both. At several stages in the analytical presentation, as well as at the end of each chapter, there is a critical discussion of the possible interpretations of assumptions and results from the perspective of Islamic finance. It is toward these sections that readers who are not familiar with analytical methods may seek guidance and further understanding about the relationship between Islamic finance and conventional finance.
The analytical parts of the book may be technically demanding, but they can be avoided by readers who are ready to accept the economic implications of these results. Analytics is no substitute for intellectual debate about economic and financial matters, but it can, as a convenient tool, bring some clarity to the issues at hand. This book is a humble attempt to explain Islamic finance from an analytical perspective, and the mathematical accuracy of the results, economic interpretations, and practical implications are subject to debate and further development. This is not an attempt at explaining conventional finance from an Islamic perspective, but at elucidating the essence of Islamic finance based on the placement of risk sharing at the crossroads between Islamic finance and conventional finance. Islamic finance does not, indeed, contend with or take side with contracting parties, but it does set the institutional and legal framework for the promotion of economic efficiency and social justice.
The hope is that this book can provoke thought for future research and pave the way toward the preparation of more consistent and comprehensive textbooks and professional guides for Islamic finance. The main issue is to avoid losing sight of the basic intuitions behind Islamic finance. It is driven not so much by prohibitions of ribā and gharar or restrictions about short-selling as by the fundamental principle of risk sharing. This defining principle has theoretical and practical implications for asset pricing, capital structure, risk hedging, financial stability, and financial regulation. The viable solutions that Islamic finance offers to the chronic problems of financial instability, income inequality, and allocative distortions are conditional on greater socio-political awareness and action.
Finally, we are grateful to our families for their understanding and encouragement. This book is also dedicated to those who reflect upon the raison d'être of Islamic finance, about its ethics, theory, practice, and socioeconomic implications. It is devoted to those who question the heart and intellect without bias or fear of possible answers. It is commitment to truth and knowledge that can lead to better life and prosperity for all humanity. “Of knowledge, we have none, save what You have taught us” (al-Qur'an, 2:32).
About the Authors
Nabil ben Mohamed AlMaghrebi is a professor of finance at the Graduate School of Economics, Wakayama University, and visiting professor at the Center for the Study of Finance and Insurance, Osaka University, Japan. He served as director of the Keisoku Institute of Economics and Econometrics and has more than two decades of experience in academic research and teaching at Japanese national universities. He was research fellow at the International Institute for Advanced Studies in Kyoto and visiting scholar at the International Center for Education in Islamic Finance in Kuala Lumpur. He earned his Ph.D. in finance from Osaka University, and has authored several publications on the topics of financial stability, the model-free volatility index, Islamic finance, and financial regulation.
Abbas Mirakhor is currently the first holder of the Chair of Islamic Finance at the International Center for Education in Islamic Finance (INCEIF). He has served as the dean of the executive board of the International Monetary Fund (IMF) from 1997–2008, and as the executive director representing Afghanistan, Algeria, Ghana, Iran, Morocco, Pakistan, and Tunisia from 1990–2008. He has authored numerous publications and research papers on Islamic finance; among them are Introduction to Islamic Finance (Wiley, 2011), Risk Sharing in Islamic Finance (Wiley, 2011), and The Stability of Islamic Finance (Wiley, 2010).
Zamir Iqbal is lead financial sector specialist at the Finance and Markets Global Practice of the World Bank. He heads the World Bank Global Islamic Finance Development Center in Istanbul. He has more than 20 years of experience at the World Bank Treasury in capital markets, asset management, and risk management. Islamic finance is his research focus, and he has coauthored several books on Islamic finance on the topics of banking risk, financial stability, and risk-sharing. His latest coedited book, Economic Development and Islamic Finance, was published by the World Bank in 2013. He earned his Ph.D. in international finance from George Washington University and served as professional faculty at the Carey Business School at Johns Hopkins University.
Chapter 1
Epistemology of Finance
Whether it be the question of philosophy of science, epistemology, ethics, philosophy of language or the relation between man and God, free will and determinism, causality or other philosophical questions with which various European and American philosophers have been struggling during the last few centuries, the vast intellectual tradition of Islam has provided answers of enduring validity.
As with natural science, which refers to the branch of knowledge that concerns itself with the material world, finance is the discipline that deals with the properties of the financial system. The contents of Islamic finance may be better understood with respect to epistemological questions that arise also with respect to conventional finance: what is known, how this knowledge is acquired, and what determines its accumulation in this discipline. This chapter argues that there are fundamental differences in the sources of knowledge, and that there are some common epistemological threads between conventional finance and Islamic finance. It is essential to consider the notion of rationality in the behavior of economic agents, but it is also important to understand the full complexion of finance in relation to morality and justice. It is indeed the concepts of “general rules of morality,” a “sense of justice,” “natural justice,” and “natural equity” that underlie Adam Smith's theses about competitive economy. Additionally, Islamic finance derives its moral and ethical standards from the teachings of Islam, which provide a code of conduct for the behavior of financial markets and institutions. The conventional financial system is derived from the economic system, which is the product of the socio-political-economic system. The ideal conventional system can be traced back to the treatises of Adam Smith, which go beyond the ideas contained in The Wealth of Nations (which is widely regarded as marking the beginning of modern economics). These epistemological roots can be traced back to his earlier work, The Theory of Moral Sentiments. The Arrow-Debreu model of general equilibrium that embodies Adam Smith's vision of a competitive economy also provides a theoretical framework for risk sharing. The ideal Islamic finance system also proposes a set of risk-sharing instruments that cover the full spectrum of risk–return profiles, which facilitate the optimal risk allocation function of the financial sector within an Islamic economy. This economy is characterized by an institutional structure that is derived, epistemologically, from Islamic teachings as operationalized by the Noble Messenger (saws) and includes also a code of behavior for market participants. This institutional framework ensures, among other things, property rights protection, good governance, and contract enforcement. Islamic finance allows for an optimal allocation of risk through risk-sharing mechanisms, where the rewards on financial transactions are derived from the real economy and where risk and return cannot be divorced.
It can be thus argued that there are three central threads running through the ideal Islamic finance and ideal conventional finance: (1) consistency with human nature, (2) existence of a moral and justice system essential to long-term social and economic sustainability, and (3) optimal allocation of resources based on the risk-sharing mechanism. The rethinking of financial architecture following the onset of financial crises, as well as the emergence or re-emergence of Islamic finance may be better understood against their epistemological backgrounds. It can be argued that the inception of the Islamic finance industry over the past few decades has been in response to a “market failure” to meet the demand for Sharīa'h-compliant ways of financing. The development of Islamic finance reflects, in part, the need expressed over the years by Muslim scholars not only for the elimination
