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Unmask the World’s Financial System in the Light of Islamic Finance

 

Today, the Islamic financial system is being viewed with a measure of envy and respect. There is growing appreciation of its symbiotic link to real economic activities. As the financial crisis reaches out to even more areas around the globe, some Islamic financial and related institutions are being affected, though not to the extent that has crippled many of their conventional counterparts.

This naturally means that the Islamic finance community should not be complacent; rather, it must continue to critically evaluate itself. Malaysian Prime Minister Abdullah Ahmad Badawi asks: “Have we truly established an alternative system, or are we still very much mimicking the established conventional system?” His challenge: Prove to the global market that the Islamic financial system is truly a robust and viable alternative to the conventional system. (Islamic Finance News)

The current financial crisis provides that opportunity. As it is, despite the crisis, new Shariah compliant banks continue to emerge in various places (Sudan, the Gulf and Malaysia); they continue to record strong profits (ABC Islamic Bank’s net profit for the first nine months of 2008 increased by 60% over the same period last year); Britain, despite being in the thick of the crisis, remains committed to launch the first Sukuk by a western government; and Gulf Finance House is embarking on its latest Energy City project, in Libya, worth US$5 billion. Additionally the International Swaps and Derivatives Association is to launch standards for over-the-counter (OTC) Islamic derivative contracts early next year that will be a key tool in Shariah compliant risk management.

As part of efforts to add depth to Islamic finance, the International Shariah Research Academy for Islamic Finance (ISRA) has been set up to foster collaboration between Muslim scholars in different countries to develop knowledge in areas of specific interest to the global Islamic finance community. In particular, it will help find a middle ground for the standardization of Islamic finance practices.

At the same time, Malaysia has embarked on an initiative to promote a more consistent application for Islamic financial contracts. The central bank’s “Shariah parameters” project is aimed at determining the essential features of Islamic financial products derived from underlying Shariah contracts such as Murabahah, Istisna, Mudarabah, Musharakah, Ijarah and Wadi’ah. These features will serve as a guide for Shariah contracts pertaining to Islamic financial products, and can be applied when designing new products or enhancing existing ones.

Even as these moves take shape in bringing about a certain level of standardization and uniformity in Islamic finance, a debate is ongoing: According to some scholars, binding legal standards for the industry would challenge the Islamic concept of Ijtihad, or reasoning, that continuously re-assesses Shariah law. Standardization, they argue, will also limit the diversity of Islamic finance products. On the other hand, regulators and industry practitioners contend that legally enforced standards are required to enhance investment certainty and reduce transaction costs.

Finally some of the largest pension plans in the US are reported to be restructuring their entire portfolio to venture into infrastructure investment in a major way. Experts estimate that infrastructure spending will average US$2 trillion a year through 2015 as emerging markets build and expand rapidly while developed markets are upgrading their existing infrastructure.

 

What’s obvious now is that capitalism is no longer governed by democracy. Rather, it exploits democracy. Incoming US president Barrack Obama says one of his priorities is making sure the plumbing works, meaning stabilizing the financial system. In the face of what has been said to be the darkest economic outlook for the US since the Great Depression, voters said the economy was overwhelmingly the most important issue in the election, and this was clearly an advantage to Obama. This is a crisis of capitalism and the reality is that when capitalism fails it has to be bailed out by the state. It is capitalist when it goes up and socialist when it comes down.

Sovereign funds were considered dirty money just a couple of months ago, but they are now being eagerly sought as a savior. Barclays is banking on them to get out of the quicksand. But these sovereign funds are being extra cautious, especially after they were derided when they attempted to move in a few months ago. It appears that US officials now realize what is needed to lure the sovereign funds from the Gulf: Islamic finance.

Hence the statement by the US Treasury Department that it is looking into the important features of Islamic banking that could help in tackling the current financial crisis. Deputy secretary Robert Kimmitt said: “Islamic banking is an important issue being discussed right now by experts both in the public and private sectors.” And this week, the department organized, together with Harvard, a forum on “Islamic Finance 101” for the public and private sectors, as well as Congress personnel.

The consequence of the crisis could be that as Gulf sovereign funds become more important, Islamic banking could play an increasing role in global financing, its expansion relatively unaffected by the financial crisis. This, of course, does not mean that Shariah compliant finance can suddenly present itself as a comprehensive alternative to capitalism. Instead, the current shift in perspective in Washington ought to be viewed as an opportunity for Islamic financial institutions to have joint investments with governments and other financing sources, including multilaterals, in funding the public works program that Obama has in mind to help generate economic activity in the US .

The point is that Obama is inheriting, as one report put it, an economic estate that has been pillaged by his predecessor. US public sector debt is well over US$1 trillion, equivalent to around 80% of US economic output. The nonpartisan Committee for a Responsible Budget estimates all the government economic and rescue initiatives, starting with the US$168 billion in stimulus checks issued earlier this year, total even more — US$2.6 trillion.

Obama faces the nation's worst financial crisis in 70 years. The US presidency is powerful, but the economy is in such a mess that no one leader will be able to change things dramatically any time soon. However, he has had an electrifying effect not only on Americans but also the rest of the world. Banking on this impact, and driven by the pressing situation, will he be bold enough to accept the use of Islamic finance to help salvage the US economy?

 

While global markets struggle to pick up the pieces from what has been dubbed “the worst economic crisis in decades”, the Islamic finance industry was dealt a blow when Standard & Poor’s revealed that more than US$5.6 trillion had been wiped off the value of Shariah compliant equities worldwide during the third quarter of 2008.

