110 AN INTRODUCTION TO ISLAMIC FINANCE
monitoring and transaction costs; (iii) the infl ow of vast amounts of gold
and other riches into Europe from the colonies in the Americas and else-
where, which reduced the incentive for the elite classes to continue fi nancing
trade on the basis of risk sharing, preferring fi xed-interest debt contracts;
(iv) the emergence of nation - states whose governments needed fi nance for
wars or other state activities, but could not raise resources except by means
of fi xed interest-rate contracts, according to which an annuity was paid in
perpetuity without the need for governments to repay the principal (Michie
2007); and, most importantly, the process of securitization in the fourteenth
century, an innovation that created a revolution in mobilizing fi nancial
resources (Michie 2007). It is likely, however, that the breakdown of trust
in Europe and elsewhere was a major factor for the loss of dominance of
risk - sharing fi nance by the end of the Middle Ages.
CONCLUSION
Islamic fi nance is all about risk sharing. It encourages risk sharing in its
many forms but generally discourages risk shifting or risk transfer, in par-
ticular interest - based debt fi nancing. It is, in part, so designed to promote
social solidarity by encouraging fi nance to play an integrating role. This
form of fi nance would be inclusive of all members of society and all enti-
ties, especially the poor, in enjoying the benefi ts of economic growth, and
to bring humankind closer together through the sharing of risk. Since risk
sharing is the foundation and a basic activity in Islamic fi nance, it is gov-
erned by rules that, if and when observed, lead to lower transaction costs
than in conventional fi nance.
These rules ordain trust; demand faithfulness to the terms and condi-
tions of contracts; command compliance and prohibit violations; encour-
age transparency and truthfulness in transactions; prohibit interference with
market forces, such as through the hoarding of commodities to force price
increases or through the formation of coalitions to infl uence prices and/
or quantities; and market supervision to ensure compliance. These, plus
others mentioned earlier, when observed, reduce the incidence of informa-
tional problems that plague the conventional interest - based fi nancial system
(Mirakhor 2007).
A further implication is that fi nance based on risk/return sharing means
that the rate of return to fi nance is determined ex post, by the rate of return
on real activity rather than the reverse, which is the case when interest - based
debt contracts fi nance production. This has a further economic implication
in that risk/return - sharing fi nance removes interest payments from the pre -
production phase of an enterprise and places it in the post - production, after -
sales, distributional phase. In turn, this has price–quantity consequences.
It should be clear that compliance with the behavioral rules prescribed
by Islam reduces risk and uncertainty, both of which are facts of human
existence. When risks to income materialize they play havoc with people’s