Islamic finance

In November 2008, the US Treasury Department announced that it would convene an ‘Islamic Finance 101’ Forum to teach Islamic Finance to US banking regulatory agencies, Congress and other parts of the executive branch in Washington, DC.1 Collaborating with the Harvard University’s Islamic Finance Project, the purpose of this Forum is ‘to help inform the policy community about Islamic financial services which are an increasingly important part of the global financial industry’.2

Islamic finance is a banking system that is characterised by five principles of Shari’ah or Islamic Law. These include: prohibition of interest (riba), prohibition of uncertainty and excessive speculation (gharar), prohibition of certain economic activities (including the consumption of alcohol and tobacco, gambling and pornography), share of profits or losses (musharakah), and use of asset-based financing (murabaha).3 Islamic finance is concentrated in the Middle East and South-East Asia (predominately Indonesia and Malaysia) but is spreading into North Africa and Europe. It is regulated by the Islamic Financial Services Board (IFSB), an international standard-setting body which ‘promotes and enhances the soundness and stability of the Islamic financial services industry by issuing global prudential standards and guiding principles for the industry’.4 In 2008 the spread of Islamic finance in Western economies was highlighted when Dublin-based maritime communications group Blue Ocean Wireless secured access to debt funding of $25 million (417 million) from Bank of London and The Middle East plc (BLME), a Shari’ah-compliant wholesale bank based in the City of London representing what ‘is thought to be the first time that an Irish company has availed of Islamic finance’5

French Finance Minister Christine Lagarde: wooing Islamic banks

French Finance Minister Christine Lagarde: wooing Islamic banks

Islamic finance accounts for approximately US$700 billion of assets and is growing at 10–30% annually, according to Moody’s Investors Service. Wall Street now offers an Islamic mutual fund and an Islamic index. The importance of the Islamic finance principles has been accepted by the UK Financial Services Authority,6 the World Bank and the International Monetary Fund. In December 2008, the Associated Press reported that France became the latest country to woo Islamic banks.7 Finance minister Ms Christine Lagarde, who believes that Western financial institutions could learn a thing or two from Islamic finance, promised to make necessary adjustments to the French regulatory framework so that Paris could become a major marketplace in Islamic finance.

The turmoil in global financial markets since mid-2008 has raised serious questions about prudential lending and borrowing practices, risk management and corporate governance.8 Added to these are two behavioural problems: greed and fear.9 The Secretary General of the Franco-Arab Chamber of Commerce, Dr Saleh Al Tayar, claimed that the 44.9 billion loss suffered by Société Générale SA as a result of Jerome Kerviel’s unauthorised trading could not have happened in an Islamic financial institution.10 And Mohammed Awan maintains that the global financial crisis ‘would not have occurred if Islamic principles were applied in international financial markets’.11 This is because, under Shari’ah principles, one cannot ‘sell debt against debt’. In turn, greed leads to sale of dubiously rated collateralised debts. A further reason advanced is that Islamic finance principles require deals to be based on tangible assets that require tight controls over debt levels.

In relation to sukuk (bond) issues, Shari’ah rules require bondholders to be undivided partners in the underlying asset(s) that are being financed. Accordingly, the effect on Islamic financial institutions has been muted as sukuk instruments are generally held to maturity.12 Thus, narrow yield spreads provide less occasion for speculation in secondary markets. Some proponents argue there is minimal probability of default with sukuks since issuers are able to meet payment obligations.13

Moody’s in its November 2008 report shows that Islamic financial institutions have been quite resilient in the current global financial crisis. As an interesting aside, no Islamic bank has acknowledged investing in Bernard Madoff’s US$50 billion fraudulent Ponzi scheme.14 The resilience of Islamic finance is summarised by Zarina Anwar15 as follows:

The development of Islamic finance in general is also important from the perspective of financial stability . . . The Shariah-based approach contains in-built checks and balances through risk- and profit-sharing structures. More critically, it demands a high level of disclosure and transparency in the financial system which is consistent with the principles of sound securities regulation as well as in compliance with Shariah requirements. This is not to say that Islamic asset markets have not been affected by the current turmoil. Indeed it has, and the value of Shariah compliant equities has declined in tandem with that of global equities. But it has been shown that Islamic finance in various segments of the market has been able to weather the storm relatively better than its conventional counterpart.

