Asian and African Area Studies, 11 (2): 93-113, 2012

Frontier of Islamic Economics and Finance: New Challenges

Conceptualising and Locating the Social Failure of Islamic Finance:
Aspirations of Islamic Moral Economy vs the Realities of Islamic Finance
Mehmet Asutay *Abstract
Islamic moral economy emerged in the modern sense in the late 1960s and early 1970s
as an attempt to develop an authentic understanding of the Islamic system of economics
and develop policies accordingly. As part of this concept, Islamic banks and financial
institutions are considered as the institutional aspects of this moral economy, which
can pool their resources together to finance real economy activity. However, thetransformation of Islamic banking into a commercial banking form since mid-1975
has resulted in unprecentedly successful financial performance, which, however, hasbeen at the expense of the ‘social and economic developmentalist’ aspirations of Islamic
moral economy. Therefore Islamic banks and financial institutions are criticised fortheir social failure. This paper, therefore, aims to explore the social failure of Islamicbanks and financial institutions and locate the sources of this failure. In moderating
the social failure of Islamic banks and financial institutions, this paper suggests that athird institutional development in the form of non-banking financial institutions, suchas Islamic social banking, Islamic microfinance, an awqaf system, ar-rahn or Islamic
pawnbroking, and zakah funds should be created with the objective of serving thesocial and developmental needs of Muslim societies.

Introduction
The search for authentic Islamic institutions set the objective of the Muslim societies in the 20th
century, which took shape in the case of financial institutions in the last quarter of the century
in the form of Islamic banks and financial institutions (IBFIs). With the establishment of firstIslamic bank (IB) in 1975 in the Gulf, institutional development took the ‘commercial form’ as
opposed to the short-lived experience of Islamic social banking as experienced in the case ofMith Ghamr in Egypt in the 1960s.
Since the first IB in 1975, IBFIs has successfully expanded in their asset bases but also interms of the number of such institutions. An important success of IBFIs is the institutional* Reader in Middle Eastern and Islamic Political Economy & Finance, Durham Centre for Islamic Economics andFinance, School of Government and International Affairs, Durham University
Accepted January 13, 201293

Asian and African Area Studies, 11 (2)developments that have taken place in West as well, such as in London, Paris, Rome, andLuxembourg among other countries that have attracted IBFIs.
Against the backdrop of the global financial crisis, IBFIs have managed to achieve modest
growth in their asset bases and also in other institutional and financial variables. Therefore,the ‘resilience of IBFIs’ has become a popular topic in conferences and writing, and in sucharticulations this ‘resilience’ is attributed to the religo-ethical foundations of Islamic banking andfinance (IBF). However, defaults in IBFIs have happened as well, in particular in Dubai, which
has brought the whole idea of resilience into ‘question.’
A critical analysis of the progress, expansion and performance of IBFIs indicates that thevalues and norms of IBF are compromised for ‘financialisation’ through financial engineering,which helped to endogenise the problems of the ‘current financial system’ into the IBFI realm.
It is therefore important to make reference to the norms and values of IBFIs as formulated by
the Islamic moral economy (IME), which give meaning to the ‘Islamicness of IBF.’ For this, theframework of IME should be articulated and IBF should be located within this framework inorder to express the distinguishing nature of IBF as a valued proposition.
This paper, therefore, aims to present the moral economy basis of IBF and compare its
performance against the value proposition articulated by IME whereby the ‘social failure’ of IBF
is identified.

1. Islamic Moral Economy as the Foundation of Islamic Finance
Islamic economics or as argued by this paper Islamic moral economy (IME) emerged mainly inthe post 1960 period as a result of a search for reform in the Muslim world since the beginningof the 20th century. In the post 1960s period, the failure of economic development in the Muslim
world and the rise in the Islamic political identity motivated certain academics, activists andfinanciers/bankers to discuss the initial foundational issues of what was later to become Islamic
economics or IME. Thus, IME is a response to the failure of economic development in the
Muslim world, whether capitalist, socialist or nationalist, with an authentic meaning derived
from the ontology of Islam, namely the Qur’an and the Sunnah or the traditions of the Prophet
of Islam [Asutay 2007a, 2007b]. It is in a way a reaction and problem solving attempt todevelop an ‘Islamic system’ of economics and economy in producing a theoretical policy base tocounter the underdevelopment of Muslim societies through the norms, values, and principles ofIslamic ontology with the objective of creating a human centred development process.
A number of academics, such as M. Umer Chapra [1992, 2000], M. Nejatullah Siddiqi
94ASUTAY: Conceptualising and Locating the Social Failure of Islamic Finance[1981], Khurshid Ahmad [1979, 1994, 2003], S. H. Naqvi [1981, 1994, 2003] in 1970s,
as the founding fathers of Islamic moral economy in modern sense, attempted to articulate
the initial theoretical building blocks of IME and therefore IBF. As a modernist movement,
IME in the process has been socially constructed within the ‘socially’ understood meaningof Islamic ontology. In this reading, and therefore, formulation, emphasis was placed on theconsequentialist nature of economic development and the substance of the process, which, asa result, produced a ‘social-welfare’ or ‘social good’ oriented developmentalist paradigm. The
concepts of ‘adalah’ or ‘justice’ and ‘haqq’ or ‘right’ are the core objectives and operational
functions for understanding this alternative system.
The initial attempt to formulate the ‘Islamic system’ of economics aimed at laying theaxiomatic foundation of IME, with direct consequences and implications for the social aspects
and developmentalist orientation of IME, as presented below [Asutay 2007a, 2007b; Naqvi
1981, 1994; Ahmad, K. 1979, 1994]:(i)

