From its humble beginnings five decades ago as a micro-lending institution in rural Egypt, Islamic banking has grown into a global industry, spreading from the Middle East to South-East Asia, Sub-Saharan Africa, Europe and the Americas. Its structure is founded upon rules set out in Islam’s religious texts; yet Islamic banks, while compliant with Shariah (Islamic law), are also, just like their conventional peers, profit-making entities, acting as intermediaries between savers and investors and offering custodial and traditional financial services.
Islamic banking industry assets grew at double-digit rates in the past decade, and 300-plus Islamic institutions, including investment/commercial banks and mutual insurance/investment companies, now flourish in over 75 countries. Islamic banks account for a quarter of financial assets in the Gulf. Major names include Al-Rajhi Bank (Saudi Arabia), Kuwait Finance House (KFH), Dubai Islamic Bank, Qatar Islamic Bank and Al Baraka Banking Group (Bahrain).
In addition, virtually all major Western banks have embraced Shariah-compliant financing, whether through subsidiaries (such as Citibank’s Citi Islamic Investment Bank and UBS’s Noriba Bank), special divisions (such as HSBC Amanah) or Islamic ‘windows’. These banks employ the services of religious scholars, who meet regularly to vet investment decisions and the acceptability of new products/services.
While estimates vary, the Shariah-compliant financial market may now be worth up to $1 trillion, compared to only $140 billion in 2000. Moody’s Investors Service, the ratings agency, reports: ‘Despite the recent gloomy economic environment globally, the industry’s total assets have scaled new heights. Islamic financial institutions are continuing to deliver Shariah-compliant returns whilst focusing on efficiently mitigating the associated risks through a new risk management approach.’ It predicts that this ‘niche’ market could eventually reach a value of US$5 trillion.
Shariah comprises a set of legal/ethical laws pertaining to all aspects of human behaviour, including economic affairs and personal morality. Laws governing commercial activities are elucidated through the discipline of Fiqh al-Muamalat (the jurisprudence of transactions); these dictate what types of contracts are halal (permissible) and what types are haram (invalid) in the financial arena.
Sources of authority
Fiqh (Islamic jurisprudence), like Islam itself, is founded upon three interrelated primary sources: the Koran, the word of God as revealed to the Prophet Mohammed (Peace be upon Him) by the angel Gabriel; the Sunnah, the customs prescribed by the Prophet Mohammed through his own actions; and the Hadith, narrations of the life and sayings of the Prophet and of those things approved by him, many of which inform the Sunnah but whose authenticity – unlike the Sunnah itself – may be subject to debate. The Koran, for example, does not discourage deposit-taking or negotiation of credit instruments; however, it does forbid the practice of interest-based financing, known as Riba (usury). (Note that while the charging of interest has historically been condemned in other religions, including Christianity and Judaism, nowadays outside the Muslim world ‘usury’ more commonly refers to an unlawfully high rate of interest.)
Where these primary sources remain silent on a specific question of law, secondary sources may be turned to. Ijma denotes a consensus opinion formed among Muslim jurists on a particular issue. Qiyas is a process of legal reasoning whereby a jurist, confronted with an unprecedented case, seeks an analogous situation in the Koran and Sunnah. Ijtihad, meanwhile, refers to independent judgements made by Shariah scholars through reasoning and logic in order to meet new challenges in new territories with diverse cultures.
According to the Koran, ‘The world can survive with justice and unbelief, but not with injustice and belief.’ As a result, the Islamic system emphasises ethical and equitable modes of financing. Wealth-creation is encouraged, but ‘super-normal’ profits – whether arising from unfair competitive advantages, Riba, exploitative contracts characterised by Gharar (excessive uncertainty or risk) or Maysir (gambling) – are not. Money has no intrinsic value, serving merely as medium of exchange; its proper use, then, is as ‘productive capital’ in the trade of tangible assets and funding of ethical businesses with the potential to yield legitimate profits and socio-economic value. In other words, money must be associated with reasonable risk and specific enterprise: Professor John Presley has said that ‘Islamic Banking is all about taking risks and sharing that risk with the client.’ Popular channels for Shariah-compliant funds are trade/commodity financing, real estate investments and leasing.
