Islamic Finance: Its Resilience, Stability & Sensible Principles

Why Islamic Finance?

Imagine — a model of finance that rejects interest payments has been firmly registering double-digit growth, even in the face of recent worldwide economic crises.

Islamic finance, though small in comparison to its conventional counterpart, is at the threshold of serious expansion. It is growing at a rate of 15 to 20 per cent a year, and according to The Economist, Islamic assets under management should rise to USD1 trillion in 2010, from USD700 billion in 2008. It is hard to imagine anyone not having noticed the recent rise of Islamic finance.

To truly understand the current interest in the development of Islamic banking and finance and how it is different from the conventional banking system, one must first understand the religious relationship originating from the Koran, and then trace the historical, geographic and political development of Islam over recent centuries. Only on this basis can one, without prejudice or cynicism, begin to appreciate Shariah law and Islamic jurisprudence. With this basic understanding, one can then go on to learn about the financial products and services offered, understand the challenges in their development, and ultimately recognise the significant opportunities that Islamic banking and finance can provide both Muslims and non-Muslims.

There is another reason to consider learning about Islamic finance, besides its increasing importance in the world economy. In the Oscar-winning documentary An Inconvenient Truth, Al Gore calls the fight against global warming a “moral imperative’. Similarly, we believe that there is a moral imperative about Islamic finance. It is not about finding billion-dollar petroleum projects or becoming the next Islamic finance multi-millionaire. Rather, it is about observing ethical yet commercially viable principles of doing business. We believe that these principles can be used by everyone including non-Muslims, and in so doing, poverty and wealth gaps around the world can be reduced.

Islamic History

Islam is one of the world’s three major monotheistic religions, the other two being Judaism and Christianity. All three share the same historical origins and hold many beliefs in common, a mutual reverence for the Old Testament prophets being among them. As in Judaism, Islam forbids the consumption of pork as well as other meat that has not been ritually killed (halah). Muslims recognise Jesus (Isa) as a prophet but reject the belief that he was the Son of God. Nor do they recognise the concept of the Holy Spirit, but insist instead on the unity of God (Allah), disavowing the Christian concept of the Trinity. They also reject the concept of original sin and the notion that there can be an intercessor between a person and God, since in Islam, each person is responsible for his or her own salvation which can be achieved through faith and good deeds, and by striving to keep God’s law which is laid down in the Koran.

What is Islamic Finance?

Islamic finance is a form of finance that is based on the body of Islamic law called Shariah. Shariah, which means ‘the path to the water source’ represents the idea that all human beings and governments are subject to justice under the law. It is a term that summarises a way of life prescribed by Allah (swt)i for his servants, and it extends to everything from business contracts and marriage to punishment and worshipping.

It is common to use the term ‘Shariah-compliant’ to describe anything that is permissible under Islamic law. In Arabic, the word halal refers to anything that is Shariah-compliant— that is, permissible under Islam. This includes aspects of human behaviour, speech, clothing and diet. It is the opposite of haram, which is anything that is forbidden.

How is Islamic Finance Different from Conventional Finance?

Unlike conventional finance, which is familiar to most of us, Islamic finance has one over-arching requirement: every financial transaction must be Shariah-compliant. In ensuring Shariah compliance, five key principles are strictly followed:

1. Belief in Divine Guidance

Muslims believe that the universe was created by Allah (swt) and that He created man on earth to fulfil certain objectives through obeying His commands. These commands are not restricted to worship and religious rituals but cover a substantial area of almost every aspect of life, including economic and financial transactions. Man needs such divine guidance because he does not have the power to reach the truth on his own. Not only is man imperfect, but also his ‘reasons’ are often confused with ‘desires.’ It is the firm belief of every Muslim that the commands given by Allah (swt) through His divine revelations to the last Messenger Muhammad (pbuh)ii are to be followed in letter and spirit.

In comparison, in a conventional financial system, religion and government are kept separate and independent of each other. This is to uphold religious freedom and secularity in government (such that it is not overly influenced by any particular religion).

2. No Interest

You cannot earn interest on a loan, or be required to pay interest on a loan.

Compared with conventional financing, this is like borrowing money from the bank and not having to pay a cent of interest. Islamic banks of course do not loan you money for free. If you were to obtain an Islamic loan for a project, instead of being charged interest for the loan, you could be paying fees or sharing a portion of your profits from the project with the bank.

3. No Haram Investments

Money is to be invested in worthy causes, while companies that manufacture haram products like alcohol, tobacco, arms or pornography are avoided.

