Running on Faith

Financial services based on interpretations of the Quran are attracting more and more attention among professionals. Politicians and journalists are taking an equally keen interest. Many European countries adapted their national regulations in one way or another to account for Islamic banking, and in some cases, even created a level playing field to enable it to compete with traditional financial institutions. Large non-Islamic business centers in Asia, such as Singapore and Hong Kong, as well as those in the United States, Latin Ame­rica, and South Africa, are looking to replicate this experience. Given today’s pace of development, we can anticipate that in 10 to 15 years Islamic banking is likely to become a global system, part of the so-called ‘parallel banking’ that both complements and competes with ordinary banking institutions operating under the Basel Agreement.

At the same time, there are those who criticize this system – a few ill-informed critics try to link Islamic banking with medieval practices or finance for terrorism, while those with a more balanced view believe that it is impossible to combine modern business processes and religious functions efficiently in a single institution.

On the one hand, the rise of Islamic financial institutions that reject (at least in theory) the classical Western notion of interest accrued on loans raises a number of interesting questions about the principles and objectives of financial institutions in today’s world. On the other hand, these institutions make modern financial services more accessible for social and cultural groups that find themselves outside of the Western economic mainstream (financial inclusion). On many occasions, critics of globalization rightly pointed out that Western domination of the world economy causes new, potentially alien economic models to be introduced in the third world, determining, among other things, personal strategies of acquiring, saving, and spending money. Islamic financing is a unique phenomenon that was born as a symbiosis of long-established, non-European commercial traditions and modern financial institutions in an attempt to respond to the economic and cultural challenges that followers of Islam are faced with in today’s world.

However, despite the hype around this phenomenon, we can still conclude that, at this stage, we are dealing with something that is more of a concept than a business notion. Overall, Islamic financial institutions account for less than one percent of the world’s financial assets. There is no Islamic bank among the world top 200, or even top 500 banks. That said, Islamic financing is growing significantly faster than ordinary banks – from $700 billion in assets in 2008 to $1,800 billion in 2013. Similar dynamics can be found in hedge funds. There are legitimate questions about how Islamic banks can operate in non-Islamic societies, especially secular, multi-cultural states, and in particular, whether it is permissible to establish a special category of financial institutions built on the principles of one religion. As a result, discussions about Islamic banking made it to the top of the agenda, even in traditional Islamic countries built on secular principles, such as Turkey, Indonesia, and Central Asian nations and countries where the Muslim population is an important minority, from Russia to South Africa.

The Ideology of Compatibility

To better understand Islamic financing, we need to be aware that it involves not just a set of religious precepts and prohibitions, but also a large-scale and well-thought-out system of institutions that collectively represent an attempt to reproduce the traditional European banking system (based on the Basel Agreement) with somewhat different underlying principles. In understanding Islamic banking, the word ‘banking’ is as important as the word ‘Islamic’. These institutions generally perform the same functions as any other modern banking system and operate in a regulated environment specifically developed in an effort to conform with the Basel Agreement. This particular attribute makes Islamic financing a unique phenomenon.

The modest share of Islamic financial assets in the global system prevents the concept from bringing really serious systemic effects to both advanced and emerging economies. Even in some countries with traditionally Muslim populations, such as Turkey, Egypt, and Indonesia, the market share of Islamic banks does not exceed five percent, so they do not play a significant role in determining economic growth

Islamic banks are very different from the semi-formal financing practices developed in the East since antiquity (such as hawaladar – a system of money transfer based on informal connections within clans). Today’s financial hot topic is a product of modern history – the first attempts to create Islamic banks date back to the 1960s, while their large-scale development began two decades later.

The process was triggered by the decolonization of Asia and Africa after the Second World War and was predicated on the political construct of a modern Islamic state. Pakistan was the first experiment in this respect. When the country was founded in 1948, it had all the key European-style democratic institutions – a constitution, a president, a parliament, a government, and elections – with Islam recognized as the official religion underpinning the country’s legal system. The Institute of Islamic Banks was the economic extension of this concept – it was designed to enable Muslims to get access to modern financial opportunities without compromising their faith.

Halal and Haram

The Quran prohibits what it calls ‘Riba’, a term generally interpreted as unjustified enrichment. Avoiding this, while encouraging trade and crafts, form the basis of Islamic finance. Reputable modern religious leaders used their interpretation of Surahs, chapters of the Quran, to come up with the following set of rules that determine which financial transactions are admissible, or halal:

•Money cannot beget money: profit may only be derived from real transactions such as trade or investments into production assets;
•Profits may only be generated as a result of a shared commercial risk, guaranteed return on investments is prohibited;
•Investments in unethical industries are prohibited (haram): this includes the production and sales of alcohol, tobacco, drugs, weapons, and pork, as well as prostitution, which may have a rather broad interpretation that encompasses parts of today’s media business.

