From the September 2008 issue of Research Magazine • Subscribe!

September 1, 2008

The Rise of Islamic Finance

Islamic finance is a fast-growing sector that seeks to conduct financial practices in accordance with sharia, or Islamic law. It is a field that has gained considerable enthusiasm among Western financial institutions, as well as in the Islamic world. And it is an area that financial advisors and their institutions increasingly will have to grapple with, as it holds both significant attractions and worrisome quandaries.

Islamic finance carries a demonstrated ability and vast potential to attract an important client base -- primarily Muslims, including the Muslim-American community, but also non-Muslims who are interested in an alternative approach to socially responsible investing. But Islamic finance also is increasingly controversial, as critics raise questions about the field's legal, regulatory, political and ethical ramifications.

Sharia (also spelled in variants such as shariah and Shari'ah) is a body of legal principles derived from the Quran, Islam's holy book, and from traditions regarding the Prophet Mohammed, who lived in the 6th and 7th centuries. Sharia also is shaped by a consensus among Islamic scholars and a process of reasoning by analogy.

Intended to govern all aspects of life, Islamic law includes prohibitions against pork, alcohol and gambling, among other things. Moreover, the Quran condemns riba, or "increase," and thus sharia is typically interpreted to include a ban on charging interest. (A view that riba only means "excessive interest" has few supporters.) If income is deemed to have been generated by interest or other prohibited means, that income is required to be donated to an Islamic charity.

Various methods are used to avoid interest. For instance, a lender may receive a share of a borrower's profits instead, an arrangement defended as more conducive to social solidarity and careful analysis of business proposals. In a real estate transaction, a bank may purchase a property and resell it to its client at a higher price rather than collecting interest on a mortgage (although such payment may be done in installments, giving a practical result that resembles an interest-based transaction).

By some estimates, nearly $1 trillion in assets worldwide are currently managed under the rubric of Islamic finance, and asset growth in recent years has run at some 20 percent. The field has attracted global institutions such as Citibank, HSBC and Deutsche Bank, while sharia-compliant indexes have been compiled by Dow Jones and Standard & Poor's. Islamic bank accounts, bond issuance and equity investment are all available, both through homegrown institutions of the Muslim world and through Islamic-oriented subsidiaries of Western firms.

Yet the growth of Islamic finance also has sparked opposition. The Center for Security Policy, a group headed by Frank Gaffney, formerly a senior Pentagon official in the Reagan administration, recently sent letters to major banks and hedge funds asserting that the institutions "may be exposed to reputational risk and/or price risk" due to participation in sharia-compliant finance. The group cited, as an example of such risk, a recent lawsuit seeking to hold a number of Islamic banks and charities among the entities responsible for the terrorist atrocities of September 11, 2001.

Such volatile contentions exemplify the issues advisors will face as they determine the appropriateness of Islamic finance for their own involvement and their clients' money. The sector may be freighted with formidable problems, but also carries the promise of considerable benefits -- not only in generating client dollars and investment returns, but also perhaps in helping bridge cultures and spur modernization and liberalization in Islamic countries. Assessing these diverse possibilities will require advisors to look closely at the field, where it may be going and where it came from.

A Brief HistoryIslam's Golden Age (traditionally dated from the mid-8th century until the sack of Baghdad by the Mongols in 1256) saw advances in fields ranging from astronomy to urban planning. As commerce grew, sophisticated contracts, limited partnerships and other instruments developed. While interest was problematical from a religious perspective, this was also the case in predominantly Christian Europe. Gradually, however, a distinction between interest and usury was accepted in Europe, which subsequently took the lead in the development of financial services.

As large parts of the Islamic world came under European domination in recent centuries, a mix of European-style banking and traditional practices prevailed. Yet Western financial methods stirred resentments, as when Britain's 1875 purchase of a controlling stake in the Suez Canal sparked a nationalist backlash in Egypt. As colonial empires receded in the mid- to late 20th century, a movement emerged among Muslim intellectuals and businessmen to develop a distinctly Islamic form of banking.

Some savings institutions in the Indian subcontinent are believed to have experimented with non-interest banking in the 1940s. But a more influential initiative began in the Egyptian town of Mit Ghamr in 1963, where one Ahmad El Najjar set up a savings bank that shared profits with its borrowers and depositors rather than charging or paying interest. The bank operated until 1967, by which time other such institutions were in business in Egypt. These banks avoided emphasizing an Islamic image, however, since tensions were rising between Egypt's secular government and religious fundamentalists.

