Is Islamic Finance Ethical?

Islamic finance is ethical in the sense that it conforms with the commonly accepted understanding among Shari'ah scholars of what is ethical.  However, the industry markets itself in a different idea of what is ethical.  Islamic finance is supposed to be a superior alternative to the current financial system, one which appeals to Muslims as well as non-Muslims and one which takes as a minimum a standard that is more stringent than the 'industry average'. 

On this metric, I think Islamic finance has much more work to do.  If one thinks that Islamic finance is supposed to meet the baseline standards of financial ethics with an additional set of constraints specific to the dictates of the Shari'ah, than Islamic finance meets the definition of 'ethical'.  However, the way Islamic finance is presented, and I would argue also how it views itself, this standard is not sufficient to be 'ethical'. 

For example, take socially responsibly investing.  It is an 'ethical' framework for investing and it has broad appeal (although there is nothing 'unethical' about disagreeing with the standards under which it operates).  However, it operates in an environment with conventional finance is a competitor and where it has to offer something valuable to consumers.  Islamic finance, on the other hand, is largely concerned with serving a market where it is not in direct competition with conventional finance. 

For Islamic finance to gain consumers--at least until that market is saturated--all it has to offer is the same types of products that conventional finance, but in a way that passes muster of a Shari'ah board.  This type of Islamic finance industry does not directly compete with conventional finance because it is targeted towards a consumer who is not deciding between Islamic and conventional financing, but instead is deciding between working with an Islamic bank or keeping his or her money under the mattress.  This market is almost entirely Muslim, although not all Muslims use Islamic finance. 

There has been a trend in recent years for non-Muslims to use Islamic finance, whether this is Islamic banks in Malaysia or Islamic mutual funds in the United States.  This decision is primarily financial: if an Islamic bank or mutual fund offers a better deal than conventional financial institutions, then non-Muslims will use it regardless of the "ethical-ness" of the product.  However, being price competitive alone does not make the product "ethical", even if it happens to be designed to fit within an ethical system like the one derived from Islam. 

Islamic finance talks a lot about being superior to conventional finance and being an alternative that is attractive to conventional finance to non-Muslims as well as Muslims.  While this is admirable, there still remains a disconnect between creating an "ethical" alternative based on the precepts of Islam.  Returning to the socially responsible investing example, that industry started (like Islamic finance) by avoiding things that were viewed as "unethical", whether that was weapons or tobacco makers or producers of alcohol or companies that produced other harmful or toxic products.  But, the evolution of socially responsible investing did not become an "ethical" alternative until it started offering a product that was defined by what it did, not by what it did not do. 

Today, Islamic finance is approaching the point where it too will have to define what it is, not what it is not.  This ties back into my earlier post on the debate between the idealists and pragmatists in Islamic finance with the former saying that creating financial products that Shari'ah scholars approve using financial engineering in some cases which fit into the current regulatory environment is sufficient.  The latter say, "no", and argue that only profit-and-loss sharing (PLS) products are true to the roots of Islamic finance. 

When viewed through the ethical lens, the idealists have the edge because they are offering an idea about what they want, not how they have not done X, Y or Z.  However, they promote an idea that I think is incompatible with financial services today because of regulatory barriers, as well as consumer preference.  Not every financial consumer's needs can be met with a PLS-based financial product.  For example, how would one structure a student loan to pay for college using PLS?

But, I do think their focus on what Islamic finance does that other types of finance do not is useful for the Islamic finance industry.  To create an ethical product in Islamic finance, financial institutions should consider not only avoiding what is haram, but also on incorporating ideas of what is encouraged within Islam into financial products.  This will make it easier to explain to non-Muslims why they should consider Islamic finance, without either resorting to platitudes about fairness and justice or hoping that the economics of the transaction are more beneficial than a conventional financial product.

