Islamic Finance has much to learn from the west

An interesting read. Mr Muhammad Saleem quetions the validity of effect of Islamic Finance on the world. He questions whether it is taking Muslims, as a community, forward. He compares it to venture capitralism in the West and its many advantages. I really don’t know too much about Islamic Finance apart from the diffrent products to be able to contribute to this. What do you think?

Islamic Finance has much to learn from the west
by Muhammad Saleem
Op-Ed page of the FT on January 19th

Proponents of Islamic finance maintain that as the Koran prohibits interest all financing must be done on a profit and loss sharing basis. In spite of all the lofty rhetoric in practice no more than five per cent of Islamic financing is done this way.

Instead, Islamic banks use a structure called murabaha, or cost plus pre-determined profit, for the vast majority of their finance deals.

Remarkably, the “profit” for an Islamic bank in a murabaha transaction and the interest a conventional bank would have charged on the same transaction happen to be exactly the same. Indeed Islamic banks in determining their “profit” even quote the rate as a margin over Libor or other similar indices!

Murabaha was a crude trading practice designed for transactions between real sellers and real buyers involving physical goods. By structuring a financing transaction while disguising it as a trading transaction – and charging interest concealed in Islamic garb – Islamic banks turn the entire enterprise into a charade.

Other modes of financing are just as dubious. Take Islamic house finance, structured as a lease: lease payments are equal to interest that a conventional bank would charge on a home mortgage loan. Sukuks, or Islamic bonds, are similar in many respects to murabaha and just as tainted. Brandishing a fatwa from a scholar of sharia law (who, like mercenaries, are sometimes for sale at the right price) blessing the structure does not absolve the bankers from the responsibility of meeting the spirit of the
sharia.

The real problem with the Islamic finance industry is that despite a 30 year history and current assets of about $300bn they have yet to add any value. Islamic banks have not created any new jobs (employment at Islamic banks does not count), financed new inventions or innovations or made the Islamic communities more just and equitable. The smoke and mirrors Islamic finance industry appear to be all about creating financial structures to comply with the letter of the law, not the spirit and intent of the Koran.

Islamic banks need to move away from the deceptive modes of financing they currently use and step towards the American style of venture capital. This has two advantages. First, the stated principles of Islamic banking – favouring profit and loss sharing over interest – are very similar to the financing techniques used by the venture capital industry, especially in the US. These private equity groups are the real Islamic finance, the genuine article. Second, by providing funds to entrepreneurs with bright ideas, the banks can assist in promoting innovation, invention and creation of new jobs and industries.

The ironic thing is that although the US is not an “Islamic country”, more authentic and genuine sharia compliant financing is done in the US than in all the Islamic countries combined. That is because American venture capital groups annually provide about $25bn in capital financing to entrepreneurs, scientists, and engineers with new ideas. As a consequence of the availability of this type of financing the venture capital industry in the US has given birth and nurtured scores of Silicon Valley companies including such modern day icons such as HP, Cisco, Intel, Sun Micro Systems, Apple, Netscape, Ebay, and Google. All were created in the last 30 years or so from ideas grounded in science and technology. Scientists and engineers came up with the ideas, innovations, and inventions while the venture capital industry provided the capital on a partnership basis. Millions of new jobs have been created as a result.

At one time – from AD750 to about AD1100 – it was the Muslim world that was making advances in science and technology, because of the availability of risk capital (from rich people or sponsorship from the rulers) and respect for education, scholarship, discovery and innovation. But nothing of consequence has been invented in the Islamic world for hundreds of years. The west’s renaissance partly came as a result of learning from the Islamic world. Now it is the Islamic world that needs to learn from the west, especially borrowing those ideas that are both consistent with its own beliefs and able to contribute to economic and scientific development. Venture capital is clearly such an idea. By becoming more like venture capital groups, the Islamic banks can practice real Islamic finance while helping the Islamic community to rediscover its tradition of invention and innovation.

The writer is a former international banker and the author of Islamic
Banking: A $300 billion Deception

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7 thoughts on “Islamic Finance has much to learn from the west

  1. Glad to see someone with pedigree writing on an oft-ignored aspect of Islamic financing. The current products are extremely debt-focused, in order to capture risk-free no-frills margin off the table. Equity-based financing was the shape I always perceived Islamic finance to take- but the re-packaged sham that is being churned out certainly left me more than disillusioned.

  2. I couldn’t agree with this article more, but there are still a few things to add. Appologies if my comment excludes people unfamiliar with the finance jargon that will follow. Briefly, Islamic finance prohibits the short selling of stocks, a routine practice at trading desks at banks in developed financial markets. This means that banks are unable to offer financial products such as options, because they are unable to hedge away the risk. Fewer financial products mean that markets are less complete, less risk-sharing is possible, and, most importantly, markets become less efficient. It’s easy to show using some basic finance theory just how bad inefficient markets can be for an economy.

  3. Easier said than done. A crucial difference between “Western” societies and Muslim countries is the enforcement of law (quite ironically). You cannot expect financial markets to perform in environments where shirking is not punished. In such contracting environments, a portfolio that comprises of mostly “debt-like” instruments such as Murabaha is a rational response by Islamic banks. Venture capital or Mudarabah schemes may be too risky to warrant a large portfolio share. Banks would simply decide not to operate if they were mandated by law to only offer Mudarabah type instruments.The portfoilio would be too risky; the sustainability of the bank will be compromised and conseqently the entire financial system. So, the bottom line is, enforcement of law is a pre requisite because it reduces the riskiness of venture capital arrangements, thereby making it profitable for banks to offer Mudarabah services.

  4. The first thing to be kept in mind is that no banking system is a perfect one, especially if looking from the Shariah perspective. Islam disallows over spending. So, in essence, any credit transaction which is being done out of unnecessity should be avoided. Having said that, we should still try to move away from the evil or by putting it the other way- move away from a greater evil to a lesser one. There is a very fine line between Islamic and conventional finance. E.g. if you look at the Hadith narrated by Abu Said Al-Khudri where Prophet Muhammad disallows exchange of 2 bad dates with one good date instead he allows the sale of the former and then purchase of the latter. These two transactions could be interpreted as the same but the ‘fine’ difference is the exchange of money twice which takes away any chance of unjustice to either parties. There are numerous other examples like this one. My view and suggestion would be to take Islamic finance as the first step towards the right. Rest would all fall in place.

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