What is Islamic finance?

I was at the US-Qatar Business Council's Forum on Islamic Finance and I returned home yesterday.  Today, I was thinking about the division between what is described as Islamic finance and how it is actually practiced.  I don't know if it was something raised at the conference, or perhaps coming out of the jetlag from the flight back home, but here is a thought I had about why there is the division between theory and practice in Islamic finance.

The idea for Islamic finance began several decades ago and the industry really never was able to put the theory into practice (for example, the idea of an Islamic bank that uses mudaraba to collect deposits and then extends mudaraba financing to businesses).  The real growth did not start until the past decade when rising oil prices led to a flow of money into the GCC countries where Islamic finance is prevalent (not to exclude Malaysia, but I think the growth there was much more heavily driven by government support and a more lax interpretation of Shari'ah-compliance by permitting BBA and trading in debt).

One of the things that enabled Islamic finance to grow rapidly was (as I understand it) a consensus among the scholars that contracts like ijara, mudaraba and musharaka could be used in conjunction with other contracts to create more complex transactions that allowed people experienced in financial engineering to develop Islamic versions of conventional financial products.  This allowed Islamic banks to synthesize a conventional bank's balance sheet in a way that would be approved as Shari'ah-compliant.  This allowed for a crossover between bankers, lawyers and other financial professionals from conventional finance to Islamic finance and these individuals then began selling Islamic financial products as a niche within the financial services industry.

Much of the criticism (although by no means all) has come from people who want Islamic finance to be based primarily on profit-and-loss sharing (PLS).  They condemn the current form of Islamic finance for its similarity in economic outcome to conventional finance.  On the other side, Islamic financial professionals deflect this criticism by holding up the existing regulatory and tax environment for necessitating products that look and feel like conventional banking products.

However, I think that this dialogue, if it can be called a dialogue, is two groups of people speaking past one another.  The root of the PLS argument rejects the consensus that allows for individual contracts to be used as building blocks for the products in the market today and, among the different types of contracts available, gives preference for mudaraba and musharaka as the more "authentic" contracts.  As someone speaking at the conference (I do not remember who) pointed out, the contracts--partnership, lease, sale with a markup--are not uniquely Islamic but are present in most groups of people where commercial trade exists.

The people who believe the appeal for more PLS is idealistic respond that they just develop something that works on the basis of a consensus that allows for contracts to be combined together into a product that can pass regulatory muster and be tax-efficient (or at least not create excessive tax burden).

However, at the root of the division is whether financial engineering can be used in Islamic finance or whether the industry should refute the consensus and return to a more basic form of Islamic finance, preferably based on PLS in the eyes of its proponents.  But, that is not what is discussed, because it requires too much of the history of Islamic finance for a newspaper article or conference panel.

My personal view is to lean towards the pragmatic approach that, given a consensus that allows some financial engineering, to use it to develop financial products that work within the existing framework of legal, regulatory and tax systems.  I don't view the move to PLS-based products exclusively as possible or necessarily desirable because it cannot cater to certain financial needs that exist.  On the other hand, excessive financial engineering can be problematic because it creates products that are not needed simply because selling them makes money for the banks offering them.

However, the key point, at least for a starting point, is whether the idea that financial engineering (using basic contracts as building blocks) can lead to a beneficial outcome in Islamic finance.  Can products be developed using financial engineering that pass Shari'ah review and be useful to consumers of those products and develop a workable Islamic financial system.  I don't know, but I also don't know whether that question is being asked specifically enough to start a discussion.