Until Islamic finance moves towards this idea, it will be stuck selling its products to the segment of Muslims who will not deal with conventional banks, or those who prefer to deal with Islamic banks, if the cost is similar.  There will remain examples that can be tossed out to refute my argment based on the large non-Muslim customer base, but in large part, those will be isolated examples where the economics work out better for the consumer.  There will be little progress in making inroads on the non-Muslim market (and also among many Muslims) if there is not something being offered that is not solely based on superior performance. 

What is Islamic finance?

I was at the US-Qatar Business Council's Forum on Islamic Finance and I returned home yesterday.  Today, I was thinking about the division between what is described as Islamic finance and how it is actually practiced.  I don't know if it was something raised at the conference, or perhaps coming out of the jetlag from the flight back home, but here is a thought I had about why there is the division between theory and practice in Islamic finance.

The idea for Islamic finance began several decades ago and the industry really never was able to put the theory into practice (for example, the idea of an Islamic bank that uses mudaraba to collect deposits and then extends mudaraba financing to businesses).  The real growth did not start until the past decade when rising oil prices led to a flow of money into the GCC countries where Islamic finance is prevalent (not to exclude Malaysia, but I think the growth there was much more heavily driven by government support and a more lax interpretation of Shari'ah-compliance by permitting BBA and trading in debt).

One of the things that enabled Islamic finance to grow rapidly was (as I understand it) a consensus among the scholars that contracts like ijara, mudaraba and musharaka could be used in conjunction with other contracts to create more complex transactions that allowed people experienced in financial engineering to develop Islamic versions of conventional financial products.  This allowed Islamic banks to synthesize a conventional bank's balance sheet in a way that would be approved as Shari'ah-compliant.  This allowed for a crossover between bankers, lawyers and other financial professionals from conventional finance to Islamic finance and these individuals then began selling Islamic financial products as a niche within the financial services industry.

Much of the criticism (although by no means all) has come from people who want Islamic finance to be based primarily on profit-and-loss sharing (PLS).  They condemn the current form of Islamic finance for its similarity in economic outcome to conventional finance.  On the other side, Islamic financial professionals deflect this criticism by holding up the existing regulatory and tax environment for necessitating products that look and feel like conventional banking products.

However, I think that this dialogue, if it can be called a dialogue, is two groups of people speaking past one another.  The root of the PLS argument rejects the consensus that allows for individual contracts to be used as building blocks for the products in the market today and, among the different types of contracts available, gives preference for mudaraba and musharaka as the more "authentic" contracts.  As someone speaking at the conference (I do not remember who) pointed out, the contracts--partnership, lease, sale with a markup--are not uniquely Islamic but are present in most groups of people where commercial trade exists.

The people who believe the appeal for more PLS is idealistic respond that they just develop something that works on the basis of a consensus that allows for contracts to be combined together into a product that can pass regulatory muster and be tax-efficient (or at least not create excessive tax burden).

However, at the root of the division is whether financial engineering can be used in Islamic finance or whether the industry should refute the consensus and return to a more basic form of Islamic finance, preferably based on PLS in the eyes of its proponents.  But, that is not what is discussed, because it requires too much of the history of Islamic finance for a newspaper article or conference panel.

My personal view is to lean towards the pragmatic approach that, given a consensus that allows some financial engineering, to use it to develop financial products that work within the existing framework of legal, regulatory and tax systems.  I don't view the move to PLS-based products exclusively as possible or necessarily desirable because it cannot cater to certain financial needs that exist.  On the other hand, excessive financial engineering can be problematic because it creates products that are not needed simply because selling them makes money for the banks offering them.

However, the key point, at least for a starting point, is whether the idea that financial engineering (using basic contracts as building blocks) can lead to a beneficial outcome in Islamic finance.  Can products be developed using financial engineering that pass Shari'ah review and be useful to consumers of those products and develop a workable Islamic financial system.  I don't know, but I also don't know whether that question is being asked specifically enough to start a discussion.