The vertical ethicality of the equality of individuals in their relations to the Creator, God,and having equal opportunity to enjoy the bounties on Earth created by God; namely
tawhid;(ii)

Social justice and beneficence (adalah and ihsan), which constitutes the horizontal equality
between individuals within the tawhidi framework;(iii)

As a direct result of the vertical and horizontal ethical axioms, IME assumes growth inindividual, social, economic and biological environments to take place in harmony withthe stakeholders within the spiritual framework of tazkiyah;(iv)

IME, as a consequence of the above axioms, assumes in a functional sense an enabledindividual, society and natural environment so that each of these can reach its perfection
within the tawhidi framework, as God has chosen perfection as a path by definition foreveryone and everything. This refers to rububiyah as the functional axiom;(v)

In fulfilling rububiyah in all aspects of individuals, society, economy and environment
the tazkiyah process aims to overcome the conflict between individuals and society.
Therefore, IME assumes that in order to overcome the perceived conflict between theindividual and society, voluntary action is not perceived to be enough; and therefore
certain socially oriented financial and economic obligations are made mandatory, or fard,
so that moral economy objectives can be achieved;(vi)

In operationalizing such expectations as expressed within the axioms of IME, as part95

Asian and African Area Studies, 11 (2)of the tawhidi framework, individuals are perceived to be the vicegerent of God on the
Earth, namely khalifah, and expected to fulfill their duties within the social, economic,
financial and other realms and to make their decisions through a moral filter. In otherwords, since individuals are considered to be the representative of God on Earth, they are
expected to fulfill such roles and responsibilities.

All these axioms, as the foundational framework of IME, are the articulation andoperationalisational aspect of maqasid al-Shari’ah or the ‘objectives of Shari’ah’ process, which isdefined as realizing ‘human well-being.’ In other words, the entire objective of IME and also its
operational aspect of Shari’ah is to serve ‘human well-being’ which is the main and essential aimof all efforts within the tawhidi framework.
It should be noted that IME assumes a morally oriented individual at its methodologicalbase, which can be considered as ‘homoIslamicus’ [Asutay 2007a, 2007b]. Such an imagined
individual is expected to aim at achieving ‘ihsan’ or ‘beneficence/excellence’ in whatever he/she does through the ‘falah’ or ‘salvation’ process in this world and the Hereafter [Zaman andAsutay 2009]. Thus, endogenising ‘Hereafter’ as an essential part of perpetual life spiritual
accountability is introduced to the individual objective function, as one might aim at maximizing
the benefits in this world but has also to be concerned with the consequences of such actionsin the Next, as one has to aim to maximize the falah for the Hereafter as well. Thus, twodimensional utility maximization is a process considered and theoreticised by IME.
In terms of the consequentialist approach, as implications, the foundational axioms
demonstrate, as a system, that IME refers to economic and sustainable development, social
justice and social investing oriented principles. They assume a human centred development
strategy with individuals aiming to reach ihsan or beneficence or excellence due to aiming
for falah or salavation in this world and in Hereafter as the aim of this life. Within such aframework, IME assumes to develop functioning individuals in terms of ‘doings’ and ‘beings’
through creating the right and just environment and opportunity spaces for such development totake place [Zaman and Asutay 2009].
IME is thus based on system understanding by directly defining foundational axioms, values
and norms, a particular methodology, operational principles and functional institutions. As
examined by Asutay [2007a], IME fulfils all these conditions to be considered as a system. It
is only within the system of IME that IBFIs are considered as functional institutions in termsof raising and pooling the necessary funds and financing for economic activity, progress and96

ASUTAY: Conceptualising and Locating the Social Failure of Islamic Financedevelopment.

Thus, IME is a moral system of economy and society providing a systemic

approach to the economic sphere through a multi-dimensional and multi-discipliniary approach.
IBFIs therefore, should be located within this framework and systemic understanding in order toserve the aims and objectives of IME and therefore contribute to the falah process for individuals
by expanding the ihsani social capital in the society. Therefore the following section, aims tolocate the ethical foundation of IBFIs.

2. Islamic Banking and Finance as a Value Oriented Proposition
As discussed in the previous section, IME assumes and offers a moral based value solution for
the economic and financial problems faced by the humanity. When the current global financial
crisis hit the world, people from different circles criticised capitalism for its ‘moral deficiency’
and attributed the financial failure not only to ‘reckless financing’ instruments but also to the‘greed’ of the financiers and bankers. Therefore, the financial crisis brought the importance of‘morals’ into the agenda with the objective of ‘moderating’ the consequences of the ‘capitalist
financial system.’
The origin of Islamic banking and finance (IBF) can be traced to the initial years of theIslamic civilisation, as Islam through its teaching under the supervision of the Prophet of Islam
aimed at regulating and shaping economic and financial activity according to the moral norms
and values of Islam. While in one way or another such a tradition continued to exist at the
periphery of the Muslim world, its re-mergence with systemic understanding has only beenpossible in post the Second World War period when some of the newly independent Muslim
states searched for an authentic meaning for economic and financial activity through Islamicvalues. Therefore the rise of IME is a result of this authentication process with the objective ofcreating an economic system with understanding of Islam.
IME, however, refers to a ‘system,’ which in essence is possible only through a politicalprocess [Asutay 2007a].