However, it added that Shariah investors had benefited from their lack of exposure to financials, which have been the focus of the market selloff. Its Index services vice president Alka Banerjee said: “While equity markets around the world have experienced a tumultuous quarter, Shariah investors continue to be shielded to some extent by the exclusion from their portfolios of financial stocks and other highly leveraged companies, which do not satisfy the strict compliance criteria associated with Islamic law.”

Standard & Poor’s Ratings Services had also revised its outlook on six banks in Gulf Cooperation Council (GCC) countries to stable from positive, which included Islamic banking giant Kuwait Finance House, citing the less supportive environment in which they operated from as a factor. (Islamic Finance News)

The financial turmoil has boosted perception of Islamic finance, which is now being considered by many Western countries including the US and even Australia . It was reported that the US government was studying the salient features of Islamic banking to ascertain how far it could be useful in fighting the ongoing world economic crisis.

Prominent Egyptian-born , Qatar -based cleric Sheikh Yussef al-Qaradawi told participants of a recent conference to take advantage of the financial crisis to create a Shariah compliant economic system. 

“We have all the wealth... the Islamic nation has all or nearly all the oil and we have an economic philosophy that no one else has,” he said, alluding to the fact that Saudi Arabia holds a substantial portion of the world’s proven crude oil reserves.

The head of theological studies at Doha University shares Sheikh Yussef’s view, saying the global economic meltdown shows the need for a radical and structural reform of the global financial system. He says the system based on the principles of Islam offers an alternative that can reduce risks.

On the flip side, others say that although interest, derivatives and short selling are forbidden under Shariah law, which means that Islamic financial institutions were not burdened any subprime loans, hedge funds or credit default swaps, investing in halal finance would not be a shield against a global financial or even economic crisis.

Our country reports focus on Japan , where the private sector has shown its full commitment to the growth of the Islamic finance industry. The government has now realized the potential of attracting petrodollars from Middle Eastern investors and government officials and industry practitioners are diligently studying Islamic finance.

The first of two market reports paint a dreary picture for Islamic investors saying they were not immune from stock market crashes while Monem Salam, in the other, urges the industry to avoid similar disasters by analyzing the failings of conventional finance instead of displaying a false sense of pride.

 

British Prime Minister Gordon Brown’s admission that the global economic downturn is “likely to cause recession” in the UK saw markets slump. Bank of England governor Mervyn King said that not since the first world war has the international banking system been so close to collapse. Brown said: “Having taken action on the banking system, we must now take action on the global financial recession which is likely to cause recession in America, France, Italy, Germany, Japan and — because no country can insulate itself from it — Britain too.”

The upside is that genuine interest is emerging in Islamic finance as an acceptable alternative. UK Trade & Investment is supporting a briefing to give financial companies a better understanding of Islamic finance by explaining whom it applies to, how it can complement existing financial services strategy, and what the benefits are.  Chief executive Andrew Cahn said: “In these tough times, it’s more important than ever that we make the most of growing sectors like Islamic finance.”

The Islamic Bank of Britain has reported a growth of 5% in customer numbers and 13% in customer financing. The reason is that the bank “has been better protected from the credit crunch affecting mainstream banks”, said its commercial director, Sultan Choudhury. He attributed the rise to people “looking for a safer option for their money”. In Australia , financial institutions and the government are considering introducing Islamic banking and its principles.

Indeed, Islamic banking has largely escaped the crisis, but according to experts, because of its heavy reliance on property investments and private equity, the industry could be hit if the turmoil worsens and real assets start to crumble. Still, Kuwait Finance House reports that the outlook for Islamic financing is bright and it will likely take the lead in terms of providing funding for major projects as the conventional banking system reevaluates its business model.

Islamic Banking fares well in the Credit Crunch

Islamic Banks do not face the same liquidity problems (problems of getting cash) as conventional banks as:

Islamic Banks do not rely on wholesale fundingfrom other banks as its assets are funded in one of three ways
i. Islamic banks use its own capital to fund asset products
ii. They have Islamic contracts with its savings customers, and that money can be used to finance low risk activities in return for offering the customer a target profit rate with a Mudaraba contract.

iii. They also offer its savings customers deposits based on the principle of Murabaha and in doing so can also offer the customer a fixed rate for his investment. Conventional banks have suffered from poor and risky lending decisions

Partnership - The principle of partnership underlying Islamic finance means Islamic banks would never enter into the subprime-style agreements currently affecting the current crisis. For the benefit of the customers and the bank themselves, they enter into a partnership agreement. Islamic banks don’t just enter into any agreement, they make sure the agreement is right for both partners.

Transparency - Long before consumer legislation came into play, Islam said that there must be no deception involved in a transaction, that a transaction must be transparent for the consumer. Many of the investments that led to large losses were not transparent.This is a good example where Islamic principles help in Treating Customers Fairly, and ensuring any deal is right for the customer also.
Conventional banks have suffered from complex derivative products ‘going bad’.

Islamic Banks do not engage in complex derivatives as Islamic stipulations that you must own the asset you are trading in also mean practices such as short-selling are not a feature of Islamic banking. Banks that are now in crisis effectively traded in paper, whereas Islamic finance deals have to be underpinned by tangible assets

The explosion in complex derivative products over the last few years has left Western banks reeling from exposure to ‘toxic assets’ (increasingly worthless assets) often far-removed from their everyday activities. In contrast the more risk-averse Islamic finance system did not embrace this kind of deal.