Introduction:
The area of Islamic finance is relatively new to the finance field. While it was commonly known among Muslims, Islamic finance has grown not only to include Muslims, but also to include non-Muslims. Now, Islamic banking is widely known in Europe and many Asian countries. It is growing in the United States as well, but it is in its first steps. That is primarily because of the attractiveness of many Islamic- compliant corporations who have enjoyed a relatively healthy financial position compared to other comparable corporations. Islamic finance now accounts for more than $500 billion worldwide, and it is projected that Islamic securitization will exceed more than $100 billion (Delaigue, 2009). Basically, Islamic finance prohibits the practice of “Riba”, interest earned on money. So how can Islamic corporations make profits if they do not deal with interest rates? And if they do not deal with interest rates, are they immune to the current financial crisis? And what is the relationship between Islamic finance and real estate?
This article tries to answer these questions. It should be noted that, because Islamic finance prohibits the practice of Riba, a major source of income for many Islamic financial institutions is in real estate. In fact, whenever two Muslims talk about an Islamic financial institution, they are primarily talking about the real estate sector of that corporation because of its importance to the corporation as a whole. In other words, real estate is the major source of income in Islamic finance but without dealing with interest rates, “Riba”, to earn revenue or to calculate mortgage payments.
What is Islamic finance?
Islam’s prohibition and condemnation of Riba is found in various places in the Quran (see 2:275–280, 4:161 and 30:39 for examples) and also in various Hadith (sayings of the Prophet Muhammad), which cite instances wherein the Prophet explained what qualified as Riba and what did not, such as ‘the selling of wheat for wheat is Riba, unless it is exchanged from hand to hand and is equal in amount. According to this traditional understanding of Riba, modern conventional finance is impermissible since it incorporates the lending of money for a later repayment that includes a premium (i.e. interest) for the time elapsed between disbursement and repayment (Nayeem, 2009). Many Muslim scholars developed models that do not include Riba but allow for profit to occur. Such models include “Murabaha”, “Musharaka”, “Ijara” and “Sukuk”. While the definition and implementation of each model is beyond this article, it should be noted that each model allows for risk to occur between the borrower and the lender. For example, in the Murabaha (cost-plus sales) contract, the seller acquires the desired product at a price known to both parties and then agrees to sell the product to the buyer for the original price plus an additional premium (Nayeem, 2009). This is different from the traditional way of financing in that the premium is not based solely on interest rates or Riba. In other words, if a person would like to buy a home for $200,000 and wants to finance it in the Islamic way, the Islamic bank will acquire the house for $200,000 and sell it back to the buyer with a premium. The installment payments are simply the lump-sum amount divided by the number of years. If the Islamic bank sold the house back to the buyer for $400,000 in 20 years, then the annual payment is simply $20,000. In other words, a Muslim may earn a profit, for instance, by selling an item for more than he paid for it, provided the two transactions are kept separate. An Islamic-compliant mortgage may involve a bank buying the property on behalf of the customer, who then pays off the principal loan along with “rent” or a “fee” for using the property until it finally transfers into his name when the loan amount is fully settled. (Goodenough, CNSNEWS.com, 2008). The payment on the mortgage is not based on future value of money or some kind of discount rate because Islamic finance says that money cannot grow by itself. It should grow by real output in the economy, which is that risk should be shared among all parties. One cannot simply lend someone money and expect to be paid back with interest. Instead, one would acquire the product and sell it to the buyer with a premium and in this way share the risk with him. There is nothing risk free. This is a crucial concept in Islamic finance and the whole Islamic financial real estate sector depends on it.
Moreover, when a person deposits money in an Islamic bank, there is no guaranteed interest earned on that money. In fact, the person may lose that money because he/she agrees to share the risk with the bank in their operations. Despite that, as noted earlier, Islamic banking continues to grow worldwide despite what seems to be their higher risk compared to other financial institutions. One of the models that has been growing enormously in the past couple of years is the “Sukuk” which is basically an Islamic bond. But again, there is nothing guaranteed and everybody is sharing the risk. In fact, some kinds of Sukuks do not even have fixed coupon payments because that depends on the profitability of the project in question. For example, a developer may want to build an apartment complex and issues “Sukuks”, Islamic bonds, to finance his project. The lenders in this case would agree to share the risk with the developer and also agree to share the profits together. The payments on the “Sukuks” would depend on the rents paid by the tenants and that is the only form of “Sukuks” that tend to be steady over time because of relatively small changes in rental rates.
In short, “financial systems based on the principles of Islamic law (shari’a) have been growing in popularity in the Islamic world and increasingly among Muslims in western societies too. Shari’a forbids Riba or usury – the collection and payment of interest – and also shuns excessive risk and heavy borrowing, thus helping to insulate parties from overexposure to risk. “Shari’a-compliant” banking and financial products aim to avoid companies that are heavily indebted or have links to products or conduct frowned upon in Islam, such as gambling, pork, alcohol and pornography.” (Goodenough, CNSNEWS.com, 2008).
Islamic finance and the financial crisis:
Many Muslim Academics argue that the current financial crisis would not have happened if Islamic finance principles were employed in the global economy. For example, Dr. Mohammed Mahmud Awan, a leading scholar and Dean at Malaysia-based International Center for Education in Islamic Finance (INCEIF), told the participants of a conference in Manama, Bahrain that the current global economic crisis has opened many windows of opportunities for Islamic finance. “This crisis is seen as a big opportunity for Islamic finance as it has the capacity and capability to bring stability to the market.” Dr. Awan said. The current global crisis which caused colossal financial losses running in billions of dollars, he said, would have not occurred if the Islamic principles regarding collateralized debt obligations (CDOs) were in vogue in the international financial market. “Islamic bonds, carrying unique structure features, cannot fall foul of a crisis such as subprime mortgage crisis. Subprime mortgages are backed by dubiously rated collateralized debt packages which subsequently precipitated a global credit crunch.” (Arab news, 2008). He added: “A crisis such as the mortgage one would technically be unthinkable in the Islamic capital markets sector because it would be against Shariah (Islamic law) principles to sell a debt against a debt.”
