The whys and wherefores of Islamic finance

A short introduction

Faith-based finance

Sep 4th 2008
From The Economist print edition

The whys and wherefores of Islamic finance

THE modern history of Islamic finance is often dated to the 1970s, with the launch of Islamic banks in Saudi Arabia and the United Arab Emirates. But its roots stretch back 14 centuries. Islamic finance rests on the application of Islamic law, or sharia, whose primary sources are the Koran and the sayings of the Prophet Muhammad. Sharia emphasises justice and partnership. In the world of finance that translates into a ban on speculation (or gharar) and on the charging of interest (riba). The idea of a lender levying a straight interest charge, regardless of how the underlying assets fare in an uncertain world, offends against these principles—though some Muslims dispute this, arguing that the literature in sharia covering business practices is small and that terms such as “usury” and “speculation” are open to interpretation.

Companies that operate in immoral industries, such as gambling or pornography, are also out of bounds, as are companies that have too much borrowing (typically defined as having debt totalling more than 33% of the firm’s stockmarket value). Such criteria mean that sharia-compliant investors steer clear of highly leveraged conventional banks, a wise choice in recent months.

Despite these prohibitions, Islamic financiers are confident that they can create their own versions of the important bits of conventional finance. The judgment of what is and is not allowed under sharia is made by boards of scholars, many of whom act as a kind of spiritual rating agency, working closely with lawyers and bankers to create instruments and structure transactions that meet the needs of the market without offending the requirements of their faith.

Non-Muslims may find the distinctions between conventional finance and Islamic finance a trifle contrived. An options contract to buy a security at a set price at a date three months hence is frowned upon as speculation. A contract to buy the same security at the same price, with 5% of the payment taken upfront and the balance taken in three months upon delivery, is sharia-compliant. Then again, winning over non-Muslims is not really the point.

There is no ultimate authority for sharia compliance. Some worry that this may hold the industry back. Malaysia has tackled this by creating a national sharia board. Some industry bodies, notably the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in Bahrain, are working towards common standards. That a few scholars dominate the boards of the big international institutions also helps create consistency. But differences between national jurisdictions—between pious Saudi Arabia and more liberal Malaysia, say, are likely to remain.

Both of these countries feature in the top three markets for Islamic finance, measured by the quantity of sharia-compliant assets (see table). Top is Iran, although international sanctions keep its industry isolated. The Gulf states, awash with liquidity and with a roster of huge infrastructure projects to finance, are the most dynamic markets. Britain is the most developed Western centre, although France, with a much larger Muslim population, wants to close the gap.