INSIDE ISSUE 17

THE LAST WORD

What can Western finance learn from Islamic finance, asks Brian Kettell. Apparently, quite a lot

In view of the growing interest in Islamic finance, it is useful to outline the distinguishing features and delineate the unique characteristics that make it attractive to a growing segment of consumers and investors. These characteristics were in place before the sub-prime market debacle. It is no coincidence that this has largely bypassed the Islamic financial marketplace. Indeed, the US sub-prime meltdown has hit the balance sheets of banks worldwide, thereby hurting companies and consumers alike. Despite this meltdown, the group CEO of Doha Bank estimated that the effect of financial leverage on Western banks was still rising and was not quantified. However, only some 0.4% of the total bank assets in Middle East and developing Asian region represent holdings in these sub-prime securities.

There are at least three characteristics that make Islamic finance different. First, it prohibits interest. The rate of return is variable and determined by the profit and loss that the bank makes during a given period, and the returns on assets depend on the particular mode and purpose of financing: murabaha (trade finance), mudaraba (profit-sharing), musharaka (partnership) and ijara (leasing). Second, Islamic finance does not allow undertaking or financing of anti-social and unethical businesses such as gambling, prostitution, alcoholic liquor, nightclubs and narcotics. Islamic banks are prohibited from opening accounts or provide financing to persons or institutions involved in such activities. In this respect, it is clearly part of the recent surge in ethical finance and socially responsible finance that are becoming popular in the Western world. Third, Islamic finance has to be compliant with the basic percepts of Shariah, the legal code of Islam based on the principles of justice, fair dealings and harmony through equitable distribution of wealth. Islam is totally opposed to exploitation of an individual or institution by the other for self-aggrandizement. riba or usury is considered exploitative by its construct and is, therefore, prohibited. The equitable distribution dimension of Islamic finance is, therefore, an add-on that is clearly absent from the conventional modes of financing.

There are several possible reasons why Islamic financial services are spreading so fast in the West. First, there are around 15 million Muslims residing in non-Islamic countries in Europe, mostly in France, Germany and the UK. Islamic finance is effectively contributing towards penetration of financial services and inclusion of this particular target group that previously avoided using existing banking facilities because of their faith. The members of the Islamic community in Europe that were not benefiting from the conventional banking on religious grounds are now participating through this particular mode in conformity with their beliefs. This group naturally provides the scale for the financial services industry to build on.

Second, there are investors— who in their quest for diversifying their portfolios—are looking for new asset classes, new instruments and new products with low correlation with the existing asset classes or products. Islamic financial products cater to this particular need and have, therefore, become attractive to that investor group. Third, there is a growing trend, particularly among the younger population, to move away from unethical or socially irresponsible investment funds and businesses. Many funds have emerged that are exclusively devoted to meet the specifications of investments in ethical products or socially responsible services. Islamic finance conveniently fits into this food chain because of its natural affinity and congruence with its end-use restrictions. In addition to normal audits, Islamic banks have to conduct Shariah review of their transactions for ensuring Shariah compliance. This review will catch any funds mobilised or used for haram (prohibited) activities.

Nowadays, lawyers and officials In the United States and Europe speak frequently of ethics and integrity, a phenomenon driven largely by recent experience with corporate scandals and, more recently, the drive for fees and speculative activities as well as a quest to beat the regulator . The word “integrity” literally means adherence to values. The West needs to understand Islamic finance because such an understanding is necessary to implement one of its own core values. The core value Is freedom of religion. The Western market economies grew out of cultures that were, and are, largely non-Muslim and were essentially secular in nature. But is the West’s secular law, based on the receipt and payment of interest and the time value of money, sufficiently tolerant of the practitioner of Islam? Of course it is.

Accordingly, we must ask whether some of the customary practices in our market economies could be modified and enable the West to learn from practices of the Muslim faith. To foster banking and financial market integrity we need to see whether Western practices may be changed to accommodate and learn from those of the Muslim faith. Part of the difficulty emerges from lack of knowledge, with respect to the banking and financial market practices associated with Islamic financing principles. This is a gap which urgently needs to be addressed.

The discussion of the Muslim communities in the West leads to another factor motivating the West. Western economies are market economies, and growing populations are likely to receive attention from entities seeking to provide services to those populations, including banking services. Even US financial institutions now offer Shariah-compliant products, including University Bank in Ann Arbor, Michigan, Devon Bank In Chicago, Illinois, and HSBC Bank USA in New York City. In 1998, Dow Jones debuted its Islamic market indices, which track Shariah-compliant stocks from around the world.

Dow Jones maintains nearly 50 Islamic market indices. This is happening, I suspect, predominantly because these commercial firms see a market to be served; they do not consider themselves to be in business purely for altruistic reasons. To accommodate and to serve the Muslim community, we in the West need to understand the basic religious principles that must be satisfied. Because our secular commercial and regulatory law developed in an environment where those principles were unknown—or at least not well known—we need understanding, analysis, and an action plan. While the challenges are real, they are not insurmountable.

First, Western banking law, though conceived in an interest-based economy, is neutral with respect to religion. This is not enough, to be sure, but it is a good start. Second, Western and US regulators have shown they are more interested in substance than in form. Religious law—perhaps more than secular law, as it has evolved in common law jurisdictions like the UK and the US—tends to focus on form as well as substance. There is probably sufficient common ground to harmonise the needs of both. Of course, there are other things that the West may learn from Islamic finance. By requiring Muslims to take part only in activities or ventures that are considered halal, the Shariah represents an early form of socially responsible investing. Investments in certain industries or products are forbidden, including investments in alcohol or pork-related products, riba-based financial services, and the entertainment industry (including companies engaged in gaming or pornography).

Shariah scholars often advise against investments in tobacco manufacturers and defence or weapons contractors. Once these unacceptable business activities have been excluded, Islamic funds and indices apply a set of financial filters to exclude companies that are highly leveraged or have a high proportion of accounts receivable an their balance sheets. Although based on Islamic principles, these filters serve a broader purpose of excluding unhealthy companies that may generate problems for society at large . After numerous scandals in the US and EU, business has turned its attention once more to issues of corporate governance and disclosure. Here, too, Islamic finance can offer practical lessons. In the wake of the Enron collapse, some US financial institutions have created special senior management committees to consider whether certain complex structured financial products are “appropriate”.

While not directly analogous, the Shariah supervisory boards of Islamic financial institutions have long been engaged in similar conduct. They review the appropriateness of proposed investments from the perspective of Islamic law. When necessary, the scholars on such boards issue fatawa, formal legal opinions, concerning issues of Islamic law. Typically, they oversee compliance with the institutions’ responsibilities under the Shariah. This may include audits to ensure that investors’ funds are being handled appropriately. Such corporate governance issues are ones that we in Western market economies might learn.

So why should a Western lawyer and central bank official pay attention to Islamic finance? First, to be true to Western sets of values and beliefs. Because the free exercise of religion is one of those values and beliefs, Western lawyers need to understand Islamic finance principles or we cannot hope to break down the barriers that may exist in our secular law and may well fetter Muslims who seek to freely practise their faith. The second reason is even simpler: given that, in the West, we operate within market economies and that Muslims are a growing population within those economies, we need to understand the needs to be served.

The third reason is that Islamic finance principles may be imported by the West because they may lead to an improvement in our own institutions, especially in the areas of ethics and transparency where the West has been challenged in recent years. Indeed, the transparency and structures established by Islamic finance could well have provided early warnings of impending problems. A build-up of debts in the various potential structures would certainly have been flagged up.