Islamic Finance - Fad or the Future? - Part 1

How Islamic finance allows for growth whilst removing the aspects of finance which make it dangerous and unsustainable

Mar 03, 2023

Islamic Jurisprudence or Shariah is the body of revealed laws, with the Quran & Sunnah being the primary sources guiding judicial systems. Islam has always had a distinct difference between what is (permissible)Halal and (impermissible)Haram. It governs more than just a set of values for personal adherence. It also aims to regulate societies and their functions via various instruments, such as the Quran and hadiths, which form the interpretation of Shariah law. Through jurists, Shariah provides guidance in forming relationships in finance, trade, and culture. As this is a controversial topic, we have included references and evidence below.

However, as Islamic Finance laws are distinctly different from conventional Western banking systems, there is a major clash when adopting debt-based financing known as Riba[1]. Although Islamic banking radically differs from Western economics, events such as the Global Financial Crisis pose the question, do we need to rethink money?

And to those who think this is some Tiktok fad, Islamic banking has existed for centuries. Over $1 Trillion dollars call these banks home.

It’s a burgeoning Industry, not just a utopian concept

Over the next two articles, we will assess five key themes to understand the efficacy of Islamic Finance. We will:

Analyze policy in Middle Eastern economies during the GFC.
Assess how well Islamic principles are interwoven into Western law.
Find a tangible economic benefit to using Islamic banking.
Analyze Islamic banking products like Madarabah, Sukuk & Musharakah,
Look at how Islamic law manages economic growth, currency depreciation, and Inflation.

Islamic finance and the GFC

The GFC devastated the West. It is a well-told story at this point. However, no one inquires about how countries in Asia and the Middle East fared. We will examine how risky credit and Riba-yielding instruments such as Collateralized Debt Obligations (CDO) affected different parts of the world.

There is consensus that Islamic finance principles would prevent Islamic financial institutions from being directly exposed to the credit crisis[2]. The hallmark of the GFC was the nature of the products that propagated it. Complex instruments formed a new financial structure of under-pricing of risk, over-leveraging, creation of new risk, breakdowns in working partnerships between issuers and borrowers & a lack of control over the underlying asset backing the debt obligations[3].

Most of these contributing factors are forbidden in Islam, where ambiguity and uncertainty, known as Gharar, restrict the excessive complexity in contracts[4]. The aim of this restriction is to require parties to communicate their Intention clearly through writing, where there is less possibility for parties to breach their contracts unknowingly. Furthermore, Islam demands transparent relationships and only loans to stable borrowers based on a legitimate need, not to punt CFDs [5].

The global defaults of Riba products were limited to the Middle East and parts of Asia such as Malaysia and Indonesia. Furthermore, when comparing the average solvency between 2007 and 2009, Islamic Banks fared better in all countries, such as Jordan, Saudi Arabia, and Turkey, with exceptions such as Bahrain, Qatar, and the UAE.

This suggests that Islamic Banks have been affected differently during the crisis, with no uniform banking model to follow. Furthermore, as the impacts of the GFC leaked from the financial sector and into the real economy of these countries, Islamic Banks in some nations faced larger losses than their conventional peers[6].

Evidently, the asset-backed finance model in Islam may have shielded most countries from the initial credit crisis. Although it is still debatable whether it could stop the credit crisis from leaking into a full-blown financial crisis, Islamic finance provides quantifiable differences that limit exposure.

Compatibility with Regulatory bodies

Determining how various financial regulatory bodies governed by Shariah law measure against Western economies is also essential. This requires a review of Shariah-compliant policies which act as filtration systems that alert advisory boards to potentially dangerous and risky financial products.

A Shariah Supervisory Board (SSB) is the peak body that certifies Islamic banking products as Sharia-compliant. There are also federal sharia boards in Muslim-majority nations that regulate entire financial institution conduct.[8].

Now ask yourself, if there is a global standard for Accounting under the AASB to curb accounting issues, WHY is there no global standard for banking? Why don’t we have external advisory boards to mandate what products pass the test and which don’t? SSB’s attempt to address this.

All products can be marketed and issued but will be cut down should they fail to pass the standards of the sharia board

Now ask yourself, how many products in today’s world, like Robodebt, CDO, CFD, NFTs, and Crypto gambling, would pass this test? A good board unencumbered by external pressure and answerable only to a mandate set By GOD would cut each and every one of these toxic products at the stem before they say the light of day.

And thus saving how many countless of us from financial ruin, bankruptcy, suicide, and depression.

There is an attempt by developed Western economies to synthesize financial regulatory bodies into the UK, albeit recognizing them in an advisory capacity. Even landlocked European countries such as Luxembourg have successfully incorporated the legal system with Islamic finance requirements. A KPMG report outlined how Luxembourg implements extensive tax treaties and repatriation networks with 70 Muslim-majority nations. Furthermore, financing regulations allow for instruments to be structured with direct links to assets or investments, bearing a variable yield based on the income derived from the asset[10].

The Bad

It is evident that regulatory bodies can integrate Shariah principles into their system without manipulating the scope of their own laws. However, the issue may not lie with acceptance in the West but with the Lack of uniformity on what Shariah standards are. This also gives rise to the phenomenon of Fatwa Shopping, where religious approval is commodified, likewise to the role of rating agencies providing high credit ratings to toxic products during the financial crisis[11].

The finer points are still debated, but having seen the effect of unsafe, unregulated financial products and how they can break mankind, we welcome all the change we can find.

Conclusion

We are only halfway there. We wanted to get the nitty gritty out of the way and prove to the naysayers that you may have a view on Islam, but there are protections in its’ jurisprudence to protect the neediest and desperate of us from vicious, toxic product mongers.

Now that we know it can work, next week we will look at how Islamic Finance can be adopted in today’s world rife with issues such as Inflation and poor economic growth.

References

[1] Hassan. K & Kayed. R, The Global Financial Crisis, and Islamic Finance (2018), University of New Orleans, Pg. 12

[2] Alaqahtani. F & Maye. D, The global financial crisis and Islamic banking: The direct exposure to the crisis, (2017)

[3] Hassan. K & Kayed. R, The Global Financial Crisis, and Islamic Finance (2018), University of New Orleans, Pg. 12

[4] ibid

[5] Farooq. M, Islamic Finance and Debt Culture: Treading the Conventional Path? (2015) International Journal of Social Economics, Vol. 42, No. 12, pp. 1168 -1195 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2684407

[6] International Monetary Fund, The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study, (2010)

https://www.imf.org/external/pubs/ft/wp/2010/wp10201.pdf

[7] Warde. I, Islamic Finance and the Global economy, (2014)

[8] Khan. A, What Is Wrong with Islamic Economics: Analysing the Present State and Future Agenda, (2013)

[9] Global Islamic finance report (2010)

[10] KPMG, Luxembourg: A hub for Islamic finance investments https://assets.kpmg/content/dam/kpmg/lu/pdf/lu-en-luxembourg-a-hub-for-islamic-finance-brochure2016.pdf

[11] Barnett-Hart. A, The Story of the CDO Market Meltdown: An Empirical Analysis, (2009), Harvard Kennedy School