Shariah’s Black Box

Prior to the twentieth century, there was no discipline termed Shariah-compliant financing or even a Shariah sub-code relative to commercial transactions per se.[34] There are rulings by Shariah authorities authorizing certain contract forms dating back hundreds of years, but as late as the 1900s, there was still some debate among Shariah authorities whether the prohibition against interest was absolute or just against usurious interest. When contemporary Islamic political thinkers began to confront the collapse of the Ottoman Empire after the First World War and the intrusion of Western modes of social, political, and commercial life into the heart of the Muslim world, Shariah authorities followed their lead and began to issue legal rulings to confront this new reality.[35] Beginning with the early political-theological writings of men such as Maulana Abul Ala Mawdudi who argued for an Islamic political resurgence and a unique Islamic political economy, Shariah authorities followed suit by issuing authoritative legal rulings forbidding interest on deposits and calling for the establishment of “Islamic banks”. Over time, these rulings have incorporated prohibitions against transactions considered too uncertain or speculative and also rulings to prevent Muslims from investing in businesses engaged in un-Islamic behavior.[36] The development of these rules and the formalization of SCF have matured over the past three decades so that today there are entire university departments in the Middle East, Asia, and even in Western universities dedicated to the study of SCF.[37] Most observers connect this recent development to the emphasis of Shariah in the oil-producing Arab states and their wealth-driven influence throughout the Muslim world and the West.[38]

Effectively, SCF is an attempt to embrace modern interest-based commerce and finance, but to do so within a framework of Shariah-approved structures. For example, while almost all Shariah authorities forbid any transaction or investment which provides for interest income, SCF rules allow for interest in two ways. One way is to rule that a Muslim can invest in a permitted business that earns or pays interest but only if the amount is below a maximum level.[39] Any profit earned by the Muslim from that interest component, however, must be purified by contributing that portion to a Shariah-approved charity.[40] A second way to accommodate modern commercial transactions is to structure the forbidden transaction within Shariah-approved contract forms. These nominate contracts are based upon contract forms found in the classical rulings of the Shariah authorities prior to the advent of contemporary finance. Thus, a loan might be structured as a “cost-plus sale” where the lender buys the property and immediately sells it back to the borrower for a “profit”. This profit is the interest component in the typical loan transaction. The purchase price with the profit component included can be paid over time to resemble an amortized loan repayment schedule. A host of other forms are available to deal with interest and also with unduly speculative transactions including sale-lease back contracts, and partnerships with variations and combinations. For the more complex transactions, these Shariah approved nominate contracts are often pieced together and used in combination to arrive at a Shariah-compliant modern commercial deal.[41]

B. Why is SCF important?
As a burgeoning industry, SCF is touted as one of the fastest growing sectors in what has been termed the global financial markets.[42] Estimates for total funds committed to some kind of SCF investment or transaction is $800 billion worldwide[43] with $200 billion of assets under management in Shariah-compliant banks.[44] Annual growth in this industry sector is estimated at between 15-20%[45] based upon current trends fueled mainly by profits and liquidity in the Muslim oil- and gas-producing countries and by a worldwide Muslim population reported to be the fastest growing among the world’s major religions.[46]

Within the SCF market, Shariah-compliant bonds, known in Arabic as sukuk[47], are the most explosive segment driven by huge petro-dollar profits creating enormous sovereign wealth and liquidity. As of the end of the second quarter 2007, outstanding Shariah-compliant bonds totaled $80 billion with another $37.3 billion worth issued in the third quarter, which is double the amount issued during the same period the previous year.[48]

All of this growth, underwritten in the main by the mobile, highly liquid capital flowing out of the GCC states[49], has generated an entire industry of financial institutions, law firms, accounting firms, financial advisors and money managers establishing domestic and international links with the key investment figures in the GCC states in an effort to exploit the opportunities for substantial profits.[50] This enthusiasm has been translated to domestic U.S. financial industries in many ways.[51] U.S. financial institutions seek to underwrite Shariah-compliant bond issuances domestically and globally;[52] Dow Jones and Company[53] and Standard & Poor’s[54] have both established Shariah-compliant indexes that screen equities based upon software filters meant to eliminate Shariah-non-compliant businesses; Shariah-compliant U.S.-based managed equity funds[55] and off-shore hedge funds[56] managed or advised by entities related to U.S. financial institutions have been established and can now peg their performances against these indexes; and U.S. banks have begun to offer Shariah-compliant home loans and other credit facilities[57] with federal banking authorities opining about their legality and at least one state tax authority issuing a ruling on the tax implications of a Shariah-compliant transaction[58].