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Islamic Finance: Principles and Practice

by Visser, H.
a
G. Jason Goddard
a
Wells Fargo , Winston-Salem, NC
Published online: 16 Aug 2011.

To cite this article: G. Jason Goddard (2011) Islamic Finance: Principles and Practice by Visser, H.,
Journal of Asia-Pacific Business, 12:3, 304-312, DOI: 10.1080/10599231.2011.592428

To link to this article: http://dx.doi.org/10.1080/10599231.2011.592428

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 Journal of Asia-Pacific Business, 12:304–312, 2011
Copyright © Taylor & Francis Group, LLC
ISSN: 1059-9231 print/1528-6940 online
DOI: 10.1080/10599231.2011.592428

BOOK REVIEW

Visser, H. (2010). Islamic Finance: Principles and Practice.

Cheltenham UK, Northampton, MA: Edward Elgar, 184 pages. ISBN-10:
1849808821, ISBN-13: 978-1849808828.
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In the wake of the recent financial crisis, international business headlines

questioned whether Islamic finance was insulated from the vagaries of inter-
est rate sensitivity that plagues the conventional international banking system
(Oakley, 2009; Wigglesworth, 2009). In more recent times, articles in the
Financial Times provided further discussion that the soundness of the prin-
ciples and practice of Islamic finance had helped in weathering the storm
of the lending crisis in Dubai, and that predominantly Muslim developing
countries were primed for growth given increasing populations and existent
and nascent oil wealth (“Future of Islamic Finance,” 2010; “Islamic Finance,”
2011). Many of the articles I have read concerning Islamic finance provide
topical coverage but are sparse in the products offered and how they are
different from traditional banking and compliant with the Islamic interpreta-
tion of what is acceptable. A recent book titled Islamic Finance: Principles
and Practice by Hans Visser, Professor Emeritus of Money and Banking and
International Economics at Vrije Universiteit (VU) University in Amsterdam
thus piqued my interest. It was the Practice part of the title that drew me to
review this book. Additionally, because the author was from outside of the
faith, this, for me, helped to provide some additional measure of academic
distance in the analysis of a topic that blends the spiritual and the economic.
What I was hoping to find was an even-handed discussion of the benefits
and limitations of this niche contribution by developing countries to inter-
national finance. Thus, I review this book as a commercial banker interested
in increasing my understanding of Islamic finance, and as instructor of inter-
national business and finance courses hoping to introduce students to an
interesting alternative to conventional international banking.

THE PRINCIPLES OF ISLAMIC FINANCE

Sharia, or Islamic law, distinguishes between things and actions that are
strictly forbidden (haram) and those that are permitted (halal). As is

304
 Book Review 305

discussed more fully in the next section, Sharia law forbids the charging
of interest. Additionally, credit, deposit, insurance, and investment activities
must be free of uncertainty (gharar) and free of gambling or speculative
activity (maysir). Gharar is seen as excessive risk, as it is acknowledged
that all risk cannot be avoided. Equal treatment is important in exchange,
as one party should not be seen as benefiting from the lack of knowledge
of another party. Gambling and speculation is seen as a zero-sum game
that does not increase welfare. When comparing Islamic finance with cap-
italism and socialism, the author notes that capitalism accepts profit and
interest, socialism rejects them both, and Islamic finance accepts profit but
not interest. Dr. Mahathir Mohamad, former prime minister of Malaysia, feels
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that Islamic finance ends the “slavery of debt” and creates a “fair distribu-
tion of risk” for lenders and borrowers. Many Muslims with less outspoken
ideals are attracted to Islamic finance because they can practice Islam in
the modern world to emphasize a part of their identity, without isolating
themselves. The increased participation in the banking industry, which is a
primary ingredient for economic development, was a strong benefit per the
author of Islamic finance. Those individuals that might not hold their money
on deposit or apply for a traditional home loan might be encouraged to par-
ticipate in Islamic banking. Many Western banks offer traditional and Islamic
financial products to their clients in an attempt to pursue the increased profit
potential that Muslim participation provides.
Another basic principle in Islamic finance is zakat. This is defined as
purity or cleanliness that one obtains by giving a portion of their assets to the
poor. Zakat mal is a wealth tax of 2.5% of assets not deemed for personal
use. The author notes some confusion in what is subject to taxation, and the
capriciousness of some of the conclusions. For example, dates are subject
to zakat, but pomegranates are not. My only thought on this delineation
is that pomegranates can be seen as having wealth-creating potential these
days, considering the variant new products in the Western world utilizing
the fruit for purported health benefits. Muslims should not only provide
the poor with money for food and shelter, but should also enable them to
purchase productive assets. This concept seems to provide a link with the
origins of another developing country contribution to international finance,
microfinance, which was reviewed in this journal in 2009 (Goddard, 2009).
Some argue, however, that zakat increases the carrying costs of money and
makes it less attractive to hold deposits.
The author describes how the Muslim world is still divided on the desir-
ability of Islamic finance. There are four different schools of Islamic law.
These schools vary from the very flexible with a strong emphasis on inter-
pretation (ray), to the absolute rule of literal interpretation with concomitant
rejection of independent reasoning (ijtihad). Schools of thought in between
the extremes utilize analogies (qivas) to compare the current situation to the
Quran to interpret present-day consensus (ijima) for halal actions.
 306 Book Review

