Streamline Training & Documentation: Islamic Banking

Tuesday, November 04, 2008

Islamic Banking

At the end of last month, the Faiza Saleh Ambah, a reporter based in Saudi Arabia, published an informative article on Islamic banking in the Washington Post.

The article's hook is the idea that Islamic banking institutions have fared better in the the current distressed financial environment than non-Islamic banks, the obvious question being why. A large part of the answer would seem to be that Islamic banks, in addition to being forbidden under sharia law from charging interest on loans — the restriction people are most familiar with — are also forbidden from using derivatives and from assuming excessive risk ("gharar"). As Ambah explains:

The theological underpinning of Islamic banking is scripture that declares that collection of interest is a form of usury, which is banned in Islam. In the modern world, that translates into an attitude toward money that is different from that found in the West: Money cannot just sit and generate more money. To grow, it must be invested in productive enterprises.

The enterprises would include such activities as buying real estate, providing services, and selling goods. A bank's depositors become, in a sense, partners with the bank because the return they receive is viewed as a share of the profits from the enterprises in which the bank invests deposited funds.

Ambah describes the example of home purchase. In lieu of providing a mortgage loan, an Islamic bank can help a customer finance the purchase by buying the home itself and then leasing it to the customer. Over time, the customer makes enough payments on the lease to cover the cost of the home and a reasonable profit for the bank. At the conclusion of a set period, the title to the home is transferred to the customer.

You can read an overview of the characteristics of Islamic finance in a brief 1995 article published in Nida'ul Islam magazine.¹ The article cites five requirements:

Any predetermined payment ("riba") over and above the principal amount of a loan is prohibited.

The lender must share in the profits or losses arising from the enterprise for which money is lent. "This is unlike the interest-based commercial banking system, where all the pressure is on the borrower: he must pay back his loan, with the agreed interest, regardless of the success or failure of his venture."

Making money from money is not acceptable; there must be actual investment in an enterprise generating whatever return is achieved.

"Gharar" — uncertainty due to ambiguity or deception, or excessive risk (e.g., due to speculation) — is prohibited.

Investments cannot support forbidden practices or products, such as alcohol or gambling

Back in February, the Harvard Business Review included Islamic finance among its twenty Breakthrough Ideas for 2008. In a brief write-up, Aamir A. Rehman, a consultant on global corporate strategy, and S. Nazim Ali, director of the Islamic Finance Project at Harvard Law School, provide an overview of the growth of sharia-compliant finance institutions and products.

Rehman and Ali suggest that some of the policies of Islamic financial institutions may be especially worth considering for adoption by non-Islamic institutions. In particular:

The sharia requirement that all parties to a contract must disclose both risks and rewards could have prevented companies from engaging in the kind of financial engineering that led to the subprime lending crisis. Similarly, the currency speculation that has historically destabilized some emerging markets would be prevented by sharia rules that effectively outlaw the practice of short selling. Opaque financial contracts laden with penalties and complex clauses would be more difficult to use because sharia requires that the risks of any product or service be clear to both buyer and seller.

Just yesterday, NPR broadcast a report of the grief a thick and confusing prospectus for collateralized debt obligations has caused five school districts in Wisconsin, which now find themselves faced with devastating losses in their retirement funds.

To get an idea of how contemporary Islamic financial institutions present themselves and their services, you can have a look at the websites of some representative firms, such as Dubai Islamic Bank or Unicorn Investment Bank (based in Bahrain).

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¹ You can read more extensive treatments of Islamic finance here and here (pdf).

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Labels: Business acumen

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