Group Names & Project topics

why Islamic finance is not THE LAW in Muslim countries. Moman & abdul
rehman

Over the last decade, the emergence of a considerably body of research on

law and finance suggested that cross-country differences in legal origins
could explain cross-country differences in financial development. One of
the important factors, which could explain the financial development, was
the flexibility of laws to evolve following the emergence of the new
socioeconomic circumstances. The law's flexibility emphasized the
formalism of laws and the ability of legal traditions to change. Particularly,
legal systems, which adapt their effectiveness to the contracting needs of
the economy, promote the development of the financial system. Whilst
considerable research examined the effect of the legal system on financial
development by concentrating on the effect of the origins of Civil and
Common Law, few pieces of research attempted to study the effects of the
legal system and especially Shari'a Law on the development of the Islamic
financial system. Even if these researches existed, these studies remained
theoretical and no empirical research had attempted to test empirically
the Theory of Law and Finance in the context of Islamic finance.
Nowadays, Islamic financial institutions operate worldwide. Being different
from conventional finance, Islamic finance and the activities of Islamic
financial institutions must be based on Shari'a Law. This is why the legal
environment, on which Islamic financial institutions operate, can have a
direct effect on the Islamic finance industry's level of development.
The worldwide different stages of development of Islamic finance drew our
attention to investigating the legal origin's effect on Islamic financial
development. In fact, a legal environment, which accommodates effectively
the intricacies of the Islamic financial industry and facilitates its
development, is crucial not only in taking the industry forward but, also,
more importantly in ensuring its soundness and stability.

The law and finance theory argues that, over time, different countries' legal
origins had influenced the evolution of their legal systems; this became a
crucial determinant in analyzing economic growth in these countries. On
the other hand, financial development was observed as a main driving force
of economic growth. Hence, the legal system was recognized as one
principal determinant of economic development. Accordingly, the causal
chain proposed by this law and finance theory is:
Legal origin → Legal system → financial development → economic growth.

Islamic finance growth equalled Islamic financial assets (financial

intermediary credit to the private sector) divided by Gross Domestic
product (GDP) and measured over the period from 2005 to 2010.
Problems of the Borrowers of Pure Loan:
The “Loan” (borrowing) has gained a prominent role in the present- day economic
activities. Apart from the loans for commercial or productive needs, the loans are
required for the personal consumption or non-productive needs. The Islamic banks
with very limited funds for such loans will thus be ignoring the needs of quite a
large class of population. Institutions will have to be developed to meet the
society’s demand for loan particularly for genuine consumption purposes. The
following possibilities are worth considering:

a. Integrating Zakah & Sadaqat with the Banking System so as to give support
to such vulnerable depositors of the bank as widow, old people etc. who
would be supported on the basis of charities/or interest-free loans whenever
the bank is running a loss or is not making a substantial profit. Islamic
Economists have already discussed this possibility but it did not find favour
with most writers. According to them it should be the responsibility of state.
Though some of the Islamic banks do have a Zakah Fund it is not yet clear,
how far they can be successful in meeting such needs of the society. Thus
launching of an Islamic banking system will need to be synchronized with
the development of an effective Zakah Fund by the state or the central bank.

Financing the Interest-Free Commercial Loan from pure savings accounts. All the
Islamic banks have savings accounts which are meant for such depositors who do
not want to stand liable for the losses and rather require their full amount to be
guaranteed. These types of depositors, however, give the banks their consent to use
their money. The banks use their money but are not obliged to pay them a share in
the profit to the same extent to which they give to the depositors of the investment
account. The amount for these deposits should obligatorily be used to provide the
interest-free loans for consumption needs. Since the banks earn profits on the use
of such deposits, therefore, the same should be used to finance the subsidy
involved in interest-free loans. As the bank guarantees the full amount of saving to
the depositors, the same can be compensated by the guarantee to be provided by
the borrowers. The attraction of the provision of interest-free, loan to depositors in
the savings account will raise the Islamic banks’ customers of savings accounts,

a. Developing a system of local community funds operated by local

communities themselves. Such institution will support the loan requirements
of the members of the community. These institutions will work on the
principle of cooperation rather than on commercial basis. The potential for
such a community cooperative exists very much in countries like Pakistan.
A recent public opinion survey in Pakistan showed that majority of the
population would be willing to lend money to friends and relations without
any compensation.* Efforts by the state can organize such institutions where
people’s cooperation can be obtained as a part of a compre- hesive social
security programme.
 Apart from these, the need (particularly in Pakistan where the whole system
is to be switched-over to interest-free banking) is for an intensive research
into the behaviour of the population of savers in general and of Muslim
savers in particular to investigate:
The ways and means by which their behaviour could be modified to become
consistent with the norms of Islamic economy and the alternative
institutional framework that can supplement the Islamic banking system to
meet all the needs of borrowers/savers.
Problems of Investment in Long Gestation Projects:
The Islamic banks have been found to be investing generally in the projects with
quick returns. This is perhaps because the banks have to pay a sizeable profit every
year on the deposit and they cannot afford to have no profit for some time if they
are competing with the interest-based banks. This means that the long gestation
projects are not likely to be picked up by these banks. If this is true then this is not
only reducing the long run efficiency of the Islamic banks vis-a-vis other banks but
will also affect the growth in developing countries if there are no banks to finance
such projects.
To shift to an interest-free system, therefore, one of the crucial requirement will be
to develop an institutional framework that can provide adequate financing for long
gestation and infra-structural pro- jects. Establishment of Islamic Development
Banks alongwith Commercial Islamic Banks will, therefore, become essential
when switching-over to an interest-free economy.