Whither Islamic Finance?

Since the credit crisis hit Middle East, people are constantly bashing Islamic Finance as a failure. I just intend to expose the ridiculousness of one of their arguments over here.

One can easily Google info about Islamic Finance over the internet, so I will not expend large amount of words on explaining it.

If you have taken Econ101, it defines three roles of money:

1. Money is a medium of exchange
2. Money is a measure of value
3. Money is a commodity (trade-able)

In Islamic Economics, the third one does not stand or is not allowed. You can not trade money, you cannot make a profit on it. As such, interest (or profit) on monetary loans is forbidden. This is the essence of Islamic Finance, the implication being that one can only trade hard assets. Hence Islamic finance is also known as asset backed finance.

People claim that money is also an asset like other assets and should be tradeable. Islam does not deny this, it just forbids you to treat it like one. It is clearly mentioned in Quran that they will claim that Riba (profit on money – interest) is like trading but Allah has allowed you to trade (assets) and forbidden you from Riba.

It is very clear that anything above principal in a money lending transaction is Riba, however, the naysayers are at pains to point out that translation of Riba is Usury and not Interest ( I have no idea where did they come up with this arbitrary differentiation). Thankfully Quran remains in its original language of Arabic otherwise I shudder to think that what else people would have claimed as lost in translation.

Now we come to the question of failed investments in Islamic Finance _ falling investment values, defaults on sokouk etc. Like any other investment, islamic (shariah compliant) investment vehicles also face risk and rewards.

Just because a company has raised money through shariah compliant means does not mean that it will definitely be profitable. If that money is used to make speculative deals in real estate (like Dubai companies have done) Shariah compliant or no shariah compliant, the investment has to go kaput.

Investing through Shariah compliant products may require you to maintain similar or even harsher level of due diligence than conventional finance because it not only restricts you from certain forms of raising money but also forbids you in making certain type of investments. If you do not do your homework, you are bound to fail.

People have used a default of a few sokouks and failed performance of few institutions to decry Islamic Finance.

If we want to use the same logic, I think the conventional banking in US, UK and Europe should be shut down as this credit crisis has shown them to be the most failed institutions/systems in the world requiring massive amounts of government funds to stand up. Similarly, such well regarded investment banks as Bear Stearns, Lehman Brothers, Merill Lynch have blown up within a year. Does this mean that investment banking and conventional commercial banking is a failure?

An argument that seems totally reasonable to decry conventional finance, people find it reasonable to bash Islamic Finance.

Islamic Finance is viable and workable economic model and is working fine wherever it is implemented. However, it has failed to gain traction not because it is flawed but the way it is practiced today. A few examples:

1. Replicating conventional methods
Most of the IF institution deal with borrowers that also borrow from conventional institutions. In order to make the borrower comfortable and  avoid teaching him intricacies of IF, IF institutions try to make their instruments look as similar to conventional instruments as possible that the only thing that is different is the word “profit” instead of “interest” in the loan agreements.

2. Offering similar investment products
By definition, derivatives are haraam in IF. Now if you go and create instruments and structures that offer you the same risk/return profile as derivatives but with a label “islamic”, then you are just trying to fool God. Might as well slaughter pigs and sell them as “halaal” pork.

3. Manpower
Conventional banks with their promises of bonus and high payscales attract top graduates. In order to not be left with low class talent, IF institions try to attract employees from conventional banks. These employees  have been trained to offer conventional instruments and are only interested in their bonuses and neither care about Islamic Finance nor educate themselves about its products. Rather than learn about the product and make a concerted pitch to the customer, they take the easy way out saying that this is a conventional product with the Islamic label.

These are some of the factors that bring a bad name to Islamic Finance and are the reason behind the infamous Urdu quote  “kaan ko, sar kay uper say haath ghuma kar, pakarna” (To grab the ear, with the hand coming around the head).

UPDATE: You can read the subsequent post in the series Whither Islamic Finance – Part II.

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5 thoughts on “Whither Islamic Finance?

  1. Interesting write-up. I just wanted to ask a question. Taking interest on the loan that one gives is prohibited in Islam but what about giving interest on the money that one borrows from another (could be a non-Muslim), is it also prohibited?

    • Interest in all its forms is prohibited. I hope I don’t misquote but the prophet has cursed anyone who pays Riba, who receives Riba and even the one who witnesses the agreement or transaction. Its one of the gravest sins in Islam.

      Banks make money by lending. The main purpose of Islamic banks is not to provide you with avenues for investments/deposits (though that goes hand in hand with lending) rather to enter into commercial lending transactions based on Islamic principles.

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