THE TIES THAT BIND

One of the primary tenets of Islamic finance is the ban on interest, or riba.
In the Sharia, riba is the addition to principal that has been fixed before-
hand. It is considered to be in violation of the principal of brotherhood
(tawheed). The author does a great job in linking the religious principles
espoused in the Quran with similar admonitions in the Old Testament of
the Bible pertaining to usury. There is an appendix in the book that item-
izes quotes from the Quran concerning eternal damnation for usurers and
from Deuteronomy and Leviticus in the Bible dealing with not demanding
interest from your countrymen. These ideals led many religious leaders to
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reject the charging of interest on the grounds that countrymen was better
translated into brothers. Pope Eugene condemned mortgage loans as indi-
rect usury in the year 1148 A.D., whereas St. Thomas Aquinas saw money
as sterile and not something from which profit should be derived. The pro-
hibition of interest also has grounds in classical literature, where Aristotle in
Politika described money as a means of exchange whereby profiting from
lending money goes against nature. This ancient viewpoint of the steril-
ity of money was fed by a disdain for the common merchant class of the
time, but the disdain for banking was seen in later classical pieces such
as in Dante’s Divine Comedy. By lumping the Florentine bankers with the
Sodomites on the burning sand of Circle 7, Ring 3, the feelings of disdain
of international banking after the recent financial crisis reveals its historical
crescendo. The bankers were linked in this manner as it was considered
that they make fertile that by its nature is sterile, while their companions
were seen as making sterile the natural instincts which result in fertility.
The Reformation brought an end to these thoughts in the Christian tradition
through the work of those like John Calvin. A similar Reformation was not
seen in the Muslim tradition, so the strong feeling about the avoidance of
interest remains a central tenant of Islamic finance today. The author itemizes
the various schools of thought in Islam, and how not all Muslims believe that
the Quran and other religious texts forbid the financial instruments rejected
by Islamic finance. Some Muslim scholars believe that only excessively high
interest is forbidden. They argue that interest payments can provide secu-
rity to small investors and should be considered halal. Others believe that
depositors should not receive interest, but that the value of their balances
should be guaranteed. Still others drew distinction between foreseen and
unforeseen inflation, which harkens back to Irving Fisher’s real rate of inter-
est (Fisher, 1928). Indexing for inflation is not favored as divine rule cannot
be relaxed for man made problems such as inflation. Many Muslim scholars
believe that all financial transactions should be asset backed, and that the
time value of money concept is devoid of sense. Although opinions vary,
those that practice Islamic finance do hold dear the principles of avoidance
of riba, gharar, maysir, and haram activities, at least to some degree.
 Book Review 307

As the principles of Islamic finance are utilized to influence industry

practice, products deemed suitable have to pass the judgment of Sharia
boards whose members determine if the planned product offering is halal or
haram. This determination must be made with the knowledge that Islamic
banks must be innovative to compete. Per the author, there are a limited
number of religious scholars with expert knowledge of financial markets and
products, thus the same individuals often sit on the Sharia boards of numer-
ous institutions. This was not a problem for conventional finance as we
learned in the aftermath of the recent financial crisis that numerous preach-
ers, ministers, and priests considered themselves highly versed in finance
given the mass of publications offering spiritual and financial knowledge in
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one publication!

