02 October 2009

A basic guide to Islamic finance

Q & A - FINANCE - Faith-based lending - A guide to the growing Islamic finance industry - Islamic financial institutions are those that comply with Sharia, a set of laws from the Islamic faith.

Conventional financial products that charge, pay or have any element of interest are generally excluded, but Islamic banks are able to structure various Sharia-compliant contracts to offer a range of products that closely mirror those of conventional finance. A commonly used mode of Islamic finance is Murabaha, which is cost plus financing. This is commonly used for vehicle and home financing.

Simply, the bank buys the item, adds a profit and then sells it to the buyer with fixed instalments over a fixed period.

For home financing, a common mode is Musharakah, which is a partnership between the bank and the client. The house is bought together, and the buyer pays rent for that portion of the home value that the bank still owns. Over time, the buyer pays out the bank and in doing so continuously reduces the rental amount due.

While Sharia-compliant finance is a tiny percentage of conventional finance, interest in the field continues to grow globally. The collapse of many conventional financial institutions has prompted economists to consider alternative financial solutions and new approaches to banking.

A report by Asian Banker states that despite the financial crises, Islamic banks’ assets climbed by 66% last year and according to ratings agency Moody’s, the sector is worth US$700bn. International consulting firm Oliver Wyman estimates that by 2012, these assets will reach 1,6 trillion. Professor Habib Ahmed from Durham University in the UK said that the sector has grown by 15% to 20% per year for the past few years.

“There is a lot of interest at the moment. People are looking for alternatives after the economic crisis,” he added. Professor Rodney Wilson, also from Durham, claims that no Islamic bank failed during the financial crises and none have needed government funds to save them from collapsing.

Islamic finance products are available globally from Islamic financial institutions, but many conventional banks also offer Sharia-compliant products. Al Baraka Bank in SA is an Islamic bank and conventional banks, including ABSA, First National Bank and Stanlib offer Sharia-compliant products. Globally, Lloyds TSB, HSBC, Deutsche Bank and Citibank all offer Sharia-compliant products.

The fundamental difference between Islamic and conventional banking practices is that Islamic banks do not charge interest. Rather than borrowers and lenders, the system is supposed to be based on buyers and sellers. Business lines prohibited in Sharia include conventional finance, alcohol, pork-related products, gambling, pornography and weapons manufacturing.

“Conventional banking is biased to the seller,” said Islamic finance scholar Aly Khorshid. “People think the Islamic system is based on faith, but it’s based on justice for the two parties. How you get to the justice is extracted from Islamic faith,” he said.

Though the Financial Times cites evidence that suggests “what happens in the world of conventional finance affects the Islamic financial world with a time lag”, popular opinion is to the contrary. Daud Abdullah at Deloitte expects double digit growth in global Islamic finance in the next few years.

But the growth of Islamic finance has brought its own problems.

“Islamic banks are also driven by profit and sometimes that can dominate the ethics,” said Ahmed. Critics say some banks use Islamic finance to package what are essentially conventional products. Industry commentators Tarek el-Diwany and Haitham al-Haddad argue that it is partially just a soft version of the conventional system.

These allegations raise serious questions around Islamic finance’s ability to be a viable alternative. Besides the fact that Islamic investment funds tend to invest in better performing companies by avoiding investing in companies that are heavily indebted with interest-based loans, a close look at the industry explains the reasons the industry is better performing. Islamic banking, primarily in the Gulf where it’s predominantly based, benefits from the cash inflows of oil revenue, and is relatively smaller than its interest-based counterpart.

These characteristics allow the industry to deal with problems quicker and without huge public bailout packages. According to El-Diwany and Al-Haddad, if the industry continues to develop the way it has, it will suffer from the same systemic problems as the conventional system.

They call for a total reconsideration of the objectives, frameworks and methodologies of the modern Islamic finance industry before it is presented as a viable alternative.

This article first appeared in FM campus: http://www.fmcampus.co.za/features/article.aspx?id=1069264

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