ISLAMIC FINANCE

Introduction

Almost three decades ago, the concept of Islamic finance was considered wishful thinking. Today, more than three hundred Islamic financial institutions are operating worldwide, estimated to be managing funds to the tune of USD 200 billion. Their clientele includes everybody and is not confined to people in the Muslim countries and to a specific religion. It is spread across Europe, the US, and the Far East, while offering investors an opportunity to invest their financial resources in accordance with the ethics and philosophy of Islam.

Expanding Frontiers Through Time

Early twentieth century - 1920s and 1930s - witnessed establishment of first Muslim-owned banks, but they adopted practices similar to conventional banks. The first thorough studies devoted to the establishment of Islamic financial institutions were made in the 1940s. In 1940s and 1950s, several experiments with small Islamic Banks were undertaken in Malaysia and Pakistan. However, the first great success in the field came with the establishment of an Islamic bank in the Egyptian village of Mit Ghamr in 1963. The discussion, debating the desirability of abolishing fixed interest rates and Islamization of financial systems, came up for the first time at a meeting of the Islamic Organization Conference (IOC) in Jeddah in 1973. Thereafter in 1974, Islamic Development Bank (IDB) was set up by the IOC to promote Islamic banking and provide funds for development projects in the member countries. The IDB provided fee-based financial services and profit-sharing financial assistance to member countries. Other successes followed quickly, including the establishment of Inter-Governmental Islamic Development Bank in Jeddah in 1975. Realizing the potential of Islamic banking, a number of Commercial banks worldwide leveraged the concept for more diversified growth. This led to the establishment of several Islamic Banks such as the Dubai Islamic Bank, the Kuwait Finance House, and the Bahrain Islamic Bank in the 1970s and 1980s.
Modern Islamic banking has undergone three phases of development. The first phase was during 1972 through 1975 as a surge in oil revenues resulted in great liquidity and a re-emphasis on Pan-Islamism. During the period from 1976 to 1980, Islamic banking expanded eastward from the Arabian Gulf to Malaysia, and westward to England. Simultaneously, Islamic banking associations or consultancy bodies broadened their operations. Post 1983, Islamic banking began to gain acceptance as the Arab world was confronted by economic setbacks, including slowdowns in oil revenues, relative strength of the US dollar, higher interest rates in the United States, and capital outflows from the OPEC nations. In order to mitigate the situation, Islamic banking began to spread its wings into countries like Pakistan and Iraq. It did not target only the Muslims, but was opened for everyone across religions. It expanded to markets like the UK, which is an international financial hub. Further, it did not aim merely at the 1.8 million Muslims living in the UK, but also others. With time, awareness of Islamic finance has significantly increased and it appears to be on the path to consolidating its position the world over.

The Principles of Islamic Finance

The recent surge of religious consciousness amongst Muslims has provided an impetus to adopt and implement Islamic principles in financial transactions. In an attempt to purify assets in the eyes of Islam, Muslims are seeking a greater balance between their lives in the modern technological world and their religious faith and beliefs.
Among the most important teachings of Islam, for establishing justice and eliminating exploitation in business transactions, is the prohibition of all sources of unjustified enrichment and dealing in transactions that contain excessive risk or speculation. Apart form this, Sharia’a allows only Halal activities and forbids activities like gambling, liquor, hoarding, and usury based lending - for example, the bank can not finance liquor manufacturing, transportation, storage or distribution companies. Accordingly, Islamic scholars have deduced three principles from the Shari’a that characterize Islamic economics, including:
Prohibition of Interest (Riba)The prohibition of usury or interest (Riba) is clearly the most significant principle of Islamic Finance. Riba translates literally from Arabic as “an increase, growth or accretion”. In Islam, lending money should not generate unjustified income and Riba represents, in the Islamic economic system, a prominent source of unjustified advantage. Shari’a refers to the premium that must be paid by the borrower to the lender along with the principal amount, as a condition for the loan or for an extension in its maturity, which today is commonly referred to as interest. All Muslim scholars believe that this prohibition extends to any and all forms of interest and that there is no difference between interest-bearing funds for the purposes of consumption or investment, since Shari’a does not consider money as a commodity for exchange. Instead, money is a medium of exchange and a store of value.
Profit and Loss Sharing (PLS)PLS financing is a form of partnership, where partners share profits and losses on the basis of their capital share and effort. Unlike interest-based financing, there is no guaranteed rate of return. Islam supports the view that Muslims do not act as nominal creditors in any investment, but are actual partners in the business. It comprises equity-based financing. The justification for the PLS-financier’s share in profit is his effort and the risk he carries, since his profit would have been impossible without the investment. Similarly, if the investment has made a loss, his money would be lost.
GharrarAny transaction that involves Gharrar (i.e. uncertainty and speculation) is prohibited. Parties to a contract must have actual knowledge of the “subject matter” of the contract and its implications. An example of an agreement tainted with Gharrar is an agreement to sell goods which have already been lost.

