The Review of Religions interviewed Dr Farooq Mahmood and talked to him about the links between finance and morality, and how the Islamic faith can contribute to a better and more sustainable economic system in the long run.
Dr Farooq Mahmood is a Senior Lecturer, teaching Management Accounting, Financial Management and Financial Institutions at Kingston University and the London School of Economics and Political Science (LSE). He is a Chartered Management Accountant and Chartered Global Management Accountant. Dr. Mahmood is a Fellow of the Higher Education Academy, serving as the secretary of British Accounting and Finance Association (BAFA) SEAG.
Below is Part II of the conversation between Dr Farooq Mahmood (FM) and Ahmad Danyal Arif (ADA), Editor of the Economics Section for The Review of Religions.
ADA: According to Islam, a true believer would demand an economic system which is also in tune with his moral and religious requirements. My question is what are the tools the Islamic faith can use to moralize Capitalism?
FM: Firstly, it is the fundamental principle of justice in Islam that can reverse many of the man-made crises and the answer to all of your questions. In his lecture at the City of Glasgow Reception in March 2009, the Worldwide Head and Fifth Caliph of the Ahmadiyya Muslim Community, Hazrat Mirza Masroor Ahmad (aba) said: ‘Peace depends on justice, and economic progress depends on peace.’ 
Similarly, a comprehensive answer to your question lies in two lectures by Hazrat Mirza Bashiruddin Mahmud Ahmad (ra), the Second Successor of the Promised Messiah (as), namely The New World Order of Islam and The Economic System of Islam.
These historic lectures, in the light of the Holy Qur’an and the practice of the Holy Prophet Muhammad (sa) highlight with excellent clarity that the responsibility lies with governments, private enterprises and individuals to collectively strengthen the well-being of all. Under the economic system of Islam, all humans in society should be provided for. In achieving that, the incentive behind individual effort and enterprise must not be weakened. Another unique feature of the economic system proposed by Islam is that it encourages voluntary sacrifices and not forcible dispossession or confiscation of assets. The system is not confined to a particular country or nation but should be universal, hence benefitting the entire humankind. It nurtures an atmosphere of love and respect between the rich and the poor and also between the government and its subjects. Such a system, therefore, is a guarantor in establishing global peace because all wars that we see around us are fought for material gains, borne out of selfish motives.
ADA: After the 2008 recession, there has been an emulation around the field of ‘Islamic Finance’. But many people are not really satisfied with the way it has been operated so far. Critics say most Islamic banks, at present, are not significantly different from traditional banks. They use different ‘hiyals’ (legal tricks) to perpetuate classic banking practices with an Islamic label. What are your thoughts on this?
FM: Economic or Finance theories will keep developing as any theory would do. However, a perfect law is not in the need for change. Careful and consistent interpretations of Islamic law and its principles are required for the current day complex financial products. To achieve it uniformly, a central hub of spiritual and moral authority is a prerequisite.
Today’s Islamic finance project has not lived up to high expectations. The prevailing global economic and financial systems are fractured due to their inherent inequities. Islamic banks are only a subset, albeit a small one, of the global financial system that is fostering several innate deficiencies and discrepancies.
A complete overhaul of the current system, that is discriminatory, will only be justified if there is a better alternative. That better alternative has to be founded on principles of equity and justice. Such a system to be practically workable would need to be overseen centrally, to ensure conformity to its core principles, which are employed reliably across the board. Otherwise, the true principles of Islamic finance cannot be applied consistently and cannot, therefore, be referred to with the adjective, Islamic.
The only logical method to achieve this would be through dynamic leadership that is spiritually guided. Only through such means is a possibility to implement and protect the highest standards of absolute justice. Can there be another way suggested to advance an Islamic Finance project that can consistently solve the numerous problems that the financial world is currently entwined in and ‘Islamic’ Finance has inevitably inherited? They have tried enough with various man-made policies that at best have a short-term myopic effect and at worst a tendency to push the world into an abyss of an unprecedented global conflict.
