Islamic Finance: A Possible Solution to a Crumbling Economy

By Nabil Ahmad

Approximately 14 months ago a financial crisis began, and it has now entered a new, far more serious phase. Remaining hopes that the damage could be limited to just a few financial institutions that simply made wrong business decisions is no longer there. While the original problem was subprime mortgages, the entire banking industry is now in trouble. And this has been the worst financial crisis since the Great Depression.
The Federal Reserve and Treasury officials have identified the problem: the out of control debt. During the credit boom, financial institutions along with households in America incurred too much debt. Between 2002 and 2006, household borrowing grew at a rate much higher than the economic growth. Borrowing by financial institutions also grew tremendously. The problem is that now many of those borrowers can’t pay back the loans, a problem that is weakened by the collapse in housing prices.
Debt-driven financial traumas have a long history, from the Great Depression to the Savings and loan crisis to the Asian financial crisis of the late 1990s. Neither economists nor policymakers have easy solutions. Even though issuing a reduction in interest rates and writing stimulus checks to families can help, it does not solve the problem. During such times, governments usually experiment with solutions with some level of success. After the market crash of 1929 President Franklin Delano Roosevelt released the new deal program.
This crisis is complicated by innovative financial instruments that Wall Street created and distributed. They’re making it harder for officials and Wall Street executives to know where the next set of risks is hiding and also contributing to the crisis’s spreading impact. Few financial crises have been sorted out in modern times without massive government intervention. Increasingly, officials are coming to the conclusion that even more might be needed. A big problem: The Fed can and has provided short-term money to sound, but struggling, institutions which are out of favor. It can, and has, reduced the interest rates it influences to attempt to reduce borrowing costs through the economy and encourage investment and spending. But the risk remains that the problem with spread from Wall Street to every street in the United States, as credit tightens for consumers and business. Already, U.S. auto makers have been forced to tighten the terms on their leasing programs.
As huge conventional financial institutions are falling apart and folding up, another financial sector is gaining new confidence— that is Islamic banking. It is interesting to note that while the financial crisis in the United States continues, a great opportunity for Islamic financial services companies has arose to provide an alternative model. The current credit crunch gives the Islamic finance industry with an opportunity to expand to even non-Muslim investors.
Islamic finance originally generated interest in the United States in the late 1990s. In 1999 The Dow Jones Islamic Index was established, and in 2000 the Dow Jones Islamic Fund was underway. However, Islamic Finance still had a lot to prove, and many were skeptical about it.
Yet now, The Islamic finance industry comes at a time in the West after the crumbling of the U.S. mortgage market has left banks holding hundreds of billions of dollars of nearly worthless credit instruments tied to home loans by a web of complex structures.
While conventional banks worldwide have tremendous amounts of losses during the credit crisis, Islamic banks are virtually unharmed. And they are very appealing to shareholders, bondholders, borrowers and depositors who are burnt out.
The current global market condition has given Islamic finance a great opportunity to show that can fill the liquidity gap. Investors that have been traumatized by the credit crisis can now find ease from the stricter regulations imposed on by Islamic law, which strictly prohibits some of the structures and financing methods that were the cause of the mortgage crisis in the U.S.
Islamic finance practices are more fiscally conservative, with direct participation by investors in plans that do not involve placing assets in vehicles off the balance sheets.
Islamic finance is based on Islamic law known in Arabic as Shar’iah. In order for Islamic financial products to be compliant with Shar’iah they need to avoid gearing and speculation. It requires that gains be derived from ethical and socially responsible investments and strictly prohibits interest-based banking and investments in sectors gambling and pornography.
It is estimated that Islamic assets globally have an annual growth of 10 percent to 15 percent a year. The increase in popularity of Islamic finance is drawing the interest of companies outside the Middle East and Asia. This is mainly because the Islamic finance industry has certain features which make it less volatile. For example, Islamic bonds, known as sukuks, replace coupons with payments backed by the performance of tangible assets. Islamic law prohibits the payment of interest and requires transactions to be linked to assets, thus deterring the kind of complexities prevalent in conventional financing operations.
While Islamic finance is an ancient practice, that looks to Shar’iah many have been advocating Islamic finance as a remedy for the current world-wide financial crisis.
Many financial experts even believe that the current crisis will prompt more countries to use rules and regulations of Islamic Finance in their countries economic system.
What makes Islamic banking so much stable than the current conventional system is that is has built-in protection from weakness that led to the downfall of so many institutions. For example, the use of financial instruments such as derivatives, blamed for the downfall of banking, insurance and investment giants, is prohibited, along with excessive risk-taking.
Monem Salam, the national director for Amana Mutual Funds (a brokerage firm which provides services for Shar’iah compliant investing) and co-author to the book A Muslim’s guide to investing in personal finance, notes that “One of the major reasons for the current crisis of financial institutions is because of collateral debt obligations. When an institution slices and dices a mortgage debt multiple times by selling portions off to multiple investors, it creates an even bigger problem if and when the consumer defaults — as opposed to if there were not multiple investors involved in the one contract.” Salam also notes that “Credit Default Swaps are a major problem as well, as they involve pure speculation and gambling.”
One of the many virtues of Islamic banking and the reason it is very attractive for being a replacement for the current market is that you only promise what you own i.e. there is no recourse.
In Islamic banking every product has and has to be asset based. Money can not be made from the lending of money. In order for money to grow, it must be invested. And before any product or service can be released to the public, it has to be approved by a board of Shariah scholars (group of religious clerics). Today Finance lawyers work closely with Islamic finance scholars, who analyze and review a product before issuing a fatwa (religious ruling) as to if it is in compliance with Shar’iah law.
In Islamic banking, depositors are partners with banks as opposed to being ones who are lending their money as looked at in the Western conventional system. The customers’ money is invested, and they share in the profits or the even losses if there are any. Basically the customers are not given a fixed rate of return since their deposits are investments as opposed to loans. In the case of mortgages, rather than lending money to a home buyer and collect interest on it, an Islamic financial institution buys the property with the customer and becomes partners in the transaction. The customer agrees to buy out the portion owned by the institution and also pays a utilization fee during the life of the contract since they will occupying the entire property from day one. The customer pays a fixed each month, and eventually becomes the sole owner of the property. Shar’iah-compliant institutions also cannot invest in alcohol, pornography, weapons, gambling, tobacco or pork. Islamic banks now even offer credit cards in which the full balance must be paid off at the end of the billing cycle.
It is important to note that while Islamic institutions are doing better than conventional banks, they are not immune to poor investments. Monem Salam emphasizes that, “This is not a time for us to be arrogant, but rather learn from the mistakes of others.” As banks continue to turn borrowers away in these times of economic distress, Islamic institutions continue to seal deals worldwide. Is Islamic Banking the solution to current economic crisis ? Many believe so. And only time will tell. ¢