THE PRACTICE OF ISLAMIC FINANCE

Now that we have covered the basic principles of Islamic finance, the
next question is how the ideology is put into practice in the modern
world. Because charging interest and speculative activities are not consid-
ered appropriate, Islamic banking revolves around profit-and-loss sharing
between the financial institutions and borrowers and that each transaction
should have at its foundation a purchase and resale of an asset between
the parties. From a conventional banking standpoint, many of the iterations
of Islamic finance have a certain lineage to participation loans, where the
lender and borrower are in partnership as to the financial performance of
a certain product or business venture. From a practical standpoint, all lend-
ing activity has an element of partnership, as in conventional banking, the
lender is typically funding a portion of the purchase of an asset or business
activity while the borrower is typically funding the remaining exposure.
Two transactions are at the heart of Islamic finance. Loans are generated
by the financier purchasing some asset and then reselling that asset to the
client at a predetermined date and price so that the uncertainty principle can
be avoided. Because the Quran is quite in favor of trade in assets owned by
the seller, Islamic finance involves the financier becoming the middle man
in the transaction. Thus the financier is saddled with storage, insurance,
and taxation costs associated with owning the asset over the life of the
loan to the client. Furthermore, collateral is typically considered haram,
as collateral is not consistent with the “partnership” element that Islamic
finance desires to achieve. Table 1 itemizes the primary permissible financial
products discussed in the book.
In Murabaha financing, the parties agree beforehand how profits will
be shared. This particular product is not very popular as the losses are
borne exclusively by the financier, and it is often difficult to determine how
 308 Book Review

TABLE 1 List of Primary Halal Financial Products

Murabaha Mark-up financing

Mushakara Equity participation

Ijara Leasing
Bai’ salam Prepaid purchase
Quard hasan Beneficence loan
Istisna Contract of manufacture
Sukuk Islamic bonds
Islamic credit cards Discounting land sale
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much profit from the project is available to be shared with the financier.
Thus, there is exclusive risk of downside loss with minimal upside potential.
The financier will buy a product and then will sell it to the other party
at the original price plus a mark-up. The mark-up is payment for services
rendered. This form of loan is suitable for financing machinery, consumer
durables, and trade supplies, but not suited for working capital needs.
Mushakara financing involves an equity participation contract. Profits
and losses are shared between the financier and the borrower. Sharing agree-
ments are typically based on pro-rata ownership. A recent book elucidated
the role that limited liability played in the recent financial crisis in conven-
tional banking (Sinn, 2010). Limiting liability to the ownership may lead to
moral hazard as no single individual is responsible for the entire amount of
the indebtedness. Two transactions are also needed here, with the mark-up
being essentially equal to the capitalized value of future interest payments
under a conventional loan. Mushakara finance has the benefit of being eli-
gible for securitization, with the share prices reflecting the nominal asset
value, (otherwise riba would be involved).
Ijara involves leasing or leasing to own (ijara wa iqtina). In this financ-
ing option, the financier purchases the goods and leases them to the client.
The option exists to transfer the title to the client at the end of the lease. The
lessor, or property owner, must remain the owner of the leased product for
the entire term of the lease, which can run from 3 to 7 years for airplanes
and machinery, and longer for home finance. The downsides here include
that the lease must run its course even if the client no longer needs the asset
being leased (due to the desire of avoiding uncertainty), and if the clients
cannot make their lease payments, they lose their stake in the asset.
Each of the three forms of Islamic finance just described is utilized in
home financing as well. Whether the client leases or is paying for the home
purchased by the bank over time, the full-amount of the predetermined
mark-up must be paid and the loan period cannot be lengthened. A weak-
ness when compared with traditional home finance is that the distinct lack of
interest eliminates the tax deductions available in traditional financing meth-
ods. Additionally, the two transaction requirement leads to higher costs for
 Book Review 309