Khazanah's renminbi-denominated sukuk

Malaysian sovereign wealth fund Khazanah is reported to be considering a renminbi-denominated sukuk, the first denominated in renminbi.  According to the FT, the sukuk would be focused on investors looking for RMB-denominated assets, rather than primarily at Islamic investors, which is an interesting strategy given that there are many investors holding RMB as a result of trade with China that they have few places to invest since the RMB is not freely convertible.

One part of the article which I find unconvincing is that "Islamic finance lawyers in Hong Kong and Dubai say that even if the offering by Khazanah is successful, the deal may have limited carry-over to the Gulf market, where bonds, to be compliant with Islamic law, often need to be structured differently from sukuk sold to Malaysian Islamic investors".

While there are differences between the Shari'ah standards used in the GCC and in Malaysia, those differences have been narrowing as Malaysia attracts funds and issuers from the GCC into its sukuk market.  For example, Al Rajhi Bank and Cagamas launched a sukuk program (Sukuk ALIM) that is acceptable both in Malaysia and in the GCC and a number of GCC-based companies have issued Ringgit-denominated sukuk in Malaysia.

The move into RMB-denominated sukuk will likely be slow because of the newness of that market, but it could provide a way for Islamic issuers to find a new market for their sukuk and introduce the concept to investors who are not already familiar with sukuk.  However, this could also be a distraction away from the challenges of developing uniform structures for the basic sukuk structures, which should be the base for growth in the size and liquidity of sukuk secondary markets. 

Turkish participation banks should enter Europe

S&P recently suggested that Turkish participation banks, as Islamic banks are known in the country, could sustain their recent growth (they accounted for 5% of assets in the country at year-end 2010, compared with 2.8% in 2005) if they leverage their international ties further (three of the four participation banks have GCC-based owners).  I would take this one step further and suggest that they could provide a lead in continental Europe for Islamic banking with financial support from their owners. It is already underway with Kuveyt Turk, the Turkish subsidiary of Kuwait Finance House, opening a branch in Germany and Bank Asya planning an acquisition in the Balkans.

Not only does the bank's affiliation with larger GCC-based Islamic banks provide the financial resources to pursue international expansion, they are geographically closer to Europe than GCC-based banks are and Turkey has been in long-running talks to join the European Union.  In addition, the history of dealing with sensitivity towards the "Islamic" label in Turkey should make it easier for them to adapt the Islamic branding to local conditions better where the "Islamic" label could attract controversy.

There is nothing that requires an Islamic bank to drop the "Islamic" branding, although many people (I have heard Rushdi Siddiqui raise this point several times at various conferences) have suggested it is better if they do so in order to allay suspicions that Islamic banking is just for Muslims.  Removing the "Islamic" label--perhaps even by adopting the "participation bank" identity that they are used to in Turkey--will focus the attention of the regulators, politicians and the broader public (i.e. the bank's potential customers) on the products they are offering.

Given the general unfamiliarity with Islamic banking in Europe, the focus should be on the products the bank offers and not the fact that they were designed with a focus on Shari'ah-compliance.  If Islamic banks are offering a superior product, there is no need to introduce an element of unfamiliarity into the marketing process.  That being said, the Islamic banks have to make sure they focus on creating products that do actually provide a benefit to the bank's customers.  While initially the focus will (naturally) be on the Muslim populations in these countries (e.g. the large Turkish minority in Germany), sustainable growth will only come by attracting non-Muslims (as has occurred in Malaysia).

If non-Muslims are going to adopt Islamic banking, there has to be a benefit.  Saying the banks work without interest will only create more questions (are you giving away money for free?).  There has to be an actual benefit.  Perhaps a focus more on the prohibition of gharar and maysir would be better.  A European participation bank could attract non-Muslims by appealing to the restriction that prohibits banks from engaging in deceptive products that contain excessive contractual uncertainty and prohibit the banks from taking speculative bets through conventional derivatives, credit default swaps and collateralized debt obligations. 

