February 05 2016

Islamic Finance: a viable alternative?

Could Islamic Finance offer a viable and more ethical alternative to conventional Western models in the wake of the 2008 crisis? Dr Edward Bace, Senior Lecturer in the Accounting and Finance Department at Middlesex University, explores the issue.

In July 2015, I represented Middlesex University Business School in a meeting with long-time professional partner the Chartered Institute of Management Accountants (CIMA), which was seeking academic input to update its highly regarded qualifications in Islamic Finance (IF). CIMA’s interest, paralleled by that of other professional associations and academic institutions, is testimony to the growing popularity of IF. Since 1975, when the first Islamic commercial bank was established in Dubai, growth has been rapid, and IF global assets are now estimated at more than US $1.5 trillion across the banking sector, capital markets, and takaful, or Islamic insurance.

Despite this growth, IF is still accompanied by a variety of different views around its economic feasibility, consistency of criteria and core principles. Compared to conventional finance, IF is still in its relatively early stages of development and, accordingly, is grappling with some issues.

Core principles

A relatively recent phenomenon developed within the last 50 years, IF is built on much older Islamic economic thought going back to the seventh century. This philosophy emphasises a moral purpose for human existence, where the individual is the trustee for God’s resources, to be deployed for the ultimate good of society. IF accordingly adheres to Shari’a, or Islamic law. This means that IF must avoid ‘sin’ (prohibited) businesses such as alcohol, and abide by the Islamic prohibitions of riba and excessive gharar, which are generally understood to include lending and borrowing of money at interest and sale of risk. In this respect money is not considered a productive asset, like a farm or a factory (a notion which actually goes back to Aristotle in Western thought), and it is forbidden to make money on money. The focus on the good of society also ties in with modern and appealing concepts of corporate and social responsibility.

Unanswered questions

There is a great deal of controversy surrounding the definition of riba. Is it interest? Is it usury? Does it mean excessive interest, or exploitation of debtors? Does it imply a predetermined profit? There seems to be some confusion, even among Islamic scholars, of its exact meaning.

Others take issue with the notion that money is considered unproductive, and should not earn a return. Money is not a farm, or a manufacturing plant, or computer software, but is it not fungible with all these and other traded financial instruments? Market activity will price out these relationships and establish a time value for money. Agents’ time preference and the time value of money demand compensation through market arbitrage, whether through interest or Islamic structures. How do Islamic finance advocates successfully address the contradiction between this market reality and a ban on interest?

Another core principle of IF is risk sharing, which sounds like a good idea. Yet if this were honestly and rigorously applied to banking, it would lead to a gross asset-liability risk mismatch, or turn banks into venture capital companies, with bank runs when they fail. It seems that even Islamic bankers do not engage in true risk sharing, but use the Islamic copies of conventional mortgages and loans.

Ethics

Many observers agree that the underlying core principles of IF are refreshingly sound. The idea of tying the financial system more closely to the real economy and tangible, productive enterprises has great appeal, particularly following the financial crisis. Its emphasis on use of equity rather than debt also reinforces perception of a safer, more secure system. The ethical principles on which IF is based should bring banks closer to their clients and to the true spirit which ought to mark every financial service.

These questions, if definitively answered in the affirmative, could make Islamic finance a global and viable alternative to conventional finance.

Some regard IF as a singular global economic force that challenges ‘rogue economics’. It does not permit investment in pornography, prostitution, narcotics, tobacco or gambling – all of which seem to have flourished in a free market economy.

Nonetheless, critics continue to point to a perceived lack of common, universally accepted standards of Shari’a compliance. Until this is seen to be achieved, IF could remain a niche area, unable to provide an ethical alternative to conventional finance. Is IF really Islamic? Is there too much emphasis on form versus substance?

A need for dialogue

Other questions are asked about long-term economic feasibility. Some query the efficiency of IF versus conventional finance, maintaining that the prohibition of interest generates massive inefficiencies. There is a view that Islamic finance has abandoned its original ethical content and placed too much emphasis on legal form. Some issuers of sukuk (Islamic bonds) have claimed that many (non-Muslim) investors bought sukuk simply because these bonds paid higher yields than otherwise similar bonds. Does Islamic finance permit free flow of capital? Will parties be equally satisfied? Can investors make money? These questions, if definitively answered in the affirmative, could make Islamic finance a global and viable alternative to conventional finance.

In sum, Islamic finance does have much to say about excessive financial leverage, bank capitalisation, risk management and financial market ethics. Instead of a parallel financial system, perhaps a dialogue on these issues with regulators and legislators may be more productive.

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Tags: banking, banks, corporate responsibility, debt, economics, ethics, finance, financial crisis, Islam, Islamic Finance, money, wealth, Western