Since changing the political process to bring a new system is notpossible, IBF was considered by the founding father as the plausible institutional dynamics
of IME, and therefore the modern versions of banks in the form of IBFIs have operated
commercially since mid-1975. However, these commercial IBFIs should be considered as thesecond stage, as initially in 1963, Mith Ghamr Bank was established in Egypt based on the
moral economy understanding of Islam beyond commercial IBF, as Mith Ghamr Bank aimed
for capacity development, and economic and individual development [Mayer 1985].

Thissocial bank, which constitutes the initial institutional nature of IBF, aimed at providing credit
97

Asian and African Area Studies, 11 (2)to small entrepreneurs and artisans with the objective of empowering individuals against theoverwhelming power of the state. However, the operation of this bank could not be sustained, as
the consequences of its operation disturbed the political power base in the country, and therefore
later it was closed by the regime towards the end of the 1960s. Thus, the moral consequences ofa ‘true’ Islamic bank (IB) were rather evident in the operation of Mith Ghamr which remains as
an aspirational ‘role model’ today.
Over the years, since the establishment of the first commercial IBF in Dubai (Dubai
Islamic Bank) in 1975, IBF has become a reality beyond the Gulf region. The performance of
IBFIs in the last thirty-five years indicates that this banking and finance proposition has been
unprecendently successful despite an entirely adverse attitude from the Muslim authorities inMuslim countries and beyond [Iqbal and Molyneux 2005]. The recent reports demonstratethat the assets of IBFIs have reached about USD 1,2 trillion, which of course still constitutes
a small portion of the global financial system [The Banker 2010]. However, this performance
should be considered against the background of simply starting from zero level in 1975. As tothe performance of IBFIs, until the recent financial crisis, these institutions grew by 15-20% perannum. However, since 2008, their growth has been more modest, less than 10% per annum,
which is still higher and better than the performance of the conventional banks and financial
institutions.
The success of IBFIs can be seen in its geographical diffusion to many countries in the world,
about 55 countries, financing everyday goods and services consumed all over the world. By theend of 2010, it is reported that there were about 650 IBFIs in these 55 countries [The Banker
2010].
This unprecedented success has attracted the attention of non-Muslim countries too,resulting in a number of Western nations adopting new strategies to facilitate and accommodate
IBFIs in their own countries, which include Great Britain, France, Switzerland, and Luxembourg
among others [Wilson 2007].
Despite the observed ‘financial’ success, it is important to critically evaluate the performanceof IBFIs against their foundational base, namely IME, as IME imposed generating the necessary
funding and financing for economic development within the norms of the social and moral
economy of Islam by conceptualising it as a ‘financing’ proposition as opposed to ‘financialisation’of the economy; the latter is considered as one of the main sources of the collapse of the financial
systems in the West. As the IME framework suggests, ethicality in this value proposition in
the original sense is not only the prohibition of riba (interest) but relates to larger social and
98

ASUTAY: Conceptualising and Locating the Social Failure of Islamic Financeeconomic development issues as discussed above [Asutay 2007b, 2010b]. In other words, IME
conceptualises IBF as a financing proposition shaped not only by the rules (fiqh) but also by themoral values of Islam constituting the ‘substance’ [Asutay 2008].
IME’s moral framework, thus, aimed at shaping the nature and operation of IBF beyond theprohibition of riba or interest. In this moral based financing proposition, a holistic approach tofinancing a society is assumed by IME. This Islamic value and norms based nature of IBF can be
described as follows [Asutay 2007b, 2010b; Iqbal and Molyneux 2005; Ayub 2007]:(i)

IBF is a tenant based financing proposition, as fundamental tenants are derived fromthe ontological sources of Islam, which is articulated in the ‘absence of interest-basedtransactions,’ ‘avoidance of economic activity involving speculation,’ and the ‘prohibition
on production of goods and services which contradict the values of Islam.’(ii)

IBF is principles based, as the concept is grounded in ethics, values and norms derived
from the Islamic ontology. Therefore, the principles of IBF are akin to ethical investing,and therefore, ethicality in funding and investing beyond the prohibition of riba isessential.

In addition, importantly, IBF puts special emphasis on risk-sharing andpartnership or profit-and-loss sharing contracts.

In this financing proposition ‘credit

and debt products are not encouraged’ and were even eagerly discouraged so that real
economy embedded financing as assumed by IME could be developed.
(iii)

IBF, as part of IME, proposes embedded financing—embedded in real economy, andtherefore it offers an alternative financing paradigm. This is articulated in the principleof asset-backed transactions with investments in real, durable assets to contribute to thedevelopment of value added oriented real economy based financing of economic activity.
As a consequence, IBF aims to bring about stability by linking financial services to the
productive, real economy. On the demand side, IBF, as part of homoIslamicus, aims to
restrain consumer indebtedness as credit is linked to real assets.