Modes of financing
The Islamic finance industry uses a variety of instruments that bear similarities to Western-style financing and venture capital projects. These include:
• Murabaha, a resale contract whereby the bank buys equipment or merchandise on the client’s behalf, with a view to eventually selling it to the client with a ‘mark-up’ agreed by both parties. This technique, mainly used in short-term trade financing, confers tax advantages and enables firms to trade without increasing their leverage. As in conventional banking, pricing depends on transaction size, types of goods being financed and the client’s credit history.
• Ijara, a lease agreement under which the bank grants the client use of an asset over a specific period in return for fixed cash installments, but without ever transferring ownership; and Ijara Wa-Iqtina, whereby the client makes fixed payments into an ‘Islamic Investment Account’ and agrees to purchase the asset at the end of the agreement period. The latter is commonly used in home mortgage schemes and to fund the purchase of cars.
• Sukuk, Islamic bonds structured to generate rents or profits in accordance with investors’ proportional ownership of tangible assets rather than from coupon interest rates. They fit well with projects that can generate the necessary cashflows to cover periodic payments. Like conventional paper, Sukuk carry maturity dates, at which point their issuers are contractually obliged to buy them back at par value; unlike Western bonds, however, they must be linked to identifiable assets. The worldwide value of Sukuk issued in 2010 was estimated to exceed $100 billion, according to Moody’s.
• Takaful, or Islamic insurance. Embracing the Islamic principles of mutual guarantee and shared responsibility, Takaful operates on the basis of periodic contributions of funds by policyholders into a collective pool administered by a Takaful company responsible for admitting participants, collecting installments (ie premiums), re-investing in Shariah-compliant assets and paying benefits to policyholders. The Takaful product-line includes general, life, health and pension insurance policies; Ernst & Young estimates that in 2010 these generated global premiums of around US$15 billion.
• Bai’ Salam, a contract that allows buyers to purchase, at the full negotiated price and subject to strict conditions, products deliverable at a future date. This instrument provides an exception to the general rule that a seller cannot sell something that he or she does not own, and only applies to products whose quality and quantity can be fully specified at the time the contract is signed. As such, Bai’ Salam is mainly associated with the agricultural and manufacturing sectors. The rate of return depends on the cash transaction rather than time dimension.
• Bai’ Mua’jjal, a sales agreement whereby the seller permits the buyer to pay a pre-determined price, by either lump sum or installment, for a product on a deferred basis. The deferred price may be higher or lower than the spot price, so long as it is fixed at the outset. The contract may not include any charges for deferred payment.
• Mudaraba, a contractual partnership agreement whereby the Rab al-Maal (investor) entrusts capital to the Mudarib (agent), who then lends his or her management expertise to an agreed undertaking. The investor bears 100-per-cent financial risk, while the agent enjoys autonomy over business decisions. Profits (or losses) are shared between the two parties according to pre-arranged ratios. Islamic portfolio business is founded upon ‘two-tier’ Mudaraba contracts, which allow banks to mobilise depositors’ savings for use by other clients seeking financing.
Islamic banks were well insulated from the recent global credit crisis, largely because certain risky financial instruments – notably, Collateralised Debt Obligations (CDOs), Asset-Backed Securities (ABS) and ‘swaptions’ (options on interest rate swaps) – are strictly forbidden under Islamic law, in light of the requirement that lending be prudently linked to real economic activity. Another reason for Islamic banks’ stability is that, in contrast to their secular peers, they tend to finance their activities from deposits rather than wholesale funding, and are thus less exposed to market vagaries.
Admittedly, substantial chucks of Islamic portfolios are tied to trade finance, real estate and infrastructural projects, not only in the Middle East and Asia but also beyond; in this respect, Islamic banks have been negatively impacted by downturns in property markets and global trade. On the whole, however, Islamic banks favour investment in utilities, telecoms, healthcare and high-tech sectors, all of which have weathered the storm in recent years.
According to the International Monetary Fund (IMF), since most Islamic nations are currently under-banked, and given ‘the tremendous need for infrastructure projects across the Muslim world, development of Islamic banking can spur growth in these regions and can be part of the solution to the slow development process.’ The direct ‘correlation’ between investment and profit remains the fundamental difference between Islamic and conventional finance.
Whereas conventional banks exploit market imperfections to reap maximum profits, Islamic banks seek to balance the needs of investors, shareholders, users and society. In today’s uncertain geopolitical climate, Islamic finance has the potential to improve, and help build bridges between, both the Western and Pan-Muslim worlds.