It is believed that Islam must develop according to a living tradition of ongoing study and interpretation of the Quran as it applies to the modern world. Thus, mutually exclusive legal opinions (fatwas) may be issued by reputable interpreters of Islam there is no universal arbitration mechanism to deal with such cases. Obviously, this situation can make it somewhat difficult to build a strict international system of professional financing. Some banking products skirt the borders of what can be considered halal and are subject to lively ethical debates.

In the image and likeness

Islamic banking products may be categorized in three groups:

•Contracts with shared profits and losses (mudarabah and musharakah), which are similar to venture financing transactions;
•Sukuk: this is in fact a bond, however, it has to be tied to a title to tangible assets where the risks of losing the assets and sustaining losses are shared (even though in practice sharing losses may be highly improbable);

Indirect participation or mark-up contracts (without shared profits and losses), which as a rule serve as a substitute for Western loan products: murabaha (trading transactions), ijara (transactions involving assets, similar to leasing), bai al salam, and bai al istisna (notionally, target project financing). This includes products for retail consumers where articles are bought on credit, but the transaction is presented in such a manner as if the product were first purchased by the bank and subsequently sold to the consumer who pays for it in instalments or leases it. For instance, a bank would buy a refrigerator, lease it, and ultimately the consumer would buy out the asset. It is a difficult proposition to create an instrument similar to credit cards – lately some banks in Saudi Arabia started offering products like this but whether they are halal is still disputed by experts.

The latter group of products account for a large part of Islamic banking assets, which attracts criticism from a number of religious leaders who point out that these instruments are virtually risk-free for the bank, thus violating one of the fundamental principles of Islamic financing.

Costs and Prohibitions

The prohibition pursuant to which ‘money cannot beget money’ makes transactions conducted by Islamic banks somewhat unconventional in terms of classical banking. An ordinary bank would borrow funds on the market – from the population, organizations or other banks – to invest them into assets that generate profits. Anyone who ever deposited into a bank account knows that generating income in the form of interest accrued from the money invested in this manner is a common market practice. Islamic banks cannot pay interest on cash deposits, so depositors do not make any money from it. Retail cash preservance contracts are the equivalent of deposits in Islamic banking – the bank does not pay any interest on those, but it guarantees that the money will be kept safe. Another form is retail investment contracts, which differ in that the depositor assumes the risk of zero or even negative income. Thus, compared to traditional banks, Islamic financial institutions offer less attractive conditions for savings.

Islamic banks are also limited in the ways they can make profits because generating cash-derived income is banned and income from foreign exchange transactions is also complicated. When it comes to costs, compliance with Sharia laws makes the paperwork significantly more complex in every transaction because of the related purchase and sale agreements that need to be formalized, as well as additional internal monitoring procedures designed to ensure that all transactions meet the halal requirements. One benefit that Islamic banks can offer is the lower level of credit risks. As a result, for clients who use these quasi loan products (in the form of leasing or retail payments by instalments), Islamic banking services usually end up costing a bit more than similar loans with interest.

All of these market challenges combined mean that not all experiments with Islamic financing are very successful, even in countries that are historically Muslim. Thus, there is only one Islamic bank – with quite modest business results – in Kazakhstan, for instance, despite the fact that the country adopted all of the necessary regulatory norms in 2009.

Islamic financing is a unique phenomenon that was born as a symbiosis of long-established non-European commercial traditions and modern financial institutions in an attempt to respond to the economic and cultural challenges that followers of Islam are faced with in today’s world

Many attempts to measure the comparative efficiency of Islamic and ordinary banks yield conflicting results. Overall, the existing research can be interpreted as follows: Islamic banks offer medium- and long-term return on assets or capital that is equal to or slightly lower than that offered by comparable ordinary banks; however, they pass through different phases of the economic cycle in slightly different ways. Islamic banks tend to be more resilient during the ‘hot’ phase of financial crises because they have virtually no assets that are purely financial and are not involved in market ‘bubbles’. At the same time, post-crisis depression puts a great deal of pressure on them because the real economy slows down and the value of their assets falls (the real-estate market, which is traditionally popular among Muslim investors, tends to be particularly vulnerable).

Questions and considerations

There are two key questions that must be considered regarding the ongoing attempts to introduce Islamic banking in non-Islamic countries: what is the purpose of these attempts and what will they cost? These questions can be answered from two different perspectives.

There is the social and cultural perspective, which is often invoked in countries like Russia or India with a large, established Muslim population. Religiously comfortable financial services could be viewed as one of the key rights of citizens. So, does this perspective make sense? Or, to put it in another way, to what extent would the absence of Islamic financing realistically prevent citizens from using modern banking services, taking into account the fact that Islamic financing, as we saw earlier, does not offer more attractive conditions?

