Economic Substance or Legal Form: An Evaluation of Islamic Finance Practice

Abstract

Modern Islamic financing was started in the last quarter of 20th century and got momentum in the first decade of 21st century. Global volume of assets under Islamic financial system, have reached to US$ 2,000/- billion by the end of December 2014 (MIFC-2015). Islamic financing is based on ideology of Islam, proposing a different economic system than capitalism. Essence of Islamic financing is either trading of goods, provision of services and/or investment under profit and loss sharing. This study is conducted to examine legal form as well as economic substance of the contracts used by Islamic financial industry. In order to conclude on the objectives of the study, five most widely used contracts (modes/products) including Murabaha, Ijarah, Diminishing Musharaka, Sukuk and Mudaraba (deposits), were selected to test against the theory of Islamic financial system. It is found in the process that legally (legal form) contracts/products are in line with theory; however economic substance is not very different from conventional counter parts. Through application of alternative calculation measures/methods and proper training of human resources, Islamic financial Institutions can shift economic substance of contracts in line with theory of Islamic finance. Islamic finance is an emerging area and reasonably good amount of literature is available, however perhaps this is the only piece of work focusing on calculation methods, contributing in economic substance of contracts, being used in modern Islamic finance in addition to legal form as per essence of Islamic financial system.

Keywords: economic substance, legal form, Islamic finance, Pakistan, Evaluation

JEL Classification: G15, G20, G21