Reasons for Emergence of Islamic Finance

Islamic finance has been around for decades, but its wide acceptance, particularly in the GCC region, is a recent phenomena. One of the many reasons responsible for this are: First, wealth accrued by high oil prices in parts of the Middle East that are rich in oil reserves, whereby, the current account surpluses of oil exporting countries witnessed a healthy growth. Earlier in the 1970s, when oil prices touched new highs, the Arab world witnessed mushroom growth of Islamic institutions to absorb the surplus liquidity, benefiting the depositors (who are investors in Islamic finance). When oil prices picked up once gain post 2000 (ref the chart), the GCC countries rolled in high oil revenues, resulting in more liquidity and in turn excessive cash flow to the public in the region. Currently, rich Muslims are parking their funds with the Islamic financial institutions.

Excessive revenues in the region accelerated the execution of development plans and major infrastructure projects by the GCC Governments to boost the non-oil sector. The funds generated through Islamic banking institutions were channelized into these initiatives. This further boosted the confidence in the investment climate of the states. Substantial oil revenues, accompanied by growth in worldwide financial networks have fostered further expansion of Islamic banking.

Other Drivers of Islamic Finance
Muslim PopulationThe growing population of Muslims across the world has also been a major factor behind the success of Islamic finance. Since Muslims are inclined to follow Islamic traditions, there is a tendency to establish an Islamic economic system in every Islamic nation and to restore Shari’a law as the founding rock for legislation. Currently, Muslims account for around one-fifth of the world’s population. The average growth rate of the Muslim population, coming in at 1.9% (between 2000 and 2006), is far higher than the world’s average population growth rate, which is 1.22% for the same period - much faster than in any other religious group. According to the CIA, in 2006, globally the Muslim population stood at 1.6 billion, accounting for 22% of the world’s total population.

9/11 AttackPost-9/11, investors were reticent of too much exposure to the US and Europe. After September 2000, investors from the Gulf States took back billions of dollars of invested capital from the US and poured it into their own backyards. The concomitant rise of Islamic banking has given a good option to the GCC investors in their own home, where they can park funds for good returns.
Real Estate BoomThe huge current account surplus and solid liquidity in the Middle East (resulting from high oil prices) encouraged the Governments to take up several major infrastructure projects to boost the non-oil sector. Consequently, the real estate sector has experienced unprecedented growth rate of 15%-20% in the last few years. Interestingly, the real estate sector lends itself to Islamic finance as it is easier to formulate Shari’a compliant investment products.

