Islamic Finance: Lower Risk, But at What Cost?

Posted by: Carol Matlack on November 05

Financial products based on 8th-century religious laws may seem an unlikely haven during a global crisis. But Islamic banking and financial services, based on traditional Muslim laws known as Sharia, are enjoying a major resurgence.

A survey released on Nov. 5 by The Banker magazine found that assets held by Sharia-compliant banks rose 28.6% in 2009 to $822 billion, while assets held by conventional banks grew only 6.8%.

True, Islamic finance still accounts for only about 1% of the global financial-services market, according to the Organization for Economic Cooperation and Development. But Sharia’s strict rules against speculation, hedging, and off-balance-sheet holdings are attracting investors worldwide. Already, some 50% of clients of Islamic financial institutions are non-Muslim, Anthony O’Sullivan, head of private-sector development at the OECD, said at a Nov. 4 conference in Paris on Islamic financing.

Rather than targeting Muslim clients, “We try just to be a good bank,” said Lilian Le Falher, executive manager of the Bahrain operations of Kuwait Finance House, one of several Islamic banks represented at the Paris conference. The gathering was hosted by French Finance Minister Christine Lagarde, as part of a push by French officials to promote Paris as a global center for Islamic financial services.

Under Sharia, money can only be lent if fully backed by collateral, and debt cannot be repackaged – restrictions that helped cushion Islamic financial institutions against the worst of the global turmoil last year. Some, though, have been hurt more recently because they have extensive real estate holdings in the Persian Gulf, where property values have plummeted.

Despite its attractiveness as a haven from risk, Islamic finance still has a major drawback: It’s generally more-expensive than traditional forms of financing. Renault Nissan boss Carlos Ghosn, another speaker at the Paris conference, said that if it weren’t for the higher costs, his company would gladly use Islamic financing in countries such as Morocco where it is making major investments. Some carmakers are already experimenting with Sharia auto financing: Mercedes-Benz parent Daimler has recently set up such a unit in the U.A.E. to boost car sales there.

Because Sharia forbids charging or paying interest, Islamic institutions often set up elaborate arrangements in which borrower and lender form nominal partnerships. For example, a bank making a Sharia-compliant home loan could form a partnership with the buyer to purchase a property, then rent it to the buyer. Such arrangements aren’t always the most efficient.

Still another problem is that authorities in different Muslim countries don’t always use the same interpretations of Sharia, making it difficult to develop financial products that can be sold across borders.

Islamic finance could one day become a major global force. But, as Ghosn put it, before that happens it will have to become “less expensive, simpler, and better understood.”