In the 1970s, Islamic banking spread throughout much of the Middle East, and abandoned the downplaying of religion that had marked its initial appearance in Egypt. Institutions established in that decade included the Dubai Islamic Bank, the Bahrain Islamic Bank, the Faisal Islamic Bank of Egypt and the Faisal Islamic Bank of Sudan. The flood of petrodollars associated with the growing power of the Organization of Petroleum Exporting Countries helped further this expansion. The Islamic Development Bank, a Saudi-based multilateral development institution, began operations in 1975.

Government actions, as well as market demand, played a large role in fostering the growth of Islamic finance. Pakistan issued a series of decrees from 1979 to 1985 intended to make its banking system Islamic; the banks already had been nationalized by a previous government. Iran's revolutionary regime nationalized banks and passed sweeping laws against interest in the early 1980s. By the end of the decade, Sudan had placed its entire banking sector under sharia.

Malaysia's first Islamic commercial bank, the Bank Islam Malaysia Berhad, was set up in 1983. An earlier Islamic financial institution had operated in the country since the 1960s whose purpose was to invest the savings of people planning to perform a pilgrimage to Mecca. Malaysia would go on to become a major center of Islamic finance, which it remains today. In the Philippines, the government had set up a bank in the early 1970s aimed at appealing to Muslim customers, in order to weaken a growing Muslim rebellion.

Islamic finance first came to a Western nation in 1978, with the opening in Luxembourg of the Islamic Banking System, an institution that was later renamed Islamic Finance House. This was followed by other firms such as the Islamic Bank International of Denmark and the Islamic Investment Company in Australia. The first major Western institution to enter the Islamic banking fray was Citigroup, which set up its Bahrain-based Citi Islamic subsidiary in 1996. That same year, Dow Jones unveiled its first index of stocks that had been approved by a panel of sharia scholars.

Western ReactionsIslamic finance has attracted growing attention from Western academic institutions and think tanks. Much of this attention has been positive. Harvard Law School maintains an Islamic Finance Project, currently sponsored by four Islamic financial institutions -- Abu Dhabi Islamic Bank, Arcapita Bank, HSBC Amanah and Kuwait Finance House. The Project states that it "seeks to develop an increased awareness and understanding of Islamic finance both within the Muslim world and in the West."

In recent months, Gaffney's Center for Security Policy has launched a campaign against sharia-compliant finance. According to the group, such finance legitimizes oppressive and expansionistic forms of Islam, empowers sympathizers of Islamic radicalism on panels advising financial institutions and opens the way for funds to go to charities that may provide material support for terrorism. The group focused attention on Mufti Taqi Usmani, a Pakistani cleric who has advised Dow Jones and who earlier this year signed a statement suggesting that suicide bombing can be justified in Islamic law.

As part of its campaign, the Center for Security Policy circulated a memo by attorney David Yerushalmi arguing that U.S.-based institutions participating in sharia-compliant finance may face legal problems over matters ranging from adequate disclosure to investors, to due diligence regarding the use of funds, to antitrust or racketeering issues arising from reliance on a small group of sharia advisors and even to sedition charges for abetting efforts to overthrow the U.S. government by force.

However, some observers see in Islamic finance a more moderating influence. In a 2007 article in The American magazine, Cairo-based writer Aaron MacLean argued that Islamic finance has become pragmatic and flexible, even to the point of raising alarms among traditionalists. MacLean wrote that "there's something reassuring about the way that the rational profit motive trumps strict ideology. The willingness to put profit first is, it turns out, the real shared value that links Islamic and Western civilizations."

The future of Islamic finance will depend greatly on whether the field is seen as fostering moderate or militant forms of Islam. It is a debate that is only just beginning.

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Key Concepts Used in Islamic Finance

Ijara -- A leasing arrangement; a bank makes equipment or other assets available to a customer for a specified period of time at a specified price.

Ijara-wa-iktana -- A leasing arrangement in which the customer agrees to purchase the asset at the end of the leasing period.

Mudaraba -- A profit-sharing arrangement in which a bank provides capital to an entrepreneur.

Murabaha -- A cost-plus transaction; the bank purchases an item (such as real estate or a vehicle) and resells it to the customer at a profit margin agreed in advance.

Musharaka -- A bank and entrepreneur both contribute capital, and share profits.

Qard Hassan -- Interest-free loan in which the debtor is required to repay only the amount borrowed but has the option of paying more as a token of gratitude.

Sukuk -- The Islamic counterpart to bonds, these are financial certificates in which parties agree to partial ownership of debts or assets rather than exchanging interest.

Takaful -- Islamic insurance, intended to avoid any element of interest or gambling.

Tawarruq -- Arranged transaction in which a customer purchases an item from a bank and immediately resells it to a third party, in order to obtain cash without taking a loan.

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Kenneth Silber is a senior editor at Research. His work on science, economics and history has appeared in a variety of publications, including The Wall Street Journal

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