Going east to prevent finances going west

4th October 2011

Outside the small community of bonus-fuelled investment bankers with seven figure bonuses, most would probably prefer the second, traditional model over the first with its emphasis on the casino side of finance – a veritable alphabet soup that goes well beyond VIX.

But if saying the old fashioned non-casino model could be found in Islamic finance, lays one open to a veritable torrent of misunderstanding and worse.

Back in 2008, the US Treasury announced "Islamic Finance 101" – it wanted staff to understand the basics of this financial model which eschews interest in favour of profit and loss sharing and which bans betting.

The blogosphere result was predictable:

One of the less strident responses, claiming it was opening "a door to American funding of Islamic extremism". It was nothing of the sort. The US Treasury was not endorsing Islamic finance, merely giving employees the chance to learn more.

Here is a more balanced understanding of Islamic finance, 

The two basic tenets of Islamic banking are the ban on interest (known as Riba) and a prohibition on investing in certain areas such as alcohol or pornography (many socially responsible funds would share in this) while also refusing to be involved in gambling. Islamic world banks were not involved in casino-style activities.

So could Islamic finance have prevented the worst of the banking crisis with its knock-on effects on so many economies?

Possibly, but that would only apply if it had become the dominant financial force in Europe and the Americas.

A Times article shows that Islamic finance has only a small share of UK banking – mainly servicing Muslim communities – but that some non-Muslim investors see merits in its model. The article quotes UK property investor Roger Smee who decamped to Doha to avoid the worst of the west's addiction to high turnover investment banking and what he saw as irresponsible lending. His disenchantment with "watching the world of Western finance become a casino" led him to concentrate many of his activities in Doha, Qatar where he found Sharia principles to be "based on a deep sense of partnership, with your bank or other investors".

Led by Lloyds and HSBC, from around 2002 onwards, UK banks started actively to court British Muslims, offering a range of products, from current accounts to mortgages, which complied with Sharia. HSBC even has its own Sharia-compliant wealth-management company. But business has been slow and many of these initiatives have been rolled back.

This could be because Islamic finance in the UK was dominated by big banks with many questioning whether their loans and other products were merely an Islamic veneer onto existing models. So while "rent" replaced interest on mortgages, that rent was tied into Libor, an interest rate.

But despite remaining very much a minority product, the thinking behind Islamic finance can be attractive. Earlier this year a blogger Imaduddin Ahmed wrote: "Imagine a world without a financial crisis. No moral hazard, so brokers won't sell mortgages without carrying out appropriate credit checks. Imagine banks not deliberately selling complex derivatives, knowing that they will be worthless. No short-selling speculation, so companies tinkering on the edge won't be pushed over. Imagine a world with Islamic finance.

"The practices that caused the financial crisis would not have passed muster with sharia boards – committees of religiously inspired legal scholars who conduct a religious audit of a bank's activities. Neither the securitisation of sub-prime loans nor credit-default swaps are acceptable in Islamic finance," says Ibrahim Warde, author of Islamic Finance in the Global Economy and a professor at Tufts University.

"As for the systematic vetting of new products by sharia (Islamic religious law) advisers, it could be looked at as a system of checks and balances, a useful corrective to the groupthink that had overtaken conventional finance."

Islamic banking counts helping with defaults on mortgages as part of Zakut – a sort of charitable tax. But deciding which customer in trouble to help and which to ignore can be difficult – although probably no more difficult than a typical UK or US bank deciding whether to allow a borrower more time or to foreclose.

Leaving aside the extreme bloggers, what is wrong with Islamic finance?

It does not abolish inherent business risk, and it can finance an asset bubble as well as any Western bank. Reflecting in part the world it comes from, it can be conservative and far from enthusiastic about innovation in either technology or finance.  And – this may be positive or negative – Islamic banking would have been unable or unwilling to finance growth through debt. A ban on interest can mean the baby's thrown out with the bathwater.

Understanding Islamic finance – the US Treasury 101 – can be difficult as religious authorities differ in their standards. Islam has many variations – like other religions – but present day Christianity, for instance, does not seek to lay down rules for investment and other financial institutions.

As Imaduddin Ahmed says, Islamic finance "is not necessarily an end in itself, but it does serve to remind of the need for humane banking, the elimination of moral hazard and the reassessment of assumptions that speculators and derivatives add more value than they destroy."

More from Mindful Money:

A Brief History of Socially Responsible Investing (SRI)

European debt crisis: what is the answer?

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