Islamic Finance - Risk Reward

1 Riskupdate20102010 The quarterly independent risk review for banks and financial institutions worldwideRisk Reward Risk Reward Ltd UK. All rights reserved. Available by subscription only not for sale or resaleIslamic FinanceFOUR ARTICLES INTRODUCING ISLAMICBANKING AND Finance CONCEPTSWRITTEN BY MARK ANDREWS, HEAD OF Islamic BANKING AND Finance , RISK Reward LTDT here is much to both admire and praise about IslamicFinance. Its stated ethos and principles are probably as closeto a model for truly ethical and moral banking that has yetbeen developed and actually implemented on a large scale. Based on the Quran, Islamic Finance offers its clients Shari ahcompliant banking but the real meaning and to be fair, thetrue benefits of this, are often lost on Western observers,some of whom have tended to dismiss the sector as yetanother example of fundamentalist religious doctrine appliedto real life. But this cynical view is not only undeserved it isalso mostly inaccurate.

2 In reality, even a cursory study ofIslamic Finance and its guiding principles will confirm it isindeed probably the most successful model for ethicalbanking to date. But it is not without its weaknesses, not leastof which is whether any institution can actually achieve theblueprint and live up to its full potential. The answer is almostcertainly no but does this detract from its merits?The whole concept of Shari ah compliant banking is byWestern terms still very much in its infancy. Someconventional banks have been trading for more than 400years, most for at least 50 and it is often a surprise to manyobservers that modern Islamic Finance actually started in itspresent format as recently as 1985. Of course trading andcommerce in the Islamic world is actually thousands of yearsold and pre-dates not only banking but Islam itself. Theremarkable legacy of this ancient history is that the basictrading contracts have been refined over millennia and stillsurvive, still work (in the main) and still underpin guiding principle of Islamic Finance is to provide bankingand financial services which are compliant with Shari ah is the Divine Law as revealed in the Quran (Book ofAllah SWT) and Sunnah (words or acts) of His ProphetMuhammad (PBUH).

3 The primary authority for Shari ah is the Quran which means the text of God and is actually a blueprint for running asociety with detailed rules covering every aspect of aMuslim s life including religious, family, community and ofcourse trading obligations. It stresses fairness, honesty,integrity and morality to all, even towards non- believers,which comes as a surprise to some is the Sunnah which means well known path . It coversthe words, acts and tacit approvals of the Prophet (PBUH) asrecorded at the time and subsequently and includes theSayings (Hadith) which He used to lay down the law and givemoral guidance. Next comes Ijma or consensus/agreement under whichsuitably qualified Islamic Scholars or Jurists are asked to ruleon points of Shari ah law where the answer is not immediatelyavailable from the two senior sources. Then follows Qiyas or analogy , which extends the law by applying commonunderlying attributes. Finally there is Ijtihad or interpretation , where Islamic Scholars are asked to rule on an apparentlyunique problem.

4 This structure seems to be comprehensive enough until youare reminded that the primary sources, the Quran and theSunnah, are actually 1,400 years old and chronicle the moral,commercial and religious challenges of that time. Eventhough the Prophet (PBUH) was clearly a pragmatist and maywell have accommodated some of the modern structuraldifferences, it is obviously a matter of faith that the historicaltexts are doctrine and must be applied literally and to apply ancient standards to modern banking is andhas been a real challenge. Critics say it is disingenuousinvolving replication and retrospective shoe horning tomake it fit, but this dismissive swipe cheapens unreasonablythe value of what has been achieved in a very short time. Ifyou study the subject in detail it is hard not to congratulatemost scholars for reaching remarkably successfulcompromises even where the challenge seemed incapable ofbeing resolved. Underpinning Islamic Finance are several basic rules whichcannot all be listed in detail in this article but the main onesare: No uncertainty Trade must be in real goods and assets Sellers must be honest, totally frank and actually own whatthey sell There can be no speculation or gambling No trade in activities or products considered Haram orun-IslamicThese prohibited activities are generally well known andinclude no trade in pork, alcohol, armaments, pornography, most significant basic rule and the one that perhaps mostdefines the ethos of Islamic Finance , is that all commercemust involve the real sharing of both profits and losses so thatall parties, including the bank, have a real and tangible stake inthe outcome of the transaction being , and unlike a conventional bank which does, anIslamic Bank does not have a debtor or creditor relationshipwith its depositors and customers.

