Islamic Finance: safer than Wall Street?

Posted by: David Rocks on October 15, 2008

I spent the past few days in Kuala Lumpur at a conference on American relations with the Muslim world sponsored by the Brookings Institution, the Asia Foundation, and Malaysia’s Institute of Strategic and International Studies. I was on a panel that looked at economic issues in Muslim countries, and one thing that came up was whether Halal financial instruments had held up better than traditional stocks and bonds. I hadn’t thought about this much, but it makes some sense given that Islamic finance is based on the concept of shared risk. The main instrument is called a sukuk, and any money proffered (it’s not technically a loan) is backed by some collateral held by the person or institution putting up the funds. That would pretty much eliminate the arcane instruments such as collateralized debt obligations and credit default swaps that got the Western financial world into so much trouble.

Since I really didn’t know much about it, I spent some time looking into the question today. I still have to plead relative ignorance, so I’d be grateful for any insights readers might have. But I found this story that said the total money invested in Halal instruments had grown to $1 trillion, five times the level of a half-decade ago.(As it turns out, the story came out of a conference in KL—which has become a center for Islamic finance—on Monday and Tuesday, the same days I was there at the Brookings gathering.)

I also found this story out of Australia that says the Dow Jones Islamic Finance Index rose nearly 5% in the most recent quarter. As I understand it, though, the DJ index measures shares in companies that have been judged to be Shariah-compliant (they don’t sell alcohol, pork products, and the like), not a measure of how well sukuks have fared in the market recently.

So that leaves me still looking for some kind of broader measure of the health of the Islamic finance sector. One of the other panelists yesterday, by the way, noted that while sukuks aren’t subject to the kind of turmoil now facing Wall Street, they have some disadvantages. Since they require collateral, they’re often backed by real estate—not necessarily a smart investment these days. In any event, as I discovered from this story in the Guardian, it appears Asian investors aren’t yet convinced Islamic finance is the right place to invest their money.

Reader Comments

P.J. Wilkins

October 15, 2008 10:02 PM

"...arcane instruments such as [CDO's] ... that got the Western financial world into so much trouble."

Really? So the mere existence of these instruments is the problem? If I'm not mistaken, I think someone had to buy them. Anyone with half a brain would have to understand the inherent risk. Yet they kept on buying...

Blake Goud

October 16, 2008 2:28 AM

As someone with a fair degree of knowledge about Islamic finance (my website is www.sharingrisk.org) I appreciate your point about sharing risk compared with the crisis on Wall Street. Although I see the benefits of the Islamic financial model, its current form disguises its risk profile to some degree. First, most products are structured using LIBOR as a benchmark (perfectly halal to use it as a benchmark, but it exposes the industry to contagion from the conventional financial industry). Second, the fall in sukuk (Islamic 'bonds') is blamed on an AAOIFI ruling on their Shari'ah compliance rather than a more important factor of crisis in all credit markets. Third, Islamic finance is most prevalent in the Gulf Cooperation Council (GCC) countries and Malaysia whose economies are still relatively strong.

I do believe that Islamic finance makes an extremely valuable contribution to the development of an ethical financial system, there are many myths (both positive and negative) about it. On balance, it adds a positive force within the financial system (and can make even more), but naive claims that it is the cure-all in its current form are misguided and hurt future developments that can create a better financial system for all.

nazari

October 17, 2008 5:53 AM

I read with interest some comments going around that if Islamic Banking is practiced, then the current global financial crisis could have been avoided. I find the comments to be quite naive and reflects a misunderstanding of the nature of present-day Islamic Banking. Islamic Banking, at least as practiced in Malaysia is in many aspects not radically different from conventional banking. In an attempt to make the country emerge to be a global Islamic financial center, the Malaysian financial authority has been encouraging the growth of sophisticated Islamic finance products that are in essence similar to conventional banks' practices. Unfortunately in some cases the products have been questioned by many Islamic scholars as being in non-compliance with Islamic principles.