(iv)

IBF is a society oriented financing proposition, as it aims to serve the community andnot the markets. Since IME aims to create a framework of developmentalist financing,
instruments of poverty-reduction are an inherent part of IBF. For this purpose, in addition
to Islamic financing of economic activity for development, zakah and qard hasan can be
mentioned.

These principles within the framework of IME values indicate that IBF cannot be relegated99Asian and African Area Studies, 11 (2)only to the prohibition of riba in the sense of Shari’ah or ‘form’ compliancy, but importantly it
essentialises ‘substance’ as defined by IME. Thus, IBF is directly related the axioms of IME invery aspect. For instance, ethical financing is essential not only that the concepts of rububiyah
and tazkiyah may be fulfilled but also that adalah and ihsan can be achieved [Ahmad, K. 1994].

3. Evaluating the Performance and Locating the Social Failure ofIslamic Banking and FinanceIn the previous sections, it is argued that IBF aims to fulfil the aspirations of IME by contributing
to the development of the society through ethical investing.

However, in looking criticallyat the reality and performance of IBFIs, one witnesses the overwhelming convergence withconventional banks and financial institutions in terms of operations and products at the expenseof the aspirations of IME. Over the years, as part of this convergence, IBFIs have compromisedon their ‘moral economy’ related objectives and outcomes by locating themselves within neoclassical economics. In other words, their attachment to ‘efficiency’ has been at the cost of‘equity,’ while IME as the foundation and framework for IBFIs prioritises social as well as
economic optimality by placing emphasis on ‘equity.’Thus IME, conceptually, suggests that IBF should be more than financial contracts, as it
represents a holistic approach to financing a society. In addition, conceptually, Islamic finance isrooted in developmental aims, and therefore conceptualised as providing the financial means forthe development of societies rather than services for the markets. Therefore, the embeddednessof IBFIs’ financing in real economy is an essential feature.
A critical analysis of the performance of IBFIs, however, indicates that there is a growing
divergence between the aspirations of IME and the realities of IBFIs. This divergence mainly
demonstrates itself in ethical and social expectations related areas, and therefore it is valid toclaim the ‘social failure’ of IBFIs with the evidence produced by a growing body of empiricalliterature. Therefore the debate in recent years has been around ‘form vs substance’ or ‘Shari’ahcompliant finance vs the Islamic based finance,’ which indeed brings the entire legitimacy ofthe current practice of IBF into question. It should be noted that the substance in this debate isdefined through the IME’s suggested ethical and developmentalist or social economy oriented
value proposition, as explained above.
3.1 Locating the Social Failure in IBFIs
In the previous section, the tenants and principles of IBF are identified within the value
framework of IME. These can be used to evaluate the current practice of IBF, as follows:100

ASUTAY: Conceptualising and Locating the Social Failure of Islamic Finance3.1.1 The Relationship between IBF and the Conventional Monetary System
IBFIs operate within the existing economic and monetary system, and therefore they are
inevitably affected not only by the operation of the monetary system but also by the businesscycles of the economy in which they are operating. Therefore, the ‘resilience’ of IBF during thefinancial crisis is an overly exaggerated issue, as when the business cycle is running into difficulty,
it is inevitable that the IBFIs will also be affected, as was the case in Dubai.
Important however, is the return of riba or interest through different mechanisms into the
IBFI operations, as interest is still used as a benchmark to measure the time cost of money in
IBFIs in their project evaluation, markup value and beyond. A number of recent studies, among
other Gan, Pei-Tha and Kian-Teng Kwek [2010] and Chong, Beng Soon and Liu, Ming-Hua[2009], evidence the correlation between IBFIs’ returns and the change in the interest rates andmonetary operations.
Not having developed a benchmark for its operation should be considered as an important
shortcoming, which results in a convergence between IBF and conventional finance and banking.
3.1.2 Financialisation of IBF as Opposed to ‘Financing’
As mentioned above, IBF within the IME is considered as embedded financing being directly
related to the financing of the real economy.

However, in recent years, through financial

engineering a number of new instruments have been produced in responding to the sophisticatedfinancial needs of the corporate and financial sectors. However, developments of such products
bring IBF even closer to conventional finance by endogenising the shortcomings of conventional
finance into the IBF realm. In other words, ‘financialisation’ through such new products is a
result of mimicking the conventional sector. Considering that such products are responsible forthe failure of the conventional financial sector, the fear of their impact on the IBF industry isimportant to consider.
It should be noted that the value system in which IBF is located suggests the removal of
speculation and the linking financing with the real economy. However, these new products,
as the controversy around tawarruq and sukuk as well as other Islamic derivatives and futuresindicates, are constructed by compromising the value system of IBF. The result, therefore, hasbeen the financialisation of IBF, which as a principle was considered detrimental to a robust
economy by IME. Thus, the particular and pragmatist path followed has resulted in internalising‘financialisation’ as an essential part of IBF, which runs against the aspirations and values of IME
and IBF.
In a recent study by Asutay and Aksak [2011], the performance of IBFI indices were101