title transfers and other closing costs. In many Western nations, laws limiting
banks owning title to real estate for their operations or when taken as part
of foreclosure proceedings makes Islamic home finance problematic. These
Western laws were enacted to discourage land and property speculation on
the part of conventional banks.
Bai’salam involves a sales contract where the buyer pays in advance
for the goods. This is popular for agricultural credits as well as for work-
ing capital for small traders. The full price of the product must be paid in
advance, and at maturity the buyer must take possession of the good. These
rules relate to the desire to avoid uncertainty as Prophet Muhamad instructed
followers that food can only be sold if possessed in advance.
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Quard Hasan is a category of beneficence loans where no interest is

charged. These loans are typically provided to poor consumers, farmers, and
small business owners. They are also provided for educational purposes.
Although no interest is charged, recipients have the ability to “reward” the
provider with a return at the end. Because the reward is not agreed upfront,
it is permissible in Sharia law.
Istisna involves a contract of manufacture where Party A agrees to con-
struct an object at a predetermined price and with predetermined features for
Party B. Payments are made as the object comes closer to completion. This is
similar to construction lending in conventional banking, where the borrower
only pays interest during the construction period, and once the building is
completed, the borrower begins to pay down the principal balance.
Sukuk are also known as Islamic bonds and are tradable, asset backed,
medium-term notes. Although no predetermined interest rate is paid, the
bonds are tied to indexes such as LIBOR or EURIBOR. Sukuk are backed by
real assets and may represent ownership of those assets. They are therefore
seen as securitization of assets with the price based on the market value of
the assets. Various forms of sukuk exist, with the categories being delineated
in a similar way as is shown in the types of financial products listed in table
one. The formation of sukuk offerings involves setting up special purpose
entities that own the assets being financed via the sukuk offering. Islamic
bonds are also a primary method of public finance. The central bank uti-
lizes these bonds as a way to control the money supply via Islamic banks
purchasing commodities on its behalf (to achieve a temporary drop in bank
liquidity), or by increasing bank liquidity by the central bank making imme-
diate payments to banks for the purchase of commodities and agreeing to
receive payment for the sale of those commodities later.
Islamic credit cards also involve the purchase of an asset to facilitate
the credit. The Islamic bank will sell a parcel of land to the client and
immediately repurchase it at a discount, with the proceeds disbursed into
an account that can be drawn and redrawn to purchase items. Islamic credit
cards cannot be used for haram activities, such as discos, bars, or gambling,
nor can they be used to purchase haram products such as alcohol. It would
 310 Book Review

appear that the primary differences with conventional credit cards are that
the “profit” is not compounded and that higher minimum monthly payments
are often required.

EXPANDED PRODUCT OFFERINGS

Derivative products are seen as speculative and not as by being backed by

real assets. Speculation is forbidden and hedging is deemed not permissible
as it is seen as trading in risk. Foreign exchange hedging is viewed as haram
as it involves gharar, riba, and forward currency sales. Swaps involve for-
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ward transactions, but the bank can buy the inventory and then sell it back
with a mark-up on a time schedule geared to the firm’s needs. Thus the
bank does not sell what it does not own, and the characteristics of the good
are known to both parties. Futures contracts are seen as haram as they
are either used in speculation or for hedging. Some scholars maintain that
hedging reduces uncertainty and also helps to protect wealth both of which
would be considered appropriate activities, but this is a minority opinion.
From an investment products standpoint, clients of Islamic banks must
not invest in firms engaged in haram activities, and given the ban on riba,
Islamic banks often prefer newer firms that utilize equity rather than debt
instruments to finance their growth. Additionally, property funds are con-
sidered halal, which partly explains some funding sources for the real
estate development initiatives undertaken in Dubai over the last decade.
Additionally, income from real estate is not considered interest as the income
is seen as being earned from a tangible asset. Investment account holders
nominally share in the profits and losses of the bank, and any return for
savings deposits is not seen as riba as the return is not predetermined.
Insurance companies that invest in interest-bearing checking accounts
are also deemed problematic. Mutual insurance (takaful) is considered per-
missible as this is seen as mutual cooperation in the face of unpredictable
risks or catastrophes, and premiums are seen as payments made to reduce
insecurity and uncertainty. Issues indentified in the text as being problem-
atic for Islamic insurance is when the insurer is obligated to pay claims even
if they exceed the total premium income, and the dearth of reinsurance
(retakaful) companies.
Islamic contract law serves to obey the bans on haram activities.
Because Islamic law is not based on the concept of legal precedence, and
because there is no homogeneous interpretation of the law, English law and
commercial arbitration are often chosen as the applicable law and dispute
resolution mechanisms. Given the concepts already discussed, penalties for
late payment are restricted and seeking guarantees is difficult. Late penalties
are seen as a form of riba, and guarantees are in violation of the concept of
partnership or brotherhood.
 Book Review 311

