Islamic Banking Isnít Islamic
by Tarek El Diwany
An abridged version of this article was published in Banker Middle East during November 2002
The contractum trinius was a legal trick used by European merchants in the Middle Ages to allow borrowing at usury, something that the Church fiercely opposed. It was a combination of three separate contracts, each of which was deemed permissible by the Church, but which together yielded a fixed rate of return from the outset. For example, Person A might invest £100 in Person B for one year. A would then sell back to B the right to any profit over and above say £30, for a fee of £15 to be paid by B. Finally, A would insure himself against any loss of wealth by means of a third contract agreed with B at a cost to A of £5. The result of these three simultaneously agreed contracts was an interest payment of £10 on a loan of £100 made by A to B.
I had read about the contractum trinius some months before first encountering the full documentation behind an Islamic banking murabahah contract. It was the kind of contract that Person A might use in order to finance the purchase of good X from Person B. The bank would intermediate in the transaction by asking A to promise to buy good X from the bank in the event that the bank bought good X from B. With the promise made, the bank knows that if it buys good X from B it can then sell it on to A immediately. The bank would agree that A could pay for good X three months after the bank had delivered it. In return, A would agree to pay the bank a few percent more for good X than the bank had paid to B. The net effect is a fixed rate of financial return for the bank, contractually enforceable from the moment that the bank buys good X from B. Money now for more money later, with good X in between.
The above set of legal devices is nothing other than a trick to circumvent riba, a modern day Islamic contractum trinius. The fact that the text of these contracts is so difficult to come by is one shameful fact of Islamic banking. If so clean, why so secretive? The following is an excerpt from a murabahah contract that was used frequently by two major institutions during the 1990's. The 'Beneficiary' is the client that needs finance, and earlier clauses require that the Beneficiary acts as the agent of the Bank in taking delivery of the goods.
Promise to Purchase the Goods
2 The contract of sale of the goods to the Beneficiary shall be concluded by an exchange of telexes or telefax messages as soon as the Beneficiary has taken delivery of the Goods on behalf of the Bank.
3 If, for any reason whatsoever, the Beneficiary shall refuse or fail to take delivery of the Goods or any part thereof or shall refuse or fail to conclude the Sale Contract after taking delivery of the Goods, then the Bank shall have the right to take delivery, or cause delivery to be taken, of the Goods and shall have the right to sell, or to cause the sale of, the Goods (but without obligation on its part to do so) in a manner determined by it in its sole discretion and shall have the right to take whatever steps it deems necessary (including demand from the Guarantor to pay) to recover the difference between the price realised upon sale and the price paid by the Bank plus any other expenses incurred by it in relation to the Goods and/or any damage caused to the Bank as a result of the breach of undertaking by the Beneficiary to take delivery of the Goods or to conclude the contract of sale of the goods.
We see here that there is even a guarantor used to ensure that the bank does not lose money on the deal in the event that the Beneficiary defaults. So much for profit-sharing.
Yet the words 'profit-sharing' are to be heard constantly at all of the conferences. Some of the scholars, if pressed, will talk about moving towards more satisfactory products such as mudaraba. But then everyone goes home and works on another murabahah contract. We are told that Muslims must work within the existing banking system and change it from the inside. But we have been trying this for over forty years and nothing has changed. We are still fixing financial rates of return in advance using the Islamic triple contract.
One head of Islamic Trade Finance admitted to me over lunch not long ago that there is no practical difference between the murabahah business that he does now and the conventional letter of credit business that he used to do in his previous job. Just the labels are different. Then there's the Islamic banking department that uses interest-bearing financial instruments for the purpose of closing some of its deals. When deals are done the funds often go to lubricate the trading operations of large corporations such as BMW and General Motors. Meanwhile, in many countries, small and medium sized Muslim-owned businesses are offered no Islamic finance facilities at all. When they do finally encounter a financing proposal from an Islamic bank, many of these businessmen quickly become cynical because the financing cost is fixed at the outset of the financing agreement.
These are all signs that something has gone badly wrong in this industry. But I'm not saying that it is all the fault of the people on the inside. The Western academic establishment is at least partly responsible for the way that the Islamic financiers are thinking. For example, because Brealey and Myers have written a standard text on corporate finance, they are probably as big a force in Islamic finance as Judge Taqi Usmani. It is awfully hard to escape from the value judgements that the overwhelming mass of usury-based finance books contain. That's why an educated Muslim in Islamic finance can ask his client a shocking question such as 'what cost of finance are you looking for?' without thinking twice. He's been taught by Brealey and Myers that fixed-rate finance plays a part in any 'good' financing structure and so off he goes in search of a way to do fixed-rate finance Islamically. The possibility that fixed-rate finance may be completely incompatible with Islam in the first place may not even occur.
But there are two other reasons that prevent Islamic banks from giving up on the doubtful fixed rate products and adopting profit and loss sharing instead. The first is that the clients often prefer to take finance on a fixed rate basis. The second, more overwhelming problem, is the nature of the very business process underlying commercial banking itself.
