactions completing a tawarruq deal. As a result, a single piece of real asset can form the basis of innumerable successive tawarruq deals, and it consequently inflates the cash market with unreal transactions.[38]


This essay has sought to argue that Islamic finance is not an alternative to the conventional finance. It is rather a set of financial practices that entail the same consequences. While doing so, the essay has taken a brief look atShari'ah-compatibility and economic performance of such dubious financial products as bay' al-'inah and tawarruq. It has been demonstrated that these products are debt-creating modes the essence of which lies in the exchange of money for more money at a later stage. Therefore, their economic effect is similar to that of loans which foster unjustified expansion of credit and speculative spending.

Eventually it brings about inefficiency and instability in the economy. However, the essay has also made an argument that the fact that Islamic finance is 'business as usual' does not necessarily mean that Muslims cannot conduct their financial affairs differently. The main reason why Islamic finance is just like conventional is because Islamic discourse takes place within the episteme shaped by non-Islamic values. It is, hence, not surprising that those engaged in financial engineering innovate nothing but a replica of conventional products dressed into an 'Islamic garb.'

The essay has also argued that those engaged in the discourse over Islamic finance are trapped in thinking about social constructs such as financial system, banks etc. and attempt to extract guidelines for an impersonalized unit decoupled from human being and his or her behavior and goals. One of the shortcomings of such an approach might be preferring viability and efficiency of the social constructs at the expense of the welfare of human beings.

The essay has further demonstrated that the main difficulty in formulating an alternative to conventional finance lies in the reconsideration of fundamental assumptions about economic agency. The first step in doing so would be ''to recognize that the homo oeconomicus is just one of an infinite number of possible human figures.[39]  Islamic principles and values should inspire the invention of economic and financial practices whose economic behavior should be different from that of conventional ones both in micro- and macroeconomic terms. Moreover, these instruments would presuppose a different human behavior driven not only by self-interest and rationality.



[1]  Chapra, U. (2007). Challenges Facing Islamic Financial Industry. In Handbook of Islamic Banking ed. by Hasan K.M. and Lewis, M. (Edward Elgar). p.21.

[2]  Ibid., Dr.Chapra examines genuineness of the IFSI which in itself implies that there is Islamic finance different from conventional.

[3]  Kahf, M. Islamic Finance: Business As Usual. p.1. Retrieved on March 10, 2012 from

[4]  The author of this essay does not agree with the title Islamic finance but would rather opt for ‘financial practices informed by Muslim ethics’. Yet, for the sake of consistency and to avoid confusion, the term ‘Islamic finance’ will be used throughout the essay.

[5]  Kahf, M. et al. (1998). ''Islamic Banking and Development: An Alternative Banking Concept?'' p.21-22. Retrieved on March 20, 2012 from

[6]  Ramadan, T. (2009). Radical Reform: Islamic Ethics and Liberation. Oxford, NY: Oxford University Press. p.33.

[7]  Ibid.

[8]  The dichotomy is usually set as homo oeconomicus vs. homo Islamicus. See Daromir, R. (2011). ''Homo Oeconomicus and Homo Islamicus, Revisited: Islamic Finance and the Limits of Economic Reason.'' Paper Presented at the 8th International Conference on Islamic Economics and Finance. Retrieved on January 14, 2012 from

[9]  Ibid., p.1.

[10]  Ibid., p.2.

[11]  Ibid.

[12]  Roy, O. (2004). Globalized Islam: the Search for a New Ummah. NY: Columbia University Press. In his book, Olivier Roy argues that although Muslims claim that their new identity is authentic, it is rather a modern construction. Ramadan, T. (2009). Radical Reform: Islamic Ethics and Liberation. Oxford, NY: Oxford University Press. p.33. Tariq Ramadan associates this attitude of Muslims with „protective“ posture whereby „one adapts to the global system by creating sheltered areas in which Islamic ethics will be somewhat protected.“

[13]  Ibid., pp.336-37.

[14]  Foucault, M. The Archaeology of Knowledge, translated from French by A.M. Sheridan Smith (London: Travstock, 1986). p.191. Ramadan, T. supra note 5. p.35: „The world’s order naturally imposes itself on that [Islamic - added] reformist approach, but this latter actually imposes very little on the world’s order.“

[15]  Daromir, R. (2011). ''Homo Oeconomicus and Homo Islamicus, Revisited: Islamic Finance and the Limits of Economic Reason.'' Paper Presented at the 8th International Conference on Islamic Economics and Finance. Retrieved on January 14, 2012 from

[16]  Ramadan, T. supra note 6. p.123.

[17]  Ramadan, T. supra note 6. p.239.

[18]  Ayub, M. (2007). Understanding Islamic Finance. John Wiley & Sons. p.6-7.

[19]  Ibid., p.33.

[20]  Siddiqi, M.N. (2006). Islamic Banking and Finance in Theory and Practice: A Survey of State of the Art. Islamic Economic Studies. 13:2. pp. p.3.

[21]  Dusuki, A.W. The Ideal of Islamic Banking: A Survey of Stakeholders' Perceptions. Review of Islamic Economics, vol.11 (special issue). 2007. pp.29-52. p.31.

[22]  Ibid., p.31.

[23]  Chapra, U. supra note 1. p.3-4.

[24]  Dusuki, A.W. supra note 20. p.32.

[25]  Al-Jarhi, M.A. Iqbal, M. (2001). Islamic Banking: Answers to Some Frequently Asked Questions. IDB. IRTI. Occasional Paper No.4. p.29-30.

[26]  Dusuki, A.W. supra note 20. p.32.

[27]  Ibid., p.33.

[28]  Ibid.

[29]  Iqbal, M. et al. (1998). Challenges Facing Islamic Banking. IDB. IRTI. Occasional Paper No.1. p.27-28.

[30]  Siddiqi, M.N. (2006). Islamic Banking and Finance in Theory and Practice: A Survey of State of the Art. Islamic Economic Studies. 13:2. p.2.

[31]  Rosli, S.A., Sanusi, M. (2001). Some Issues of Bay' Al 'Inah In Malaysian Islamic Financial Markets. Arab Law Quarterly. pp.263-280. p.263.

[32]  Al-Mubarak, T. (2012). Hiyal And Their Applications in Contemporary Islamic Financial Contracts: Towards Setting Acceptable Norms. Master’s Thesis, Qatar Faculty of Islamic Studies, Hamad Bin Khalifa University. p.118.

[33]  Kahf, M. supra note 3, p.15.

[34]  Rosli, S.A., Sanusi, M. supra note 48. p.263-264.

[35]  Al-Mubarak, T. supra note 31, p. 120.

[36]  Kahf, supra note 3, p.16.

[37]  Siddiqi, M.N. (2006). Islamic Banking and Finance in Theory and Practice: A Survey of State of the Art. Islamic Economic Studies. 13:2. p.16.

[38]  Ibid.

[39]  Daromir, R. supra note 15. p.12.

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