But many other scholars disagree with that. In fact, many Muslim scholars disagree with that as well. Their main point of view is that Islamic finance and Islamic financial institutions do not live in a separate world as other traditional financial institutions. The basic macroeconomic factors affect both equally and the recent financial crisis affected Islamic financial institutions just as much as it had affected traditional financial corporations.
Performance of Islamic finance corporations:
To judge the quality and performance of Islamic finance principles, I took data from data stream and analyzed the quarterly return of the Dow Jones Islamic Index from the period of 1/1/2002 to 6/30/2009. Then, this was compared with the Dow Jones Industrial average returns for the same period. The results are shown in Figure 1.
Certainly, the overall performance of the two is very similar. But what is interesting is the beginning of the financial crisis (just about the 27th quarter in the graph). It can be seen from the graph that DJ ISLAMIC Index was in the positive category at the beginning of the crisis while the DJ Industrial was at the negative side. But just after that, we can see a sharp fall in the Islamic index while the DJ Industrial started to recover (probably because of some confidence in the stimulus package). Finally, both of them are recovering but the Islamic index at a faster rate. This will certainly create a debate between Islamic finance scholars and those of traditional finance. Pro-Islamic finance scholars are arguing that since the financial world is governed by traditional finance concepts, the crisis brought the losses to the Islamic corporations’ assets as well, which are primarily in real-estate. And that the healthy industries, those who did not participate in all the derivatives and risky operations that started the crisis, will survive at the end and that is evident by the apparent recovery of the Islamic financial institutions. For example, Kuwait Finance House (KFH), one of the leading Islamic banks in the world in terms of market capitalization, has just distributed 4.5% on its deposits to its customers as a profit from their Islamic finance operations in Kuwait. That happened at a time when most of the Kuwaiti banks lost more than 50% of their market value.
Traditional finance scholars would argue that while the Islamic finance concepts are creative and new in the area of finance, they are not immune to the financial crisis. It would be interesting to add those concepts into the already existing financial system, but it is not an alternative model. The financial crisis affected both equally and that is a fact. It should be noted that the traditional finance scholars are not arguing against Islamic finance. In fact, many large financial corporations (like HSBC, Citi Bank, and many traditional financial corporations in the Middle East) have just opened Islamic banking units not just to attract Muslim customers but also to take advantage of this new concept, which is apparently very healthy. They are arguing that this new concept should not be used as an alternative to the existing system. Conversely, pro-Islamic finance proponents are arguing that it should be an alternative because of its reduced risk and rejection of money growing by itself without real output in the economy. Plus, many of the Islamic models like “Murabaha” and “Musharaka” eliminate many of the disadvantages of the traditional system. For example, in Islamic finance there is no buying debt by debt or many other risky operations simply because they are not allowed under Shari’a law. This would add greater efficiency to and reduce risk in the financial system.
Conclusion:
In conclusion, I think that time is needed to judge the new idea and concept of Islamic finance. As noted earlier, the introduction of Islamic finance is relatively new, and, in my opinion, it should take more time to mature, just like any other industry. While pro-Islamic finance scholars argue that this model is better than the existing one, it is not realistic, at least at this point in time, to present it as an alternative.
I think that Islamic finance added some interesting new models like “Murabaha”, “Musharaka” and “Sukuk” in real estate in order to eliminate Riba. The healthiness of the Islamic corporations in general is very evident and they had enjoyed a profitable position in the last couple of decades. That is primarily why many big corporations joined this new system. However, the global financial crisis did not leave the Islamic financial industry alone. It affected them just like it affected the traditional industries despite their totally different operations. Nevertheless, Islamic corporations apparently are recovering although that is debatable.
This financial crisis affected real estate markets around the world. And, since real estate is the primary asset to any Islamic-compliant corporation, they suffered heavily by the crisis even if they did not participate in the risky practices that started the crisis. But, as pro-Islamic finance proponents would say, the healthy ones will survive at the end.
References:
- Aidham, A, (2009), “Sukuk: Pushing Innovation”, International Financial Law Review, Vol. 28 Issue 3, p32-32, 1p.
- Delaigue, B and Reillac, A, (2009), “France Adopts Tax Measures to Promote Islamic Finance”, European Taxation, Vol. 49 Issue 5, p286-289, 4p.
- “Growth of Islamic finance”, International Financial Law Review, Mar2009, Vol. 28 Issue 3, p35-35, 1p.
- “How Islamic Bond Refinancing will work”, International Financial Law Review, Mar2009, Vol. 28 Issue 3, p17-17, 1p.
- Nayeem, O, Shiliwala, M and Shiliwala, W (2009), “A CONFLICT OF INTEREST: ISLAMIC HOME FINANCING IN AMERICA”, Economic Affairs, Vol. 29 Issue 2, p22-27, 6p.
- http://www.arabnews.com/?page=6§ion=0&article=109247&d=24&m=4&y=2008
- http://www.todayszaman.com/tz-web/yazarDetay.do?haberno=156567
- http://www.businessweek.com/globalbiz/blog/eyeonasia/archives/2008/10/islamic_finance.html
- http://www.free-press-release.com/news/200902/1233484780.html
- http://www.cnsnews.com/Public/content/article.aspx?RsrcID=37332
http://www.islamic-finance.com/indexnew.htm
1 comment:
I can learn many new things in your article on Islamic finance.
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