Capitalism is associated with profit maximization, private property rights, competition, and reliance on markets. In principle, none of these are prohibited or discouraged in Islam, which is, indeed, a religion distinguished by its “pro-commerce” attitude. The economic order during the life and times of the Prophet Mohammad bore great resemblance to a market economy. But capitalism exists in many varieties. Even where markets are supposed to reign supreme, in some sectors, their scope and operation are limited by design or competition may be weak. One can argue that because of the significant share of spending by federal and state governments in the GDP of United States, it is a mixed economy as opposed to a market economy. In China, the state plays an active role in commercial enterprises, converting it into an economy often described as “state capitalism.”
As Kahf (2004) argues, the objectives of Islamic economic thought—be they the satisfaction of basic human needs or improvement in the quality of economic life—are not exclusive to Islam. They resonate with the philosophical thought of socialism, communism, capitalism, and other “isms.” What is different about Islamic economic thought, however, is the reliance on divine revelation as a source of knowledge and on its moral articulation. Islamic finance tends to assume that Islamic prohibitions and ethics can lay the basis for the moral economy of Islam, a different economic order from what is produced by capitalism or socialism.
Socioeconomic justice occupies a prominent place in the literature on Islamic economics and finance. It pertains to both distribution of economic wealth as well as opportunities. An important concern in this regard is the high degree of wealth concentration and limited access to financing opportunities. The modern banking system and capital markets tend to rely on lending that favors the resourceful, contributing to the concentration of wealth and opportunity, with the associated inequality and social ills. Islamic finance, by contrast, insists on risk-sharing in asset ownership and enterprises that are likely to distribute economic opportunity more widely and keep finance in the service of the real economy. Market-based risk-sharing modes of financing are important means of promoting economic justice in a financial system consistent with Islam. This is not to say that the preferred modes of Islamic financing, based on profit and risk-sharing principles, cannot entail injustice. For instance, one party to a transaction may reserve for itself a profit share far beyond what is deemed reasonable. Also, profit-sharing ventures even in permissible businesses can cause grievous harm to society and the environment—for example, through water pollution. At the same time, interest-based financial transactions (e.g. conventional microcredit) can also advance economic opportunity. But the literature on Islamic finance is likely to see interest-based lending of money and trading of risk as inherently problematic—if not at the micro-level in the short term, then for the overall economy in the long term.
Debt vs. Equity
Islamic economic thought prefers profit-sharing modes of financing in which the financier assumes some business risk. Although interest-bearing monetary loans are prohibited, debt resulting from credit sales and leases are deemed permissible. One reason is that, unlike the moneylender, both a seller and a lessor (in an operating lease) assume the risk associated with ownership of an asset. The literature on Islamic economics repeatedly emphasizes the need for risk-reward sharing to ensure economic justice and financial stability.
Chapra (2009) clarifies this concept by noting that greater reliance on equity does not necessarily mean that debt financing is ruled out. This is because all the financial needs of individuals, firms, or governments cannot be made amenable to equity and [profit and loss sharing].
Debt is, therefore, indispensable, but should not be promoted for nonessential and wasteful consumption and unproductive speculation. For this purpose, the Islamic financial system does not allow the creation of debt through direct lending and borrowing. It rather requires the creation of debt through the sale or lease of real assets by means of its sales- and lease-based modes of financing. (p. 21)
Equity financing is different from traditional profit-sharing arrangements developed in Islamic commercial jurisprudence, such as partnerships (musharaka) and investment management (mudaraba). Wilson (2012) highlights some of these differences. For example, Islamic partnerships are limited-time ventures, whereas a “company” is assumed to be a going concern.
Traditional Islamic partnership lacks the limited liability that is a key feature of a modern company. Compared with partnerships where partners focus on profit, shareholders in companies focus more on capital gains.
Having said that,
Profit sharing remains far removed from lending money at interest whether or not it is implemented through limited liability companies. Inequity financing, no fixed positive return is contractually stipulated ex-ante. Instead, the return depends on business performance, which is determined ex-post.
Despite its emphasis on profit-sharing arrangements, the Islamic finance industry is mainly based on debt. This disjunction between the ideals and reality of Islamic finance is addressed in the form versus substance debate later.
The concept of limited liability is not explicitly mentioned in the primary sources of Islamic jurisprudence. Because Islamic commercial jurisprudence relied on partnerships without limited liability, the idea of limited liability associated with corporations was imported into Muslim societies. Kuran (2010) argues, “Although certain institutions of early Islam prevented the emergence of the corporation from within Islamic civilization, once borrowed from abroad along with supporting institutions, it got absorbed into local legal systems and now faces no further resistance”. Nevertheless, the introduction of the concept of limited liability generated heated debates among Muslim jurists.
The debate partly concerned whether limiting the liability is fair to the creditor. Doubts continue to linger in academic circles about the permissibility of limited liability in Islam. However, in 1992, the Jeddah-based International Islamic Fiqh Academy ruled that “there is no objection in Shari’a to setting up a company whose liability is limited to its capital because that is known to the company clientele and such awareness on their part precludes deception.” (Islamic Development Bank 2000, p. 130). Limited liability is widely used in Islamic finance. For example, institutions offering Islamic financial services tend to be shareholder-owned companies with limited liability. Perhaps the doubts about limited liability pertain to how it facilitates the use of interest-bearing debt and speculative activity, which could result in the privatization of profits and socialization of losses, as witnessed during the global financial crisis of 2007–2008. Dwelling on “limited purpose banking,” a proposed alternative financial system, Kotlikoff (2010) has argued in favor of unlimited liability for such entities that cannot work like mutual funds (e.g., hedge funds).