This same exercise should not be limited to Turkish participation banks in Europe.  The Islamic banking industry needs to find some real reason why it is different.  Either it competes on cost or there has to be a substantive difference with conventional banks.  Appeals to Shari'ah-compliance alone will work for a time, but narrowing the potential market to just the Muslims who are otherwise unwilling to work with a bank risks the future growth prospects for the industry. 

UAE sukuk market evolution

An article from the Business & Banking Review (via Zawya) describes the evolution of the UAE sukuk market.   One of the most interesting parts of the article (the whole thing is well worth a read) comes at the beginning:

In 2004, only three sukuks were issued in the UAE with an aggregate value of $1.165 billion. Two years later, the number of sukuk issues had increased to seven and the value grew eight-fold to $8.755 billion. The height of the sukuk market was certainly 2007 with eleven issues with a value of $10.8 billion.

What is interesting to me is not the growth (827% over four years), but the average size of the sukuk issued in the UAE, which grew from about $385 million in 2004 to $1.25 billion in 2006 and nearly $1 billion in 2007.  This size is significantly larger than many of the sukuk issued since the financial crisis (excluding some of the sovereign issues from Malaysia).

Many of these sukuk were for real estate-related projects, or for financial institutions which financed real estate investment.  While it is not unusual to see a large volume of sukuk (and conventional bonds) come from financial institutions and real estate companies, the large size of the projects in the UAE (particularly Dubai) were financing a real estate bubble, in many cases supported by the government (the issuers were often partly state-owned or quasi-government companies).

During the boom, these sukuk were snapped up quickly, as demand for nearly any sukuk overwhelming the supply, even in the mega sukuk (a significant amount came from the three Nakheel sukuk, $2.5 billion issued in 2006, $750 million in 2007 and $3.6 billion in 2008).  Now that the sukuk markets are recovering to some degree, the demand is still there, but it is not being met by mega-sukuk.  In many cases (for example, when GCC-based institutions have traveled to Malaysia to issue sukuk), the average size has shrunk significantly, although there are still a good share of "benchmark" sized sukuk.

This is not a bad thing for the market overall.  While a smaller issue may not generate the same secondary market liquidity (given the proclivity of many buyers to hold-to-maturity), they provide more diversity in issuers, currency, ratings, industry, etc.  This is positive because it provides more opportunities for sukuk investors to diversify, so long as they can get an allocation of new sukuk or find them in the secondary market, which is never a given.

Overall, however, I think the current situation is preferable because 1) there was little secondary market activity in the sukuk pre-crisis; 2) there were far too few diversification possibilities for investors away from real estate and related financial institutions; and, 3) the real estate on which the sukuk were based turned out to have been overvalued, leading to a near collapse of the primary market for sukuk.  Risks remain from a global economic slowdown and geographical diversification is still nearly impossible.  However, the market is on the right track.  Again, I would suggest reading the whole article because there is a lot more there. 

How do Islamic banks act ethically?

My latest newsletter (sign up on the left side of the blog):

It is common for people to describe the potential of Islamic finance beyond just Muslims based on its socially responsible or ethical foundations.  However, given the structures used and limited screening methodology (focusing only on excluding what is prohibited outright), without any consideration for activities which may not be prohibited outright, but which are socially detrimental, such as environmental and labor standards. 

Even beyond this critique, some (myself included at times) focus solely on the "asset" side of the balance sheet and criticize the use of products that are functionally equivalent to conventional lending, but which have been re-structured to be sale or lease contracts instead of ones based on interest.  Part of the criticism is that by acting the same way as conventional banks, albeit with different contracts, there is no "ethical" benefit to Islamic finance.  However, that does miss the conflicting demands an Islamic bank (like any bank) faces between interest groups which may have different objectives and to which the bank may have different levels of responsibility. 

For example, as pointed out in this article, giving additional forbearance on a loan or renegotiating the terms beyond what is required in the contract or under the laws of the country in which it is executed, it may be viewed as more ethical by borrowers (and people whose interests are aligned with that borrower, like other debtors to the bank who may expect similar treatment).  However, it will be viewed very differently by the bank's depositors and shareholders, who will see a lower return on deposits or on their shareholdings in the bank.  To them, while the action of the bank may have been charitable, it was done not with the bank's money, but at the expense of the depositors or shareholders' return. 

