Islamic Finance: An evolving niche

Any opinions expressed here are solely those of the writer.

Modern Islamic finance has come a long way since initial experiments in the 1960s. As the leading and most comprehensive form of faith-based finance, it now covers banking, capital markets and insurance. And its rapid expansion in different parts of the world stems from various factors, including the use of petro dollars in the Middle East to its philosophy of inclusion of all interested participants, regardless of religious beliefs.

Small size, big potential

While traditional centres for Islamic finance remain in the Middle East, London has emerged as the Western hub, with Hong Kong, Singapore and France also working to develop their Islamic finance markets. Immigration statistics suggest there’s also growth potential for the sector in Canada.

Assets invested in the industry worldwide are estimated at upwards of $1 trillion, with annual double-digit growth being recorded—and projected to continue. (A recent International Financial Services London report on Islamic finance estimates assets invested at the end of 2008 totalled $951 billion, up 25% from $758 billion recorded in 2007 and up three-quarters on the 2006 total.)

Since the assets of any one of the world’s largest banks alone top the $1 trillion mark, it can be said the size of the Islamic finance industry remains comparatively small. Yet it’s not the current size of the industry that’s garnering international interest, but rather its rapid growth, its association with religion and its future potential: with an estimated 1.6 billion people identifying as Muslim, it’s not unreasonable to expect further growth. Thus far, products such as home financing and credit cards have been Canada’s primary exposure to Islamic finance. And it would, of course, be unwise to assume every Muslim in Canada will want to practise Islamic finance.

The study Islamic home financing in Canada, commissioned under the Canada Mortgage and Housing Corporation mandate in January, doesn’t necessarily endorse the idea that there’s substantial unmet demand for Islamic home financing here. And given the relatively small size of the domestic Muslim population, those offering Shari’a-compliant finance would like to position it as ethical finance to broaden its appeal to non-Muslims.

That said, with a Muslim population base of nearly 1 million, Canadian advisors are likely to get some requests from Muslim clients on financing and investment options not in conflict with their religious beliefs.

Religion meets personal finance

An individual’s generic 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 play.

Introducing such non-economic considerations to meet financial needs isn’t 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.

Core concepts

There’s been lots of discussion about what Islamic finance is and what it should be. Some see it as a quest for a moral economy that facilitates social and economic justice.

The crucial difference between conventional and Islamic finance, though, 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 those two terms has been debated since the beginning of Islam. While it’s tempting to translate them as interest and uncertainty, such simplistic terms often bring more confusion than clarity.

There is, however, rather broad agreement that lending money on interest and trading risk without underlying real assets falls within the scope of these two prohibitions. And their impact 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

So what financial products can an advisor suggest for an interested client’s portfolio?

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, here are some products and services that are currently being marketed as Shari’a-compliant:

Islamic equity funds use business and financial screens to avoid companies that operate in the sin industries (such as gambling, tobacco and 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. Any 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.

Islamic banking commonly uses investment accounts that are basically 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 the spot and credit prices.

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 still aren’t any global standards to judge what is and what isn’t Islamic, and views and practices differ both within and across countries. However, equity-like financing in ethical and socially responsible businesses is likely to be accepted universally.

Form versus substance

The ongoing form-versus-substance debate is an important issue facing Islamic finance. 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.

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.

Islamic finance literature emphasizes profit sharing, but critics say the industry is dominated by financing mechanisms with embedded interest masquerading as credit sales and leases of assets. The intended business, they say, is not trading goods or renting assets, but borrowing and lending money on interest.

Criticism also surrounds what’s regarded as conflicts of interest in Shari’a governance, where leading jurists are allegedly paid hefty fees by financial institutions to endorse products as religiously acceptable for Islamic finance customers.

On the other hand, proponents 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 assert, 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 Islamic finance operates within a global system shaped by lending money on interest and trading of risk. With many legal, regulatory and taxation obstacles, they say, it’ll take time before products truly based on Islamic teachings (versus those deemed compliant on technical grounds) emerge.

Outlook

Since it owes its existence to clear prohibitions dictated by the primary sources of Islam, Islamic finance would appear to have a relatively secure and long-term future. It attracts those who are motivated by their sensitivity to Islamic teachings, as well as those who consider it purely on economic grounds.

That said, modern Islamic finance is a young industry that’s seen significant growth and development in the last two decades, and it’s likely to remain subject to much debate and evolution.

Usman Hayat, CFA, director of Islamic finance & ESG Investing at CFA Institute