Exclusive Islamic Finance Article

The Growth of Islamic Banking and Finance
The credit crunch which hit the Western Banking system starting in August 2007 led many to question the foundations of the Western Banking system. By contrast,
Islamic Banking and Finance was far less severely impacted by the crisis than its Western counterpart. Islamic banking refers to a system of banking that is consistent with the principles of Sharia law (or Islamic law) whose primary sources are the Koran and the sayings of the Prophet  Muhammad. The rules of Islamic commercial jurisprudence are known as fiqh al-mu’amalat.  The focus of fiqh al-mu’amalat is what contracts are permissible and desirable (halal) and which are
prohibited and undesirable (haram). A small group of Islamic scholars in each country determine if a product is Sharia compliant. Sharia law prohibits the payment of interest (riba) on the borrowing of money and also forbids the investment of money in businesses that provide goods or  services that contrary to its principles, such as alcohol, tobacco gambling or pornography or companies that have too high debt levels (typically meaning more than 33% of stockmaket capitalization). In addition the use of money to finance speculation (qimar) or gambling (maysir) is prohibited as are contracts involving ambiguity as to subject matter (gharar).
 
There can be differences between national jurisdictions, a product deemed  Sharia compliant in more liberal Malaysia may not be deemed compliant in more conservative Saudi  Arabia.
        
In the late 20th century a number of Islamic banks were formed to apply Sharia principles to personal and corporate entities associated within the Muslim community. The first experiment with modern Islamic Banking  started in Egypt in 1963 led by Ahmad Elnaggar who set up a form of a savings bank based upon profit sharing. In 1975 the Islamic Development Bank was set up to provide funding for member countries. Today Islamic banking has more than 300 institutions in more than 50 countries and some 250 mutual funds with over $500 billion of assets under management according to Islamic principles. Many Western banks such as Citibank, Goldman Sachs and Standard Chartered also offer Sharia compliant products.
 
The basic principle of Islamic banking is that profits and losses are shared (mudharabah  which means profit sharing). Other useful terms are Wadiah (meaning safekeeping), murabahah meaning cost plus) and Ijarah
(leasing/rent).

Sharia Compliant Assets 2007                     
                       $billions
 Iran                  154.6
Saudi Arabia       69.4
Malaysia             65.1
Kuwait                37.7
UAE                   35.4
Brunei                31.5
Bahrain              26.3
Pakistan             15.9
Lebanon             14.3
Britain                 10.4

Source: The Banker

 
Because interest cannot be charged a typical house purchase can be finance by the bank purchasing a house on behalf of a buyer and then selling the house to the buyer at a higher price and allowing the buyer to pay the bank back in instalments such a contract is
known as Musharakah Mutanaqisah Partnership. Similarly a car purchase can be financed by the bank buying the car and then onselling it to the buyer at a higher price and
  allowing payments by instalments with the bank retaining ownership of the vehicle until the final installment is paid such a contract is known as Murabaha. In a business transaction an Islamic banks may lend their money to companies based on a certain percentage of the company's profits. Once the principal amount of the loan plus cost is repaid cost plus contract is known as mudarabahah ends. A partnership or joint venture namely Muskarakah is an arrangement whereby an entrepreneur provides labor while financing is provided by the bank so that both profit and losses are shared. 

The sharing of the capital provided by the bank and the labour by the business reflects the Islamic view that the borrower must not bear all the risk and cost of a failure, resulting in a balanced distribution of income and not allowing lender to monopolize the economy. Depositors in Islamic banks keep their money in mudoraba or wakala accounts and receive a percentage of the profits rather than a given rate of interest, although most Islamic banks maintain “profit equalisation reserves” to ensure minimum payments even of losses are made.  

More recently Islamic finance has developed a Sharia compliant bonds called sukuks used to finance companies and development in Islamic countries. A typical sukuk is based upon an asset backed Ijarah structure which is an asset backed bond a sale and leaseback arrangement that uses revenue from an asset usually a property to pay investors. These payments are based on rent or profits which is not considered a guaranteed return as the
property could fall in value although investors invariably get their principal back. While a conventional bond is a promise to repay a loan purchasing a Sukuk constitutes partial ownership in a debt, asset, project, business, or investment.
             
Sharia principles meant that Islamic banks did relatively well compared to their Western counterparts during the financial crisis. They had low amounts of leverage, little exposure to the toxic subprime mortgages and a relatively
stable deposit base. The main hit to the Islamic banks was their exposure to the real estate market in the Middle East which had boomed prior to the outbreak of the crisis but was significantly hit during the crisis. There are still some problems that confront Islamic banks one particular problem is that they cannot access the interbank market as they are not allowed to pay interest so short term liquidity has to be managed by other means. When it comes to derivatives then their use may be sanctioned if they are used to hedge risk but not for speculative purposes. The future development of Islamic finance sector will depend on its ability to innovate and offer wider range of products and services at competitive prices so as to be able to compete with Western based banks.