Nevertheless, the impact of an economic downturn and evaporating asset values was having an effect on Islamic financial institutions, and led to a number of events at the end of 2008 to discuss measures to mitigate those impacts. For example, on 25 October 2008, the Islamic Development Bank convened an urgent meeting to discuss the impact of the global financial crisis on the Islamic banking industry and agreed on policy initiatives to tackle the challenges and opportunities for the industry. In November 2008 in Kuala Lumpur, the IFSB and the Institute of International Finance (IIF) jointly organised a conference, entitled Enhancing the Resilience and Stability of the Islamic Financial System, to examine whether the Islamic financial system is strong enough to weather the crisis. The connectedness of global finance and the global economy means that, although principles may protect Islamic financial institutions from the extreme impacts of the financial crisis, they cannot be insulated entirely. This raises a question that has hitherto been avoided by the Islamic finance community: should they engage more assertively in international policy processes to promote their principles to non-Islamic governments and financial institutions, for mutual benefit? An affirmative would imply a reversal of a dominant assumption of recent centuries: that the ‘West’ has a version of economics that is suitable for the rest of the world, while non-Western approaches are seen as exotic, at best filling a niche, at worst being mere artefacts from pre-modern societies. That is an assumption that some non-Western communities have been complicit in maintaining, by assuming their own ways of organising are specific to their society, rather than relevant for all societies.

The rest of the world could benefit from the Islamic financial community assuming a greater role in international initiatives to achieve financial stability. That is not only because of the problems described above, but because Islamic finance recognises the deep problems associated with interest. As money enters economies as debt, being lent by banks, so interest is attached, thereby requiring organisations and people to pay back more than they originally borrow. This creates a growth imperative, as the economy must keep expanding in order that the interest is paid. That poses a problem for a world of finite resources. Interest also promotes a competitive approach to society, as people need to acquire more money than they began with, because of the interest payments. In his description of money systems, one of the originators of the euro, Bernard Lietaer, explains how interest-money therefore necessitates increasing economic inequality.16 Although many financial institutions would be wary of Islamic finance principles being seen as a blueprint for a new global financial system, as it would curtail many of their lucrative but risky activities, leaders of the ‘real economy’ could support such a view, as they would benefit from a more stable financial system. That is not to say that Islamic finance does not present areas for substantial refinement. First, the emphasis on debtors having tangible assets could restrict loans to the economically disadvantaged, such as those currently being helped through microfinance. In addition, the processes for discriminating against certain economic activities or systems of financing on the grounds of their being considered morally inappropriate would need to be refined. For instance, the sukuk market declined at one point in 2008 as a ‘Bahrain-based group of Islamic scholars decreed . . . that most bonds ran afoul of religious rules . . . Only one that complies with the edict has been issued, pushing up borrowing costs on projects including $200 billion of real-estate developments in the United Arab Emirates capital’.17 The growth of Islamic finance therefore raises challenging questions about the accountability of those who have greater power in interpreting religious texts and their contemporary spiritual implications. This highlights how an ‘Eastern turn’ in economic power is likely to present a range of novel questions for corporate responsibility.

» Sovereign wealth fund responsibility

(The references are available in the pdf download and hard copy versions of this annual review, available from Lifeworth’s bookstore.)

This section can be referenced as:

Bendell, J., and N. Alam, S. Lin, C. Ng, L. Rimando, C. Veuthey, B. Wettstein (2009) The Eastern Turn in Responsible Enterprise: A Yearly Review of Corporate Responsibility from Lifeworth, Lifeworth: Manila, Philippines. (Page numbers for this section are available in the pdf download and hardcopy.)

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