This is similar in some ways to the conventional concept of socially responsible investing (SRI), which seeks to maximise both financial return and social good. In general, SRI favours corporate practices that promote environmental stewardship, consumer protection, human rights, and diversity. Some practitioners of SRI abstain from businesses similar to those that Islamic ventures would avoid.

4. Risk Sharing is Encouraged

The idea of risk sharing is conscientiously promoted and regularly practised between business partners, such as between a customer and a financial institution.

For an Islamic institution, risk sharing is favoured in business dealings with its customers. This fosters the equitable distribution of risk, profits and losses. It also means that the due diligence an Islamic bank performs covers not only the creditworthiness of the customer but also the financial viability of the project. All in all, risk sharing is meant to enhance transparency and very importantly, to promote mutual trust and fairness in dealings among business partners, institutions and consumers.

5. Financing Must be Based on Real Assets

Financing extended through Islamic products can only expand in step with the rise of the real economy, thereby helping to curb excessive speculation and credit expansion.

In contrast, conventional financing is typically based on the promise to pay where real assets are not tied to the transaction. This means that conventional financing activity can grow several steps ahead of the real economy, thereby causing speculation and unjustifiable asset price inflation.

Islamic finance offers similar services to what conventional finance does. This includes taking deposits, giving loans, providing trade finance, investing in financial assets and distributing insurance. The difference is that Islamic financial transactions must be Shariah-compliant.

By embracing these essential features and the objectives of Shariah in its entirety and by exemplifying the true practice of Islamic finance as required by the principles of Shariah, the resilience of the Islamic financial system is strengthened. It is therefore paramount that Islamic financial professionals, practitioners, scholars and regulators fully understand the inherent requirements of Islamic finance, which are in fact consistent with the international best practices and standards in the conventional financial services industry. It is the very elements of Islamic finance that provides an additional in-built mechanism that enhances its prospects for soundness and stability.

Is Islamic Finance Less Risky Than Conventional Finance?

If both systems are equally competitive in terms of returns and performance, but Islamic finance is deemed less risky, it would make sense for many conventional finance users to switch. Given the severe negative effects of past financial crises in the conventional system, adopting Islamic finance to some extent makes economic sense. But is Islamic finance really less risky than conventional finance?

Yes, It Is

The US subprime mortgage crisis caused several large international banks to collapse and brought many others to the brink of it. Yet to our knowledge, no Islamic banks have failed as a result of the mortgage crisis.

One explanation is that Islamic finance requires the use of real assets and prohibits highly speculative financial derivatives. Such derivatives were a major cause of the mortgage crisis. The focus on asset-based financing puts natural limits on the level of debt, preventing excessive leverage.

A second explanation is that Islamic finance encourages the sharing of risk, such as between banks and consumers. When investments in a mudharabah (profit-sharing) deposit account, for example, do poorly, the depositors (capital provider) absorb the full loss. But at the same time, Islamic banks are fully aware that if depositors do not receive ample returns on their investments, they would take their business elsewhere. This encourages Islamic banks to be conservative in order to minimise losses yet ensure that a reasonable and competitive return is generated.

Heavy risk-taking is curtailed as a result of these principles of asset-based financing and profit-sharing.

No, It Is Not

Can we conclude that Islamic banks are less risky per se? While that might be a tempting conclusion, they can be prone to serious risks as well. For example:

• Islamic banks are more exposed to the property and infrastructure sectors. Given the ‘large and lumpy’ nature of such assets and the tendency for asset bubbles and crowd sentiment to build up quickly, it is a risk that could mimic even the subprime crisis (although probably not as strongly because the expansion of debt is restricted to asset-based financing).
• There are risks unique to Islamic finance such as Shariah-compliance risk. If products are later found to be not Shariah-compliant, the institutions face both reputation damage and the costly unwinding of such structures, with likely losses for investors.
• By providing financing based on risk sharing (rather than just lending money), Islamic institutions open themselves to risks that conventional banks do not normally have. Risk sharing means that a bank’s equity is directly affected.

The last point is backed up by an International Monetary Fund (IMF) study on the risk profile of Islamic banks and conventional commercial banksiii. The study found that over the 11-year period from 1993 to 2004:

• small Islamic banks were financially stronger than small and large commercial banks (large banks are those with total assets of more than USD1 billion);
• large commercial banks were financially stronger than large Islamic banks; and
• small Islamic banks were financially stronger than large Islamic banks.

An important observation of the study was that smaller Islamic banks provided more debt-based financing than equity-based financing, and for larger Islamic banks, it was the opposite—they provided more equity-based financing.

