One of the highlights for the US Islamic home finance industry began in February 2007. The Federal Home Mortgage Loan Corporation (Freddie Mac) sent out a press release announcing that it would no longer buy the riskiest subprime mortgages and mortgage-backed securities. Two months after the announcement, a leading subprime mortgage lender filed for Chapter 11 bankruptcy protection. Three months after that bankruptcy filing, financial institutions nationwide warned of “difficult conditions” ahead. Manifestations of such difficult conditions appeared on the financial market horizon when once well-established mortgage companies suddenly began filing for Chapter 11. Similar circumstances came to the UK when the Bank of England approved an authorization to provide liquidity support to Northern Rock, the country’s fifth-largest mortgage lender. Five months later, the UK Treasury became the owner of Northern Rock.
Until that time, the severity of these “difficult conditions” was not fully understood by the majority of the population. In late 2008, the Federal Reserve Bank of New York was authorized to lend $85 billion to AIG. This was the beginning of the most severe recession in the United States since the Great Depression. What followed was a chain reaction that led to an unprecedented global financial crisis, as the world suffered from rising unemployment, rampant foreclosures, and severe skepticism of financial instruments.
This led to a renewed focus on an unknown market segment that seemed comparatively more stable and, importantly, much more ethical: the Islamic financial sector. From the financial centers of Malaysia to the Middle East to more than seventy countries, Islamic finance in the US rose from $5 billion in the 1980s to $1 trillion in 2010. This phenomenal growth caught the attention of global investors seeking to safeguard their investments through more ethical and trustworthy financial instruments. When workers in the financial sector realized that these Shariah-compliant instruments avoided many of the worst effects of the global financial crisis, they became an attractive investment vehicle to support a more diverse portfolio. The Shariah compliant financial sector has avoided investing in predatory lending businesses and excessively leveraged financial instruments due to the strict ethical nature of the Shariah governance system. The media and news began covering this ancient but unknown industry in the hope of learning from the mistakes of the mainstream banking sector.
The concept of the modern Islamic financial services industry has its roots in the principles of Islamic legal jurisprudence dealing with financial transactions, a branch of Islamic jurisprudence called Fiqh Al Muamalat. Fiqh Al Muamalat is a framework under Islamic Law that outlines the conduct of Muslims in commercial or economic endeavors. Islamic financial products and regulations are based on specific injunctions in the Qur’an that prohibit certain features of financial transaction patterns and related economic activities.
The Qur’an forbids interest, also called usury or riba. The underlying reasoning is that Islam views lending as an act of charity to help another member of society in their time of need; therefore, it is strictly forbidden to take advantage of someone’s difficulties. In the conventional banking system, when interest is charged on a loan, the risk of that transaction is transferred to the borrower, while the lender profits from the transaction based on interest. There is no consideration for the hardship endured by the borrower in case he suffers any loss from the transaction.
By its nature, Shariah law prohibits unethical financial practices. It also promotes the distribution of wealth among all people to reduce poverty and inequality. This is manifested in the prohibition of activities such as excessive speculation, gambling and investment in products harmful to society according to Islamic law (alcohol, pornography, etc.). The structure of Islamic financial products and services, especially its ban on speculative transactions, has helped the industry escape most of the adverse effects of the global financial crisis. The governance model of Islamic financial institutions has been praised as an ethical alternative by institutions such as the International Monetary Fund and the World Bank. Economic experts have suggested that Islamic financial principles can be harnessed to promote financial inclusion that improves the quality of life in developing countries. Islamic financial principles can also contribute to financial stability and economic development around the world.