Asian and African Area Studies, 11 (2)examined for a number of cases and compared to conventional finance, a direct correlation
between the performance of both the financial sectors is established, and it is argued withevidence that IBF does not necessarily bring stability to the financial system. It is assumed by the
IME that IBF should provide stability to the financial system and should also be a moral compass
for capitalism [Asutay 2007a, 2008]. However, Asutay and Aksak [2011] could not find any
evidence for this, thus revealing another source of divergence between the ideals of IME and therealities of IBFIs.
3.1.3 Overwhelming Popularity of Debt Financing over Asset Based Financing
IME assumes that IBF should be based on the ideal form of asset based financing as opposed to
debt financing, and therefore debt financing is discouraged, as the proposition aims to develop
a healthy and stable economy by preventing the financialisation of the economy. Therefore, as
mentioned above, risk sharing and profit-and-loss sharing financial instruments are prioritised todevelop a participatory economy.
A critical examination of IBFIs financing, however, quickly identifies that debt financing has
become the majority financing method in IBFIs. A number of studies, among others Aggarwal
and Yousef [2000], Iqbal and Molyneux [2005], Zubair Hasan [2007], Nagaoka [2007] andJan [2011] show that debt-based financing has become the major source of financing in the
IBF industry as in conventional banking. Nagaoka [2007] evidences that on average, from1984 to 2006, murabahah instrument financing (mark-up priced financing products, which are
debt-based) constituted 88.1% of the mode of financing for the Bank Islam Malaysia Berhad,
and 67.3% for the Dubai Islamic Bank for the period of 1988 to 2006. For the same period,
however, mudarabah and musharakah instruments of financing (both joint venture capital
products and therefore asset-based) remained on the average about 1.7% for the Bank Islam
Malaysia Berhad, and 9.3% for the Dubai Islamic Bank [Nagaoka 2007]. In a more recent
study, Jan [2011] also provided similar evidences, as can be seen in Table 1.
As Table 1 illustrates, financing through musharakah, mudarabah and qard al-hassan, which
are the preferred financing methods of IME, is mostly very limited and in most of the cases isnegligible if not nil. The rest of the financing in these selected banks, as in others, is conducted
through murabahah and other debt-financing instruments.

Therefore, considering that in

IME equity or profit-and-loss sharing financing is considered superior to debt-like financial
instruments, having IBF institutions involved in more debt-like financing is an indication that IBF
has deviated from its aspirational origins and inclined towards more conventional banking andfinance.
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ASUTAY: Conceptualising and Locating the Social Failure of Islamic Finance

Table 1. Distribution of PLS Financing Methods in Selected IBFIs
Islamic BanksIBF Instruments

2006

2007

2008

2009

2010

Meezan Bank

Musharakah
Mudarabah
Qard al-hassan

14.46%
0015.15%
0023.55%
0022.74%
00.01%

27.30%
0
0.01%

Kuwait Finance House

Musharakah
Mudarabah
Qard al-hassan

0
0
0

0
0
0

0
0
0

0
0
0

0
0
0

ABC Bank

Musharakah
Mudarabah
Qard al-hassan

0
0
0

0.21%
0
0

0.32%
0.07%
0

0.09%
0.09%
0

0.10%
0.10%
0

Al Rajhi Bank

Musharakah
Mudarabah
Qard al-hassan

0
0
0

0
0
0

0
0
0

0
0
0

0
0
0

Bahrain Islamic Bank

Musharakah
Mudarabah
Qard al-hassan

4.16%
7.13%
0.04%

8.97%
8.27%
0.03%

13.40%
9.79%
0.02%

12.64%
8.75%
0.02%

11.67%
6.17%
0.001%

Bank Islam Malaysia

Musharakah
Mudarabah
Qard al-hassan

0.49%
0.21%
0

0.51%
0.18%
0

0
0.09%
0

0
0.08%
0

0
0.05%
0

Gulf Finance House

Musharakah
Mudarabah
Qard al-hassan

0
5.18%
0

0
0
0

0
0
0

0
0
0

0
0
0

Bank Muamalat
Indonesia

Musharakah
Mudarabah
Qard al-hassan

N/A
N/A
N/A

16.46%
43.10%
1.12%

29.23%
18.46%
1.77%

40.21%
12.22%
2.68%

38.11%
8.82%
7.47%

Dubai Bank

Musharakah
Mudarabah
Qard al-hassan

6.98%
7.53%
0.03%

6.80%
9.83%
0.01%

16.72%
12.00%
0.01%

18.32%
9.50%
0.01%

15.07%
5.75%
0.01%

Qatar Islamic Bank

Musharakah
Mudarabah
Qard al-hassan

0.17%
3.37%
0

0.17%
9.23%
0

0.00%
5.87%
0

0.23%
4.47%
0

0.17%
2.91%
0

Source: [Jan 2011]

Such an outcome is again related to the fact that IBF has opted for profitability andefficiency over equity and value propositions of IME. Due to the microeconomics of credit andloans, equity oriented financial products are rather risky, while mark-up oriented murabahah, forexample, is much less risky and brings a much higher (fixed) return.