CAPULET’S GARDEN

From the author’s viewpoint, the ban on riba severely constrains an Islamic
bank’s ability to move and safeguard its liquidity given the lack of alterna-
tives available in conventional finance. Profit-and-loss sharing banking may
protect a bank against interest rate and credit risk but does not protect it
from operational risk. Moral hazard arises given the incentive issues created
by financing mechanisms where the banks are required to monitor how
much profit or welfare enhancement has been obtained from the various
loans made to a specific borrower. Additionally, financing situations where
borrowers do not stand to suffer under a loss creates an adverse selection
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problem as borrowers with riskier business visions typically seek this sort of
financing structure. The ability to collateralize these loans does not exist with
the primary corrective mechanism being depositors removing their deposits
from underperforming financial institutions. Islamic banking principles pro-
vide for less speculation generally, but also provide for less hedging of risks.
Given the requirements of asset-based lending, Islamic banks are less likely
to fall prey to fad investments and hard to fathom derivative products. The
two transaction nature of the practice of Islamic finance leads to higher costs
with a limited supply of capital available for small and medium enterprises
and consumers. Given the level of disagreement concerning what is consid-
ered appropriate from a product offering standpoint, it appears that the ban
on interest specifically has been in name only for some of the more inno-
vative (liberally interpreted) financial products. If higher transaction costs,
more difficult enforcement of contracts, and less investment and monetary
policy options are combined with the lack of agreement concerning which
products are universally seen as being halal, the benefits of Islamic Finance
may not exceed the costs imposed. Some attempts to reduce the levels
of risk and uncertainty have been successful, but other forms of risk and
uncertainty have been created. It is for the reader to decide, after read-
ing this fine book by Professor Visser, if the ultimate objectives of Islamic
finance have been achieved, or if they have been achieved in name only. As
Juliet asked in Capulet’s Garden in Act I, Scene II of the famous Romeo and
Juliet:

What’s in a name? That which we call a rose by any other name would
smell as sweet. (Shakespeare, 2010).

G. Jason Goddard
Vice President, Wells Fargo, Winston-Salem, NC
 312 Book Review

REFERENCES

Fisher, I. (1928). The money illusion. Binghamton, NY: Vail-Ballou Press.

Future of Islamic finance: Financial Times special report. (2010, December 14).
Financial Times. Retrieved from http://www.ft.com/intl/cms/9e2790e2-064d-
11e0-976b-00144feabdc0.pdf.
Goddard, G. J. (2009). The Economics of Micro-finance book review essay. Journal
of Asia-Pacific Business, 10(1), 97–106.
Islamic finance: Financial Times special report. (2011, May 12). Financial
Times. Retrieved from http://www.ft.com/intl/cms/da1ea92c-7aac-11e0-8762-
00144feabdc0.pdf
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Oakley, D. (2009, September 16). Sukuk issuance plunges in face of liquidity crisis.
Financial Times, 16.
Shakespeare, W. (2010). Romeo and Juliet. New York, NY: Signet Classics.
Sinn, H. W. (2010). Casino capitalism. Oxford, UK: Oxford University Press.
Wigglesworth, R. (2009, October 20). Defaults will test limits of Islamic debt.
Financial Times, 17.