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Banking: can Shariah show the way?

Islamic finance shows that lending and morality can be compatible, Ryan Koorosh writes. And its appeal is fast growing in the West as well as in Muslim countries.

More than two years after the global financial crisis shook the foundations of world banking, the system is under scrutiny with an intensity not seen since the Great Depression. Philosophers and economists routinely call for a revamp of banking practices and the introduction of a range of measures, from increased regulation to greater emphasis on moral practices. "People are now beginning to ask what is the purpose of business and really think about such issues as sustainability," says Roger Steare, a corporate philosopher and Professor of Organisational Ethics at Cass. "The western capitalist system is a feudal plutocracy where the only real winners seem to be the mercenaries with golden parachutes."A crisis that is blamed on banks' complex loan portfolios and consumers' insatiable appetite for borrowing has naturally put the spotlight on credit. In this atmosphere, Islamic finance, with its ban on the payment of interest, is increasingly positioning itself as an alternative to the conventional financial system.

A share in the profits
"The key result of the financial crisis is lack of confidence in the conventional [banking] system," says the economist Iqbal Asaria, special adviser on business and economic affairs to the Secretary-General of the Muslim Council of Britain and Visiting Lecturer in Islamic Finance at Cass. "Suddenly people are looking at what possibilities there are and one alternative possibility is Islamic finance." Islamic finance is based on the system of law and moral obligations known as Shariah, and it goes beyond the widely quoted ban on charging and receiving interest payments on loans. It also requires loans to be backed by assets and, in place of interest, it insists on sharing the profits, or losses, arising from a loan. Advocates of Islamic finance say that this leads to greater economic stability. "In conventional banking the lender gets paid regardless," says Asaria. "When you make a loan in Islamic finance you receive profits based on the performance of the [financed] asset. If the borrower reaps benefits from the investment, then the lender gets paid; if there is a loss, then they all share the loss." This, Asaria says, makes the lender more prudent and prevents the irresponsible lending of the past decade when financial institutions extended credit to borrowers they knew were likely to default on the loan.

A share in the risk
"When there is risk sharing, you don't underprice risk," says Asaria. "Since the crisis, the Islamic assets have gone down much less."According to a research paper, The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study, published by the International Monetary Fund (IMF) in September 2010, Islamic banks made more profit in 2008 than conventional banks but this was reversed in 2009 as the crisis hit the economy. The paper, written by Maher Hasan and Jemma Dridi, said: "Factors related to Islamic banks' business model helped contain the adverse impact on profitability in 2008, while weaknesses in risk-management practices in some Islamic banks led to larger declines in profitability compared to conventional banks in 2009. Thanks to their lower leverage and higher solvency, Islamic banks were able to meet a relatively strong demand for credit and maintain stable external ratings." A key drawback of Islamic banking from a business and ethical standpoint is that Shariah-compliant banks often repackage conventional products, meaning there is little difference between the two systems.

The good and the bad
Khalid Howladar, Senior Credit Officer at Moody's Investors Services in Dubai, says: "In its pure form Islamic finance is different [from conventional finance] but in its current state most of Islamic finance replicates the conventional system, and when you replicate something you take the good and the bad." Professor Steare does not believe that the practices of Islamic financial institutions make them more ethical because many of them "get around the law". One such example is Islamic bonds, known as sukuk (plural of sakk - a legal instrument). Under Sharia, Islamic bonds should grant the investor a share of an asset or business along with cash flows and risks. However, "while this is indeed the Sharia ideal," says Howladar in a 2009 study about the future of sukuk, "most current structures have more in common with conventional fixed income or debt instruments from a risk/return perspective." The 2010 IMF paper also asserts that the type and size of financial risks in Sharia-compliant contracts are not significantly different from those in conventional contracts. "One key difference," it says, "is that [Islamic banks'] model does not allow investing in or financing the kind of instruments that have adversely affected their conventional competitors and triggered the global financial crisis. These include toxic assets, derivatives and conventional financial institution securities."

A share in the market
Islamic finance is creating a niche market for itself but its reliance on replicating conventional products has created crisis in the industry. In 2008 the Bahrain-based Accounting & Auditing Organisation for Islamic Financial Institutions said that 85 per cent of sukuk were not in compliance with Sharia-based principles. Overall, though, the strength and appeal of Islamic finance lie not so much in what it is in practice but rather the concepts it is founded on and the public perception of it. "It generates news disproportionate to its size and there is a lot of emotion surrounding Islamic finance," says Howladar. "Because of that there is a lot of room for growth because it's a strong brand." Tariq Minaj, a Palestinian living in the United Arab Emirates, uses the Dubai Islamic Bank for all his banking needs. "Whenever I can, I would only use Sharia-compliant products because I'm a Muslim," he says. But he has to take on trust the assertion that a financial product is Sharia-compliant. "They tell me it's Islamic and I just have to believe it," he says. Whether non-Islamic finance will adopt more of the Sharia ideals remains to be seen but the market for it is expected to continue growing. For many, like Minaj, the label alone is enough. The brand of Islamic finance is also drawing Muslims in the West to investments that bear the Islamic label in the Gulf and elsewhere. The IMF estimates that global Islamic banking involved $820 billion by the end of 2008, making it and its potential for growth too large to ignore.

Participation banking
Demand is growing as the world's 1.57 billion Muslims become more affluent and assertive of their identity and as investors continue to question traditional banking practices. Islamic banking is also rising in rich and fast-growing economies such as the oil-producing nations, Turkey and Malaysia. In the wealthy countries of the Gulf Cooperation Council, which comprises Saudi Arabia, UAE, Kuwait, Qatar, Oman and Bahrain, the market share of Islamic finance grew to as much as 35 per cent in 2008 from about 24 per cent four years earlier, according to the IMF. In constitutionally secular Turkey, Shariah-compliant banks brand themselves as "participation banks". By 2008 their number had grown to more than 15 and their assets accounted for 3.5 per cent of Turkey's total banking system, a growth rate of 41 per cent since 2001. By comparison, assets of Turkey's conventional banks grew by 19 per cent during the same period, according to the IMF. Getting into Islamic finance is also a matter of prestige. Financial institutions, particularly large banks that aim to be relevant across retail and corporate markets, need to offer Islamic products as diverse as consumer accounts and issuance of sukuk. Competition and regional rivalry also fuel the growth of Islamic finance. The sukuk market, for instance, stands at about $100 billion - $120 billion, with 50 per cent of the issuances in Malaysia. Gulf countries, particularly Dubai, have long vied to shift the centre of this market to the Arabian markets. The potential for growth in Islamic banking will surely be in retail banking, where Muslim consumers, driven by emotions, would increasingly flock to it.

A mixed portfolio
Another factor is that Islamic finance is positioning itself as a separate asset class to appeal to Muslims and non-Muslims who are not motivated by a religious duty. "Some people want to have a mix of conventional and Islamic finance to balance their portfolio," Asaria says. "This is based on the belief that over-leveraged activities are more risky." Conversely, as long as many believe that Islamic finance is not distinct enough from conventional banking, Shariah-compliant investments would not constitute a diversifying factor. Professor Steare, an advocate of ethical practices, believes Islamic finance and all religions have an opportunity to make a positive impact in the aftermath of the financial crisis. He says: "The opportunity for Islamic finance is to offer itself as a more sustainable business model and we should call on all faiths and philosophies to reset our thinking about shared, universal moral values. Money, after all, is simply a promise we trust."

Ryan Koorosh is a freelance writer.

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