The situation is quite controversial. On the one hand the successful development of Islamic banks in European countries was clearly predicated on the demand coming ‘from below’, directly from the population. Moreover, a significant part of these banks’ customer base in Europe are non-Muslims, so in principle, these institutions improve financial inclusiveness on the market. However, if we look at traditionally Islamic areas in Russia’s Volga region, the picture is very different. Tatarstan and Bashkortostan are ranked among the most advanced regions in Russia in terms of their financial sector, with successful operations of federal and local banks, and the level of penetration of loans in particular is above average compared to the rest of the country. Judging from the available statistical data, if Islamic banks were to open in Kazan or Ufa, they would not hardly cause significant changes in the financial market there.

The picture gets more complicated in regions with underdeveloped financial systems, which include many African countries, for instance. As a rule, the reasons why financial services have low penetration in these regions have little to do with religion. They are more to do with the overall level of social and economic development, security considerations, and the degree of risk. For poor countries with struggling banks, any development of the financial system and the local banking market would be relevant and positive; in addition, offering specifically Islamic financial services could play a positive role in terms of credit risk management.

To better understand Islamic financing, we need to be aware that it involves not just a set of religious precepts and prohibitions, but also a large-scale and well, thought-out system of institutions that collectively represent an attempt to reproduce the traditional European banking system (based on the Basel Agreement) with somewhat different underlying principles. In understanding Islamic banking, the word ‘banking’ is as important as the word ‘Islamic’

The question gets a different perspective if we talk about the specific role of Islamic banking in the development of national financial systems. Arguments of this sort are often presented as a package deal that also includes cultural considerations. However, for the purposes of planning regulatory activities, they should be viewed strictly as two separate phenomena. In theory, Islamic financial institutions can truly contribute to forming a more sustainable and efficient banking system; for instance, they could offset ordinary banks’ appetite for financial speculations that are detrimental to investments in the real sector.

Islamic banks proved more resilient during the ‘hot’ phases of various financial crises, especially in the 2008-2009 crisis. In a number of countries, they also proved successful in stimulating the development of small- and medium-size businesses. Theoretically, all of these attributes combine to make them quite attractive; what is also important is that this perspective does not require fully Islamic financial institutions. This objective could be met by simply removing those restrictions that prevent banks from financing commerce, investments, leasing, and other transactions compatible with Islamic norms. There is no need to comply with Sharia oversight or to use religious labels for these financial institutions. This would remove the aforementioned political and legal challenges impeding the development of legislation governing religious institutions in a secular multicultural system. However, it begs the question whether the banks that operate based on the Basel Agreement could use these new opportunities to expand their own operations in more profitable and risky segments – after all, wasn’t there a reason why the banks’ latitude to engage in trading operations was restricted some time ago? One possible answer was offered in the form of quasi-banking legal forms of sorts like ‘trading and investment houses’, but introducing new entities into an already saturated regulatory landscape is bound to bring about new challenges.

The modest share of Islamic financial assets in the global system prevents the concept from bringing really serious systemic effects to both advanced and emerging economies. Even in some countries with traditionally Muslim population, such as Turkey, Egypt, and Indonesia, the market share of Islamic banks does not exceed five percent, so they do not play a significant role in determining economic growth. Islamic financing in Western European countries is even more of a niche product. About half of the European countries that started moving toward Islamic financing were driven by a desire to experiment and diversify international sources of lending. Issuing corporate or regional sukuks instead of ordinary bonds can be an efficient – or more likely an ostentatious – marketing move. It is important that far-reaching legislative innovations should not create risks that are greater than the desired result. An analysis of European legislative practices geared toward facilitating the integration of Islamic financing shows that creating a level playing field first needs a transformation of tax and accounting legislation. Again, it begs the question of whether in principle it is permissible and justified to create a de facto stand-alone legal regime for a separate group of citizens and corporations.

It makes sense to view the issue of integrating Islamic banking into a secular national financial system from a long-term strategic perspective. On the one hand, taking into account the fact that there are unlikely to be any immediate significant effects, it would make sense to benchmark the scale of legislative transformations against the results that this process would yield. The experience of European countries that successfully developed Islamic financing shows that gradual, measured steps taken in response to real market requirements create genuine added value. At the same time, a strategic move towards a symbiosis of the traditional banking system based on the Basel Agreement and Islamic financing may improve the quality of banking worldwide by fostering inclusiveness, expanding financing instruments in the real sector – especially for small- and medium-size businesses – and, to a certain extent, by strengthening resilience to economic cyclicity.