The risks and rewards from the explosive growth in Sharia finance

BOOMING Middle Eastern economies and increasing affluence across the Islamic world are fuelling rapid growth in the $1 trillion (£502bn, E677bn) market in Sharia finance.

The ownership can be structured so the “financier” holds a diminishing share of the asset over time, which eventually passes to the entrepreneur. This joint-investment model contrasts with conventional finance, in which the lender earns interest on a loan regardless of the profitability of the debtor’s business.

To comply with the ban on interest, large companies, financial institutions and governments from Muslim nations issue sukuk, which share certain features of conventional bonds – they are tradable, raise funds from a large investor base and have fixed maturities – but they also have key differences.

The biggest is that sukuk gives those providing the capital a stake in real assets; they are not merely creditors. Sukuk buyers acquire part ownership in the underlying assets for a pre-arranged period, at which point the “loan” is repaid.

Unlike conventional bonds, regular coupon payments issued by sukuk must be paid for out of income generated by existing businesses and assets such as property (or assets that the borrower is contracted to purchase).

The use of future payments from creditors, as with mortgage-backed securities, is banned. Coupons are either variable or fixed. Variable coupons are typically linked to the London Inter-bank Offered Rate (Libor) plus a margin. To avoid losses if an issuer cannot repay the bond or its coupons, the issuer can buy insurance (or dhaman) to compensate investors.

Although they have grown at an annual rate of 85% since 2001, sukuk are still in uncharted territory, however. According to Barclays Capital, there have been no reported defaults on sukuk, but that is not to say this is impossible. Some influential figures in the Islamic finance world have warned that some supposedly Sharia-compliant products have been badly designed.

Sheik Mohammed Taqi Usmani, chairman of the Accounting and Auditing Organisation for Islamic Financial Institutions, an influential group that comments on Islamic finance issues, has recently claimed that 85% of sukuk are not fully Sharia-compliant.

Usmani says that because some sukuk are sold with an agreement by the issuer to pay back the face value of a bond at its maturity, these products are essentially no different from conventional bonds. He has a point.

None of this is stopping the British government from looking at issuing Islamic-compliant bonds to sell to Middle Eastern and domestic Muslim investors.