Shari’a Arbitraging in Islamic Finance

In the years after the financial meltdown and the following efforts to restore the economy, more and more people are considering Islamic banking to secure their wealth and limit the dangers of the modern economy. The question that is being asked is, “what guarantee do we have that Islamic banking will stay afloat in turbulent times?” The answer to this question lies in determining the mechanisms by which Islamic Finance remains a profitable industry. Mahmoud El-Gamal, a theorist of finance and jurisprudence at Rice University, asserts that Islamic Finance contains some inherent inefficiencies, but makes up for them by engaging in “Shari’a-arbitrage” in order to remain profitable. His greater argument here is that through practices like these, in addition to the vulnerabilities that the industry possesses, Islamic Finance can become significantly un-Islamic as well as dangerous in an economic sense.

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Islamic Finance and Innovation

Muslims are taught legal and moral guidelines when they are very young, usually when they are too young to actually use the specifics for their intended functions. Still, the prohibition of unjust and unfair business dealings is an idea embodied by many Muslims around the world, and takes on a second nature in their everyday actions. Even small dealings, such as selling a used product to another person or buying a day’s groceries from the store, are subject to these moral guidelines. When these Muslims are of age, and when the society ‘comes of age’ as well, these very principles are used to create and maintain a strong system of finance.

These guidelines can be seen as a universal set of regulations on human behavior: in a society without an impetus on fair dealings, the economy could not function properly. This is why the emphasis on fair dealings also appear in secular societies. In fact, in secular circumstances, societies have their own ‘corrective’ nature, reeling in the ‘broken’ aspects of the market and subjecting them to the law, as decided by the society at large. The difference between those societies and Islamic ones is that those rules are enforced through divine injunctions rather than collective social compact. So, for general legal-moral guidelines, the system of finance will look similar, despite the difference in origin. However, the specifics are what set these systems apart: the prohibition on interest has only come from divine sources (whether Islam is the only religious tradition that enforces this is a matter of debate), as well as the prohibition on excessive uncertainty. These specific rulings are innovative and market-changing forces, while the other, more general rulings are newer expressions of the perennial human desire for fairness and just dealings. This paper will focus on the specific rulings that set Islamic banking apart, and the particular ways they present an innovative vision in contemporary economics.

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Islamic Finance and Prohibition

The idea of a financial environment driven by the principles of Islam have been around since the revelation of this religion to Muhammad (d. 632) in the Arabian Peninsula. Ever since, the foundations and evolution of financial theory have been introduced in the various Traditions of the prophet, direct injunctions in the revealed Qur’an, and in scholarly discourse leading up to the present. As a result, Muslims around the globe have endeavored to hold tight to this tradition by opening financial institutions that abide by its principles.

In the West, there has sprung a fascination with the idea of a financial system governed by religious principles, in no small part due to its particular restriction on usury and general disfavor of credit-based economies. This has led some to characterize Islamic finance as a ‘prohibition-driven’ institution. As we will see, there is some truth to the matter, as prohibition is an integral part of the religion of Islam, but positive commands (which are very much the opposite of prohibitions), play a large part in ensuring the ethical bases of the financial system.

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