To explain the first reason, let me tell you about a discussion I had with the Chairman of a major construction company in Asia. His company specialised in building toll roads. It had borrowed heavily at fixed interest in the middle of an economic boom. I told the Chairman that we could develop a toll revenue-sharing financing package. We would part-finance the toll road and share the toll receipts. No toll receipts, nothing for us to share. This would be good for his company because if no one used the road, there would be no financing cost. With the interest based alternative, whether the toll road was full or empty, there would still be a financing cost.
But the Chairman felt that 7% interest was a good deal and so our suggestion was not adopted. Probably this was because he knew that the toll road was going to provide profits of 30%, and there's no point paying out 30% in profit share when you can pay out 7% in interest instead, is there?
Well, the economy turned down, fewer motorists than predicted used the toll roads, but the interest still had to be paid. And so the company had to be rescued. The Financial Times commented a few days later that the rescue was required because 'interest costs exceeded toll revenues'. I kept that article because it summarised with a real life example everything that true profit-sharing would have avoided. The moral of the story is that the chairman wants to fix his financing cost because he believes his business is going to be profitable and he wants to keep most of the profit to himself. He's practicing financial leverage like all those un-Islamic textbooks tell him to.
The unfortunate fact is that even if the Chairman had given the go ahead for profit-sharing, no Islamic bank would have offered it to him. This brings me on to the second of the two reasons for the general failure of Islamic banking to provide profit-sharing finance. Now the story becomes a serious and alarming one.
Let us start with what we should already know. When the first banks began lending paper money, they knew that they were taking a huge risk. They had spent many years promoting their paper money. Some of the phrases they used to persuade the public are still with us today ... 'as good as money in the bank' ... 'prudent' banking. Bankers were respectable chaps who only wanted to conduct honest business and make a reasonable profit in the process. Your paper, they promised, could be converted into gold simply by presenting it at the bank.
So the public came to believe this promise and put their trust in the bankers' paper money. And then the bankers did their little trick and began to print more paper than there was gold in the bank to redeem it with. They could then lend this paper money at interest and make a fat profit.
The banker's promise to redeem this extra paper money with the state's gold coinage was an empty promise, but one that he took because it gave him the power to manufacture money. The crucial idea that Muslims everywhere must understand is that, because this process was in itself risky, the bankers did not want to take any further risks. So they therefore avoided investing money on a profit sharing basis. Why take the additional risk that the borrower's business would fail? Better instead to create money, lend it at interest and take a mortgage on the borrower's assets as security. Then a profit would be much more likely for the banker. This has always been the business process underlying commercial banking.
Today of course the banks practice their 'business' in a different way. Remember, the bank still manufactures your cheque book and cheque card, and sends you an account statement with numbers printed on it at the end of the month. The bank tells you that these numbers can be converted into state money, but if everyone held the banks to their promise on the same day, the banks would all collapse just like the banks of old.
I propose that if banks couldn't manufacture money, they could not survive commercially. They could not survive if all they did was to rent out the entire stock of money created by the state. The banks must create extra money on which to collect interest in order to have a viable business. And they must fix their financial rate of return in advance because profit sharing is one risk too many when you're in the business of money creation. Today, at least 91% of UK money supply is manufactured by the banking system. State money supply is £30 billion, bank money supply is at least £300 billion. Even if the banking system charged a clear 20% interest on the whole £30 billion, it still could not generate sufficient revenue to survive. Hence it has manufactured an extra £300 billion on which it can charge interest.
An Islamic bank is no different. It must partake in the money creation business. And it must therefore fix its financial rate of return at the outset in most of its business. That's why Islamic banking cannot succeed in being Islamic. At least, not in the way that we understand the terms 'banking' and 'Islamic' today.
It gets worse. Because the banks create money by agreeing new loans, society must be in constant debt to the banks by an amount approximately equivalent to the total of a nation's money supply. But when the banks create money, they do not create the money needed to repay the loan plus the interest charge. The loans that the banks make are therefore unrepayable. The unrepayable debt in turn forces society to compete instead of co-operate since the borrowers in aggregate experience a constant shortage of money. Only one thing can save current borrowers, and that is the creation of more money, either by the state or by the banks. This provides sufficient new money with which current borrowers can repay old debts. When the banks and the state don't create enough new money, we have a recession. If they create too much, then we have inflation. And always we have more debt.
Wherever you live in the 'developed' world, look at your country's monetary statistics. You will see a steady expansion of total debt (private plus public) accompanied by expansion of money supply to a similar degree. More telling is the fact that total debt is in almost all cases showing substantial growth as a proportion of Gross Domestic Product. So despite decades of hard work, using ever more productive technology, the people are more in debt than they have ever been. Net, they own less of the wealth in their possession than they have ever done. Does this make any sense to you? Only when we understand that modern money is manufactured mostly by the banks for the sake of profit, can we understand the modern economy. Then it will all make sense.