A reasonable explanation is that larger Islamic banks take on more risk-sharing projects that bring about extra due diligence and surveillance costs because of the uniqueness of each project.

Also, Islamic finance is closely linked to the real sector. Unexpected adverse developments in the real sector can adversely affect the business activities and performance of Islamic banks in the absence of robust and effective risk management practices. On the other hand, smaller Islamic banks that focus on debt-based financing provide loans which tend to be more or less standard in structure.

How Islamic Banks Already Mitigate Risk

Some market commentators have declared that Islamic finance has not only withstood the financial crisis, it has grown stronger. There are others who have proclaimed that any Islamic financial institution collapsing is simply unthinkable.

We feel it may still be premature to make these proclamations. Modern Islamic finance is just a youthful 50 years of age, and will have to survive and thrive through many future challenges to earn its stripes. Furthermore, while the vehicle (Islamic finance) is like an impregnable armoured tank, it still relies heavily on the man behind the wheels (the financial sector and its participants). Likewise for the conventional system, which is governed by many rigorous and ethical principles, but has been let down by ‘the man behind the wheels.’

To give a few examples how risk is mitigated in Islamic finance:

• In a murabahah (cost-plus sale) debt-financing contract, the bank can use an agency contract to assign certain responsibilities to the customer during the initial procurement of an asset. The bank can also purchase insurance to limit the risks of asset ownership and use special purpose vehicles (SPVs) to hold assets.
• In an Al-Ijarah-Thummal Al-Bai (AITAB) lease-financing contract, ownership of an asset is transferred to the customer at the end of the lease, either as a gift or through a sale. This mitigates the risks of ownership for the bank.
• In a diminishing musharakah (joint venture) contract, risk is mitigated as ownership of the asset is gradually transferred to the customer.
• Banks commonly take collateral from customers in order to have recourse on customers if they default.

The vehicle itself, which is Islamic finance, has provided its users with a set of rules and principles that, if followed strictly, would result in a system that is just, fair and equitable to all parties, Muslims and non-Muslims alike.

Some Practical Advice

Dr. Zeti Akhtar Aziz, the Governor of Bank Negara Malaysia, provides some very practical adviceiv on improving the resilience of the Islamic finance system in withstanding the impact of any future crisis. Two examples follow.

Promoting Shariah-based innovation

The mortgage crisis has shown that unbridled innovation can become highly destabilising, resulting in major disruptions in the financial system. The innovation that Islamic finance achieves must have clear Shariah objectives and adhere to the requisite principles of Shariah. In Malaysia for example, the International Shariah Research Academy for Islamic Finance (ISRA) was set up for this purpose -- to engage in applied research on innovation that is Shariah-centric.

Developing standardised Shariah parameters

Bank Negara Malaysia (BNM) has been developing a series of Shariah parameters that provide standard guidance on constructing various Islamic finance contracts. In fact, BNM in December 2009 published its latest draft concept paper – a Shariah Parameter Reference 3 (SPRC 3) – on the mudarabah contract. This follows the publishing in October 2009 of ‘Concept Paper – Guidelines on Takaful Operational Framework’ which outlines the parameters governing the operational processes of the Takaful business.

Islamic Finance: Why It Makes Sense

Islamic finance principles are not only ethical, they are also sensible. Transparency, risk-sharing, interest-free financing, asset-based transactions, and the avoidance of undesirable activities – these are hallmark features.

Non-Muslims find them appealing as well. The OCBC Al-Amin Bank in Malaysia, for instance, has non-Muslims making up half of the bank’s Islamic banking customers.

To quote the Vatican’s official newspaper Osservatore Romano, the “ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service.”

NOTES

i Allah is the Creator of the Universe, known as ‘God the Father’ to Christians and ‘Yahweh’ to Jews. The set of initials ‘swt’ stands for subhanahu wa ta’ala, and means ‘Glorified and Exalted is He’. It is considered more pleasing to Allah to praise Him as such, whenever one mentions Him.

ii Muslims praise the name of the Prophet Muhammad as the last messenger of Allah (swt). To show their devotion to the Prophet, Muslims put the set of initials ‘pbuh’ after his name; ‘pbuh’ stands for ‘peace be upon him’.

iii ‘Study Shows Larger Islamic Banks Need Prudential Eye,’ IMF Survey Magazine, June 2008. Note that the study focused only on full-fledged Islamic banks and did not cover Islamic windows (Islamic branches operated by some commercial banks).

iv Zeti, Dr. Akhtar Aziz, Governor, Bank Negara, Malaysia at IFSB and IIFC Conference, KL, November 2008.