Identity crisis for Islamic finance

The rapid growth in Islamic banking is a measure of its popularity in the Muslim world and beyond. But some say commercial pressures are forcing a dilution of the values that set it apart from western banks.

Islamic finance is gaining popularity, but there are also several challenges facing the segment. There is a general feeling that Islamic banks are modelled on conventional banks. Lee Hoagland / The NationalShow less

Islamic finance is flourishing as corporate and retail demand booms, but some question whether the industry is abandoning the values that inspired it.

"The industry I work in, am immensely attached to, and want to be a force for social good and social change is, in some respects, being hijacked," says Harris Irfan, managing director of the European Islamic Investment Bank, and author of Heaven's Bankers.

“Islamic finance is struggling to differentiate itself both in terms of product and culture,” he said.

Professor Habib Ahmed, Sharjah chair of Islamic economics and finance at Durham University, agrees. “There’s a difference between the theory of Islamic finance and the practice.

“In theory, Islamic finance is based on Sharia,” Prof Ahmed says. “But when we look at the practice, there is a general feeling that Islamic banks are modelled on conventional banks, with the objective of making profit.”

The prohibition on Riba, or interest earned outside of commercial activity, bars Islamic banks from earning money from increments charged on loans and deposits.

Sharia prohibits Gharar – speculation or gambling – and requires that all transactions are based on the real exchange of goods and services. It also says that individuals should not take advantage of significant informational asymmetries, or exploit those with weaker bargaining positions.

These principles are alien to most conventional banks.

In 2007, Muhammad Taqi Usmani, chairman of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), based in Bahrain and the closest thing the Islamic finance world has to a central standards authority, said that around 85 per cent of sukuk as then designed did not comply with Sharia.

The problem was that returns on sukuk al musharaka should vary with the market value of the underlying asset. A musharaka contract sees parties pool money to invest in a profit-sharing enterprise.

But because the sukuk al musharaka behaved like a conventional bond with a guaranteed rate of return, Mr Usmani argued that it was not a genuine profit-sharing enterprise, and so not Sharia-compliant.

Mr Usmani’s intervention led to a precipitous decline in the popularity of the sukuk al musharaka. Issuers now prefer the sukuk al ijara, where underlying assets are transferred to a trust, with rental incomes deriving from beneficial ownership accruing to the sukuk holder.

While the products have changed, the worries have not.

One paper from the Islamic Sharia Research Academy showed that, of a sample of 560 sukuk, only 11 involved the transfer of an asset off the issuing company’s balance sheet to the sukuk holder – a necessary step for the transfer of usufruct, and legal rights.

"If you look at early experiments in Islamic finance, they were as much social experiments as economic experiments," says Mr Irfan. "The hope was that Islamic finance would be about trading in the real economy, and with asset-backed products.

“Although the products are certified as being Sharia-compliant, you end up with too many that look like their conventional equivalents,” he says.

Commercial pressures and the need for Islamic equivalents of tools used by conventional banks have forced Islamic banks to compromise, Prof Ahmed says.

“Islamic banks are modelled on conventional banks, which are debt-based institutions,” he says. “The organisational format is such that you can’t do anything other than debt-based lending.”

“Clients of Islamic banks often don’t see any difference between Islamic and conventional banks.”

Yet Sharia emphasises equity-based transactions. This means Islamic banks should more closely resemble venture capital firms or merchant banks, instead of modern retail banks, Mr Irfan argues.

Commercial pressures force Islamic banks to compromise between principle and the needs of a modern retail bank. For example, Islamic banks cannot tap the money market for day-to-day liquidity operations, because most money market products are not asset-based.

Whether Islamic or conventional, retail banks need to make their accounts tally at the end of the day – or face technical default.

And to compete with their conventional counterparts, Islamic banks have a strong incentive to make products that look and feel like conventional products.

This means that Islamic financial engineers have come up with a range of products that mimic the economic functions of conventional transactions, from short-term money market papers to mortgages.

“There are some genuine market needs, and Islamic banking is trying to fulfil these. But it’s not an easy thing in terms of complying 100 per cent with Sharia,” Prof Ahmed says.

Client expectations, the legal environment, and economic reasons all pressure Islamic banks to more closely resemble conventional banks, he says.

One common Islamic substitute for many kinds of conventional financial transaction is a commodity murabaha transaction, or tawarruq.