103

Asian and African Area Studies, 11 (2)3.1.4 Withering Development Financing
IBF, as a proposition, is considered by IME as financial institutions, which can pool financial
resources for economic and social development. While IBFIs in their over thirty-five years ofexistence have undeniably contributed to economic growth, their contribution to economic andsocial development is negligible.
Since economic development is a larger concept than economic growth, the former requires
the financing of value added creating industries, long-term financing and contributing to socialand human development. With the emergence of IME in the 1970s, the main focus has been on
how to achieve human-centred economic development, which has been imposed on IBF as an
objective function. However, the performance of IBFIs over the years has not been encouraging
for delivering economic and social development.
The evidence, however, does not provide much confidence in terms of development andlong term financing in IBFIs. Aggarwal and Yousef [2000], Iqbal and Molyneux [2005], Zubair
Hasan [2007], Nagaoka [2007] and Jan [2011] show that“Islamic banks rarely offer long-term
financing to entrepreneurs seeking capital”[Aggarwal and Yousef 2000: 94]. In addition, G.
A. Ahmed [2005] in the case of Sudan shows that after the initial years, Islamic banks moved
away from financing agriculture and industry using profit-loss sharing schemes. Furthermore,Jan [2011] evidences that financing sectors such as agriculture, industry, and manufacturing havenot played a major part in the financing strategy of IBFIs. As does Warde [2000], Jan [2011]provides detailed analysis of the investment patterns among IBFIs in various countries anddemonstrates that real estate as well as foreign financial investments are preferred investmentareas for IBFIs. Therefore, the contribution of IBFIs to economic development is rather elusive,
as IBFs prefer to opt for short-term financing which brings a much higher return as the maturityof their financing evidences, such as the real estate market. Recalling that it was the real-estateboom which brought conventional finance into the crisis in the first place, the possible fate of
IBFIs focusing on such investment areas creates unease.
In attempting to locate the impact of IBFIs on human development, Asutay [2010c] rana simple correlation between the IBFIs assets of twenty-five countries and their respective
human development index scores. The correlation analysis result does not indicate any positive
correlation, indicating that IBFIs, despite expanding in their asset bases, have not contributed
investment to any fields that can bring about economic and social development.
Considering that economic and social development remains a difficult challenge in mostparts of the Muslim world, it is essential that IBFIs should be reconfigured to serve such a noble
104

ASUTAY: Conceptualising and Locating the Social Failure of Islamic Financecause, as a priori. The human development index evidences that even the rich Gulf countries
are still suffering from a low rate of human development. Since IME aims directly to generate
an environment in which social and economic development can be achieved, the realities suggestthat IBFIs are far away from realising such an objective. The difficulty is that IBFIs are further
diverging away from such aspirations in everyday life.
3.1.5 Failures in Social Responsibility
While corporate social responsibility (CSR) is an exogenous activity for the conventional
corporate and finance sector, it is an inherited part of IBF, as IME principles and foundational
axioms directly refer to CSR related activities. In other words, by definition and construct
IBF has to comply with CSR expectations.

The IME axioms all in all, but particularly

tawhid, adalah, rububiyah, and tazkiyah among others, directly refer to social development,
environmental concerns, and human and economic development. Therefore, it is expected by
IME that IBFs should be CSR compliant in addition to their Shari’ah compliancy in financial
terms.
The critical analysis of the performance of IBFIs, however, evidences that their CSR
performance has been rather weak and poor. Among others, Sarially [2005], Dusuki [2007],
Haniffa and Hudaib [2007], Hassan et al. [2010] and Mohd Nor and Asutay [2011] provide
evidence for the lack of CSR initiatives in the IBFIs indicating that IBFIs have failed to develop
a pro-actively engaged understanding in relation to IBFIs. In particular, Sarially [2005] andDusuki [2007] show that the CSR perception of IBFIs remain within the framework of zakah
distribution and other non-systemic charitable activities.

The CSR scoring method used by

Haniffa and Hudaib [2007] and Hassan et al. [2010] in various case studies also produces
similar weak results for CSR commitment in the IBFIs industry. A recent and modest study
Al-Sabti [2011] also produced evidence for poor CSR scores for Saudi Arabian Islamic banks, as
the highest score that could be reached was around 0.55, which is about half the expected full
CSR compliance.
An interesting example of the social failure of CSR in IBFIs is their investment attitude, as
ethically CSR is expected to shape their investment strategies. However, the evidence shows thatthey are not much different than conventional banks and financial institutions. For example, theinfamous Zamzam Towers in Makkah, which were built in very close proximity to the Kabah,
the holiest place in the Muslim world and the focal point of the prayer, can be considered as
an example of the ‘social failure’ of IBFIs. Zamzam Towers was built by financing facilitatedthrough Islamic finance to provide up-market luxurious accommodation for high-net-worth
105