Islamic finance is not a product to be offered to a niche market. It is a system. It must be promoted and implemented as a system. Where the monetary system is concerned, I am beginning to feel that this is something that cannot be achieved by the private sector alone, Islamic or otherwise. A lead is required from the State since we must redefine the meaning of the words 'legal tender'. We must somehow overturn the monetary system as it is. And that will require us to defeat the monster that faces us.
Some of our scholars have yet to recognise the monster for what it is. They think of the banking system as a necessary part of economic activity. They do not connect the deaths of millions of children in Africa every year with the burden of debt repayments to the banks (the United Nations Development Programme's annual Human Development Reports 1997 - 1999 do show this connection). We need a payment transmission system, a safekeeping service, and investment advisory services. To all these things, yes. To money creation for the sake of profit, no.
Which politician will be brave enough to challenge the wealthy bankers and their friends in the leveraged corporate boardroom? The prize awaiting a successful challenge will be huge. Such a nation will be a light for the world to follow. Imagine no more debt. Imagine all those bankers being released from their unproductive industry (the largest by value on the London Stock exchange) to do something useful instead. Imagine a world free of dominance by a few huge firms, huge and dominant because they have been leveraged with the bankers created money. Imagine what we once had before all of this. A world of small businesses, a world of variety, of individual responsibilities and co-operating communities.
Failure to defeat the monster means a never ending necessity for growth. A world awash in the dust of riba, ruled by the 'Money Power', paying perpetual interest on an unrepayable debt.
Oh, I know they'll say I'm being extreme, it's just that these other fellows have all been saying it too ...
"The Bank hath benefit of interest on all moneys which it creates out
The unlimited emission of bank paper has banished all specie ....
private fortunes, in the present state of our circulation, are at the
mercy of those self-created money lenders, and are prostrated by the
floods of nominal money with which their avarice deluges us.
And I sincerely believe with you, that banking establishments are
more dangerous than standing armies; and that the principle of spending
money to be paid by posterity, under the name of funding, is but
swindling futurity on a large scale
The distress and alarm which pervaded and agitated the whole country
when the Bank of the United States waged war upon the people in order to
compel them to submit to its demands cannot yet be forgotten. The
ruthless and unsparing temper with which whole cities and communities
were oppressed, individuals impoverished and ruined, and a scene of
cheerful prosperity suddenly changed into one of gloom and despondency
ought to be indelibly impressed on the memory of the people of the
United States. If such was its power in time of peace, what would it
have been in a season of war, with an enemy at your doors? No nation but
the free men of the United States could have come out victorious from
such a contest; yet, if you had not conquered, the government would have
passed from the hands of the many to the few, and this organised money
power, from its secret conclave, would have dictated the choice of your
highest officials and compelled you to make peace or war, as best suited
their own wishes.
The government should create, issue and circulate all the currency
and credit needed to satisfy the spending power of the government and
the buying power of the consumers. The privilege of creating and issuing
money is not only the supreme prerogative of government, but it is the
government's greatest creative opportunity. By the adoption of these
principles, the long-felt want for a uniform medium will be satisfied.
The taxpayers will be saved immense sums of interest, discounts and
exchanges ... money will cease to be the master and become the servant
of humanity. Democracy will rise superior to the money power.
I am afraid that the ordinary citizen will not like to be told that
the banks or the Bank of England can create and destroy money.
In the abstract it is absurd and monstrous for society to pay the
commercial banking system interest for multiplying severalfold the
quantity of the medium of exchange when a) a public agency could do it
all at negligible cost, b) there is no sense in having it done at all,
since the effect is merely to raise the price level, and c) important
evils result, notably the frightful instability of the whole economic
By allowing private mints to spring up, Parliament has fundamentally
and perhaps irretrievably betrayed democracy. Before the War it was
customary even in the works of apparently respectable economists to find
absolutely dishonest hair-splitting distinctions between the invisible
money so created and paper notes. The latter were really money and the
former was not! In fact the reader can always tell in such standard
works on the subject when he is approaching the fishy part of the
business. The essential fact, the creation of new money, becomes
obscured in a cloud of anticipatory justification and special pleading.
Despite the accusations of neo-imperialism leveled at the IMF and the
World Bank, in the same way that a country's domestic banking system is
carried out with apparently scrupulous honesty, the financial conduct of
the IMF and World Bank appears above reproach. If a nation borrows, it
must repay. Naturally! What other conclusion can there be? The true
injustice of the IMF and World Bank only become apparent when the
fraudulent nature of these 'loans' is understood, and how they relate to
the debt-based banking system ... It is an injustice amounting to
international slavery and extortion; it is an aggressive injustice,
involving the subjugation of whole nations and their sovereign peoples,
operated on a scale that exceeds the total of all the more obvious
efforts at dominance by individual nations indulging in warfare over the
by Tarek El Diwany
An abridged version of this article was published in Banker Middle East during November 2002
Please report any
broken links to
Copyright © 1988-2012 irfi.org. All Rights Reserved. Disclaimer