Thus, there is a serious debate about the systemic failures of the actual financial architecture. The intellectual discourse about the inherent instability and inconsistencies of the financial system underlines an increased awareness about the limits of regulation, and about the need to reform the basic fabric of the financial system in ways that are cognizant of human nature. The convergence toward an ideal conventional financial system rests on moral philosophy and competitive economy. The efficient risk allocation in a competitive exchange economy is achieved through risk-sharing mechanisms that do not depend solely on the completeness of markets, completeness of contracts, and perfect information, but also on a system of morality and justice. The epistemological roots of an ideal Islamic financial system can be also understood in light of Islamic thought, the full spectrum of Islamic financial instruments, and contributions of Muslim merchants to the early development of modern corporate entities and Muslim scholars to the disciplines of Islamic finance and economics. It is shown that an ideal Islamic financial system is also based on a risk-sharing mechanism that promotes the optimal allocation of risks and resources, and on the internalization of the code of conduct based on moral and ethical values.
Epistemology of an Ideal Islamic Financial System
Any epistemology of Islamic finance must, as with Islamic economics, find its roots in al-Qur'an, which constitutes the fountainhead of Islamic thought. It is from al-Qur'an, then, that the discussion of an ideal Islamic financial system can be started, based on the fundamental rule of the permissibility of al-bay' exchange and impermissibility of al-ribā derived from its chapter 2 verse 275. This constitutes, arguably, an organizing principle in Islamic finance and economics, establishing an important distinction between two types of common transactions, and their separate treatment under Islamic law.7 As noted by Kamali (2000), in the absence of an explicit injunction, the general provision of permissibility (ibāhah) applies to all bay' transactions clear of interest (ribā), ambiguity (gharar), or gambling (maysir), such as the exchange of goods for their monetary value, sale of one object for another or one currency for another, sale at cost plus profit, and forward sale of salam, among others. It can thus be argued that the contract of al-bay' represents an agreement of mubādalat-al-māl bilmāl, which entails the exchange of property with property, or exchange of two bundles of property rights claims that find expression in modern laws and customs.
Several translations of the meaning of al-Qur'an proceed on the basis that al-bay' is the Arabic term for trade or commerce. This implies that no distinction is made with respect to at-tijārah, which is also usually translated into the same English terms trade or commerce. However, these terms appear simultaneously in chapter 2 verse 282, and chapter 24 verse 37, suggesting thereby some conceptual differences. It can be argued upon closer examination of major Arabic lexicons, including Lisān al-a'rab, and Mufradat alfādh al-Qur'an, among others, that there is a significant, albeit subtle, difference between al-bay' and at-tijārah. With reference to alternative verses in al-Qur'an, such as chapter 35 verses 29–30, and chapter 61 verses 10–13, it is suggested that at-tijārah is a trade contract entered into with an anticipation of profit, and certainty about such benefits is only guaranteed for covenants entered into with The Law Giver. It can be also argued that there is a sale (bay') transaction in each trade (tijārah) insofar that the object of trade is purchased with the prior intention of selling, and that all bay' transactions necessarily involve the exchange of property with property.
Apart from spot transactions where delivery and settlement take place simultaneously, there is an element of risk inherent to all exchange contracts with deferred delivery or deferred settlement, because they involve time. Indeed, because the conclusion of transactions depends on the exchange and commitment of cashflows over time, they necessarily take place in an environment of uncertainty. The element of risk arises when different outcomes are possible, or mutually exclusive states of nature can be defined. The nature of risk and amount of quantifiable risks may differ from one transaction to another. It is possible to consider, for instance, the risks in salam contracts with immediate payment but deferred delivery. There is a price risk or valuation risk that derives from the volatility of future price levels, and which is shared by both contractual parties. There are additional risks, such as substandard quality risk and nondelivery risk borne by the purchasers, and production risks and transportation costs risks borne by manufacturers. These risks are borne by both parties to contracts with deferred deliveries or deferred payments.
There are also counterparty risks in the sense that the ability of each party to meet its own production schedules and its own payment obligations may depend on the performance and default probability of third parties. In particular, the risks associated with the production process are inherent to the concept of specialization through comparative advantage, which is at the foundation of the classical thesis about the advantages of trade. It is important to note that the risks of specialization also arise with respect to spot exchange, and that pre-exchange risks of production are also shared by both parties to the exchange, either on spot or deferred delivery. The argument of risk sharing applies to all other forms of permissible contracts under the Islamic law of transactions (mu'amalat), including partnership-based contracts at the other end of the spectrum such as mudhārabah (principal-agent partnerships), and mushārakah (equity partnerships). Arguably, the permissibility of al-bay' exchange activities can be explained by the existence of risk elements inherent to exchange, and the necessity of dealing with uncertainty through a risk-sharing mechanism.
There is a general principle of freedom of contract (hurryat at-taā'qud), and the normal state of permissibility (ibāhah) prevails unless there is a clear injunction haram, such as the prohibition of ribā. In light of the discussion with al-bay' or exchange, it can be argued that the rationale for the prohibition of interest lies in the absence of opportunity for risk sharing. Indeed, interest-based transactions are founded on risk transfer rather than risk sharing mechanisms. The event of default can only be defined in terms of the inability to deliver “promised” payments made on an ex ante basis with respect to credit or fixed-income securities. Default cannot, however, be defined with respect to equity, where risk sharing applies and the extent of profits and losses can only be determined ex post. Thus, “promises” of fixed returns determined ex ante do not take the organic relation between the real economy and financial sector fully into consideration. Financial returns are thus dissociated from the return from the real economy, and the relation between risk and return is thus dissolved. The replacement of risk sharing with risk-transfer and risk-shifting mechanisms is distortive of the exchange relations on which economies can potentially thrive.
The notion that economic growth can only be achieved by sacrificing social and economic equity in mainstream economics promotes a laissez-faire variant of capitalism that does not promote social equity and instead reinforces a dehumanization of economic life. It can be argued that Islamic finance also supplies a coherent theory of rational individual behavior, competitive markets, and social equity. It is based on the same assumptions about economic activities in terms of savings and investment, and considers risk sharing the optimal mechanism for efficient risk allocation in a vibrant and dynamic economy. However, the principal challenge faced by scholars in Islamic economics and Islamic finance is to provide some convincing evidence that these objectives of socioeconomic justice and economic development are not mutually exclusive. The requirements of an ideal Islamic financial system that promotes the twin objectives of efficiency and equity include an optimal set of institutional building. Thus, to understand the relation between the objectives of efficiency and equity in Islamic finance and economics, the discussion proceeds hereafter in relation to three central precepts of institutional economics: (1) property rights protection, (2) enforcement of contracts, and (3) good governance.
The Institutional Structure
The