Asian and African Area Studies, 11 (2)pilgrimages. However, even its promotional literature indicates that the project is not sociallyand religiously correct, as it undermines equal opportunity in this most holy place, undermines
its spirituality and historicity, and damages its environmental nature. A personal discussion
with the financiers and the Shari’ah scholar who approved the financing of the project however
indicates that they even failed to consider such ethical issues in their decision-making. In otherwords, their decision-making process was based on efficiency and equity; moreover CSR issues
did not even cross their minds. This is indeed a disturbing issue, as conventional banks do
withdraw from projects due to their social costs, and yet the IBFIs could not even attempt tofully understand such a matter, let alone withdraw from such a project.
In sum, the scores of IBFIs and their CSR performance is rather disturbing, as it brings
into the question the entire legitimacy of the IBFI proposition, because by definition IBFIs are
expected to be CSR compliant as part of their fulfilment of the substance requirement of IME. In
other words, CSR is an existential issue for IBFIs and unfortunately this data proves the ‘social
failure’ of IBFIs conclusively.
3.1.6 Shortcomings in Corporate Governance Performance in IBFIs
When the current financial crisis erupted, one of the sources for such a devastating crisis was
located in corporate governance (CG) structures and practices of the financial institutions. IME,
being an ethical proposition, aims to develop the best practices in CG for IBFIs, as the tawhidi
or shuratic [Choudhury and Hoque 2006] model suggested by IME is a much larger and robustmodel than the stake-holder model which is commended for its endogenising efforts of larger
stake-holders in the CG as compared to the US share-holders model. Thus, IME aims to develop
a comprehensive CG model for IBFIs in their practices so that the ethical value system of IME
can be fulfilled.
A number of studies have been conducted to evaluate the CG performance of IBFIs.
However, what is common in these studies is that none of the IBFIs have developed anunderstanding of Islamic CG model. Safieddine [2009], for example, evidences some governanceflaws relating to audit, control, and transparency.
The other side of CG is related to the whole idea of responsible finance as articulated by
IME, which requires systematic checks on financial providers as part of CG. However, theinitiatives by AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions)and IFSB (Islamic Financial Services Board) remain weak and are not generally accepted. A
number of studies have investigated the Shari’ah governance of IBFIs. For example, Hasan andAsutay [2011] which examines the Shari’ah governance in terms of the practices of Shari’ah106ASUTAY: Conceptualising and Locating the Social Failure of Islamic FinanceFig. 1. The Overall Shari’ah Governance Scores
Source: [Hasan and Asutay forthcoming]boards in relation to IFSB rules shows that there is no best practice IBF. As can be seen in Figure
1, Hasan and Asutay [forthcoming] found through the Shari’ah indexing of IFSB rules in relation
to Shari’ah Boards in thirty-five IBFIs in various parts of the world that there is no best practice,as none of the sample banks could score 46-50 by being compliant with all fifty items in the IFSB
rules; while 33% of the sampled IBFIs could score 36-45 and 40% of them could only score
around 26-35 to be classified as ‘improved practice.’
References can be made to other studies in providing further evidence for the shortcomings
in CG practices. However, the common result in all the relevant studies is that CG structures
have to be developed to prevent further problems in the performance of IBFIs.
3.2 Locating the Sources of Social Failure in IBFIs
In order to be able to remedy the observed failure, it is therefore important to locate the sourcesof this failure, and this is discussed below within the limited space available.
The paradigm shift from IME to IBF in particular with the adoption of commercial
institutionalisation of IBFI since the mid-1970s represents an important divergence, as theformer aimed at developing an ‘Islamic based environment’ in which IBF could be located. The
shortcomings in developing the necessary knowledge resulted in IBFIs following a neo-classicaleconomics framework. Thus, IME’s call for social and sustainable development is not considered
as an aim by IBFIs; therefore the social good is not prioritised.
In the observed social failure of IBFIs, commercial banking, as an institutional format of IBF
is also important to mention; as commercial IBFIs totally ignore developmentalists efforts, theirprinciple aim being entirely devoted to profit maximisation rather than ethical profit.
The legalistic-rational method applied by the Shari’ah scholars should be considered as
an important part of this observed social failure, which by definition ignores the ‘substance’107Asian and African Area Studies, 11 (2)by prioritising the ‘form.’ While substance requires a consequentilistic approach in terms ofoutcomes, in the ‘form’ oriented approach, the entire emphasis is relegated to the process ofconstructing a product by ignoring the outcomes of the product. For this, the celebrated Islamicscholar Ibn Qayyim’s position from many centuries ago is extremely important, as he warned ofriba-free products leading to greater ‘harm’ in the society if they were not designed according to
the identified moral objectives. The debate on ‘form’ versus ‘substance’ is an essential issue, andin order to overcome the observed failures, it is essential that Shari’ah scholarship endogenises
moral principals into their decision-making process.
The IBFIs as institutions have been made possible through the transformational intellectual
position developed by the Islamisation of knowledge movement in the late 1960s, which aimed
at Islamising the institutions of Western construct without even considering the existential
question about whether the concept of commercial banking should be an institution of Islamic
construct. As the history and financial anthropology of Muslim and Mediterranean geography
indicates, perhaps other ‘non-banking financial institutions’ could also be considered anddeveloped to respond to the ‘substance’ related expectations or fulfil the aspirations of IME.
Because, in the existing construct, as mentioned before, there is a conflict between aims referring
to social economy and developmentalism, and instruments and institutions, namely banks. Thus,
with the commercial IBFIs, Islamisation of capitalism has been taking place in recent years in
the Muslim world: considering that Weber argued for religious work ethics (Protestantism)generating capitalism, it seems that IBFIs are now delivering the new capitalism in the Muslim
world. Indeed, it is questionable whether this is desirable considering the systematic and chronic
economic and financial crises that have been experienced over many decades. Surely, IME cameinto existence as a response to the capitalist and socialist failures of developmentalism implyingthat the perceived and increasing capitalism practised by IBFIs is not necessarily fulfilling
the right expectations. Thus, the institutional construct of Islamic financing in the form ofcommercial banks has to be questioned.
While the corporation and supply side of IBFIs is important, the demand side should also
be critically analysed in assessing its importance in shaping the nature of IBFIs. Consideringthat the ethical finance movement in the West is very much a product demanded by ethicallymotivated individuals, the clients of IBFIs should be in a position to express their demands
concerning the way their monies are invested by IBFIs in relation to their ‘social anddevelopmentalist’ objectives. Thus, the role of the civil society is important to tame the ‘capitalist’
trends in IBFIs. However, evidence indicates that clients of IBFIs have surrendered themselves to108

