Banking governed by Koranic principles is a rare growth market in a shaken financial world, says Edie Lush — but is it really more stable than its Anglo-Saxon equivalent?
The clash of civilisations between the Muslim world and the West takes many forms. Even on the financial front, there are deep differences of philosophy in relation to money, debt and profit. But at a time when the Anglo-Saxon mode of banking is flat on its back after the credit crunch, its Islamic counterpart is gaining wider acceptance, and even laying claim to be a more stable alternative.
The requirements of Islamic finance — lower proportions of debt to equity, a condition that the lender share profits and losses with the borrower, and a focus on transactions based on tangible assets — mean that Islamic banks have not become entangled in the toxic debt instruments that sideswiped Western banking giants. And while most of the West’s banks were in crisis, Islamic finance continued to grow — by about 15 to 20 per cent in each of the last four years.
Islamic traditions of trade financing can be traced back many centuries, but the first modern bank to operate according to sharia principles drawn from the Koran, Dubai Islamic Bank, did not open until 1975; today, more than 300 such banks operate in some 75 countries. In Asia and the Gulf Co-operation Council (GCC) countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates) Islamic banking assets and wealth under management have reached $736 billion.
Meanwhile, Moody’s expects the market in sukuk (Islamic bonds, designed to give investors effective ownership of the underlying assets that are financed) to rise to $123 billion in outstanding issuance this year, despite a fall in new issues by some 56 per cent in 2008 compared to 2007, and some high-profile recent defaults.
In essence, the Islamic world is rapidly acquiring its own versions of the major elements of modern Western finance, including private equity, venture capital, hedge funds and infrastructure project finance, as well as public markets. According to Nasser Saidi, chief economist of Dubai International Financial Centre Authority, over $1.8 trillion of building works is currently planned in the GCC countries — and it will all need financing. Given that one person in five on the planet is a Muslim, forecasters see a long phase of growth ahead across the whole range of Islamic financial activity. And it’s not just for Muslims, according to its proponents. ‘Islamic finance is a viable alternative to conventional finance,’ says Humphrey Percy, chief executive of Bank of London and the Middle East (BLME).
Islamic banks are arguably more transparent and, with prohibitions on lending to businesses involved in gambling, alcohol, pornography and weapons, they’re more ‘ethical’ than many conventional banks.
Muslims are troubled by conventional lending because it appears to put the burden of risk on the borrower rather than the lender. In the Islamic view, no transaction is ethical unless risk is fairly distributed between the parties.
Jeremy Green, a partner at Quantum Capital, says that the commitment to profit- and loss-sharing means that there can be a ‘much deeper relationship between the lender and the borrower than in conventional banks. Banks are famous for pushing you to take money when you don’t need it and demanding it back once conditions deteriorate. The benefit of an Islamic bank is that [it’s] less likely to take the umbrella back once it starts raining.’
The ‘corporate social responsibility’ credentials of Islamic banks are also strong, because they are obliged to give a certain amount to charity every year — the practice known as zakat.
Islamic banks tend to favour leasing techniques, based on tangible assets. Earlier this year BLME extended a £10 million lease facility to Ocado, the online grocer that delivers Waitrose produce. It was used to lease an automated machine that picks food off the shelves — Percy hastens to add that it doesn’t pick alcohol or pork, but ‘it’s a common misconception to believe that only clients from a Muslim background would be interested in sharia finance’.
Several new Islamic banks have sprung up to meet the increase in demand. BLME, founded with Kuwaiti backing in 2006, is the largest of the five purely Islamic banks based in London; recent arrivals include Qatari-backed European Finance House and another Kuwaiti venture, Gatehouse Capital. In addition, many of the larger banks, including HSBC, Citibank, RBS, Barclays and Standard Chartered have Islamic ‘windows’.
Humayon Dar, chief executive of the BMB Islamic, the Islamic financial advisory arm of the Brunei-based BMB Group, says London is the hub for Islamic banking in Europe. ‘The government introduced tax efficient legislation for Islamic financial services and [the regulatory authorities] have shown a genuine desire to accommodate the industry… Eddie George was the first governor of the Bank of England who attempted to understand the need for financial inclusion of Muslims.’
More recently, France has been bidding for a slice of this potentially lucrative business. Economy minister Christine Lagarde has said she wants ‘to make [Islamic banking] activities as welcome in Paris as they are in London and elsewhere’. In September the French parliament altered its banking laws to allow sukuk to be issued for the first time and a Qatari bank has applied to operate as the first Islamic bank in France.
But Islamic banking is never likely to threaten the dominance of Western finance. Humphrey Percy of BLME describes the two sharia ‘screens’ that Islamic banks use to test the businesses in which they can invest. The ‘industry screen’ prohibits Islamic banks from doing business with firms involved in pig farming, alcohol, weapons, gambling or adult entertainment.
A second ‘financial screen’ looks at the use of interest, banned because of concern about usury — lending at interest in the Western way is seen as taking advantage of the borrower. In addition, if a company keeps large cash balances in conventional banks it may not be eligible to do business with Islamic banks because of the interest it is earning on its cash deposits. Hoarding cash is seen as an inefficient use of resources in the Muslim world, and is also prohibited.
And the drive to jump on the Islamic finance bandwagon is by no means risk-free. The biggest potential hazard could be termed ‘sharia risk’. Every aspect of Muslim life is governed by the evolving body of rules know as the sharia — translated as ‘the path to the headwater’ — founded on revealed truth from the Koran and stories from the Hadith, the sayings and doings of the Prophet.
But the real influence of the sharia lies in the ways this material is constantly re-read and interpreted by modern Islamic scholars. Each Islamic bank, besides having an executive board, also has a sharia board which declares each product the bank develops either sharia-compliant or not, by issuing a fatwa, or ruling.
Problems arise from both the lack of a central Islamic authority and the lack of standardisation of competing financial products — one sharia board may declare another’s product invalid, something that can cause tension between more accommodating banks — such as those in Malaysia — and those such as the Saudis who tend to the strictest interpretations.
Scholars in the Bahrain-based Accounting and Auditing Organisation for Financial Institutions (Aaoifi) rocked Islamic bankers last year by saying that 80 per cent of current sukuk structures were not sharia-compliant. This comment, on top of global financial upheavals, provoked the dramatic fall in sukuk issuance in 2008.
And while Islamic banks were somewha
t protected from the full impact of the credit crisis, they weren’t totally immune. Three issuers of Islamic bonds defaulted this year and others are likely to follow, particularly those raised to finance major real estate projects that have been hit by the global downturn. A further layer of risk comes from the fact that, because sukuk is a relatively new concept in international markets, there is no established mechanism for resolving defaults and disputes over creditors’ rights.
So Islamic finance is not without pitfalls and challenges. But a year on from Lehman Brothers’ collapse, with conventional banks still reluctant to lend to corporate borrowers, Islamic banks are finding more than enough business to take care of — and the rest of the financial world may have lessons to learn from them.
In March this year, one European newspaper made just that point: ‘The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service.’ It was Osservatore Romano, the official newspaper of the Vatican.
This article first appeared in the print edition of The Spectator magazine, dated October 17, 2009