Across the Muslim world today ambitious experiments are underway to create an Islamic alternative to conventional finance. These initiatives are inspired by the strict prohibitions in the Qur’an against the payment of interest. Whereas interest-based lending is the primary mechanism for the mobilization of capital in financial centers such as Wall Street and the City of London, Islamic finance experts are devising instruments that pose investment as the central mechanism. In so doing, these experts offer an alternative to the debt-fueled excesses and recurrent crises that have roiled economies around the world in recent years.
Fall 2018 marked 10 years since the collapse of Lehman Brothers, an event that represented the apex of the financial crises that have reverberated in the years since. Although a decade has passed, practices have scarcely changed. Indeed, the world of conventional finance has largely continued along the lines of “business as usual.”
However, far from the North Atlantic, innovative plans aim to create alternatives to the conventional financial system. The most promising among these experiments are efforts to facilitate the provision of capital through investment, rather than debt. Money for business development and expansion is made available through partnership and profit-sharing, rather than through the individualization of risk that characterizes debt-fueled capitalism.
Perhaps most notable has been the effort to create a transnational Islamic alternative, an initiative I have been documenting since 2010 from one of its emerging hubs in Kuala Lumpur, Malaysia. As I describe in my new book, Beyond Debt, in recent years, the growth of Islamic finance around the world has been nothing short of spectacular: at the end of 2017, assets held by Islamic financial institutions totaled over $2 trillion. This number is forecast to surpass $3 trillion by 2020. Amid this robust growth, however, a central question for Islamic finance experts remains: exactly what kind of alternative to the conventional system does Islamic finance provide?
Debates over the potential of Islamic finance should perhaps be expected. Islamic banking is a relatively young industry, which has moved in fits and starts since the first modern Islamic financial institutions were established, in the wake of the postcolonial nationalism of the 1960s. The conventional financial industry had a roughly 500-year head start in building its institutional infrastructure, a point to which Islamic finance experts often call attention.
Interest in Islamic finance dramatically accelerated after the Asian financial crisis of the late 1990s. This was in no small part at the behest of Malaysian state officials. The country embarked on an ambitious project to make the country’s capital, Kuala Lumpur, a central node in an emerging network of Islamic financial hubs linking Southeast Asia, the Middle East, South Asia, and beyond.
As in other economic sectors, rapid growth often breeds both innovation and competing visions. For most of its recent history Islamic finance has been defined by three restrictions drawn from Islam’s sacred texts, most notably the Qur’an. In addition to the injunction against interest noted above, these texts also forbid gambling and ambiguity. These latter restrictions have been interpreted as prohibitions on overtly speculative activities and excessive uncertainty in financial arrangements.
Historians contend that these prohibitions were not out of step with the economy of the Arabian peninsula at the time of the revelation of Islam. Gambling was a serious social ill, and debtors occasionally had to sell family members and even themselves into servitude to settle their liabilities.1
Today the three prohibitions often serve as a litmus test for the validity of Islamic financial activities. In this sense they are similar to the rote preflight safety check conducted by an aircraft pilot. Islamic religious officials hired by financial institutions to ensure compliance can deem an arrangement permissible by testing it against the checklist of interest, speculation, and ambiguity. This has offered a considerable degree of latitude. As the CEO of one Islamic bank put it, “Anything that is not specifically identified as impermissible in the texts is permissible.”
For example, the overwhelming majority of contracts used in Islamic finance entail a crafty workaround for Qur’anic injunctions against interest. In a nutshell, this comprises two sales of the same asset. The asset may be anything, from a computer to a building. A party with surplus capital sells an asset they own to an entrepreneur in need of capital on a deferred-payment basis. Immediately thereafter, with a wink and a nod and under a separate contract, the entrepreneur resells the asset back to the first party at a discount for cash on the spot.
The entrepreneur now has cash to use as she pleases, but she has also accrued a debt far greater than the amount of the cash received that must be repaid over a set period of time. The markup and the deferred payment effectively mimic an interest rate, although some Islamic scholars have judged them legitimate because, on paper, they involve two sales rather than a loan. These “sale-and-repurchase” contracts can be recombined into a dizzying number of often baroque variations: the arrangement can be reversed so that the original asset is held by the party in need of capital, the asset need not be physically present, a third party can be added to the transaction, and so on.
Due to a desire to create a workable version of Islamic finance, for the past 30 years religious scholars, experts in Islamic law, and banking regulators have looked the other way when confronted with such maneuvers. They have interpreted these contracts as compliant with the letter of Islamic law, if not entirely in keeping with its spirit. Managers and employees at many Islamic banks have cheered approval, as these contracts resemble ones with which they are already familiar from previous careers at conventional institutions. Indeed, so close is the resemblance, much of the software and back-end processes used by conventional banks can be easily modified to accommodate such arrangements.
exactly what kind of alternative to the conventional system does Islamic finance provide?
Nonetheless, the tide is beginning to turn, as Islamic finance continues to mature. In recent years, in Malaysia especially, experts have begun to question the prevalence of workaround sale-and-repurchase contracts. In seeking to create a more authentic Islamic finance, distinct from conventional finance, they seek to substitute contracts that emphasize partnership and profit sharing instead.
Referred to by experts as “equity-based,” partnership contracts entail a joint venture between two or more parties. Rather than relying on a sale and a repurchase to facilitate the provision of capital, an equity-based agreement entitles the investor to a portion of the profits from the concern, much like the ownership of stock in a publicly owned firm entitles an investor to a share of its profits in the form of dividends.
A partnership-based approach is not without its downsides. Investment can be far more risky than lending, as it is often uncollateralized. This can lead to extensive losses, as the failure rate for new businesses everywhere is startlingly high. And the restrictions placed on lending mean that the exponential growth rates of debt-fueled capitalism are unlikely to be replicated.
Nonetheless, as Islamic finance experts are quick to point out, equity-based financing has been the preferred method for the provision of capital in some of today’s most celebrated sites of technological and commercial innovation, most notably Silicon Valley. Indeed, the partnership contracts advocated by those seeking to remake Islamic finance bear a striking similarity to the venture capital arrangements that have spawned some of the biggest success stories of the new economy, such as Google, Facebook, and Twitter.
Ten years on, people around the world are living with the reverberations of the worst financial crisis since the Great Depression. Proponents of the equity-oriented version of Islamic finance are convinced that it offers a solution that will not only avoid crisis but also reduce inequality, if through somewhat slower economic growth.
In an equity-based Islamic system, banks cannot lend money that they do not already possess. This inhibits the accumulation of vast debts by financial institutions, which have heretofore been able to compel bailouts with public money under the dictum that they are “too big to fail.” Further, as Thomas Piketty has pointed out, the proceeds of debt-fueled capitalism have been allocated in vastly disproportionate fashion across societies in the West.2
Given that the benefits of economic prosperity in the past 40 years have been so unequally distributed, investors have been growth-obsessed, and carbon-intensive capitalism is pushing the global environment beyond its limits, why not give the moderate growth solutions offered by Islamic finance a chance?
A podcast episode about Beyond Debt is available here from the New Books Network.
This article was commissioned by Caitlin Zaloom. 