As a result, it becomes more of a challenge to decide whether an Islamic bank is 'ethical' simply by viewing how it treats borrowers who are in distress, either because of factors out of their control like an economic downturn, or where they overextended themselves by buying a property they could not afford (in the latter case, some of the responsibility lies with the bank for not analyzing the borrower's ability to pay).  In normal times, and where there are no disputes about the bank acting in bad faith, it is perfectly ethical for a bank to demand repayment or to foreclose on the borrower to minimize the loss of depositors and shareholders.

However, in strained times, when there is a general economic downturn, especially when a lot of the bank's assets are exposed to a particular sector that has been hit hard, the Islamic banks should react differently and consider offering payment moratoriums, reducing the amount borrowers owe.  However, it should not do these out of charity to the borrowers, it should do so out of the responsibility to maximize the return (or minimize the losses) to shareholders and to protect depositors.  It should be a strictly economic decision--if the bank has high exposure to real estate, it cannot hold onto hope that all of the assets it holds will be worth their book value. 

By getting in front of the problem and determining what assets are impaired and which are not, it can decide how to maximize the value of its assets.  If the Islamic financial contracts and the bank's balance sheet is simpler and clearer than a conventional competitor, then it should be easier to identify losses, supplement capital where needed and move forward than in a conventional bank with a complicated balance sheet where its assets are more difficult to understand and value.  This may be more ethical in the end, but only if the bank 's management is willing and able to deal with the problems quickly.

If Islamic banks keep their operations simple and don't get too heavily leveraged with balance sheets filled with assets that are difficult to impossible and the management is honest with itself and its constituencies, then it may be judged to be more ethical.  The screens used in Islamic finance (particularly those relating to gharar and maysir) may tie the hands of management in a good way, it cannot be relied upon to keep the Islamic banking system any safer than the conventional banking system, or more ethical and transparent.  Combining the limitations on some types of activities may help, but in the end qualified, competent and ethical management has to be in place for the ethical ideas to be translated into practice.  Another reason why Islamic banking should not be viewed as inherently better, more ethical or more stable than conventional banks.

Is Indonesia's Islamic banking market structure optimal?

An article in the Indonesian paper, Bisnis Indonesia describes how two Islamic banks, Bank Syariah Mandiri and Bank Muamalat Indonesia, dominate the market for Islamic banking, which the paper attributes to "late expansion by other sharia banks on building infrastructure and network as many of them just being spinned off their parent companies recently". 

This is an interesting market structure and contrasts to several GCC countries where there are a large number of small Islamic banking companies, which has led to many instances where experts call for greater consolidation.  However, in Indonesia, the dominance by two large banks may not necessarily serve the market well when they rely on mudaraba and musharaka more than Islamic banks in other countries. 

This is not a criticism of a higher percentage of profit-sharing contracts in Islamic banks.  It may benefit the market to have a better balance between the profit-sharing and the debt-based products, if for no other reason than it will provide a clear "difference" between Islamic and conventional banks.  However, an IMF study from 2008 found (pdf) evidence that smaller Islamic banks are more stable than large Islamic banks and conventional commercial banks, while large commercial banks were found to be more stable than their Islamic counterparts. 

One study does not prove the case; there is a much greater diversity among large conventional commercial banks than there is among large Islamic banks.  For example, in contrast to what I expected when I looked back to the study, the Islamic banks (only wholly Islamic banks were considered, not Islamic windows) were larger on average than the conventional banks when measured by total assets.  This is contrary to a piece of conventional wisdom that Islamic banks need to grow in size to compete with their conventional competitors, but could also indicate that the sample used in the study does not include the "mega" banks, the conventional international financial behemoths that many people see as competition for Islamic banks. 