5 With one exception (Amanah or Trust accounts which are safecustody deposits and are not usually significant in numbers oramount) depositors are actually investors, all of whom agreeto invest alongside or via the Islamic bank and whose return isbased on a share of the banks actual profit and place money in the Islamic bank as trading partnersand are given a profit (and loss!) sharing share based on theISLAMIC Finance AN INTRODUCTIONThis is the first of three articles introducing Islamic Banking and Financeconcepts written by Mark Andrews, Head of Islamic Banking and Finance ,Risk Reward Update2009 Q22term,purpose, maturity, etcof the investment. The actual investor accounts are based on theancient contracts of Amanah, Wikala, Wadia,Mudaraba and Musharaka but are generally also reported ascurrent accounts, investment accounts and special investmentaccounts by many Islamic key difference between Islamic investors and the depositors in a conventional bank is that Islamic investorsagree to share profits and losses whereas conventionaldepositors do not, especially the loss part!

6 In theory,therefore, a loss making Islamic Bank could and should passon these losses to its investors who would see theirinvestments reduced as a consequence. So far, this has not been put to the test in a major way and itis debatable whether an Islamic Bank could actually pass onlosses on a large scale, given that in reality most investorsregard their stakes as a one way bet. Would it trigger aNorthern Rock exodus? Possibly. There are many myths about Islamic Finance principally thatit is banking for Muslims only. This is not true at all. Anyonecan open an investment account and apply for the full rangeof services on offer. Non-Muslims are biggest challenge facing the sector is liquidity but not inquite the same sense that we use when looking atconventional banks. In a conventional bank liquidity is neededto repay depositors and liquidity difficulties usually meansthe bank cannot meet their withdrawal requests. It is fearthat drives this process and usually triggers panic, which inturn starts a wholesale stampede as depositors jostle toget their money out first.

7 Restoring confidence, veryquickly, is the only solution, something the authoritiesfailed to do with Northern Rock. Faced with bank collapses in the West, all Islamicjurisdictions made it clear in unequivocal terms thatthey stood fully behind the Islamic banks in theirterritories. As these territories included some of the richestcountries in the world, most Islamic investors are nowsatisfied that the risk of losing their money is evidence from various institutions suggestsinvestors having seen the worst are now relaxed and no majorwithdrawals have been reported. The liquidity challenge in Islamic banks is actually a treasuryand profitability problem. There is no effective Islamic inter-bank market and banks cannot lend to or borrow from eachother in conventional terms. As a result a bank that finds itselfwith too many investments or is short of cash, has limitedoptions. The issues posed by this are beyond the scope ofthis article but typically surplus funds have to be held in lowor nil yielding cash form and shortfalls are met by seekingdiscreet deposits from sovereign departments on a lender oflast resort basis.

8 This super tanker approach to liquiditymanagement will be a real constraint on future Finance : Part 2In the next quarterly Risk Update we consider Riba or thebanning of interest and the asset side of an Islamic Bank,including Musharaka which should be the star of Islamicbanking but sadly is Update2009 Q23 Understanding the Concept ofRibaIn over simplistic terms Riba means interest and Islamic Banks mayneither charge nor pay interest on theirfunds. Its prohibition is contentious insome quarters, especially amongst non- Islamic institutions, but the factremains that there is unanimoussupport amongst all Islamic Scholars fora total ban. This ban or prohibition is oftenreported in critical terms by outsiders,which is ironic given that mostdeveloped economies have bannedinterest to some degree or other duringtheir histories. However a total and notjust partial ban seems both draconianand anachronistic at first sight. There is also an unhelpful elephant inthe room which makes understandingmore challenging.

9 It is quite a bigelephant actually and is normallydescribed thus: If it is correct thatIslamic Scholars have banned thecharging or paying of interest of anykind and for any reason, why is it thatall Islamic bank accounts, deposits,savings plans, loans, bonds, leases,credit cards, in fact almost everyIslamic product, are linked in practiceto one kind of interest rate or another?This is surely either a fudge or iteffectively undermines the ruling! The standard answer to this accusationis that linking something to an interestrate is not the same as actually chargingor receiving interest . This is obviouslytrue in academic terms but it doesn tconvert many doubters. Moreconvincing and comprehensiveexplanations are required to do thatand we will consider a few of these keyarguments and foremost, Riba as originallydescribed, is not the same as modernday interest and it is a bit confusing toconnect the two directly even thoughthe latter is now banned under Islam asif they were.

10 Secondly, there is nodirect or accurate translation fromancient Arabic into English of the word Riba , which adds to the closest modern approximation is Usury or an unwarranted,unreasonable or unearned premium,excess or surplus which is neitherdeserved nor fair . As mentioned earlier, the prohibition ofinterest, especially usury, is notconfined to Islam and has a long historyspanning several traditions andcivilisations including our own. Whilsteveryone would accept that forbiddingUsury is both correct and morallyright, it is less clear to outsiders whyIslamic Scholars have decided to baninterest completely given the crucialrole it plays in Western economies. Thesimple answer is that an Islamiceconomy was and still is ReferencesThe Quran (Book of Allah SWT )refers to the term Riba several timesbut no definition is available and nodetailed explanation is given in thepractices of the Prophet (PBUH). Islamic Scholars don t know why, butthey believe there are two likelyreasons for this.