After giving an opinion on the context, I come to the specifics of the current day ‘Islamic’ finance. In the contemporary world, financial products are quite intricate, calling out for a central authority that can interpret compliance of complicated financial transactions, uniformly across the board with an Islamic way. Currently, Islamic banks employ their own Shariah boards or do “fatwa-shopping” for verifying the conformity of a bank’s practices with Islamic law. Hence, there is a large scope for subjectivity and potential bias in search of what the client wants to hear. As the majority of Muslims does not accept one worldwide spiritual authority, there will remain an issue with consistency in applying Islamic practices.
There is a gap between Islamic finance ideals and what has been practically achieved in the past few decades. One may argue that in effect, Islamic banking products are indistinguishable from the conventional banking ones. This is despite the commonly used Islamic terminology by these institutions, but a deeper study suggests, in essence, there remain questions on the legitimacy of various complex financial arrangements, from a truly Islamic jurisprudence perspective.
Another issue is that, in the current world, Islamic banks run into liquidity shortage problems because of their limited funding sources. Depositors withdrawing money on demand remains a big liquidity risk. This niche industry also needs a large number of qualified financial professionals who are well versed with Islamic traditions too.
The Islamic terminology with features of Islamic financing is a useful starting point to appreciate the desired goals for Islamic finance e.g. Qard-e-Hasana (interest-free loan), Musharakah and Mudarabah (joint ventures). Under Musharakah all shareholders share the return on their financial capital whereas under Mudarabah some may even be rewarded for the intellectual capital they bring to the enterprise. Hence, in an Islamic joint venture relationship an Islamic bank would be one of the shareholders, hence a risk-taker in the arrangement. As Islam clearly prohibits interest and gambling, financial products should be carefully and scrupulously studied in this regard. However, there is widespread subjectivity and inconsistency in practice.
The main source of cash for an Islamic bank would predominantly be the deposits, and if the depositors are risk-averse then there are some other issues too. Fixed income is a term mostly used for interest. Finance theory suggests that risk-averse investors prefer fixed income to dividends. Therefore, an Islamic bank may be more inclined to lending as opposed to equity sharing with the client firm, in essence, deviating from the Islamic finance ideals. A unique selling point for Islamic finance should be the risk-sharing arrangement, whereas the preference for Islamic banks has been contrary to that.
Under Islamic finance, the bank buys a real estate asset and resells it to the customer at a higher price. Here the return for the bank is the difference between the purchase price and the selling price, as opposed to the interest income in the case of conventional banks. The Islamic bank owns the asset and leases it out to the occupier until all instalments are repaid. One may argue that it is a convenient way around interest but the bank bears the risk of the underlying asset. Hence there are both sides of the argument.
Every bank, or every investor for that matter, aspires for a mode of finance that maximises their return with minimal risk. According to theory private equity or joint venture products face higher ‘adverse selection’ and ‘moral hazard’ problems than debt. Islamic finance is more akin to a joint venture type agreement between the bank and its client. However, as noted above the debt contracts are a preferred route for Islamic banks. It is because on average, lending bears a lower risk than equity investment. When a bank has to share in a firm’s losses, particularly in the times of distress, the real risk of its client’s insolvency is hugely uncertain.
A requirement to remain just and honest applies to both parties, the lender and the borrower. Truly Islamic finance would also expect the borrower to be transparent and truthful. Imagine how many Islamic banks would have gone into bankruptcy during the pandemic if the major part of their balance sheet were through Musharakah (a joint venture) type agreement. Through a joint venture arrangement, while screening various applications for a limited capital resource, a bank faces a starker danger due to ‘adverse selection’ risk. A further risk associated with information asymmetry develops when the client turns less honest or diligent through the passage of time. The lender, as a result, will get lower returns on investment or worse still share in unreasonably high levels of losses. Similarly, there are risks of financial reporting manipulation (referred to as earnings management in literature), where the business may be motivated to under-report its profits, in order for it to share a lower amount with the lending institution. These potential problems need a central authority that monitors behaviour or incidence of foul play on either end.