In this transaction, the lender purchases a liquid commodity from a commodity exchange, then immediately sells it to the consumer at a mark-up with a delayed repayment schedule.

The bank simultaneously arranges for the consumer to sell the commodity via a broker, which may also be the bank, for the initial price.

This means that the consumer receives cash equal to the cost of the commodity, and the bank receives repayment plus a margin over a longer period, equivalent to any other purchase on credit.

In this transaction, the purchase of the commodity is simply a device to replicate the economic effect of a loan. The tawarruq can be used as a device for banks to lend cash to each other on a short-term basis, or as a form of personal finance. It can be used to mimic a whole range of conventional finance products – from trade finance to credit default swaps.

“This product is used commonly in the Gulf – the bank buys and sells commodities so that the client walks out with cash,” Prof Ahmed says.

Abu Dhabi Islamic Bank, for instance, offers a "covered card" – which behaves exactly like a credit card, and makes use of a tawarruq contract. Every time the consumer makes a purchase, the bank purchases an equivalent value of a commodity from a listed exchange, sells it to the consumer, then sells it back to the market on the consumer's behalf – the proceeds of which are used to fund the consumer's payment.

Just like a credit card, this gives the consumer money now, and allows them to choose whether they pay interest on the balance.

The series of transactions happens almost instantaneously, but the price the bank charges for the commodity sale depends on how long the consumer waits before “paying off” the card.

If the consumer pays off their card before the compounding period, the consumer pays the bank the commodity’s value – which is equal to the cost of the card purchase. If not, the bank adds a mark-up.

Critics of the tawarruq contract point out that neither the bank nor the consumer gains usufruct of the asset, which some scholars consider essential.

The Organisation of Islamic Conference’s Fiqh Academy issued a fatwa in 2009 stating that the tawarruq was “considered a deception” and “contained an element of Riba”.

Nonetheless, this kind of product is ubiquitous in the Arabian Gulf.

Abu Dhabi Islamic Bank says that its covered cards “should be used only when there is a dire need and cash is not available – not as an “easy loan” facility that promotes the wrong spending habits”.

This illustrates the amount of disagreement on which products are Sharia-compliant. Different banks have different Sharia boards, and not all scholars agree.

The lack of a common set of rules for products is holding the industry back, says Prof Ahmed. 
“When different products are used by different banks, that creates legal risk. Clients may not understand the products they are buying, and courts might interpret the law differently,” he says.

“As we saw during the crisis, you can end up mis-selling Islamic products. Islamic banks are not immune to this kind of problem.”

Hamad Buamim, president and chief executive of Dubai Chamber of Commerce, said that standardisation was an important step to enable Dubai to become the centre of the Islamic economy by 2016.

“The issue of standardisation will be tackled,” he told The National this year. “We’re trying to agree with other parts of the world over similar standards.”

Compliance with Sharia is more than just ensuring business aren’t involved in “pork and wine”, he says.

“If a company isn’t paying its staff on time, or has underage employees in bad conditions ... these things are not halal.

“We need to raise awareness of [the importance of] fairness and ethical standards. That’s what the Islamic economy is all about,” he says.

Encouraging ethics in banking is hindered by the fact that many Islamic bank executives have only limited familiarity with the principles of Sharia, says Mr Irfan.

“They are influenced by conventional practices. They look at existing financial products and ask, how can we reverse-engineer these products?

“But doing that is like trying to fit a square peg into a round hole,” he says. “They should be trying to create innovative, asset-backed structures, instead.”

Despite the challenges, the values underpinning Islamic finance are worth encouraging, Mr Irfan says.

“It’s important to have people [in the industry] who feel that it’s a force for change. If they don’t feel that, then we will end up replicating conventional banking,” he says.

“I like meeting students of Islamic finance because they have the idealism, and want to see the industry as a force for change.”

Prof Ahmed agrees. “Even with the problems that we are talking about, Islamic finance still has some red lines that it’s not crossing,” he says.

“Islamic banks’ post-crisis performance was better than conventional banks, and they cannot invest in derivatives, which was a big part of the financial crisis.”

For Mr Irfan, one solution is a return to merchant banking, of a kind seen before the dramatic regulatory changes that hit Wall Street and the City of London in the 1980s.

“Imagine a merchant bank that acts as a buyer and seller of commodities,” he says.

“Trade finance is a real economy activity, where you are lubricating the cogs of the world economy, rather than creating a piece of paper. “That’s the essence of Islamic finance,” he says.

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