However, returning to the impact of size on stability, the authors of the IMF report, Cihak and Hesse, posit that the larger an Islamic bank gets, the harder it is to manage risk.  This is likely to be particularly true as the size of the bank's profit-sharing portfolio increases, which leads to my suggestion that a market structure dominated by two large Islamic banks may reduce the overall stability of the Islamic banking system compared to a more balanced one where five or six banks share the bulk of total assets.

Indonesia plans sovereign sukuk, targets GCC

Indonesia is planning another dollar-denominated sukuk sale and there were a few interesting points highlighted by the Jakarta Globe.  The sukuk will be targeted at Middle Eastern investors, who accounted for 30% of the buyers in the last sale, which was heavily oversubscribed.  Rahmat Waluyanto, director general of the debt management office at the Ministry of Finance, told the Jakarta Globe, "We are targeting Middle East investors to buy our global [Islamic bonds] [...] Investors from other parts of Asia, Europe and the United States are also welcome."  The last sale was subscribed primarily (40%) by Asian investors, with Americans (19%) and Europeans (11%) making up the balance.  With the market turmoil, particularly in Europe, since the first one this sukuk could signal whether investors are continuing to pour money into emerging market sovereign sukuk.

Bank Asya expanding into the Balkans

Bank Asya, a Turkish participation bank (i.e. Islamic bank), made a couple of interesting announcements recently.  First, it plans on a $10-$20 million acquisition in the Balkans in partnership with the Islamic Development Bank.  Secondly, it is planning a $300 million sukuk by year-end, depending on market conditions. Third, it has asked for bids for the bank from interested buyers, and has received some which it says are below the bank's "potential". These three developments highlight areas of Islamic finance that I think are going to be important going forward. 

The first development of an acquisition in the Balkans is important because there is currently very little activity in Islamic banking in the Balkans, despite a sizeable Muslim population in some countries in the region.

Albania - 2.5 million - 79.9%
Bosnia-Herzegovina - 1.5 million - 48%
Bulgaria - 920,000 - 12.2%
Greece - 310,000 - 3%
Kosovo -  2 million - 89.6%
Macedonia - 680,000 - 33%
Montenegro - 111,000 - 17.7%
Serbia - 244,000 - 3.2%
Slovenia - 49,000 - 2.4%

This is probably fertile ground for Islamic banking even as the more developed countries like France and Germany struggle to adapt their legal systems to allow Islamic banking.  It is particularly valuable, I think, for the Islamic banking to be offered through an acquisition by a Turkish participation bank, which has significant experience offering Islamic banking products in an environment where the "Islamic" aspect is minimized for political reasons.  Unlike in GCC where the "Islamic" label is used without much dispute, it is much harder in secular Turkey to brand an Islamic bank as "Islamic".  It is no surprise that the first Islamic banking branch on the Continent (in Germany) was opened by KFH-Turkey.  If this acquisition becomes successful, it is quite likely in my opinion that future growth of Islamic banking in non-Muslim majority countries could adopt a more neutral brand (e.g. participation banking) to offer the same products, while avoiding political challenges from being labeled as "Islamic". 

The second move by Bank Asya is to offer a $300 million sukuk.  While this would be a relatively large sukuk, although not quite of benchmark size, it is pretty small relative to the bank's YTL14.5 billion ($8.5 billion) balance sheet. However, it would be a modest increase to their YTL 191 million ($111 million) reported funds borrowed as of the end of 2010 (compared with deposits of YTL9.1 billion ($5.3 billion)). 

Finally, the fact that the bank is accepting bids from potential buyers is significant, more for the rarity of Islamic banks (particularly outside of southeast Asia) putting themselves up for sale.  Many of the GCC Islamic banks are probably too small and operate in too competitive Islamic banking marketplaces, but are 'trophy assets' and are not open to offers from potential acquirers.  Yet, Bank Asya, even while posting profits and developing acquisition plans of its own is willing to consider bids from potential acquirers.  Perhaps we shall see Turkey take the lead into Europe, while also being open to acquisition by larger players within the global Islamic banking industry.