Monday, March 31, 2008

Can Islamic Investment and Banking Appeal to Non-Muslims?

Islamic Finance News
Almost three decades ago, the concept of Islamic finance was considered wishful thinking. Today, more than 400 Islamic financial institutions are operating worldwide and managing funds of about US$1.3 trillion.

The bases of these Islamic financial institutions are global and their markets are growing aggressively. It attracts Muslim investors, especially those from the Middle East, as well as non-Muslims and is growing aggressively. But can ethically-based banking compete with the global debt-based system, which has been around for more than 400 years?

Some commentators consider judgments on the potential of Islamic banking to be premature as it is an industry that is still in its infancy, while others consider Islamic financial practice to be the answer to problems created by the conventional debt-based money system.

Which group is right? Could both be right? And how realistic are Islamic bankers’ dreams of penetrating non-Muslim markets as a global alternative to conventional finance?

Essence of Islamic finance

At the risk of oversimplifying, the essence of Islamic finance is that all parties engage in trade without any use of riba (interest). The Shariah rules governing the prohibition of riba are well known to most, and the values underpinning the rules are righteousness, benevolence and fair profit. Muslims and non-Muslims share these values, with most people wanting to govern their personal and business affairs in accordance with basic, yet extremely important, ethics.

While the majority of conventional bankers will of course conduct their business in a principled manner, the nature of the interest-based money system is nonetheless at odds with the Shariah.

Conventional finance models treat money as a commodity; the global foreign exchange markets see billions of dollars traded every day, but the majority of these trades are speculative and often underpinned by complex derivative structures. In reality, these trades are “virtual” trades and nothing more.

In contrast, the Shariah prohibits the trading of money as a commodity for several different reasons. First, money is considered not to have any intrinsic value. Second, whereas commodities can be of different qualities, the same cannot be said of money.

Third, units of money of the same denomination cannot be identified in any given transaction; i.e. the US$100 bill shown at the time of negotiating a sale need not necessarily be the same US$100 bill used to complete the transaction. In simple terms, the Shariah distinguishes between money and commodities because the intended use of money is to act as a measure of value rather than to be the subject matter of a trade.

Debt begets debt

Goldsmiths of medieval Europe first employed the concept of creating money out of money. Through their simple system of lending gold, the goldsmiths realized that they had the ability to lend more than they actually had. Their lending was therefore increased in the form of gold deposit receipts. It is this basic principle that has been followed over the years and, as we see now, has evolved into the modern debt-based money system.

Analysis of various economic data shows that the volume of coins and notes issued by some governments as debt-free money is much lower than the money actually in circulation, the balance being “virtual” money created in the form of loans advanced by institutions. In short, the debt-based money system creates money in parallel to an equivalent quantity of debt with interest.

The problem is that the impact of a debt-based money system has been devastating. The World Bank’s global finance development report shows that total debt continues to rise. Despite ever-increasing payments, the debt obligations of some countries far outstrip their total income, meaning that citizens of all religions and ethics suffer economically under their national debt burden.

The list of shocking statistics in respect of debt and interest payments is long and well documented, yet relatively few alternative solutions have been offered and, often, the best creditors can come up with is to restructure repayments or to waive portions of state debt in times of crisis.

The Shariah principles governing financial transactions, on the other hand, promote an equity-based and asset backed financial system by abolishing the concept of money production and by prohibiting riba on the advancement of money.

Islamic finance is built on the principles of exchange, rather than creditworthiness and the ability to repay loans. This means that a system based on Islamic principles will neither punish people who need access to capital for not having it already, nor allow them to take on the burden of debt.

Conventional economists and writers have already recognized the benefits of some of the principles that the Islamic system of finance follows. One of them is John Tomlinson, chairman of the Oxford Research and Development Corporation Limited, which explores the use of equity instruments and the development of equity markets for areas of finance currently served by debt.

In his book Honest Money, the Oxford-based economist presents strong arguments for the conversion of the current system to an equity-based one. In building his case for a change in the system, Tomlinson cites reasons that are similar to the principles present in the rationale employed for prohibiting riba, not least of which is the value of focusing on real as opposed to theoretical assets.

Of course, while Islamic banking could make excellent sense as the foundation of a new money system, the conventional debt-based system is deeply entrenched in every sphere of life, and an overhaul would take many years and require substantive reviews of legal, accounting and regulatory structures.

That said, if Islamic banks and institutions continue their aggressive growth and development of innovative and competitive products, it will be difficult for the wider non-Muslim audience to ignore the benefits of such a system.

It may be too late to entirely replace the debt system, but on the face of it, there is no reason the Islamic system cannot be offered in parallel and promoted as the preferred system. Non-Muslims who are fed up with punitive interest payments — and who are attracted to a system that imposes ethical practices on business leaders — might well be the first to sign up for such services.

If the Shariah principles employed by Islamic banks have allowed them to be profitable, — and, more recently, to achieve double-digit growth figures — then the argument for expanding the net of Islamic banking is a compelling one.

Growing sector

On the investor front, market studies have repeatedly shown that given the option to invest in Shariah products with competitive performance, Muslims prefer to do so. As the Shariah sector moves forward, advancing financial education for investors and improving product distribution will stimulate a response from the retail sector.

Today, the institutional market and the ultra high net worth in numerous family offices already deploy assets according to the Shariah, many in the real estate and private placement market.

A breakout opportunity for the Islamic asset management business is possible, particularly after 2007, which is considered a “stage-setting” year for many financial institutions in both the capital markets and asset management businesses.

General market consensus suggests growth rates of between 15% and 20%. International finance consultant Celent feels the global market could average 38% over 2007-10, with greater momentum in 2009.

Equity fund assets are expected to jump from US$15.5 billion to US$53.8 billion by 2010, not including the vast amount that will make its way to private placements in alternative investments by institutions and family offices.

More financial firms implementing investment programs, growing awareness of investment options and cash-rich investors are the drivers of this growth. The Shariah compliant industry is formalizing its infrastructure and building up assets quickly. It will become a significant and profitable component of the financial services industry globally.

Dr Aly Khorshid is an Islamic finance scholar and Shariah consultant with Elite Horizon Economic Consultant, based in the UK.

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