ASUTAY: Conceptualising and Locating the Social Failure of Islamic Financethe will of Shari’ah boards in terms of their responsibilities with the expectation that such boards
do deliver according to the ethical and social expectations. The evidence contradicts this; andtherefore, a pro-active civil society is essential for the robust development of the IBF industry,
which has so far been shaped by the markets.

4. Second-best Solution or Going Back to the Basic: Correcting the Social Failure
The discussion so far has clearly identified the social failure of IBF despite its financial successes.
However, by definition IBFIs successes should be considered beyond their financial success, as
IME assumes that IBFIs should fulfil the aims of developmentalism identified by IME.
Considering the urgent need for development in the Muslim world, as well as in the restof the world, the crucial importance of ‘moral’ oriented financing cannot be denied. Whenexamining the Human Development Index as well as other social indices, it is clear that IBF
has to endogenise the developmentalism of IME into its objective function, which by definition
should be part of its operations.
The ‘Islamic’ as a prefix in IBF suggests ‘social justice,’ ‘social good’ and ‘moral oriented
developmentalism’ and therefore financial institutions carrying ‘Islamic’ in their title must
respond to the responsibility imposed on them by the very title they carry. Thus, a return to thebasics of IME is essential to prevent the risks of future performance imposed by the converging
of IBF with conventional banks and financial institutions.

In this ‘return,’ the implicationsof ‘Islamic’ in the title and therefore the aspirations of IME should be served through new
institutions and perhaps through non-banking-financial institutions, which can include Islamicsocial banking [El-Gamal 2006; Asutay 2007b], Islamic microfinance [Ahmed, H. 2004;
Asutay 2010a], economic empowerment oriented awqaf (pious foundations), zakah funds
for development, ar-rahn or Islamic pawnbroking institutions [Abdul-Razak 2011], Islamic
development banks, social investment institutions, and ethical funds etc.

These institutions

would not only be able to respond to the ‘substance’ of IBFIs beyond attachment to the ‘form,’
but would also contribute directly to the developmentalist expectations in the Muslim world
beyond economic growth.
In short, Mith Ghamr in 1963 in Egypt with its short-lived experience, and Tabung Hajj in
Malaysia since 1967 have demonstrated that IBFIs can contribute to the development of society,as the first institutional phase of IBF. The ‘commercial’ IBF since the mid-1970’s constitutes the‘second stage’ of the institutionalisation in IBF. However, despite bringing economic growththrough their innovations and financial pooling, they have not contributed to the development of109

Asian and African Area Studies, 11 (2)society nor have they managed to touch the lives of ordinary people on the streets of the Muslim
world and beyond. Therefore, there is a need for an institutional development to respond to thedevelopmentalist need. In this third stage of development, the above suggested non-bankingfinancial institutions and Islamic social banking can be considered along with commercial IBF tofulfil the aspirations of IME.
This new institutional formation, endogenosing ethics, can thus provide a new identity basedon substantive and ethical religious tenets. In reorienting towards social banking,“the ‘Islamic’in ‘Islamic banking and finance’ should relate to the social and economic ends of financialtransactions, rather than the contract mechanics through which financial ends are achieved”[ElGamal 2006: xiii]. In other words, a paradigm shift towards goals and policy rather than only
the mechanistic and legal compliance of IBF will serve human well-being much better [Siddiqi
2004].

Conclusion
In concluding, since ‘development’ is a larger concept, IBFIs with their current structure havenot been able to affect nor have they aimed at affecting the development of the societies in which
they operate in a systematic manner. This does not mean that IBFIs do not have an impact on
economic growth; on the contrary due to financial development and pooling of funds they docontribute to economic growth. However development, which is the aim of IME, lies beyond thegrowth of the economy.
It should be reiterated that ‘Islamic’ in IBFIs refers to a particular value system beyond theunderstanding of conventional banking; and therefore they are expected to fulfill the maqasid
as identified through the values and norms of Islam.

This suggests a socially acceptablefinancing option for the development of society, which by definition is in contradiction with the‘financialisation’ trends observed in the IBF industry.
The correction of the observed ‘social and developmentalist’ failure is essential forsustainable development and therefore for fulfilling the promise of IME.

In serving suchobjectives, new Islamic financial institutions beyond but in addition to IBFIs are necessary andessential. Therefore, in the new institutionalization stage, IBFIs should relate to the ‘substance’
and the ‘consequences’ rather than merely the ‘form,’ which would help to moderate and remedy
the divergence observed in the present practices of IBFIs.

110

ASUTAY: Conceptualising and Locating the Social Failure of Islamic Finance

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