To illustrate my point, let us focus on the often-mentioned distinguishing feature of Islamic banking which is the linking of tangible assets to financial transactions. That feature is supposed to prevent the phenomenon of over-lending, especially of the risky type akin to sub-prime mortgage problem in the US. But is it really true that loans in Islamic banking are all solidly backed by tangibe assets? Well, let us take a look at one financial product offered by Malaysian Islamic banks called Bay' ul Innah. In this type of transaction, customers are able to obtain cash loans from banks in a `halal' manner, free of interest elements. How is this possible? Well, let us create a scenario of a customer who is in need of RM50,000 in cash. He approaches an Islamic bank. Instead of telling the person to go elsewhere for cash loans since interest-charging-cash-loans are not allowed in Islam, some Malaysian banks practicing the so-called `Islamic Banking' will `sell' to him an asset, say a car, for RM80,000 on credit terms with the payment to be made over an agreed period, say 5 years. The customer is then instructed to immediately re-sell back to the bank the car for RM50,000 for cash. So at the end of the two `sales' transactions, the customer walks out of the bank with RM50,000 cash in his hands whilst the bank has an account receivable of RM80,000. The bank therefore stands to make a profit of RM30,000 over the 5-year period. Both parties are happy with the `halal' deal, and probabaly assumed that God did not realise that they had essentially entered into a loan agreement because the contract documents outwardly seem to indicate that two sales transactions have taken place rather than a `loan' transactions.

Now, what if another customer comes along to the same bank and also applies for a cash loan of a similar amount of RM50,000? The bank and the new customer will again enter into exactly the same two consecutive sales transctions involving the bank and the new customer and involving the same assete i.e. the car (The car is probably parked in the bank's basement for years, oblivious to the fact that it has experienced scores of temporary and short changes of ownerships whenever `Bay' ul Innah' transactions involving itself are carried out upstairs as the months go by). The total amount of debt created by the bank, based on the single unit of asset (the car in the basement) could be in the hundreds of thousands or perhaps millions, depending on the reserve-ratio requirement imposed on banks by the central bank. But you tell me... is this the type of asset-backed transaction that is supposed to give Islamic banking the edge over convenional banking system as far as stability and lack of riskiness is concerned?

For your information, the majority of scholars in the Middle East say that this type of transaction is against the Islamic shariah which prohibits profit-motivated loan transactions. `Bay ul Innah' transactions are obviously profit-motivated loan transactions camouflaging themselves as sales transactions. Only a small minority of Muslim scholars (mostly in Malaysia) allows it. Their opinion is based on a previous opinion of a famous scholar. However the scholar actually imposed an additional condition to `Bay ul Innah' transactions in that the `sales' transactions must be genuine sales transactions and not `loan transactions' in disguise. In other words, the parties to the transactions must have genuine intentions of selling the asset to each other rather than to enter into a loan agreement via dubious sales contracts. When I put the matter to a Malaysian legal expert involved in Islamic banking in Malaysia (since as far as i am concerned it is pretty obvious that the intentions of the parties are to enter into loan transactions thereby rendering the transactions haram) her answer to me was that they are not concerned with that aspect since `intentions' are in the hearts of the parties, are not stipulated in the contracts and also not for the lawyers to find out! As such such transactions are allowed by many Malaysian shariah advisory panels of Malaysian banks which are desperate to for business.

In conclusion, it is true that real Islamic Shariah if practiced globally can prevent global financial crisis from taking place due to unique features such as insistence on asset-backed transactions and opposition to `lending-for-profit' transactions. But we are talking about `real and genuine Islamic financing practices' and NOT pseudo-Islamic Shariah as practiced by some Islamic banks in Malaysia. Pseudo-Islamic Banking is not going to prevent financial crises from taking place and that is the reason in the long term it is going to give Islam a bad name.

mashood yunus

October 20, 2008 11:12 AM

I agree with Black Goud. I am happy to see the healthy feedback yet not exaggerating this important ethical and faith driven option but its growth has to be natural and it should not be seen as "it will fix all of my personal financial problems in a worldwide financial turmoil". this option requires people to be driven by ethics and certain important values in the life and as such, I do not see people full ready for that yet.

faynuus

October 21, 2008 6:29 PM

Nazari- That was an interesting comment.

What would you advise anyone with interest in an Islamic Finance entering career:

in terms of what area of Islamic Finance, qualifications and routes of entry.

I haven't seen any IF entry level jobs advertised anywhere.

I am non-finance graduate with research postgraduate qualification.

If anyone has any advise I would be grateful to know.

Thanks

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