The Historical Development of Islamic Finance

The history of Islamic finance extends from the earliest days of the Muslim community in Arabia through the great commercial civilizations of the medieval Islamic world to the modern Islamic banking and finance industry that has grown into a multi-trillion-dollar sector over the past half century. Understanding this historical trajectory is essential for appreciating both the authenticity of contemporary Islamic finance as a continuation of a living tradition and the novelty of the specific institutional forms that modern Islamic finance has developed in response to the conditions of the global financial system.

The earliest documented forms of Islamic finance are found in the commercial practices of the Prophet Muhammad himself and his Companions. The Prophet (peace be upon him) was a merchant before his prophetic mission and managed commercial transactions on behalf of his first wife Khadijah — transactions that employed forms of partnership and profit-sharing that remain models for Islamic finance today. The mudarabah partnership — in which one party provides capital and the other provides labor and entrepreneurship, with profits shared according to a pre-agreed ratio and losses borne by the capital provider — is attested in the commercial practice of the Makkan merchants before Islam and was endorsed and refined by Islamic law.

The musharakah (full partnership), the murabahah (cost-plus sale), the ijara (leasing), and the salam (forward sale, where payment is made in advance for goods to be delivered later) are all commercial arrangements endorsed by the Quran, the Sunnah, and the scholarly consensus of the early Muslim community. These instruments formed the backbone of the commercial finance system of the medieval Islamic world — a system that facilitated the long-distance trade that connected the Islamic world from Andalusia to China and from Sub-Saharan Africa to Central Asia.

The medieval Islamic financial system demonstrated remarkable sophistication. The sakk — the medieval Islamic equivalent of the modern cheque — allowed merchants to transfer funds across great distances without carrying cash. The hawala system — a network of trusted agents who accepted and transferred funds on the basis of trust and reputation — provided an efficient cross-border remittance infrastructure. Letters of credit (commenda in European sources, clearly derived from Islamic mudarabah practices) facilitated complex multi-party commercial transactions across the Mediterranean world.

The decline of the Islamic commercial tradition and the gradual replacement of Islamic economic practices by European-dominated financial systems in the colonial era created the crisis that contemporary Islamic finance has sought to address. When Muslim-majority countries began to develop modern banking systems in the twentieth century, these systems were initially modeled entirely on European interest-bearing banking, creating a profound tension between the religious commitments of the Muslim population and the financial system through which their economies operated.

The modern Islamic banking movement began in earnest in the 1960s and 1970s, with pioneering institutions in Egypt, Malaysia, Saudi Arabia, and other Muslim-majority countries seeking to demonstrate that an interest-free banking system was practically viable. The establishment of the Islamic Development Bank in 1975, the founding of Faisal Islamic Bank in Egypt and Sudan, and the development of the first Islamic mutual funds in Malaysia established the institutional foundations of a global industry that has grown, by some estimates, to over three trillion dollars in assets under Islamic management. Kahf traces this development with attention to both the achievements and the ongoing challenges of the Islamic finance movement.