The system of fractional reserve banking (FRB) in conventional financial systems makes Islamic banking less competitive for its client firms and investors. Under FRB, banks can extend loans to borrowers while holding only a small fraction of the bank’s deposits. FRB is akin to creating purchasing power out of thin air and is therefore contrary to Islamic principles. Hence, presently, this domain lacks a level playing field for Islamic finance. The current prevailing system of conventional banking is entirely based on the FRB system. Islamic financing has been going through an evolution through fragmentary transition over the past number of decades. One hopes that there will be several improvements along the way. After all, the supply of a product or service depends on its price or the level of demand by its customers. At present, Islamic finance may appear uncompetitive for its investors.
Unless morals take precedence over economic gains, it is likely that people would choose between Islamic finance and conventional finance on the basis of comparative financial returns. The Islamic banks with their current limited resource of cash are not a supportable course compared to the more established banks that can afford to take the risk for higher rewards, as mandated by their wealthy investors. Add to that, due to the FRB facility, conventional banks are likely to be more profitable on average, therefore can return better to their shareholders.
In short, Islamic finance is a work in progress that is faced with some difficult challenges at this less developed stage.
This needs an enormous shift in human thought and practice, which demands a moral revolution. That has only happened through prophethood in the past. In these times of multifarious challenges, the world is clamouring for the leadership that can ensure consistency in approach on a global scale. Only if they recognised that there indeed is such leadership that is guiding with clarity and consistency already!
ADA: Until quite recently, the economic models were essentially based on economic variables. There was clearly a need for adopting a more comprehensive and dynamic model if these issues (economic, social, moral), all linked together, are to be resolved. Don’t you think it is first essential to define a reform strategy that is not just about reforming the financial system, but also about reforming the human being as well as the socio-economic institutions that affect their behaviour and well-being?
FM: In predicting true human success, no model can ever be complete without including God. The all-important reformation of human behaviour is not the job of these financial systems; in fact, it is quite the opposite. The Promised Messiah (as) said that love for money and God cannot coexist in one’s heart. The purpose of economic models is limited to economic well-being and not to the most logical human pursuit i.e. contentment. It is more beneficial to be content than to be materially rich. No economic model can capture the intangible value of the invaluable. Therefore, it is important to start teaching children in schools from a very early age to value those intangible pleasures of contentment that come with generosity, philanthropy, selflessness and sacrifice. Unfortunately, the moral standards are declining as too much value is attributed to material items from a very young age.
How could the health of the loved ones be valued? Can it even be valued? If someone was to ask how much could we sell both eyes for, was there a number that could come to our mind? Let us say if one could come up with a number, what about the following question then: what would we do with that cash without the eyes? There are several variables, which are absent from the economic models but lead to well-being.
The Worldwide Head and the Fifth Caliph of the Ahmadiyya Muslim Community, Hazrat Mirza Masroor Ahmad (aba), has been saying for a long time, that we should be more concerned with fulfilling our responsibilities and not remaining constantly fixated on our rights. True happiness cannot be purchased by tangible wealth. Yes, we need means to achieve pleasure, and a necessary amount of wealth is one of the several means, but not the end in itself.
Surely, life has more to it than what the quantifiable economic variables can explain on their own. However, not all is futile. Economics has developed in methodology over the last century. The discipline has come a long way from classical and neoclassical economics to increased recognition of behavioural and development economics as mainstream. There have been steps in the right direction but a lot of work is still needed. It is widely recognised now that in making economic decisions, not every human is homo economicus, the economically rational man of classical economics. There exists a range of biases because of the way people think and feel. People’s perceptions of value and preferences are now covered extensively in economics.
A big challenge now is to come up with theoretically sound proxies for the latent explanatory variables such as morality, happiness, religiosity, etc. The extensive usage of further variables may only be a matter of time but how such theoretical developments will serve the cause for equity and justice is a far more vital and pressing question.
 Peace Depends on Justice and Economic Progress Depends on Peace: Address delivered by Hazrat Mirza Masroor Ahmad (aba) to the City of Glasgow Reception, 7th March 2009