The Current Economic Crisis - Is Islamic Finance a Solution?

05/29/2010 05:12 am ET | Updated May 25, 2011

Throughout the current economic and financial crisis one contrarian statistic has stood out. Financial assets offered by the Islamic Financial Services Industry (IFSI) and generally classified as "Shariah-compliant," were less affected by the crisis. Economist Loretta Napoleoni during a lecture at the University of New Mexico proclaimed, "Islamic finance ... [a] system [that] could help us to get out of the current crisis." Writing in the influential Turkish daily Today's Zaman, columnist Ibrahim Ozturk declared, "Islamic finance has entered a bright new stage of development, emerging after the global financial crisis as a more equitable and efficient alternative to the Western approach." The widely read Arabic daily Asharq Al Awsat opined, "Islamic banks are untouched by the current crisis due to the nature of Islamic banking especially that it does not deal in debt trading and distances itself from market speculation that takes place in European and American banks." How do such claims stack up against reality? Is Islamic finance different enough from conventional finance to avoid its pitfalls?

The IFSI, which has marketed itself as being an alternative to the conventional financial system, has come a long way from its rather modest and relatively recent beginnings. The IFSI was recently estimated by Moody's to be worth $700 billion and projected by the Islamic Development Bank to be $2.8 trillion by 2015. By 2015, majority of the IFSI will be geographically centered in the Gulf Cooperation Council (GCC) region while the South Asian region will provide about 15 to 25 percent of the total services. The IFSI encompasses almost all of the institutional and architectural features of the conventional finance industry. However, it should be noted that the size of IFSI relative to the Conventional Finance Industry (CFI) is very small (about 2 percent). In other words the IFSI has not been sufficiently stress tested to proclaim its efficacy when applied to a broader set of economic situations.

One distinguishing feature of IFSI has been its insistence that in complying with Shariah (the jurisprudence of Islam) it considers dealing with interest as totally unacceptable. The avoidance of interest reflects verses in the Holy Quran (3:130; 2:175; 4:161) which forbid riba, most often and commonly translated as interest rates. The IFSI contends that it has replaced interest rates with rate of profit on equity, profit sharing finance and markup transactions.

In practice, the contracts of the IFSI fall short of the "interest-free" claims it makes. IFSI contracts do allow for presence of interest rates, mostly indirectly but sometimes directly, albeit in small measures. Islamic mutual funds for example allow investment in stocks of companies that use interest based debt (current practices allow 33 percent debt-ratios). Sukuks, described as Islamic bonds, guarantee a fixed rate of return, which to most financial observers look like interest. In murabaha, Islamic jurists opine that home buyer (mortgagor) is involved in credit sales and not a loan contract (as in traditional mortgages). Yet murabaha loan documents use the conventional terms like "note," "loan," and "interest" to describe its features much like any home mortgage contract. Moreover, the mark-up used in murabaha is usually benchmarked to a conventional interest rate.

This has given rise to what Rice University's Mahmoud El-Gamal pejoratively calls Shariah-arbitrage, defined as the practice of extracting premium rents from participants in a captive-market for products labeled and perceived to be Shariah compliant. The paradox is not merely of academic interest. Among the producers and users of Islamic financial products there is pervasive skepticism. A unique insight about this perception is gathered from a recent research on the attitude of customers and bankers using IFSI. A significant majority (6 in 10) believe that the development of Islamic banking has more to do with being faithful to Islam than any other criterion (although the proponents of Islamic finance often cite the superiority of IFSI is due to its purported commitment to social justice and welfare). Nearly 7 in 10 believe that the "rate of profit" or "markup profit" charged by Islamic banks do not differ much from interest based transactions offered by the CFI. Potential patrons (7 in 10) are unwilling to transact with the IFSI because they do not find much difference between the IFSI and the CFI.

In discussing how bankruptcy courts are likely to rule on foreclosures under IFSI contracts like ijarah (lease-based transactions), murabaha (cost plus markup sale) and musharaka (partnership contract), legal experts observe, "We would not anticipate that this type of foreclosure would differ materially from that of a conventional mortgage foreclosure. ... The 'borrower' holds all the benefits and risks of ownership in a Musharaka transaction as well." As such in bankruptcy and foreclosure proceedings, IFSI providers have the same legal protections as those afforded to CFI institutions in debt based transactions.

The current state of IFSI is prohibition driven primarily centered on taking existing CFI contracts and pronouncing the Islamicity or lack thereof for those contracts. The IFSI then proceeds to institute contractual changes that alter the structure of the contract to make them contractually Shariah-compliant without addressing any of their possibly inherent fault lines. This process is enabled by Shariah-boards, which pronounce the Islamicity of such contracts. The Shariah-boards are beset with agency problems (conflict of interest) as they are not subjected to disclosure rules equivalent in scale and scope to those for corporate boards, which many argue are in urgent need for more reform and transparency themselves! According to a recent study the top 5 Shariah-scholars makeup 15 percent of the entire universe of Shariah board positions. Only 180 scholars are involved in nearly 1000 Shariah board positions. This stifles innovations and fosters unhealthy imitations.

One thing is clear, if Islamic Finance is to remain restricted to Muslims then not only will Islamic Finance not save the day but it will also pervert the mission of Prophet Muhammad, described in the Quran (21:07) as a mercy to all humanity (creation, to be precise). The emphasis on the prohibition based aspects of Shariah have led to missed opportunities to promote the maqasid or objectives of Shariah whose aims are not prohibition-driven but rather, inclusive and egalitarian. The maqasid or objectives of Shariah, is to protect and preserve life, mind, faith, property and offspring, which according to the noted Andalusian Islamic scholar Abu Ishaq al-Shatibi is a set of objectives that are common to all religions and must be the transcendent framework to evaluate all Islamic law, social obligations and contracts (financial or otherwise). The attainment of these goals require the development of a positive and inclusive vision, which can truly address the many shortcomings that plagues the world of finance -- from bad regulation, to un-transparent contracts, to plain old greed.

Islamic finance has a role to play in the world of finance. But to do so, the IFSI will have to de-emphasize its innovations based on Shariah-arbitrage and engage in developing a more holistic vision that will resonate with all people of conscience, not just Muslims. Islamic mutual funds, for instance, will have to beyond the negative screens it primarily imposes in selecting stocks to developing positive screens that steer investments towards those opportunities that can lead to sustainable development strategies. Islamic finance must also promote the highest ethical standards and the most transparent disclosure rules, enabling a healthy dose of sunshine into the complex world of financial engineering (responsible for the now infamous credit default swaps that produced the toxic home loans). Islamic banks must also provide a positive vision of efficient and effective distribution of zakat wealth. Islamic financial institutions must develop innovative programs to produce equity based partnerships with small and medium enterprises, which are often the forgotten sector in the world of high finance. The Islamic financial service industry can truly differentiate itself by adopting a more socially conscious role that will enable them to not only fulfill the objectives of Shariah but also inject an alternative vision into the world of global finance allowing a necessary paradigm shift if only to avoid another global economic crisis.

Prof. Parvez Ahmed is a Fulbright Scholar and Associate Professor of Finance at the University of North Florida. With Seth Anderson he co-authored, "Mutual Funds: Fifty Years of Research Findings." He is also a frequent commentator on Islam and the American Muslim experience. His blog can be read at: