The Islamic finance industry has experienced growth, but the industry is still a work in progress.
The modern Islamic finance industry has come a long way since its initial experiments in the 1960s. It now covers banking, capital markets and insurance, and its rapid expansion in different parts of the world is the result of various factors, ranging from petro dollars in the Middle East to its philosophy of inclusion of all interested participants, regardless of religious beliefs.
Small Size, Much Growth
Assets in global Islamic finance are currently estimated at upwards of $1 trillion, with annual double-digit growth being recorded, and projected to continue. According to the 2010 report on Islamic finance by International Financial Services London (IFSL), assets in Islamic finance reached "$951 billion at end-2008, 25 percent up from $758 billion in 2007 and three quarters up on the 2006 total."
The assets of any one the world's largest banks alone top the $1 trillion mark, so the size of the Islamic finance industry remains very small. It is not the current size of the industry that's garnered international interest, but rather its rapid growth and its association with Islam.
While traditional centers for Islamic finance include Saudi Arabia, Malaysia, Kuwait, UAE and Bahrain, London has emerged as the Western hub, with Hong Kong, Singapore and France also working to develop their Islamic finance markets.
Islamic Finance In The United States
Islamic finance is not new to the United States. Domestically, it is thought to have been around since 1987, with a focus on home financing and equity funds. There are some financial services providers in the U.S. (for example, Guidance Residential and Saturna Capital) that target American Muslims, which is estimated at around six to seven million people. The U.S. is also home to some of the most elite experts in Islamic finance--both critics and proponents. The Islamic finance project at Harvard Law School's biennial Islamic finance conference is a significant global industry event. Furthermore, some well recognized names in U.S. financial services are actively engaged in Islamic finance overseas, such as the Bahrain based Citi Islamic Investment Bank, which is a subsidiary of Citicorp Banking Corporation.
Bringing Religion Into Personal Finance
An individual's basic financial needs are independent of religion: Everyone needs to earn a living, pay taxes and worry about issues such as retirement and protection from death and disability. It's not so much the needs but rather the means of fulfilling them that change when religious values are brought into personal finance.
Introducing such non-economic considerations in meeting financial needs is not new. Just as a responsible investor is concerned about environmental, social and governance issues, the religion-sensitive investor wants financial services without necessarily compromising on risks and returns.
The primary impact of introducing non-economic considerations is that investment and financing choices are reduced, although the degree of this effect is perhaps much greater in the case of Islamic finance than in socially responsible investing.
Intellectual discussion abounds on what Islamic finance is and what it should be. Some see it as ethical finance and a quest for a moral economy that ought to facilitate economic justice. However, the crucial practical difference between conventional and Islamic finance is that certain prohibitions in the primary sources of Islam impact the purpose and structure of financing. Simply put, Islamic finance can't be used for transactions involving activities prohibited in Islam, such as gambling and the consumption of alcohol and the structure of financing must also avoid riba and excessive gharar.
The exact meaning of these two terms--riba and gharar--has been debated since the beginning of Islam. While it's tempting to translate them as interest and uncertainty, such simplistic translations often bring more confusion than clarity.
There is, however, broad agreement that lending money on interest and trading risk without underlying real assets fall within the scope of these two prohibitions The impact of these prohibitions is tremendous, as many modern finance instruments, ranging from treasury bills to currency futures, involve lending money on interest, the sale of risk, or both.
Prohibitions and products
In Islamic finance, financing should come with an asset; and risks are to be borne or shared but not sold. Despite such seemingly restrictive rules, there are products and services that are marketed as "Shari'a compliant":
Islamic equity funds use business and financial screens to avoid companies that operate in the sin industries (e.g., gambling, tobacco, alcohol) or that have a relatively high reliance on interest-bearing debt. Some interest-bearing debt--usually a third of assets or market cap--is tolerated in the remaining companies because using zero-tolerance would leave no investment choice. Dividend income attributable to religiously unacceptable earnings is donated to charities.
Sukuk, which are often referred to by the oxymoron "Islamic bonds," are based on the underlying idea that investors should derive return from ownership of a real underlying asset, such as lease rentals from a building.In Islamic banking, commonly used investment accounts are profit-sharing accounts where losses incurred on investments made by the bank on behalf of account holders can be passed on to those account holders. Islamic bank financing assumes different forms, but mostly banks buy assets on spot and then sell or lease them to the customer on credit, earning the difference between spot and credit price.
Islamic insurance is based on the principle of mutuality and risk-sharing, where participants pool their contributions to create protection for themselves.
Of course, much in Islamic finance remains subject to interpretation. There aren't yet any global standards to judge what is and what isn't Islamic. Views and practices differ both within and across countries. However, equity-like financing in ethical and socially responsible businesses is likely to be considered universally acceptable.
Theory Versus Practice
There is much debate in the Islamic finance circles on whether and to what extent the practice follows the theory.
Critics such as Mahmoud El-Gamal, a Rice University professor, question the religious authenticity and economic efficiency of the modern Islamic finance industry. They argue that instead of respecting the religious guidance, the industry is merely replicating conventional finance and charging naïve religious followers a faith premium by changing the contractual form of financing through legal fiction while retaining its economic substance.
Others, such as Tarek El-Diwany, known for his bold writings in the field, aren't convinced commercial banking can abide by Islamic prohibitions within the prevailing framework of fiat money and credit creation where most of money supply is in fact interest-bearing debt.
Islamic finance literature emphasizes profit sharing, but the industry, as per the critics, is dominated by financing mechanisms with embedded interest which masquerades as profit in credit sales and leases of assets.
Criticism also surrounds what is regarded as conflicts of interest in Shari'a governance, where leading Shari'a scholars allied to the industry are said to be paid hefty fees by financial institutions to endorse products as religiously acceptable.
On the other hand, proponents of modern Islamic finance argue that technical legal grounds are enough for religious authenticity, and Islamic finance need not always be different in economic substance from conventional finance. Further, they maintain, Islamic finance doesn't participate in sin industries, maintains close ties to real economy and avoids the speculative excesses of conventional finance.
Proponents also say that Islamic finance operates within a global financial system shaped by lending money on interest and trading of risk. In the face of many legal, regulatory and taxation obstacles, they insist, it will take time before products truly based on Islamic teachings--as opposed to those deemed compliant on technical legal grounds--emerge.
Since it owes its existence to clear prohibitions from the primary sources of Islam, Islamic finance seems to have a relatively secure and long-term future. It attracts those who are motivated by their sensitivity to ethics and Islamic teachings, as well as those who consider it purely on economic grounds. While some see the ongoing political controversies as limiting the prospects of Islamic finance in the U.S., others see Islamic finance as a possible venue for those in the U.S. to engage with the world Muslims. Since the financial crisis, there has been a lot more interest in ethics in finance and the theory and practice of Islamic finance seems to be gathering intellectual attention. That said, modern Islamic finance is a young industry that has seen significant growth and development in the last two decades and it is likely to remain subject to much debate and evolution.
Usman Hayat, CFA, is director of Islamic finance & ESG Investing at CFA Institute. Any opinions expressed here are solely those of the writer.