Current Scenario

In 2005, there were around 270 Islamic banks worldwide with a market capitalization in excess of USD 13 billion, managing total assets worth more than USD 300 billion and financial investments above USD 400 billion. Islamic bank deposits are estimated at over USD 250 billion worldwide with an average growth of 20%. Additionally, Islamic equity funds have an estimated size of more than USD 3.3 billion worldwide. While a majority of those assets are held in the Middle East and Asia, a growing number of European and North American institutions involved in Islamic equity funds bears testimony to a rising trend in this emerging market. Islamic bonds, known as sukuk are currently estimated at round USD 30 billion and are hot issue in Islamic finance. The last five years have witnessed rapid growth of sukuk, and major western banks such as Citigroup, HSBC, Deutche, UBS and Merril Lynch have opened a window that offers Islamic banking services and products. Thus, Islamic finance is gradually eating into the market share of conventional banks, particularly, in the Middle East. In Saudi Arabia, more than 30% of banks’ assets are now classified as Shari’a compliant, while in other Gulf States it ranges from 10% to 20%. Meanwhile, in Malaysia, around 10% of the banking assets are Islamic.

As an industry, Islamic finance is expanding. Islamic banking licenses for financial institutions in Asia and the Middle East is on the rise. Kuwait and Malaysia have granted more than eight licenses in the past few years. Malaysia, the leader in Islamic banking, granted licenses to four foreign Islamic banks in 2004 alone, in order to become regional Islamic financial hub. Islamic banking is evolving in the West along the same lines as it did in the Muslim countries in the last decade. Conventional western financiers such as HSBC, Lloyds TSB, and UBS have all been attracted to the market, setting up their own Islamic banking operations or subsidiaries. Citibank has started “Citibank Islamic” in Bahrain and is now providing limited Islamic financing windows out of its international operations in New York & San Francisco. Such interest has arisen off the back of enhanced recovery and performance of global banking as a whole, as well as solely Islamic banking advances. These include the pace at which new Shari’a-compliant products are being brought into the market, and the willingness of borrowers to use Sukuk as a way of generating funds.

Islamic banks are expanding at a rapid rate, especially in Saudi Arabia, Kuwait, and Bahrain. In Pakistan, Iran, and Sudan, Islamic banking concepts have been supported by government action: in Pakistan, the government has ordered Islamization of banking practices; Iran has recently implemented an Islamic banking system; Sudan is applying Shari’a to many of its economic activities. Internationally, two banking conglomerates - Dar-al Maal Al-Islami (DMI) and AI-Barak.a - and the International Islamic Banking System (IBS) have established Islamic branch banks in different countries of Asia, Europe, and Africa.

An example of the expansion can be seen in the recent Dubai Ports World Sukuk issue. Dubai Ports Customs and Freezone Corporation raised USD 3.5 billion, with the issue initially intended to raise USD 2.5 billion only. This was due in part to the fact that the issue was oversubscribed heavily, to the tune of USD 11.5 billion. Similarly, the IPO of the Islamic bank Al Salam (Bahrain) which raised USD 111.4 million, closed on February 19, 2006 - over 63 times oversubscribed.

New methods of accepting deposits and providing financing without interest pose challenges for financial regulators. Consequently, there has been much debate about whether Islamic banks can be regulated in the same manner as conventional banks, or whether different criteria should be used. One perspective even questions if Islamic banks are actually banks, as their savings and investment accounts cannot be guaranteed and, therefore, arguably possess some of the characteristics of investment companies. Further, much Islamic financing involves trading and leasing rather than conventional lending and, consequently, the institutions involved could be regarded as trading and leasing companies rather than banks. Further, some Muslim scholars see Islam and banking as being incompatible. They object to the term “Islamic banking”, which is seen as using religion to promote banking. Therefore, in Kuwait, the largest Islamic financial institution - Kuwait Finance House - is designated not as a bank but as a finance house.

Political factors ultimately determine the regulatory environment. In some countries, notably in North Africa and in Libya or Morocco, Islamic banks are perceived as being linked to Islamic political parties, and are, therefore, refused banking licenses. Elsewhere, such as Egypt, Algeria, and Tunisia, the governments are extremely cautious. In contrast, there has been tremendous official support in Bahrain and Malaysia, reflected in the positive regulatory approach. Meanwhile, in Iran and in Sudan, all domestic retail and commercial banking has been made interest-free.