al-bay' or exchange, it can be argued that the rationale for the prohibition of interest lies in the absence of opportunity for risk sharing. Indeed, interest-based transactions are founded on risk transfer rather than risk sharing mechanisms. The event of default can only be defined in terms of the inability to deliver “promised” payments made on an ex ante basis with respect to credit or fixed-income securities. Default cannot, however, be defined with respect to equity, where risk sharing applies and the extent of profits and losses can only be determined ex post. Thus, “promises” of fixed returns determined ex ante do not take the organic relation between the real economy and financial sector fully into consideration. Financial returns are thus dissociated from the return from the real economy, and the relation between risk and return is thus dissolved. The replacement of risk sharing with risk-transfer and risk-shifting mechanisms is distortive of the exchange relations on which economies can potentially thrive.
The notion that economic growth can only be achieved by sacrificing social and economic equity in mainstream economics promotes a laissez-faire variant of capitalism that does not promote social equity and instead reinforces a dehumanization of economic life. It can be argued that Islamic finance also supplies a coherent theory of rational individual behavior, competitive markets, and social equity. It is based on the same assumptions about economic activities in terms of savings and investment, and considers risk sharing the optimal mechanism for efficient risk allocation in a vibrant and dynamic economy. However, the principal challenge faced by scholars in Islamic economics and Islamic finance is to provide some convincing evidence that these objectives of socioeconomic justice and economic development are not mutually exclusive. The requirements of an ideal Islamic financial system that promotes the twin objectives of efficiency and equity include an optimal set of institutional building. Thus, to understand the relation between the objectives of efficiency and equity in Islamic finance and economics, the discussion proceeds hereafter in relation to three central precepts of institutional economics: (1) property rights protection, (2) enforcement of contracts, and (3) good governance.
The Institutional Structure
The institutional framework for an ideal Islamic financial system is to some extent consistent with the fundamental principles of institutional economics, but it is also inclusive of rules of conduct and enforcement, which are derived from the morality and justice system embedded in Islamic teachings. Consistent with the objectives of Sharīa'h, the principal purpose of this institutional framework is to achieve social welfare through the internalization of ethical and moral rules of behavior. Three main features of the institutional structure are addressed below (1) ownership and property rights, (2) contracts and markets, and (3) trust and mutuality. It remains, however, true of any society that trust remains its permanent lubricant.
Ownership and Property Rights
The central argument is that economic justice demands that wealth is created only through labor and enterprise and that there are no restrictions that curtail the rights of people to work or that prevent equal access to resources. It is in the abolition of legal and institutional hurdles against equal opportunities that socioeconomic justice can be better served. Thus, ownership is recognized over the resources thus created from the application of labor, and only then can property rights be subject to free transfer through exchange, inheritance, contract, gift, or redemption of rights. This redemption of rights allows for an equitable sharing of wealth with the less able. There is a clear emphasis on social justice and harmony where the insatiable desire for wealth is consistent with an insatiable desire for charity. There is reference in al-Qur'an to righteousness, birr, as the state of active participation in deeds of benevolence. Thus, an insatiable desire to increase wealth may be explained by an equally insatiable desire to contribute toward philanthropy and may not constitute a sign of unfettered self-interest.
An important implication of the principle that property rights are created through labor and enterprise is that there is no room for sources of instantaneous creation of property rights, such as theft, interest (ribā), or gambling (maysir). Also, the principle of ultimate divine ownership in Islam implies that the owner's freedom to dispose of property rights is not absolute. There are, for instance, restrictions against the use of property rights in prohibited transactions, and against waste and destruction. The injunctions against excessive accumulation of wealth are injunctions against the amassing of property rights that are conducive to a monopoly over opportunities, intrusion upon the rights of others, and privileged access to resources. Given these restrictions about absolute ownership, wealth circulation is allowed to play an essential role in economic development and social justice.
Another corollary to the principle that wealth is created through labor and enterprise is that it can only be shared through either a redistributive mechanism or risk-sharing mechanism. As noted above, redistribution through zakah constitutes a form of redemption of property rights to the poor. The risk-sharing mechanism provides an opportunity to increase wealth, but only under the conditions of appropriate exposure to risk. Thus, wealth-increasing arrangements such as al-ribā, which do not take into consideration the trade-off between risk and reward, are deemed impermissible. Thus, restrictions imposed on the scope of individual freedom with respect to property rights are essential to achieve the right balance between individual rights and social interests. They are also consistent with the office of gerency and conducive to capital formation, which is required for economic development, and social justice through poverty alleviation. Thus, this institutional setting differs from the conventional property rights system not only in the restricted freedom of disposal through impermissible transactions, but also in the consideration of property rights as a means of inclusion of the less able, because of idiosyncratic factors such as illness and disability, in the wealth of the more able. It is through risk-sharing mechanisms, in addition to inheritance rules, that wealth is necessarily shared with the society to provide new opportunities for property rights through labor and entrepreneurship.
Contracts and Markets
The second facet of the ideal Islamic financial system is represented by the rules of behavior in the domain of property rights transfer through contract and organized exchange. Since the concept of “property” represents a set of usufruct rights, powers, duties, and liabilities defined with respect to an underlying asset, it is possible to appropriate rights through the combination of one's labor with the resources, but the concomitant duty of sharing remains. Property is therefore associated with rights and obligations in the use of resources: (a) the right not to be excluded and (b) the obligation not to exclude others. In principle, the property rights and obligations cannot be dissociated from each other, but as argued by Askari, Iqbal, and Mirakhor (2015), it is the advent of the market system in Western economies that led to a revision of the concept of property, which eliminated the right not to be excluded from the use of assets owned by third parties. The rationale behind this exclusion is that this right is not consistent with market economy because it was deemed not marketable. Thus, the Western conception of property rights is presently centered on the right to exclude others. But the right not to be excluded by others remains intact, as it does not undermine the functions of markets in the allocation of resources based on the risk-sharing principle.
From the economic perspective, contracts provide a legal institutional framework for the transfer of property rights, but also for the allocation of risk. Because of the uncertainty about the future outcome of labor and enterprise, contracts are useful in facilitating the allocation of risks. The Islamic jurisprudence includes an entire class of classical nominate contracts, including participatory arrangements such as mudhārabah (principal-agent partnership), mushārakah (equity partnership), and mushārakah mutanāqisah (diminishing equity partnership). In particular, mudhārabah partnership contracts provide the basis for an essential part of the business of Islamic banking institutions. The full spectrum of permissible contracts also includes ijarah (leasing contract), istisnā' (consignment to manufacture), among other things. All these contracts have a basis in the Islamic law of muā'malāt, which implies that their purpose is congruent with the fundamental objectives of
