and consistent with the principle of risk sharing.
There is also an essential place for the market system in an Islamic economy because private enterprise, freedom of contract, property rights, and pricing mechanisms are consistent with the promotion of social welfare and economic efficiency. In conventional economics, the market system constitutes, after the retreat of socialism, the raison d'être of capitalism and its defining ideology. In an Islamic economy however, this market system is also a necessary mechanism for the allocation of risk, but the mere existence of markets may not be sufficient to ensure social justice. The need for competitive markets arises because of their ability to allocate risk efficiently and provide an effective system of price discovery. But it is only in a world of perfect markets with no transactions costs, and perfect information about financial assets that this function becomes effective. It is understood that there were, for instance, no taxes imposed on market access, no barriers to entry or exit, and no transaction taxes, no restrictions on international and interregional trade, no import or export taxes in the free-market system designed under the Noble Messenger (saws). But there were prohibitions on price controls and against hoarding of commodities. There was also free movement of goods across markets, as well as free and transparent sharing of market information. The guarantee of contract enforcement was also associated with the obligation of clear specification of the terms of contract, including the conditions of delivery and settlement, and property rights and obligations of all contractual parties. There was also the institution of market supervisors to ensure the compliance of market participants to the rules prescribed for the proper operations of markets.
The supervisory bodies similarly established in the conventional system to guarantee compliance to market regulation are deemed to be not only necessary but also sufficient for the proper functioning of markets. This is not the case of the institutional market conditions in an Islamic economy, which requires also a morality and justice system. There is indeed an additional requirement to the enforcement of a code of morality that is internalized by all market participants. Thus, the institutional structure of markets in an Islamic economy depends on the free flow of information, protection of property rights, and legal contract enforcement system, but also, as argued by Askari, Iqbal, and Mirakhor (2015), on trust as well as the right not to be harmed and obligation not to harm others.
Trust and Mutuality
Thus, the third facet of the ideal Islamic financial system is about trust and mutuality. Trade requires mutual consent, and there is thus no coercion (ikrāh) in the conclusion of contracts, as much as there is none in the adherence to the first covenant (mīthāq) with Allah (swt).8 The sacred principle of the freedom of contract implies that all contractual obligations are fully honored. It is indeed stated in al-Qur'an that believers are required to fulfill all obligations. Faithfulness to contracts is therefore deemed a sign of strong belief. However, to enter into an agreement implies not only that promises are binding, but also that each party expects the other to fulfill its own obligations. The concept of mutual trust is thus essential to the conclusion of contracts and has also implications for contract enforcement. This is not just an issue of asymmetric information, which would render the contract invalid from the perspective of Sharīa'h. Such a prohibition is based on ambiguity, gharar, about the terms and conditions of contractual agreements. However, even in the presence of perfect information, the conclusion of an agreement rests on mutual understanding and trust that each party is committed to the fulfillment of its obligations. This implies that it is exchange that nurtures a culture and reputation for honesty, sincerity, and trustworthiness.
As noted above, the importance of the institution of trust is also recognized by Arrow (1974). It is important to note that the socio-political-economic system can be governed by different types of relationships. Boulding (1970) draws parallels between social systems and biological systems, where the genotype represents the generic code for the growth and development of the phenotype or living entity. It is then argued that it is the genotypical relationships that define the development of social organizations and role structures. There are genotypes of relationships in social organizations, including (a) threat relations that allow one party to impose its course of action or role on another based on credible threats and restrains, (b) exchange relations based on the division of functions, and (c) integrative relations that do not fall under the classes of threat or exchange, but result from the mutual acceptance of the relative status of parties. The integrative relations based on the relative status of parents to children or judges to disputing parties, for instance, establish the legitimacy of authority and the identity and development of community.9 It is argued also that without integrative relations, neither threat nor exchange relations can be sustainable. It can be thus argued that exchange relations provide the basis for the division of labor and specialization, which are at the foundations of the theoretical arguments advanced by Adam Smith. These social generic structures that threat relations are conducive to submissive and repressive, and thus, regressive systems. The exchange and integrative relations pave the way to evolutionary and inclusive, and thus progressive, social and economic systems.
A social generic structure based on exchange relations requires the internalization of a general code of conduct, ethics and morals. Boulding argues that a degree of mutual trust and honesty is necessary for the development of financial institutions into complex structures beyond the primitive form, and that “the failure of the integrative system of a country to develop concepts of mutuality, trust and community beyond the confines of the family or the small intimate group is often one of the major obstacles to its economic development” (1970, 13). Also, an environment characterized by poor protection of property rights, costly information, and higher transactions costs is naturally conducive to weaker trust in the enforcement of contract. This argument is also consistent with the virtue of truthfulness, sincerity, and trustworthiness. Mutuality is also central to the concept of Islamic insurance, takāful. It is the intending or intention, niyyah that determines one party's commitment to contractual terms and its own expectations about the other party's intentions. Thus, when the fulfillment of obligations is indicative of belief, an effective mechanism for contract enforcement is in place, and reference to the code of conduct of the Noble Messenger (saws) is made, al-amīn (the trustworthy), then trust and mutuality may not be regarded as naïve acceptance of vulnerability. It remains true of any society that trust is the lubricant of the economy and that social capital should be taken into account as a determinant of long-term economic development.
Islamic Finance in the Classical Age of Islam
In light of the institutional structure of Islamic economics, it is possible to actualize Islamic finance based on exchange relations, devoid of threat and coercion and devoted to the promotion of economic efficiency, equity, and justice. This objective is achieved through an optimal allocation of resources and transfers of property rights based on risk sharing. Since the increase in property rights can only be achieved through the application of labor to available resources, there are inherent risks in economic enterprise. Thus, there are arguably no legitimate means of increasing wealth without submitting it to the prospects of profit and loss. The allocation of resources under uncertainty constitutes also an allocation of risk. By design, the classical nominate contracts, including mudhārabah and mushārakah, among others, constitute forms or participatory profit–loss sharing arrangements that are perfectly legitimate according to Islamic jurisprudence. Prior to discussing the actual state of affairs of Islamic finance, it is important to start with a historical perspective of the crucial role it played in the development of corporate entities in modern capitalist systems based on equity partnership.
It may be argued at prima facie that the prohibition of usury was responsible for retarding the development of capital markets. According to Koyama (2010), the persistence of the Church's prohibition in medieval Europe constituted a barrier to entry, which benefited secular rulers, small groups of merchant bankers, and the Church itself. This proposition is consistent with the concept of regulatory capture. In contrast, the prohibition
Economic agents are commanded to act lawfully for their own benefit as well as the welfare of others. But the moral and ethical code of conduct may not be covered by modern laws governing the socio-political-economic system. This may explain in part the failure to internalize the morality and justice system, which may be, as argued by Adam Smith himself, sanctioned by religion, as is the case indeed with Islamic finance.
Boulding (1970) provides a clear definition of the different types of relationships. Whereas exchange relations can be expressed as “
